Unit III: Aggregate Demand

Unit III: Aggregate Demand

What is aggregate demand?

1. It shows the amount of real GDP that the private, public and foreign sector collectively desire to purchase at each possible price level.
2. The relationship between the price level and the level of real GDP is inverse.

There are 3 reasons why AD is downward sloping:

1. Real-Balances Effect - When the price level is high, households and firms can't afford to purchase as much output.
2. Interest Rate Effect - The higher price level increases the interest rate, and the lower price level decreases the interest rate.
3. Foreign Purchases Effect - The higher price level increases demand for cheaper imports.

So how does the Aggregate Demand and Supply model look like?

Full Employment equilibrium exists where AD intersects SRAS and LRAS at the same point.

A recessionary gap exists when equilibrium occurs below full employment, (LRAS).

An inflationary gap exists when equilibrium occurs beyond full employment, (LRAS).

The followers of the Keynesian view believe in a horizontal AS curve, because when the economy is below full employment, AD shifts outward. And what happens?

1. Increase in real GDP
2. Unemployment drops
3. Price level stays constant
4. Demand creates its own supply

So what are those ranges?

1. Classical Range - in the long run, the AS curve is vertical, because the only effects of an increase in AD is already when we are at full employment. Thus, you have an increase in price level, and supply creates its own law, (Say's Law).
2. Intermediate Range - AS is between classical and Keynesian range. When this occurs, AS shifts outward.
3. Keynesian Range -  The horizontal segment of the Keynesian aggregate supply curve that reflects rigid prices and wages. Shifts of the aggregate demand curve in this range lead to changes in the aggregate output, but not changes in price level. 

What determines the changes of AD or AS?

Investment Demand - this is the money spent or expenditures on:

1. New factories
2. Capital equipment
3. Technology
4. New homes
5. Inventories

Expected rates of return 

1. How does business make investment decisions? (Cost/benefit analysis)
2. How does business determine the benefits? (Expected rate of return)
3. How does business count the cost? (Interest costs)
4. How does business determine the amount of investment they undertake? (Compare expected rate of return to interest costs)

If the expected rate of return > interest costs, then invest.

If the expected rate of return < interest costs, then don't invest.

Real (r%) v. Nominal (i%)

So what's the difference?

1. Nominal is the observable rate of interest. 
2. Real subtracts out inflation (pi%) and is only ex post facto.

How do you know / compute real interest rate?

1. r% = i% - pi%

What then, determines the cost of an investment decision?

1. The real interest rate (r%).

Investment Demand Curve (ID)

1. What is the slope of the investment demand curve?

             - Downward sloping.

1. Why is it downward sloping? 

             - When interest rates are high, fewer investments are profitable; when interest rates are low, more    investments are profitable.

             - There are few investments that yield high rates of return, and many that yield low rates of return.

What shifts the investment demand curve?

1. Costs of production
2. Business taxes
3. Technological chance
4. Stock of capital
5. Expectations

Consumption and Savings

1. Disposable Income (DI) is the income after taxes or net income, (save or spend).
2. Consumption (C) consists of the amount of DI, and the propensity to save.
3. Do households consume if DI = 0? Autonomous consumption, dissaving.
4. Savings is the amount of DI, and the propensity to consume.
5. Do households save if DI = 0? No.
6. Some determinants: Wealth, expectations, household debt, taxes.

Average Propensity to Save (APS) and Average Propensity to Consume (APC)

APS + APC = 1.

1 - APC = APS.

1 - APS = APC.

If APC > 1, dissaving occurs. If APS is negative, dissaving occurs too.

Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS)

Change in Consumption / Change in Disposable Income

Change in Savings / Change in Disposable Income

The Spending Multiplier Effect - this is the initial change in spending, and causes a larger change in AS or AD.

Multiplier = Change in AD / Change in Spending

Why does it happen?

1. Expenditures and income flow continuously which sets off a spending increase in the economy.

Multiplier = 1 / MPS  or 1 / 1 - MPC (Spending Multiplier).

Calculating the Tax Multiplier - When the government taxes, the multiplier works in reverse. Why? Because money is leaving the circular flow.

The Tax Multiplier is negative:  -MPC / 1 - MPC    or  -MPC / MPS.

If there is a tax cut, then the multiplier is increasing, because there is now more money in the circular flow.

Fiscal Policy

What is fiscal policy? Fiscal policy is the changes in the expenditures or tax revenues of the government. There are 2 tools of fiscal policy:

1. Increase spending, decrease taxes
2. Decrease spending, increase taxes

Fiscal policy is enacted to promote our nation's economic goals: Full employment, price stability, economic growth.

Discretionary Fiscal Policy (action)

1. Expansionary fiscal policy - think deficit, recession
2. Contractionary fiscal policy - think surplus, inflation

Discretionary v. Automatic Fiscal Policies

Discretionary deals with increasing spending, decreasing taxes, and policy makers are responsible.

Automatic deals with social security, etc., and no policy makers are no included.

Contractionary Fiscal Policy

1. Policy designed to decrease spending, and increase taxes
2. Decreases AD, controlling inflation.

Expansionary Fiscal Policy

1. Increases AD
2. Strategy for increasing GDP, combatting a recession, reducing unemployment.

Progressive, Regressive / Proportional Tax System

1. Progressive: Average tax rate, (tax revenue / GDP), rises with GDP.
2. Proportional: Average tax rate remains constant as GDP changes.
3. Regressive: Average tax rate falls with GDP, the more progressive the tax system, the greater the economy is built-in stability.

Deficits, Surpluses and Debt

Balanced budget - revenues = expenditures.

Budget deficit = revenues < expenditures.

Budget surplus = revenues > expenditures.

Government debt = sum of all debt - sum of all surpluses.