Chapter 13 Determining Aggregate Demand AD

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Chapter 13 -- Determining Aggregate
Demand (AD)

• This chapter -- looks at the components of
  Aggregate Expenditure.
• Examines the major causes of Consumption (C),
  Investment (I), Government Expenditure Net of
  Taxes (G - T), and Net Exports (X - M).

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Unzipping Aggregate Expenditure
(AE)

• Causes of AD
• I. Price Level (P)
• II. AE C I (G T) (X M)
• (a) C
• (i) -----------------
• (ii) ----------------
• (b) I
• (i) -----------------
• (ii) ----------------
• (c) (G T)

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Causes of Consumption (C)

• Aggregate Income (Y),
• Y? ? C?
• Wealth,
• Wealth? ? C?
• Consumer Confidence (CC),
• CC? ? C?

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Applying the Causes to Aggregate Demand (AD)

• Aggregate Income (Y), appears on the graph, Y ? C
  relationship affects the shape of the AD curve.
• Changes in Wealth or Consumer Confidence make up
  autonomous consumption (consumption due to causes
  other than Y) -- shift the AD curve.

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Consumer Confidence and the Economy

• Example -- effect of a decrease in consumer
  confidence.
• CC? ? C?
• Therefore the AD curve shifts leftward.
• In the AD-AS model, this results in Y?, P?

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Causes of Investment (I) The Capital Market

• Investment (I) primarily business purchases of
  new plant and equipment. Also includes new
  residential housing and changes in inventories
  (small).
• Large expenditures create the need for long-term
  borrowing. Borrowing is done from banks (or
  similar loaning institutions), or by companies
  issuing bonds or stock.

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Investment and Capital Market Behavior

• Investment results from behavior in the
  (financial) capital market.
• The Capital Market -- The Demand and Supply for
  financial capital needed to finance purchases of
  plant and equipment and new residential housing
  (I).

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The Demand For Financial Capital (DI) -- Major
Causes

• Nominal (Long-Term) Interest Rate (r) cost of
  borrowing to finance investment.
• r? ? DI?
• Expected Inflation Rate (?e)
• ?e? ? DI?
• Business Confidence (BC)
• BC? ? DI?

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Formalizing the Demand for Financial Capital
(DI)

• Graph DI against one of its causes -- the nominal
  interest rate (r).
• Inverse relationship implies that the curve is
  downward sloping.
• Changes in r are described as a movement along
  the curve.
• Graph is drawn assuming that other causes are
  constant (ceteris paribus).

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Shifts in the Demand for Financial Capital

• Changes in causes other than r are described as
  shifts of the DI curve.
• Changes that increase the Demand for Financial
  Capital shift the DI curve rightward.
• Changes that decrease the Demand for Financial
  Capital shift the DI curve leftward.

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The Supply of Financial Capital (SI) -- Major
Causes

• Nominal Interest Rate (r)
• r? ? SI?
• Expected Inflation Rate (?e)
• ?e? ? SI?
• Tastes/Preferences Toward Saving (SAVE)
• SAVE? ? SI?

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Other Causes -- Supply of Financial
Capital

• Monetary Policy -- affects banks ability to loan
  (more later).
• Foreigners willingness to buy US bonds or stock
  (Capital Flow).
• Next Step -- Formalizing the above SI relationship

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Formalizing the Supply of Financial Capital (SI)

• Graph SI versus one of its causes -- the nominal
  interest rate (r).
• Positive relationship implies that the curve is
  upward sloping.
• Changes in r are described as a movement along
  the curve.
• Graph is drawn assuming that other causes are
  constant (ceteris paribus).

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Shifts in the Supply of
Financial Capital

• Changes in causes other than r are described as
  shifts of the SI curve.
• Changes that increase the Supply of Financial
  Capital shift the SI curve rightward.
• Changes that decrease the Supply of Financial
  Capital shift the SI curve leftward.

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Equilibrium in the Capital Market -- Determining I

• Investment (I) occurs where the Demand for
  Financial Capital (DI) equals the Supply of
  Financial Capital (SI).
• Shifts in the Demand or Supply of Financial
  Capital, as a result, change Investment (I)
• Because they change Investment, they also change
  Aggregate Demand (AD), and Y and P as a result.

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Example 1 -- An Increase in Business Confidence
(BC)

• BC? ? DI?
• DI curve shifts rightward ? I?
• Because investment increases, the AD curve shifts
  rightward.
• In the AD-AS model, this results in Y?, P?.

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Example 2 -- An Increase in Foreign Capital Flows
to US

• Capital Flow? ? SI?
• SI curve shifts rightward ? I?
• Because investment increases, the AD curve shifts
  rightward.
• In the AD-AS model, this results in Y?, P?.

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Causes of (G - T)

• Government Purchases of Goods and Services (G),
  Net Taxes (T), are policy variables.
• Basically controlled by the government.
• G, T changed for policy purposes (Fiscal Policy),
  other reasons as well (as in war example).

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Causes of US
Net Exports (NX)

• General Concepts
• -- NX (X M), must consider
• causes of both exports and
• imports.
• -- Assume for simplicity that the
• world consists of 2 countries,
• the US and the rest of the world.

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Specific Causes of US Net Exports (NX
X - M)

• World Output or Income (YW)
• YW? ? X? ? NX?
• US Output or Income (Y)
• Y? ? M? ? NX?
• Barriers to Trade (Tariffs, Quotas)
• The Exchange Rate (e)
• e? ? NX?

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Introduction to Exchange Rates

• Exchange Rate (e) -- the amount of foreign
  currency needed to be exchanged for one (US)
  dollar.
• Also known as the value of the dollar.
• Conversion Ratio, in units of
• (foreign currency)/(US dollar).

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Types of Exchange Rates

• Bilateral Exchange Rate -- exchange rate between
  the US and an individual country.
• Multilateral (Trade Weighted) Exchange Rate --
  weighted average of bilateral exchange rates
  expressed as an index (macro measure of exchange
  rate).

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Using Exchange Rates as a Conversion Ratio

• In Both Examples US exchange rate vs Japanese
  Yen 100 (yen/).
• Example 1 -- Suppose that dinner for two people
  in the US costs 50. Find its price in terms of
  yen.
• (50)(100 yen) 5000 yen
• (1 )

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Example 2 -- The Exchange Rate as a Conversion
Ratio

• Example 2 -- Suppose that dinner for two people
  in Japan costs 6832 yen. Find its price in terms
  of US dollars ().
• (6832 yen) (1 ) 68.32
• (100 yen)
• Note e 100 (yen/)

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Exchange Rate Changes

• e? ? price of American goods and
• services to foreigners?
• ? price of foreign goods and
• services to Americans?
• e? ? price of American goods and
• services to foreigners?
• ? price of foreign goods and
• services to Americans?

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The Exchange Rate and Net Exports

• e? (appreciating dollar, stronger
• dollar) ? X?, M? ? (X - M)?
• e? (depreciating dollar, weaker
• dollar) ? X?, M? ? (X - M)?

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Exchange Rate Regimes

• Fixed (Pegged) Exchange Rates -- exchange rates
  are fixed by the government, unless changed by
  economic policy (e.g. US and China).
• Floating Exchange Rates -- exchange rates are
  determined by natural forces in the foreign
  exchange market (e.g. US and Japan, US and
  European Union).

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Return to Aggregate Demand -- An Example

• Example -- effect of a decrease in world output
  or income (YW).
• YW? ? X? ? (X - M)?
• Therefore the AD curve shifts leftward.
• In the AD-AS model, this results in Y?, P?

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Aggregate Demand Changes and the Economy

• Lots of factors shift aggregate demand (AD),
  affect Y and P.
• Poses challenges economy subject to buffeting
  winds, blows the economy off course (either to
  where Y lt YF or Y gt YF).
• Role of Economic Policy medicine designed to
  move Y closer to YF.