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Chapter 8

Chapter 8 . Aggregate Demand. AS Vertical. The A g g r e g a t e S u p p l y C u r v e. Zero unemployment No excess capacity. Prices. Prices rise. An increase in Demand. Prices do Not change. AS Horizontal. Unemployment & excess capacity. Output. Output can not increase.

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Chapter 8

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  1. Chapter 8 Aggregate Demand © 2004 Claudia Garcia - Szekely

  2. AS Vertical The Aggregate Supply Curve Zero unemployment No excess capacity Prices Prices rise An increase in Demand Prices do Not change AS Horizontal Unemployment & excess capacity Output Output can not increase Output Increases

  3. TheKeynesian Model • Firms have excess capacity • An increase in demand causes an increase in production and a very small or NO increase in prices Aggregate Supply curve is a horizontal line

  4. The Keynesian Model • Is a Short Run (Unemployment) model. • Assumes that Aggregate Demand determines the level of production. • Focuses on how variables that affect Aggregate Demand are interrelated. • Develops tools for the government to manage the amount of spending in the economy

  5. The Keynesian Model • Concern is finding a short term solution to unemployment • Concern is NOT inflation Developed within of the urgency to get the economy out of the Great Depression

  6. AS Vertical In the Keynesian world Or Inflation At Full Employment Prices Prices rise The economy suffers either Unemployment An increase in Demand But not both at the same time Prices do Not change AS Horizontal Below full employment Output Output can not increase Output Increases

  7. to pay Exports Stocks, Funds Bonds, CD’s, Life Insurance Consumption Saving Investment Circular Flow Diagram National Income Government Taxes Rest of World Government Spending Firms Households Imports Total Production

  8. Spending Leakages NI Taxes Imports Households Firms GDP Saving

  9. Spending Injections NI Government spending Exports Households Firms GDP Consumption Investment

  10. The Components of Aggregate Demand 1. Consumption 2. Investment 3. Government Spending 4. Net Exports

  11. 1.Consumption Expenditures in consumer goods are 70% of GDP

  12. Disposable Income is Income available for consumption. • Income generated from production is used to: • Buy goods and services: C. • Save: S • Pay taxes: Tx • The government pays “income transfers” to households. • Social Security • Welfare • Unemployment benefits

  13. Adding Net Taxes • The government collects taxes • The government pays Transfers • We are only interested in the NET effect on Incomes. Use Tx for Taxes Use Tr for Transfers Use T for Net Taxes = Tx - Tr

  14. National Income National Income Your Income The sum of the incomes that all individuals in the economy earn in the form of wages, interest, rents, and profits: Income before taxes

  15. After Tax Income Disposable Income (Yd) The sum of the incomes of all the individuals in the economy after all taxes have been paid and all transfer payments from the government have been added Yd = GDP - Taxes + Transfers

  16. As incomes rise, consumptionincrease. Time

  17. Data shows a positive relationship between Consumption and Income Consumption Disposable Income

  18. What determines the level of Consumption? All other factors which affect Consumption As income increases, consumption increases C=bYd • Disposable Income Yd • Wealth • Prices • Expectations Induced consumption Autonomous Component of consumption C=a C = a + bYd Add these two components

  19. Consumption has two components C=bYd Inducedby changes in Disposable Income C= a Autonomous Independent from Disposable Income: responds to changes in wealth, prices and expectations C =a+ bYd

  20. Consumption has two components C =a+ bYd 1175 1025 Slope 875 Consumption Billions 725 575 425 a: Intercept 300 500 700 900 1100 1300 Real Disposable Income Billions

  21. B $180 billion A $200 billion Calculating the slope “b” in C = a + bYd Choose any two points Calculate slope of this line MPC = 180/200=0.9 A 200b increase in income induces a180b increase in consumption. Fit line closest to most points 1900 MPC = DC/DYd 1700 1500 Real Consumer Spending 1360 DC 1300 1180 The slope is the Marginal Propensity to Consume 1100 900 DYd 0 900 1100 1300 1500 1700 1900 Real Disposable Income

  22. MPC for the US is 90%

  23. For each $100 increase in income, Americans spend $90: 90% of the increase in income will be consumed. MPC = 0.9 or 90% When income drops by $100, decrease savings (their own or borrowed) by $10 When income rises by $100, increase savings by $10 For each $100 decrease in income, consumption decreases only by $90 Only 90% of the decrease in income translates into a reduction in consumption.

  24. $300 b $400 b Choose any two points C =a+ 0.75Yd C =a+ bYd 1175 1025 Slope 875 Consumption Billions 725 575 425 300 500 700 900 1100 1300 Real Disposable Income Billions

  25. 725-525=a 725 =a+ 0.75(700) 200=a 725 =a+ 525 C =a+ 0.75Yd C =200+ 0.75Yd 1175 1025 875 Consumption Billions 725 Choose any point 575 425 200 a: Intercept 300 500 700 900 1100 1300 Real Disposable Income Billions Value of Consumption when Disposable Income = 0

  26. SameIntercept“a” different slope “MPC” 2750 C1 Larger Increase in consumption 1,350 Larger MPC* C0 1400 C1 2150 C0 1100 a a Smaller MPC 1500 Y0 3000 Y1 Smaller Increase in consumption 1,050

  27. Different intercept “a”same slope “MPC” 3300 C1 same Increase in consumption 1,050 Same MPC 2250 C0 C1 2150 Same Increase in consumption 1,050 a* C0 1100 a Same MPC 1500 Y0 3000 Y1

  28. Saving (S) We will assume that income not consumed is saved Stocks, Funds Bonds, CD’s, Life Insurance Saving Yd - C = S

  29. Consumption (C) Mirror Saving (S) C = a+ MPC* Yd If Disposable Income is zero: C = a + MPC*0 C = a S= Yd – C S= 0 - a When Disposable income is zero, C = a S = - a Intercept of Consumption Function is: a Intercept of Saving Function is:– a

  30. The Saving Function S S = -a + ? - a Intercept of Saving Function is – a

  31. DS = DYd – DC 20 = 200 - 180 C Causes a $20 Increase in S 3420 Causes a $180 Increase in C 3240 A $200 increase in income 3600 3800 With an extra $200 in income Consumers Use $180 to consume Put $20 into savings The MPS= DS/DYd= 20/200 = 0.1 or 10%

  32. The Slope of the Savings Function: MPS Saving MPS = DS/DYd 380 Causes a $20 Increase in S 360 A $200 increase in income 3600 3800 The MPS = 20/200 = 10%

  33. The Marginal Propensity to Save • Is the proportion of an increasein income that is saved.. • Is the proportion of an decreasein income by which saving decrease • Is a percentage or a number between o and 1.

  34. MPS = 1 - MPC • If the MPC = 90%, you will consume 90% of any increase in income… • If you consume 90% of any increase in income, you save the rest: 10% MPC + MPS = 100% MPC = 0.9 then MPS = 0.1 MPC + MPS = 1

  35. The Saving Function S = -a + (1- MPC)* Y S = -a + MPS* Y The Marginal Propensity to Save: The slope of the S line. Value of Saving when Y(Income) is 0: The intercept of the S line.

  36. Given the Consumption function, Find the value of consumption for each of these values of Y: C = 200+0.75Y C = 200+0.75*25,000 C = 200+0.75*19,000 C = 200+0.75*10,000 C = 200+0.75*5,000 18,950 14,450 7,700 3,950 Y 25,000 5,000 10,000 19,000

  37. Events that cause a movement along the Consumption Function? C Changes in Disposable Income ONLY! 18,950 14,450 7,700 3,950 Yd 25,000 5,000 10,000 19,000

  38. The Consumption Function C = a + MPC* Yd Consumption responds to changes in after tax income Consumption responds to changes in wealth, prices and expectations Changes in income: Movement Along the C line. Changes in wealth, prices and expectations: Shift C line Yd = GDP - Taxes + Transfers

  39. Factors that shift the consumption function • Changes in wealth Example: value of stocks, bonds, consumer durables, homes. When stock prices go down, consumer wealth decreases in value. Consumers feel poorer (even though incomes may be the same!) and slow down purchases A downward shift in the Consumption Line: a smaller intercept.

  40. Factors that shift the consumption function • Changes in consumer expectations: Pessimistic expectations about future: employment, incomes, wealth. Consumers slow down purchases (even though incomes may be the same!) A downward shift in the Consumption Line: a smaller intercept.

  41. Factors that shift the consumption function • Prices When overall prices rise (an increase in the CPI) consumer’s wealth lose buying power. This drop in the purchasing power of saved dollars make consumers feel poorer and they slow down purchases. • Real Wealth Decrease A downwardshift in the Consumption Line: a smaller intercept.

  42. Interest Rates are NOT in the list! Factors that shift the consumption function Changes in wealth value of stocks, bonds, consumer durables, homes. Changes in consumer expectations Pessimistic expectations decrease autonomous consumption. Changes in Prices Affect the purchasing power of assets. Shift Consumption line Statistical studies: interest rates have no effect on Consumption We will assume that changes in interest rates do not shift C

  43. C0 Wealth Expectations Prices C1 a = 300 Smaller intercept a = 200 S1 S0 -a = -200 Higher intercept -a = -300

  44. C1 Wealth Expectations Prices C0 Larger intercept S0 S1 Lower intercept

  45. C0 2170 Income Increase: Wages Increase Profits Increase Interest Increase Rents Increase Consumption Increase Move UP Along C 2080 1200 1300 S0 1200 1300 -870 Move UP Along S -880 Savings Increase

  46. Calculate the MPC • Calculate the Intercept (a) • Write the equation of the Consumption function • Write down the formula for the Savings function • What is the value of Consumption when Income is 10,000 • Calculate Savings when Income is 10,000 • At what value of Y is Consumption equal to Income? • At what value of Y is Saving equal to zero?

  47. We know that C = 700 when Y =1,000. 700 = a + 2/3 (1,000) solve fora= 700 – 2,000/3 = 700 – 666.67 = 33.33 To get the equation, we choose any two points: Write the equation for this consumption function 1200 C = 33.33 + 2/3Y 1100 MPC =200/300 = 2/3 1000 900 900 200 800 700 700 300 600 1000 1300 600 800 1000 1200 1400 1600 To calculate the intercept (a), use the MPC and the consumption function: C = a + 2/3 Yd

  48. C = 33.34 + 2/3 * Y C Set C =Y: 33.34 + 2/3*Y= Y Solve for Y = 100 C= Y What is the value of Y such that Saving = 0? What is the value of Y such that C=Y? 33.34 Y Y= 100 S S = -33.34 + 1/3*Y S= 0 Y Y= 100 Y= Set S =0: -33.34 + 1/3*Y= 0 Solve for Y = 100 -33.34

  49. 1175 1025 875 Consumption Billions 725 575 425 300 500 700 900 1100 1300 Real Disposable Income Billions

  50. Label Vertical Axis Consumption Function Value of Y when C = Y C= Value of S when C = Y Intercept Label Horizontal Axis Label Vertical Axis Y= Savings Function S= Y= Label Horizontal Axis Intercept

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