Unit III:Unit III:•Aggregate DemandAggregate Demand•The Consumer Confidence IndexThe Consumer Confidence Index•MultiplierMultiplier•Crowding Out EffectCrowding Out Effect

ECONOMICSECONOMICSWhat does it mean to me?

READ

Mankiw, Chapter 33, 34

Krugman 27, 28, 29

Morton Unit 3

GROSS DOMESTIC PRODUCT---GDP

The value of the TOTAL of final goods and services

produced within the boundaries of the US whether by Americans or foreigners.

What is AGGREGATE DEMANDAGGREGATE DEMAND?

…a schedule or curve showing the sum of the demand for all goods and services in the economy……

It can also be seen as the quantity of real GDP demanded at different price levels.

It reflects the summation of desired expenditures by domestic

consumers, businesses, government, and foreign buyers

on newly produced goods and services.

The Aggregate Aggregate Demand CurveDemand Curve is

downsloping, which indicates an inverse

relationship between the price

level and the amount of real

domestic output purchased.

AD0

Real Gross Domestic Product

PRICE

LEVEL

The Aggregate Demand Curve

*Krugman

Shifts of the Aggregate Demand Curve

Changes in

Expectations

Wealth

Stock of physical capital

*Krugman

Shifts of the Aggregate Demand Curve

*Krugman

There are 3 reasons why the aggregate demand curve is negatively sloped:

1) Pigou’s REAL WEALTH EFFECT.

2) Keynes’s INTEREST RATE EFFECT.

3) Mundell-Fleming’s EXCHANGE-RATE EFFECT (also called the OPEN ECONOMY EFFECT or the FOREIGN PURCHASES EFFECT)

A higher price level reduces the real value or purchasing power of the total financial assets of the public.

When the purchasing power of your money is reduced, it is called the REAL REAL WEALTH EFFECTWEALTH EFFECT. It holds true for any asset of fixed dollar amount.

The wealth effect was emphasized by Arthur Pigou (1877-1959) and

is sometimes called the Pigou Effect.

Suppose that you were a retired person living on a pension (fixed-income) during a period of high

inflation. The costs you incur continue to rise in price but your income remains the same.

The reverse would be true if the price level were to fall. A decline in the price level will increase

the real value or purchasing power of a household’s wealth and increase consumption

spending.

In summary:

Price Level => Real Wealth => Purchasing Power => RGDP demanded

Price Level => Real Wealth => Purchasing Power => RGDP demanded

The INTEREST RATE EFFECTINTEREST RATE EFFECT also causes aggregate demand to have a negative slope.

This will increase demand for money.

Consumers will wish to hold more dollars in order to purchase those items they want to buy.

When interest rates increase, most goods and services will have a higher price tag.

As price level increases, so do interest rates.

To put it another way, the aggregate demand curve the aggregate demand curve assumes the money supply is fixed.assumes the money supply is fixed.

A higher interest rate will cause……..

The increase in demand drives up the price paid to use money (interest rate).

A higher price level increases the demand for money.

When the price level increases, people need more money for their purchases.

Other repercussions such as:Other repercussions such as:

Delayed expansion by businesses.

Delayed replacement of worn parts in businesses.

Delayed purchases of boats, cars, or homes by

consumers.

The Interest Rate Effect was emphasized by the only economist to have a branch of economics named after him: John Maynard Keynes (1883-1946). It is sometimes called the Keynes Effect.

If the demand for money increases and the

FEDERAL RESERVE SYSTEM does not alter the

money supply, then interest rates will rise.

At higher interest rates, the opportunity cost of borrowing

rises, and fewer interest-sensitive investments will be

profitable, reducing the quantity of investment goods

demanded.

Price level Money demanded (money supply unchanged) Interest rate Investments RGDP demanded

Price level Money demanded (money supply unchanged) Interest rate Investments RGDP demanded

The net effect of the higher interest rate is fewer investment goods demanded and, as a result, a

lower RGDP demanded.

In summary:

and

The third reason for a negatively sloped aggregate demand curve is the OPEN ECONOMY EFFECTOPEN ECONOMY EFFECT, also called the FOREIGN PURCHASES EFFECTFOREIGN PURCHASES EFFECT

of changes in the price level.

A higher domestic price level causes the price of goods

and services to rise relative to the Global markets.

This lowers the real GDP demanded at the higher price level.

Consumers tend to buy fewer domestic goods and more foreign goods.

In summary:

Price level Demand for domestic goods RGDP demanded

Price level Demand for domestic goods RGDP demanded

and

Price level changes affects the level of aggregate spending, which, in

turn, affects the amount of real GDP demanded in the economy.

Real Domestic Output, GDP

Price

Level

AD2

AD1

AD3

Change in aggregate demandChange in aggregate demand, which is caused by changes in one or more of the determinants of aggregate demand (consumer spending, investment spending, government spending, net export spending).

AD0

Real Gross Domestic Product

PRICE

LEVEL

Change in the quantity of real Change in the quantity of real output demandedoutput demanded, caused by changes in the price level (real real wealth effect, interest rate effect, wealth effect, interest rate effect, foreign market effectforeign market effect).

To be more specific, an increase in the price

level, other things equal, will decrease the

quantity of real GDP demanded.

Real Domestic Output, GDP

Price

Level

By the same token, a decrease in the price level,

other things equal, will increase the quantity of real

GDP demanded.

1

2

3

GDP2 GDP1 GDP3

P1

P3

P2

AD

Real Domestic Output, GDP

Aggregate

GDP2 GDP1 GDP3

Expendi tures 450

2

1

3 (Ca + Ig + Xn + G)1 at P1

Additionally, aggregate expenditures schedule will rise when the price level declines and fall when the

price level increases.

(Ca + Ig + Xn + G)3 at P3

(Ca + Ig + Xn + G)2 at P2

Real Domestic Output, GDP

Price

Level

1

3

GDP2 GDP1 GDP3

P1

P3

P2

AD

Real Domestic Output, GDP

Aggregate

GDP2 GDP1 GDP3

Expendi tures 450

2

2

1

3

P2

P1

P3

Compare the GDP at each level.

With respect the U.S. exports, a $30 pair of U.S.-made blue jeans now

might be brought for 2880 yen compared to 3600 yen. In terms of

U.S. imports, a Japanese watch might now cost $225 rather than $180.

Under these circumstances, U.S. exports will rise and imports will fall. This increase in NET This increase in NET EXPORTS translates into a rightward shift in EXPORTS translates into a rightward shift in

U.S. aggregate demand.U.S. aggregate demand.

A

B

In other words, it indicates the quantities of real gross domestic product

demanded at different price levels.

The aggregate aggregate demand curvedemand curve

reflects the total amounts of goods and

services that all groups together

want to purchase in a given time

period.

AD

PL1

PL0

RGDP1 RGDP0

Real Gross Domestic Product

PRICE

LEVEL

A

B

In other words, when price level decreases ( ), the quantity of RGDP increases ( ); when price level

increases ( ), the quantity of RGDP decreases ( ).

The aggregate demand curve slopes

downward to reflect an inverse relationship

between overall PRICE LEVEL and

the quantity of REAL GROSS

DOMESTIC PRODUCT.

AD

PL1

PL0

RGDP1 RGDP0

Real Gross Domestic Product

PRICE

LEVEL

Notice that as we move from point A to point B, price level increases as RGDP decreases

But what are some of the factors that cause the curve to shift to the

right or left??

AD0

Real Gross Domestic Product

PRICE

LEVEL

AD2

AD1

Shifts of Aggregate Demand: Short-Run Effects

*Krugman

AD0

Real Gross Domestic Product

PRICE

LEVEL

AD1

An increase in any component of

GDP (C, I, G, X - M) can cause the

aggregate demand curve to shift to

the right.

AD0

Real Gross Domestic Product

PRICE

LEVEL

AD2

Conversely, decreases in C, I, G, or (X - M) will

shift the aggregate demand curve to

the left.

Long-Run Macroeconomic Equilibrium

*Krugman

THE THE MULTIPLIER MULTIPLIER

EFFECTEFFECT

The Multiplier EffectThe Multiplier Effect

• Government purchases are said to have a multiplier effect on aggregate demand.– Each dollar spent by the government can

raise the aggregate demand for goods and services by more than a dollar.

The Multiplier EffectThe Multiplier Effect

• The multiplier effect refers to the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Figure 4 The Multiplier Effect

Quantity ofOutput

PriceLevel

0

Aggregate demand, AD1

$20 billion

AD2

AD3

1. An increase in government purchasesof $20 billion initially increases aggregatedemand by $20 billion . . .

2. . . . but the multipliereffect can amplify theshift in aggregatedemand.

Copyright © 2004 South-Western*Mankiw

A Formula for the Spending A Formula for the Spending MultiplierMultiplier

• The formula for the multiplier is:

Multiplier = 1/(1 - MPC)

• An important number in this formula is the marginal propensity to consume (MPC).– It is the fraction of extra income that a

household consumes rather than saves.

A Formula for the Spending A Formula for the Spending MultiplierMultiplier

• If the MPC is 3/4, then the multiplier will be:

Multiplier = 1/(1 - 3/4) = 4

• In this case, a $20 billion increase in government spending generates $80 billion of increased demand for goods and services.

The Multiplier

THE CROWDING THE CROWDING OUT EFFECTOUT EFFECT

The Crowding-Out EffectThe Crowding-Out Effect

• Fiscal policy may not affect the economy as strongly as predicted by the multiplier.

• An increase in government purchases causes the interest rate to rise.

• A higher interest rate reduces investment spending.

The Crowding-Out EffectThe Crowding-Out Effect

• This reduction in demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect.

• The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

Figure 5 The Crowding-Out Effect

Quantityof Money

Quantity fixedby the Fed

0

InterestRate

r

Money demand, MD

Moneysupply

(a) The Money Market

3. . . . whichincreasestheequilibriuminterestrate . . .

2. . . . the increase inspending increasesmoney demand . . .

MD2

Quantityof Output

0

PriceLevel

Aggregate demand, AD1

(b) The Shift in Aggregate Demand

4. . . . which in turnpartly offsets theinitial increase inaggregate demand.

AD2

AD3

1. When an increase in government purchases increases aggregatedemand . . .

r2

$20 billion

Copyright © 2004 South-Western

*Mankiw

The Crowding-Out EffectThe Crowding-Out Effect

• When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.

Quantity of Output0 4 7

2….the increase in spending increases money demand….

1…When an increase in government purchases

increases aggregate demand…

Interest Rate

Sm

Quantity of money fixed by the Fed

MD1

MD2

r1

r2

AD1

AD2

3…which increases the equilibrium interest rate…. 4…which in turn partly offsets

the initial increase in demand.

AD3

The increase in the interest rate tends to reduce the quantity of goods and services demanded,

especially in the investment sector.

This CROWDING OUT of investment will offset the

expansion of Aggregate Demand and the AD curve will shift only to

AD3.

Macroeconomic PolicyFiscal policy affects aggregate demand directly through government purchases and indirectly through changes in taxes or government transfers that affect consumer spending. Monetary policy affects aggregate demand indirectly through changes in the interest rate that affect consumer and investment spending.

*Krugman

Compiled by:Compiled by:Virginia H. Meachum, Economics TeacherVirginia H. Meachum, Economics Teacher

Coral Springs High SchoolCoral Springs High School

Sources:Sources:Principles, Problems, and PoliciesPrinciples, Problems, and Policies, by Campbell McConnell , by Campbell McConnell

& Stanley Brue& Stanley Brue

Economics,Economics, by Krugman, Wells by Krugman, Wells

Principles of EconomicsPrinciples of Economics, by N. Gregory Mankiw, by N. Gregory Mankiw

Notes by Florida Council on Economic Education and FAU Notes by Florida Council on Economic Education and FAU Center for Economic EducationCenter for Economic Education

Notes by Foundation for Teaching EconomicsNotes by Foundation for Teaching Economics