Aggregate DemandChapter 13

Consumption

“C”

Consumption

• The aggregate nominal amount of spending we do as consumers … at the grocery or the mall and so on.– Makes up 65-70% of AD.

• Doesn’t usually change dramatically, quickly.– People tend to maintain their standard of living.

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

Consumption

• Hit by a temporary hard time, we use some of our accumulated wealth (our savings) to bridge that time and maintain lifestyle

• If harder times seem to be the new reality, we adjust our perception of our permanent income– Decrease it

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

Consumption (C = A + b (PY))

• …So if 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

“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

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 then AD and this drives Y pushing UMP

“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

“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 UMPb b

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

Investment

“I”

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

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

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 verticalaxis is the nominalinterest rate – the price of borrowing

rOn the horizontal axis is the quantityof financial capital

Q$

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

Investment (I)The Long Term Capital Market graph looks like:

r

Q$

S

DI

r0

I0

For now we are assuming that the onlydemand is for the purposesof Investment, ergo the subscript

Given our assumption … the total quantity of financial capital exchangedall goes to investment, I

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

Investment (I) LTCM Demand

0123456

The vertical axis is rates

The height of each bar represents perceived rate of return for thatinvestment 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%

Investment (I)

• Clearly, Demanders 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

Investment (I)• When Demanders become more optimistic

about the future they see more investment opportunities worth pursuing as every possible interest rate

r

Q$

DI D’I

Shift right due to increasedoptimism

Investment (I)And pessimism has the opposite effect …

r

Q$

DID’I

Shift left due to increasedpessimism

Investment (I)• We can see how pessimism contributed to the

Great Depression (GD)… – With “Depression” the future looks bleak … so DI

fallsr

Q$

D0I

S

I0D1

I

I1

Given S, the fall in DI gives a new equilibrium at a much lower IA collapse in Iwas a major factorin the GD’s falling ADfalling Y, and rising UNEMP

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

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$

S0 S1

One source of Entry could be capital flowing into a country’scapital market from other countries. Why might this happen?

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$

S0 S1

Investment (I)• Ceteris paribus, by making financial capital

cheaper entry encourages more Investment (I)– increasing AD … increasing Y … and reducing UMEMP

DIr0

I0

r

Q$

S0

r1

I1

S1

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

S0

r

Q$

S1

Investment (I)• Ceteris paribus, exit makes financial capital

more expensive, discouraging investmentr

Q$

DI

r0

I0I1

r1

S0S1

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

Investment (I)• Graphically we can represent this structure as

follows … r

Q$

sThis is the short rate line – the “floor”

To that “floor” weadd a “waiting premium”

and an “inflationaryexpectation” premium

Swhich brings us up toThe long rate line

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

Ss

S

Similarly if the short rate line shifts down, and the premiums remain constant, that will shift down the long rate line …

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$

S0

DI

r0

I0

r1

I1

S1

Ceteris paribus, a lower shortrate line pulls down the longrate line

Loweringlongrates

Stimulating Investment

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, or– 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

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.

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

X-M

The Trade Balance

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?

X-M: The Trade Balance

• People in New York and New Orleansuse the same currency: dollars

• People in New York and Paris use different currencies so the NY to Paris trade requires exchanging currency

Exchanging Currency

• In 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

Exchanging Currency

• Buying Euros with Dollars …– the Euro is the commodity priced in dollars.

• Graphically it looks like this:

S€

D€

$ and

Supplying

DemandingEuros

Priced inDollars

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$

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

DemandingDollars

Priced inEuros

€

$

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€

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

$

€

Exchange Rates

• They are reciprocals:

S$

D$

€/$

$

S€

D€

$/€

€

$2/1

if it takes $2 to buy1€

1/2€

then ½ € buys $1

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$/€

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

$400How much are they, in dollars, now? $200

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

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

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

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

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

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?

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.

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

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.

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.

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