Aggregate Demand Chapter 13 - PowerPoint Presentation

Slide1

Aggregate Demand

Chapter 13

Slide2

Consumption

“C”

Slide3

Consumption

The aggregate nominal amount of spending we do as

consumers.

Makes up 65-70% of AD.

Doesn’t usually change

dramatically or quickly

.

People tend to maintain their standard of living.

Slide4

Consumption

At any point in life we each have a perception of our “permanent income”…

The amount we need and have been able to count on to maintain our current lifestyle

If we enjoy a temporary “windfall”, we don’t change our lifestyle …we spend some and save

some (accumulated wealth)

I

f

we see our prospects improving permanently, we begin to “spend up” to our new standard of living

Slide5

Consumption

We can model this consumption behavior in the aggregate, summing up the behavior of all consumers, with the

Consumption Function:

C = A +

b

(PY)

C is aggregate nominal consumption

B is propensity to consume (amount of income used for consumption)

PY is nominal aggregate income

A is autonomous consumption

Slide6

Consumption (C = A +

b

(PY))

I

f

PY = $100 billion and b = 0.8 for the

nation…

as a nation we’d spend $80 billion of our income on consumption…

and save $20 billion of our income

Slide7

“

b

”

“

b

” is a big deal … and it’s not a constant

It varies across nations and within a nation

It varies across circumstances …

It changes with expectations about the future

It is significantly influenced by expectations about the future … which is why one of the economic indicators macro economists watch closely is the…

Consumer Confidence Index

Slide8

Consumer Confidence

Ceteris Paribus, increasing consumer confidence helps the economy because when people are confident about the future they feel more free to spend on consumption

If C

t

hen AD

and this drives Y

pushing UMP

Slide9

“

b

”

“

b

” also changes with perceptions of wealth

If you lose your job, your savings, and your house, then clearly you are poorer and you’ll reduce your consumption ...

If you still have your job and your stocks and your house, but the value of your stock portfolio and/or your house goes down significantly,

then, you

feel poorer and “b” goes down as you cut back on consumption to rebuild your perceived wealth

Slide10

“

b

”

During the Great Recession many people lost their homes and savings, but for many more the loss was a significant fall in the value of their stock portfolio and their home

This negative “wealth effect” led people to hold back on consumption …

“

b

” went down and that fed into the downward spiral of the economy

C

AD

Y

UMP

b

b

Slide11

A

“A” is the Autonomous Consumption

It is “autonomous” in the sense that it is independent of (PY)

It is spending out of wealth … often to bridge difficult times

Slide12

Investment

“I”

Slide13

Investment (I)

The aggregate nominal amount of spending we do as individuals or firms to increase our production capital and/or inventories

People generally need to borrow to make a significant investment

It takes time for the investment to pay off so they borrow for long terms … 10, 20, 30 years

Long Term Capital Market

Slide14

Investment (I)

The funds borrowed in the Long Term Capital Market are financial capital or “liquidity”

As in liquid value … value that can take any shape it’s poured into…

a new business, an expanded factory, an education

Slide15

Investment (I)

In order to understand the sources of the forces that determine I, we need to understand the Long Term Capital Market

On the

vertical

axis is the

nominal

interest

rate –

the price

of borrowing

r

On the horizontal

axis is the quantity

of financial capital

Q

$

Slide16

Investment (I)

In the Long Term Capital Market “

r

” must compensate the lender for the discount rate (waiting) and for any risks involved in the loan

Q$ - is the quantity of the financial capital, the liquidity

Slide17

Investment (I)

The Long Term Capital Market graph looks like:

r

Q

$

S

D

I

r

0

I

0

For now we are

assuming that the only

demand is for the purposes

of Investment, ergo the

subscript

Given our assumption … the total quantity of financial capital exchanged

all goes to investment, I

Slide18

Investment (I)

There are two players in the Long Term Capital Market (LTCM)

Suppliers – have financial capital, Q$ , they are willing to lend but must be sufficiently compensated for waiting on their return and the risks involved

Demanders – see investment opportunities and want to borrow financial capital, Q$ , if the interest rate they will pay is less than the perceived rate of return on the investment

Slide19

Investment (I)

LTCM Demand

The vertical axis is

rate

The height of each bar represents

perceived rate

of return for that

investment opportunity

How many of these opportunities would

be worth pursuing if the interest rate

investors have to pay is

4.5%

3.5%

2.5%

1.5%

Slide20

Investment (I)

Clearly,

d

emanders

see more investment opportunities worth pursuing as the interest rate they pay goes down …

As interest

rate,

r, goes down … the quantity of financial capital demanded for investment Q

$

D goes up and vice versa

Slide21

Investment (I)

When Demanders become more optimistic about the future they see more investment opportunities worth pursuing as every possible interest rate

r

Q

$

D

I

D

’

I

Shift right due to

increased

optimism

Slide22

Investment (I)

And pessimism has the opposite effect …

r

Q

$

D

I

D

’

I

Shift left due to

increased

pessimism

Slide23

Investment (I)

We can see how pessimism contributed to the Great Depression (GD)…

With “Depression” the future looks bleak … so DI falls

r

Q

$

D

0

I

S

I

0

D

1

I

I

1

Given S, the fall

in D

I

gives a new

equilibrium at a

much lower I

A collapse in I

was a major factor

in the GD’s falling AD

falling Y, and rising UNEMP

Slide24

Investment (I)

What determines Supply

It slopes up because the more financial capital individuals lend the greater the opportunity cost of what they are giving up, so … the more they have to be compensated

On the Supply side as

r

goes up, Q

$

S goes up and vice versa

Slide25

Investment (I)

Several different factors shift Supply

One is entry and exit

Entry shifts supply to the right…at any given interest rate there is more financial capital available

r

Q

$

S

0

S

1

One source of

entry

could be capital flowing into a country’s

capital market from other countries. Why might this happen?

Slide26

Investment (I)

Capital may flow into a nation’s capital market due to, ceteris paribus … a relatively better risk adjusted rate of return

Instability or other reasons that capital holders get nervous about keeping financial capital in that other country.

r

Q

$

S

0

S

1

Slide27

Investment (I)

Ceteris paribus, by making financial capital cheaper entry encourages more Investment (I)

increasing AD … increasing Y … and reducing UMEMP

D

I

r

0

I

0

r

Q

$

S

0

r

1

I

1

S

1

Slide28

Investment (I)

Exit shifts supply to the left …at any given interest rate there is less financial capital available

One source of Exit could be capital flowing out of a country’s capital market to other countries.

Another source of Exit could be

capital “disappearing

” as banks in an economy collapse due to fraud or irresponsible behavior

S

0

r

Q

$

S

1

Slide29

Investment (I)

Ceteris paribus, exit makes financial capital more expensive, discouraging investment

r

Q

$

D

I

r

0

I

0

I

1

r

1

S

0

S

1

Slide30

Investment (I)

Another factor that shifts

supply

is its underlying structure: Three factors determine the level of interest required by suppliers in Long Term Capital Market (LTCM)

Short run supply – this is an option for one’s capital that requires less waiting.

A “waiting premium” since the long term lenders have to wait much longer for their payment

An “inflationary expectation premium” – the longer you wait to be paid, the more vulnerable to inflation

Slide31

Investment (I)

Graphically we can represent this structure as follows …

r

Q

$

s

This is the short rate line –

the “floor”

To that “floor” we

add a “waiting premium”

and an “inflationary

expectation” premium

S

which brings us up to

The long rate line

Slide32

Investment (I)

If the short rate line shifts up, and the premiums remain constant, that will shift up the long rate

line

r

Q

$

s

S

s

S

Similarly if the short rate line shifts down, and the premiums remain

constant, that will

shift down

the long rate line …

Slide33

Investment (I)

The Fed’s standard policy tool is to manipulate short rates to influence long rates and in turn the Macro economy. Since the Great Recession began it’s lowered the short rate floor with the following intention … increasing AD … increasing Y … and reducing UMEMP

r

Q

$

S

0

D

I

r

0

I

0

r

1

I

1

S

1

Ceteris paribus

, a lower short

rate line pulls down the long

rate line

Lowering

long

rates

Stimulating Investment

Slide34

Investment (I)

If you see data that indicates that rates are rising or falling, that alone is not an indication of how the economy is doing

They can be rising because, with optimism, demand for financial capital is

growing

They can be rising because worried capital holders are moving their capital out of the country, contracting supply and making financial capital more expensive

They could be falling because pessimism reduces demand or because capital flows in based on optimism

Slide35

Investment (I)

One thing is clear … for an economy to be healthy and growing it needs healthy and growing investments

The long term capital market is instrumental in making this possible because it brings financial capital holders and potential investors together.

Slide36

Investment (I)

For the economy to be healthy, the financial market must be healthy…

As the Great Depression and Great Recession make clear, the power to manipulate this market is dangerous for the Macro Economic well-being of the nation

Slide37

X-M

The Trade Balance

Slide38

X-M: The Trade Balance

What distinguishes trade between

New York and New Orleans

from trade between New York and Paris?

…

making the latter more complicated?

Slide39

X-M: The Trade Balance

People

in New York and New Orleans use the same currency: dollars

People

in

New York and Paris

use different currencies

so the NY to Paris trade requires

exchanging currency

Slide40

Exchanging Currency

I

n order to understand trade,

we need to understand the Foreign Exchange Market

The market in which currencies are exchanged

In the Foreign Exchange Market one currency is the commodity … the item being bought … priced in the other currency… the one with which you are paying

Slide41

Exchanging Currency

Buying Euros with Dollars …

the Euro is the commodity priced in dollars.

Graphically it looks like this:

S

€

D

€

$

and

Supplying

Demanding

Euros

Priced in

Dollars

Slide42

Exchanging Currency

A case of two currencies: Euros and dollars

People supplying Euros to the foreign exchange market must be doing it in order to demand dollars

So to S

€

is at the same time to D

$

Similarly, people demanding Euros from the foreign exchange market can only do so by supplying dollars

So to D

€

is at the same time to S

$

Slide43

Exchange Rates

We can look at the euro/dollar transaction from the opposite perspective

Buying Dollars with Euros… the Dollar is the commodity priced in

euros

.

S

$

D

$

€

and

Supplying

Demanding

Dollars

Priced in

Euros

€

$

Slide44

Exchange Rates

€

$

$

€

D

$

S

€

These two red lines

represent the same

transaction:

Supplying Euros to

Demand Dollars

These two green lines

represent the same

transaction:

Supplying Dollars to

Demand Euros

S

$

D

€

Slide45

Exchange Rates

If these are two perspectives on the same transaction, then $/€ and €/$ must be related … what is the relationship between $0 and €0?

S

$

D

$

€

0

€

$

S

€

D

€

$

0

$

€

Slide46

Exchange Rates

They are reciprocals:

S

$

D

$

€/$

$

S

€

D

€

$/€

€

$2

/1

if it takes $2 to buy1€

1/2€

then ½ € buys $1

Slide47

Exchange Rates

Suppose the demand for dollars increased

S

$

D

$

€

$

S

€

D

€

$

€

$2

.5€

That would raise the euro price of the dollar (e.g., to 1€/$)

D

$’

1€

$

?

S

€’

Increased dollar demand implies increased euro supply …

Which would lower the dollar price of the euro to what?

If it now costs 1€/$,

$1 =

then it must be that it costs 1$/€

Slide48

Exchange Rates

Now suppose you were in Paris six months ago, before the currency shift shown below, and you’d seen some shoes for 200€ how much were they, in dollars, then?

S

$

D

$

€

$

S

€

D

€

$

€

$2

.5€

D

$’

1€

S

€’

$1

$400

How much are they, in dollars, now?

$200

Slide49

Exchange Rates

What a deal! Same shoes … same price tag for 200€ but for you they’re on sale – ½ off

The shift in the foreign exchange market has made the dollar stronger – it buys more of anything priced in the other currency because the other currency itself is costs less dollars

Slide50

Exchange Rates

What about the euro in our story?

If a sweater in the

U.S. would

have cost a visitor from Paris $100 six months ago – How much was it then in euros?

(Recall: it was .5€/$1 then) it was 50€ then

How much is it for that visitor now?

100€

It’s doubled in price because the euro has gotten weaker

Slide51

Currency Strength

A currency gets stronger when it can buy more of anything priced in the other currency because the other currency itself costs less

A currency gets weaker when it can’t buy as much of anything priced in the

other

currency because the other currency itself costs more

Slide52

Currency Strength

What causes currencies to get stronger or weaker?

Shifts of Supply or Demand in the foreign exchange market that, in turn, change exchange rates

What’s the most common cause of shifts in foreign exchange market supply and demand?

International flows of financial capital

Slide53

International Flow

International financial capital is, as the term “international” implies, not a “citizen" of any nation … it salutes no flag

It is liquid value that flows around the globe in pursuit of the best risk adjusted rate of return

Slide54

Capital Flow

If the holders of financial capital get nervous about the situation in a country, ceteris paribus, capital will flow out to a more secure “safe harbor” (nation)

e.g., if capital holders get nervous about the stability of the euro zone, ceteris paribus, capital will flow from there to the U.S. or elsewhere

Ceteris paribus, what would that do to the dollar?, to the euro

?

Slide55

Capital Flow

Ceteris paribus, nervousness about the stability of the euro zone causes a capital flow that weakens the euro and strengthens the dollar.

Another example: ceteris paribus, interest rates in Japan going up relative to those in the U.S. causes a capital flow…

Which way? … and what does it do to the yen and the dollar?

From the US to Japan, and it strengthens the yen and weakens the dollar.

Slide56

Trade Balance

How’s all this relate to trade?

A weakening euro/strengthening dollar would do what, ceteris paribus, to the U.S. trade balance?

A strengthening yen/weakening dollar would do what, ceteris paribus, to the U.S. trade balance?

Is one of these cases better?

US exports

US imports

US trade balance more negative

US exports

US imports

US trade balance more positive

Slide57

The Trade Balance

Absent any government intrusions, trade of any particular item is determined by:

The underlying market conditions in the producing country

This determines the domestic price

The exchange rate

This determines the currency- adjusted price for the consumers in other countries

The demand conditions in those other countries.

These conditions determine a nation’s trade balance and the direction of trade’s affect on the nation’s Aggregate Demand and the

macroeconomy

.

Slide58

G-T: The Government’s Budget Position

Ceteris paribus

…

(G – T) = 0 , a Balanced Budget, is neutral. It doesn’t shift AD

(G – T) < 0 , a Budget Surplus, is

contractionary

. It shifts AD left.

(G – T) > 0 , a Budget Deficit, is

stimulative

. It shifts AD right.

Slide59

G-T: The Government’s Budget Position

In every country the budget determination is a political decision

In the U.S. each house of Congress (Senate & House of Representatives) develops and passes a budget resolution

A Joint Committee (theoretically) resolves differences and the common bill passes each.

The President signs the bill … done

The President vetoes the bill … override or back to the drawing board