The Aggregate Economy

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The Aggregate Economy
LRAS
Price Level
AS
PL1
AD
RGDP
FE
Q1
2
The Aggregate Economy

• Economic well being is determined by the level of
  Real GDP
• The level of RGDP is determined by current
  levels of aggregate demand (AD) and aggregate
  supply (AS).
• Since spending levels are more easily changed
  than production levels most macroeconomic policy
  focuses on aggregate demand.

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The Aggregate Demand

• The level of total spending in an economy is the
  most important determinant of GDP.
• Aggregate demand is the total spending by all
  four sectors of our economy.
• AD Consumption Investment Government Net
  Exports GDP
• Aggregate demand is determined by current price
  level and the determinants of Consumption,
  Investment, Government , Net Exports

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Aggregate Demand (AD)

• AD

A change in Price Level moves the economy along
the AD curve. A change in C , I , G or NX moves
the location of the curve.
Price Level
AD2
AD
Real GDP
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Aggregate Demand

• Aggregate Demand slopes downward for three
  reasons
• The Wealth Effect
• The Interest-rate Effect
• The Exchange-rate Effect
• This differs from the demand curve for an
  individual item in that an increase in price
  level overall does NOT diminish my purchasing
  power in that overall income is tied to overall
  price levels in the macroeconomy.

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Consumption

• Consumption (C)
• spending by households on goods and services

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Determinants of Consumption

• Disposable income
• Taxes
• Wealth (Real Asset Effect or Wealth Effect)
• Expectations of prices or income
• Debt

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Disposable Income (DI) Yd

• Disposable income is the income available after
  taxes.
• All income can either be spent or saved.
• The higher your income the more you spend and
  save and vice versa.
• Taxes come out of personal income (personal
  income taxes disposable income spending
  saving)
• An increase in taxes reduces both spending and
  saving and vice versa.

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Autonomous Consumption

• There is a constant level of Consumption across
  all levels of disposable income.
• If income falls to zero Consumption does not
  become zero.
• Savings become negative because households either
  use past savings or borrow.

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Wealth

• Wealth is the accumulation of savings.
• It can take the form of financial assets or real
  assets. (Changes in stock or real estate prices
  will affect your wealth your spending habits).
• The greater your present wealth the less need you
  have to save and the more you will spend which
  increases consumption.
• An increase in savings decreases consumption.

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Expectations of Future Income or Prices

• If you expect a raise in the near future you will
  spend more now and vice versa.
• If you think prices will rise in the near future
  you will spend more now and vice versa.

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Debt

• Debt is what is owe on previous spending.
• The more I owe the less I can spend now.
• Debt accumulation is seen as an increase in
  consumption and a decrease in savings.
• Debt reduction is seen as a decrease in
  consumption and an increase in savings.

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Aggregate Demand (AD)

• These determinants of Consumption cause the
  aggregate demand curve to shift because
  Consumption is a direct component of AD.

PL
AD2
AD3
AD1
RGDP
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GLOBAL PERSPECTIVE
Average Propensities to Consume, Selected
Nations, 1999
.80 .85 .90 .95 1.0
Canada United States Netherlands United
Kingdom Germany Italy Japan France
Statistical Abstract of the United States, 2000
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Investment

• Investment (I)
• Spending by businesses on capital
• Machinery, factories, technology, inventories
• Investment Demand (Id) is the quantity businesses
  want to spend within a given time period.
• It is based on a businesss expected rate of net
  profit.
• Net profit is determined by subtracting the
  expected cost (interest rate) from the expected
  profit.

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Investment Demand
Real Interest Rate
I d
Quantity of Investment
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Determinants of Investment Demand

• Interest rates this is the cost of borrowing or
  forgoing savings
• If interest rates are high it would be more
  profitable to save and less profitable to borrow
  to spend (point A)
• If interest rates are low it would be more
  profitable to borrow to spend and less profitable
  to save (point B)
• A change in interest causes movement along the
  investment demand curve

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Affect of Interest Rates on Investment Demand
A
i1
Real Interest Rate
i2
B
I d
Q1
Q2
Quantity of Investment
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Determinants of Investment Demand

• 2. Profit expectations the following effect
  business profit expectations
• a. Cost of production
• b. Business taxes
• c. Technological change
• d. Expectations of future profit
• e. Stock of capital on hand
• Changes in profit expectations lead to a change
  in Investment demand the curve shifts right or
  left (Id1 to Id2)

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Affect of Change in Profit Expectations
Real Interest Rate
i1
I d1
I d2
Q1
Q2
Quantity of Investment
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Cost of Production

• Any change in the cost of inputs will change
  businesses profit expectations and their
  investment demand.
• Cost of inputs increases therefore investment
  demand decreases (shifts left).
• Cost of inputs decreases therefore investment
  demand increases (shifts right).
• The major costs of inputs are wages and oil.

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Business Taxes

• Increases in businesses taxes reduces businesses
  profits and therefore their investment demand.
• Business taxes include corporate income tax,
  capital gains tax, excise tax.
• Increases in taxes shift the investment demand
  curve left decreases shift the curve right.

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Technological Change

• An increase in technology allows businesses to
  produce at a lower cost and therefore increases
  their profits and their investment demand.
• An increase in technology shifts the investment
  demand right a decrease shifts the curve left.

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Expectations of Future Profit

• An expected future increase in demand for their
  product will lead to larger profits and therefore
  leads to an immediate increase in investment
  demand.
• An increase in expected future profit shifts the
  investment curve to the right a decrease shifts
  the curve to the left.

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Stock of Capital on Hand

• If companies have capital equipment (factories,
  tools, etc.) on hand that are not being utilized
  there is no reason to purchase more (investment
  demand decreases).
• If companies are maximizing their use of capital
  equipment then they will purchase more
  (investment demand shifts right).

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Aggregate Demand (AD)

• AD

An increase in Investment of causes an increase
in AD. A decrease in I causes a decrease in AD.
Price Level
AD2
AD1
AD3
Real GDP
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Volatility of Investment

• Investment demand is much more unstable than
  Consumption. It changes often and to a large
  degree, due to the following
• The durability of capital goods.
• Innovation occurs irregularly.
• Profits vary considerably.
• Business expectations are easily changed.

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Adding Government and Taxes

• Government spending creates an injection of funds
  in the economy.
• Government spending increases automatically in a
  recession.
• An increase G increases AD

An increase in Government spending increases AD
PL
AD1
AD2
RGDP
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Taxes

• Taxes are leakages
• They reduce AD, but any change in taxes results
  in a change in savings and spending
• Taxes reduce Consumption spending by change in
  taxes x households marginal propensity to consume
• AD decreases by less than the change in taxes

A reduction in taxes of 600 reduces Consumption
and AD by 450.
PL
450b
AD1
AD2
RGDP
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Net Exports

• Net Exports (exports imports)
• Determinants of Net Exports
• Income abroad (if foreign income is up our
  exports go up)
• Exchange rates (if the dollar appreciates our
  exports go down)
• Tariffs (if we place a tariff on imports our
  imports go down)
• An increase in NX leads to an increase in AD
• A decrease in NX leads to a decrease in AD

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Problems of a National Debt

• Crowding-out effect
• When government borrows it competes with
  businesses for savers dollars, raising the
  interest rate and making it harder for private
  businesses to borrow. This decrease in business
  spending can reduce overall GDP.

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The Crowding Out Effect
Investment Demand
Loanable Funds Mkt
AD/AS
Real Interest
Real Interest
s
AS
Price Level
i2
i2
PL2
i1
i1
PL3
PL1
D2
AD2
Id
AD3
D1
AD1
Q2
Q3
Q1
Q1
Q2
Q1
Q2
Q of Loans
Q of Investment
RGDP
Graph 1 At AD1 we are in a recession.
Government cuts Taxes and increases Spending to
move the economy to AD2. Graph 2 Because the
government is now deficit spending the demand for
loanable funds increases causing interest rates
to rise. Graph 3 This increase in interest
rates decreases Investment spending which causes
AD to fall back to AD3 (Graph1 again).
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The Aggregate Economy

• Aggregate supply measures total production within
  our economy
• It is determined by current price levels and
  three factors of production
• Input prices, productivity levels and
  legal-institutional factors