Aggregate Demand

Aggregate Demand Chapter 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 then AD and this drives Y pushing UMP If C

“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 b b Y AD UMP C

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 r On the vertical axis is the nominal interest rate – the price of borrowing On the horizontal axis is the quantity of 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: For now we are assuming that the only demand is for the purposes of Investment, ergo the subscript r S r0 DI Q$ I0 Given our assumption … the total quantity of financial capital exchanged all 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 The vertical axis is rates 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% 1.5% 3.5% 2.5%

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 Shift right due to increased optimism DI D’I Q$

Investment (I) And pessimism has the opposite effect … r Shift left due to increased pessimism DI D’I Q$

Investment (I) • We can see how pessimism contributed to the Great Depression (GD)… • With “Depression” the future looks bleak … so DI falls r Given S, the fall in DI gives a new equilibrium at a much lower I S A collapse in I was a major factor in the GD’s falling AD falling Y, and rising UNEMP D1I D0I Q$ I0 I1

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 S0 S1 Q$ One source of Entry could be capital flowing into a country’s capital 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 S0 S1 Q$

Investment (I) • Ceteris paribus, by making financial capital cheaper entry encourages more Investment (I) • increasing AD … increasing Y … and reducing UMEMP r S0 S1 r1 r0 DI I1 Q$ I0

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 r S1 S0 Q$

Investment (I) • Ceteris paribus, exit makes financial capital more expensive, discouraging investment r S1 S0 r1 r0 DI I0 I1 Q$

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 … which brings us up to The long rate line r S and an “inflationary expectation” premium To that “floor” we add a “waiting premium” s This is the short rate line – the “floor” Q$

Investment (I) • If the short rate line shifts up, and the premiums remain constant, that will shift up the long rate line … S r S s s Q$ 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 S0 r Ceteris paribus, a lower short rate line pulls down the long rate line S1 r0 r1 Lowering long rates DI Q$ I1 I0 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 betweenNew York and New Orleansfrom trade between New York and Paris? • …making the latter more complicated?

X-M: The Trade Balance • People in New York and New Orleans use the same currency: dollars • Peoplein New York and Parisuse different currenciesso the NY to Paris trade requiresexchanging 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€ Supplying Priced in Dollars and $ Demanding D€ Euros

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$ Supplying Priced in Euros and € Demanding D$ Dollars $

Exchange Rates 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€ S$ D€ 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$ S€ €0 $0 D$ D€ $ €

Exchange Rates • They are reciprocals: if it takes $2 to buy1€ then ½ € buys $1 €/$ $/€ S€ S$ 1/2€ $2/1 D€ D$ € $

Exchange Rates • Suppose the demand for dollars increased That would raise the euro price of the dollar (e.g., to 1€/$) Increased dollar demand implies increased euro supply … Which would lower the dollar price of the euro to what? then it must be that it costs 1$/€ If it now costs 1€/$, € $ S€ S$ S€’ 1€ $2 .5€ $? $1 = D$’ D€ D$ € $

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? $400 How much are they, in dollars, now? $200 € $ S€ S$ S€’ 1€ $2 .5€ $1 D$’ D€ D$ € $

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

Aggregate Demand