Chapter 10

AGGREGATE SUPPLY AND AGGREGATE DEMAND

R. Santos, “Economics: Principles & Application.” Prepared by Rick Helser

Aggregate Demand
AGGREGATE DEMAND INCLUDES ALL THE EXPENDITURES INCURRED IN
THE DIFFERENT SECTORS OF THE ECONOMY, AND IS REPRESENTED BY:

AD = GDP = Y = C + I + G + (X – M)
Circular Flow of the Economy
Aggregate Demand and Prices
• Income Effect
– When price increases, the value of our money income tends to
decrease
– Another term for this is the purchasing-power effect
• Interest Rate Effect
– When prices increase, the money supply circulating in the
public will decrease causing an increase in money demand
– A methodof generating capital funds aside from borrowing
would be to issue bonds.
• People sell bonds  Price of bonds decreases  Interest rate
increases  Increase in interest rates reduces investments causing
GDP to decrease.
Aggregate Demand and Prices
• International Trade Effect
– When domestic prices increase, the value of dollar
relative to other currency tends to appreciate.
– As the dollar becomes stronger, it will be more expensive
for foreigners to buy U.S. goods and cheaper for U.S.
consumers to buy imported goods.
– The volume of U.S. exports declines and increases the
volume of imports.
– Leads to a decline in net exports and eventually to a
decline in GDP.
Shifts in the Aggregate Demand Curve
• The AD curve can shift due to any of the following
– Changes in consumption expenditures
– Changes in business investment
– Changes in government expenditures
– Changes in the foreign sector
Consumption
• Most important component of GDP
– Makes up 70% of U.S. GDP (as of 2006)
• Most important economic variable that affects
consumption is income
– When income increases, personal consumption tends to go up.
• There are various ways of interpreting the link between
consumption and income.
– One of the more common ways of linking the two is through
what is called the marginal propensity to consume.
Marginal Propensity to Consume
• MPC is the change in consumption due to a change
in income.
• For example, a marginal propensity to consume of
10% means that for every dollar increase in income,
10% goes to additional consumption.
Consumption Function
• Expressed as
– C = Ca +bY
• Where Ca = Autonomous Consumption
• b = marginal propensity to consume
• Y = personal disposable income
• Autonomous consumption is independent of income,
meaning that there are other factors that can affect
consumption
External Factors Affecting Consumption
• Wealth
– Can exert a significant influence on consumer spending.
– The rise of stock prices in 1997 alone lifted the wealth of
Americans by $2 trillion dollars.
• That is more than 50% greater than the total stock of consumer
installment credit.
• Consumer Confidence
– Consumer confidence is based on the general expectation
of the public about the economy
• Stock market volatility, job layoffs, and political developments
may all combine to cast confidence lower
External Factors Affecting Consumption
• Interest Rates
– Interest rate is the cost of borrowing money
– For consumers who buy goods and services through
credit, an increase in interest rate means lower
consumption.
• In 2008, the interest rate was at its lowest level in years
• A low interest rate environment, however, is not sufficient to
guarantee a buoyant economy.
– Interest rates fall in recession, too, but do you see strong auto sales
and capital spending at those times?
• One needs favorable expectations in addition to lower interest
rates to encourage people to part with their resources
External Factors Affecting Consumption
• Taxes
– Changes in taxes can also affect consumption.
– Taxes are a cost on the part of the consumers
• For example, an increase in sales tax can reduce the sales of
consumer goods.
– Taxes are a leakage and therefore, the effect on disposable
income is negative.
Changes in Investment

• Investment
– is the expenditures incurred by the business sector
– is the most volatile out of all of the national income accounts
– Most influential variable = interest rate
– Investment function
– I = Ia
– This means that investment is autonomous
• Three Elements of Investment
• Changes in Inventory
• Durable Capital Equipment
• Residential Construction Expenditures
Equilibrium Income Analysis

• With consumption and investment functions we can analyze

two sectors of the economy
• Households (consumption)
• Businesses (investment)
• The result of our analysis will be to solve for equilibrium
income*

*A review of equilibrium income analysis can be found in the Appendix “A Math Review” of the
corresponding textbook.
External Factors Affecting Consumption

• Given:
– Y=C+I
– C = Ca + bY
– I = Ia
• To solve for Ye:
– Y = C + I = (Ca + bY) +Ia
– Y – bY = Ca + Ia
– Y(1 – b) = Ca + Ia

– Therefore,

•
Equilibrium Income Analysis

• At equilibrium, economy is assumed to be stable

• AD = AS
• In the real world, the economy is not always stable
• There will always be a point in which AD does not equal AS
• Equilibrium income analysis exists only in the product market
• If we introduce the factor market, a full-employment income (Y f) is assumed
• When the product market is stable, it is not always assumed that factor
markets are as well.
• In a situation where Yf > Ye, then AD > AS
• Looking at the graph, vertical distance between Yf and AD
corresponding to full employment level is the recessionary gap.
• If Yf1 < Ye, then AD > AS
• Vertical distance between Yf and AD corresponding to full
employment level is the inflationary gap
Equilibrium Income Analysis

•To solve the gap, we take difference between full

employment income and AD at full employment
•AD at full employment can be calculated as
•(AD|Yf) = Ca + bYf + Ia
Multiplier Effect

• We assume investment is autonomous (independent of any variables)

• For example, a Japanese investor opens a Honda plant in Ohio
• The money invested represents a shock to economy, leading to a
multiplier effect
• Investment Multiplier
• Average number of times by which equilibrium income changes due
to a $1 change in investment
• Is a function of the MPC
• Given by the formula
• ΔY = ____1____ = __1__
• ΔI 1 – MPC MPS
• Notice that the formula depends on MPC
• One way to interpret this is that the economy will grow
depending on the willingness of people to consume
other goods