Tyler’s Unit 3 Macroeconomics Study Sesh

3.1 Aggregate Demand

Aggregate demand (AD) - The inverse relationship between all spending on domestic output and the aggregate price level of that output.

Components of AD

Demand in the macroeconomy comes from four general sources

which are used to calculate the real GDP.

AD measures the sum of consumption spending by households

investment spending by firms

The shape of AD

General groups of substitutes for national output

Foreign sector substitution effect - Goods and services produced in other nations.

Ex. →When the price of U.S. output increases

consumers begin to look for similar items produced elsewhere. A Japanese computer

Interest rate effect - Goods and services in the future.

Ex.→ When more and more households seek loans

the real interest rate begins to rise

Wealth effect - Money and financial assets.

Wealth is the value of accumulated assets like stocks

bonds

As the aggregate price level rises

the purchasing power of wealth and savings begins to fall. Higher prices

The AD Curve

The combination of the foreign sector substitution

interest rate

As the aggregate price level rises

consumption of domestic output (real GDP) falls along the AD curve. (This is the movement from a to b).

%img%Changes in AD

Since AD is the sum of the four components of domestic spending [C

I

If any of these components decreases

holding the price level constant

%img%If you want to stimulate real GDP and lower unemployment

you need to boost any or all of the components of AD.

If you feel AD must slow down

you need to rein in the components of AD.

Components of AD

Consumer Spending (C) - If you put more money in the pockets of households

it is expected that they consume a great deal of it and save the rest. Consumers also increase their consumption if they are optimistic about the future.

Investment Spending (I) - Firms increase investment if they believe the investment will be profitable. This expected return on the investment is increased if investors are optimistic about future profitability or if the necessary borrowing can be done at a low rate of interest.

Government Spending (G) - The government injects money into the economy by spending more on goods and services

by reducing taxes

Government spending on goods and services is a direct increase in AD.

Lowering taxes and increasing transfer payments increase AD through consumer spending by increasing disposable income.

Net Exports ( X - M) - When sales to foreign consumers are high and purchases from foreign producers are low

the net exports increase.

Foreign incomes - Exports increase with strong foreign economies. When foreign consumers have more disposable income

this increases the AD in the United States because those consumers spend some of that income on U.S.-made goods.

Consumer tastes - If American blue jeans become more popular in France

American AD increases. If French wines become more preferred by American consumers

Exchange rates - Imports decrease when the exchange rate between the dollar and foreign currency falls. This makes foreign goods to be more expensive causing consumers to buy fewer foreign-produced items.

3.2 Spending and Tax Multipliers

Multipliers

Multiplier effect—The idea that an initial change in spending will set off a spending chain that is magnified in the economy.

Marginal propensity to consume (MPC)—How much people consume rather than save when there is a change in income. This can also be explained as the portion of each new dollar of disposable income that consumers will spend rather than save.

Marginal propensity to save (MPS)—How much people save rather than consume when there is a change in income. This can also be explained as the portion of each new dollar of disposable income that consumers will save rather than spend.

MPC and MPS

Marginal Propensity to Consume (MPC) is calculated by dividing the change in consumption by dividing the change in disposable income.

Marginal Propensity to Save (MPS) is calculated by dividing the change in savings by dividing the change in disposable income.

MPC + MPS = 1

Spending Multiplier

The spending multiplier

or fiscal multiplier

Example: Matthew is an economist in the Federal Reserve

and he has been tasked with figuring out the ideal stimulus would be to increase GDP by $5

Using the spending multiplier formula (1 / MPS)

he calculates that the Federal Reserve needs to inject (5

Why does the government only have to spend $1.7M to increase GDP by $5M? This is because of the multiplier effect. One group of consumers consumes 65% of its new money on goods produced by another consumer. This consumer now has new money and consumes 65% of it on goods produced by someone else and so on.

Thus

consumers immediately consume 65 percent of this increase ($1.7M x .65). This $1.1M of consumption then triggers another line of consumption where these consumers consumer 65% of their earnings ( .65 x .65 x $1.7M). This goes on and on resulting in a multiple of 2.86.

The Spending Multiplier is largely related to how much consumers save

so if they save only 20% of their income and spend the rest

Tax Multiplier

The tax multiplier is used to determine the maximum change in spending when the government either increases or decreases taxes.