Topic 4 Aggregate Demand, Part II

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Topic 4 Aggregate Demand, Part II

• Factors affecting C, I , G, and NX
• President Bushs tax reform
• Income determination
• Algebraic approach
• Graphical approach
• Multiplier effect

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Consumption Function

• People spend a fix proportion of disposable
  income in consumption and save the rest.

3
Consumer Spending and Disposable Income
5,237
Real Consumer Spending
2,869
3,244
5,677
0
Real Disposable Income
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Consumer Spending and Disposable Income
1900
1700
1500
Real Consumer Spending
1360
1300
1180
1100
900
0
1900
1700
1500
1300
1100
900
Real Disposable Income
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Consumption Function

• Marginal Propensity to Consume (MPC) is the ratio
  of changes in consumption relative to changes in
  disposable income that produces the change in
  consumption.
• MPC ? consumption ? ? disposable income
• Consumption function shows the relationship
  between total consumer expenditures and total
  disposable income in the economy, holding all
  other determinants of consumer spending constant.
• Consumption function C MPC x DI C0

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Consumption function C MPC x DI C0MPC
0.75 C02,700
4,200
3,900
3,600
3,300
3,000
2,700
5,200
4,800
4,400
4,000
3,600
3,200
0
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Consumption Function

• Does a one year tax cut change the slope?
• Does it shift the consumption schedule
  (function)?
• C MPC x DI C0 ------- (1)
• DI Y T ------- (2)

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Factors affecting the Consumption Function

• ? disposable income movement along the
  consumption function
• ? any other variable that affects consumption
  the consumption function shifts

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Movements and Shifts
Real Consumer Spending
Real Disposable Income
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Factors That Shift the Consumption Function

• Wealth ? / ? gt the function shifts up/down
• Wealth and income are different
• Price ? / ? gt wealth ? / ? gt the function
  shifts down/up
• Higher price erodes the purchasing power of money
• Expected future income ? / ? gt the function
  shifts up/down
• Interest rate

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Why Did the Tax Rebate fail in 1975 and 2001?

• A temporary tax cut may not stimulate consumption
  affectively.
• A permanent tax cut may be more affective.

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Why Did the Tax Rebate fail in 1975 and 2001?
Permanent
c
b
Real Consumer Spending
a
Temporary
Real Disposable Income
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Investment

• Investment is business firms spending on plant,
  equipment, and software that will add to the
  nations capital.
• Capital is the available supply of plant,
  equipment, and software. It is the result of past
  investment.
• Factors that affect investment
• Real interest rate ? / ? gt Investment ? / ?
• Tax exemption

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Factors That Affect Investment

• Technology progress gt Investment ?
• Growth of Demand
• Volume of sales relative to capacity ?/? gt
  investment ?/?.
• Expected economic growth ?/? gt investment ?/?.
• A more/less stable political situation gt
  investment ?/?.
• Better/worse protection to the property right gt
  investment ?/?.

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Factors That Affect Net Export

• National income
• Higher/lower national income gt IM?/? gt Net
  Export ?/?
• Higher/lower national income of trade partners gt
  X ?/? gt Net Export ? / ?
• Relative Price between domestic and foreign goods
  and services
• Domestic price level ? gt Domestic goods are
  relatively more expensive gt X?, IM? gt Net
  Export ?
• Foreign price level ? gt Foreign goods are
  relatively more expensive gt X?, IM? gt Net
  Export ?
• Exchange Rate

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President Bushs tax reduction plan in 2003
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Demand-Side Equilibrium

• What is demand-side equilibrium?
• Differences between the demand-side equilibrium
  and the market equilibrium
• The demand-side equilibrium and the market
  equilibrium are equivalent only if AS is
  horizontal

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Income determination, an algebraic approach

• Example In the economy, I 900, G 1300, NE
  -100, T 1200, C 300 0.75DI. What is the
  equilibrium (demand-side) GDP?
• Y C I G NX --- (1)
• C 300 0.75DI ----- (2)
• DI Y T --------------- (3)
• Sub (3) into (2) gt C 300 0.75(Y - T) ----
  (4)
• Sub (4) into (1) gt Y 300 0.75(Y T) I
  G NX ---- (5)
• Plug the number of I, G, NX and T into (5)
• gt Y 300 0.75(Y 1200) 900 1300 100
• gt Y 0.75Y 300 900 900 1300 -100

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Income determination with algebraic approach

• Y 0.75Y 300 900 900 1300 -100
• Y 0.75Y 1500
• 0.25Y 1500
• Y 6000

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Income determination, an graphic approach

• Construct the total expenditure schedule
• Expenditure Schedule is the table showing the
  relationship between GDP and total spending
• Ignore induced investment
• Induced Investment is the part of investment
  spending that rises when GDP rises, and falls
  when GDP falls.
• Income expenditure diagram plots total real
  expenditure against real income. The 45 degree
  line marks off points where income and
  expenditure are equal

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Total expenditure schedule
6,100
6,000
Real Expenditure
4,800
3,900
7,200
6,800
6,400
6,000
5,600
5,200
Real GDP
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Income-Expenditure Diagram
7,200
6,800
6,400
6,000
Real Expenditure
5,600
5,200
4,800
5,200
5,600
6,000
6,400
6,800
7,200
0
4,800
Real GDP
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Multiplier Effect

• Multiplier is the ratio of the change in
  equilibrium GDP (Y) divided by the original
  change in spending that causes the change in GDP.
• Multiplier is bigger than 1

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Illustration of the Multiplier
Real Expenditure
0
6,800
6,000
Real GDP
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The Multiplier Spending Chain

• A portion of the increase in income is spent on
  consumption, creating more income, which in turn
  creates more consumption spending, and so on.

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How the Multiplier Builds
4.0
3.0
Cumulative Spending Total
2.0
1.0
20
15
10
8
6
4
2
0
Spending Round
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Illustration of the Multiplier
Real Expenditure
0
6,800
6,000
Real GDP
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Multiplier Effect

• For 1 dollar ?I, ?Y 1 (0.75) (0.75)2
  (0.75)3 .
• ?Y 1 / (1 MPC) ?I
• I multiplier 1 / (1 MPC)
• It is also true for the G and NX multipliers
• T multiplier - MPC / (1 MPC)

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Derive multipliers using algebraic approach