Aggregate Demand, Aggregate Supply, and the Investment Demand Curve

*Aggregate Demand*

Shifts in aggregate demand:there are two parts to a shift in ad
  - a change in c, Ig, and/or Xn
  - a multiplier effect that produces a greater change than the original change in the 4 components

• increase=shifts to the right
• decrease=shift to the left

Determinants of AD:

Consumption
   - household spending is affect by: 
       - consumer wealth
           . More wealth= more spending (AD shifts ->)
           . Less wealth= less spending (AD shifts <-)
       - consumer expectations
           . Positive expectations = more spending (AD ->)
           . Negative expectation = less spending (AD <-)
       - household indebtedness
           . Less debt = more spending 
           . More debt = less spending 
       - taxes 
           . Less taxes = more spending 
           . More taxes = less spending

Gross private investment 
• investment spending is a sensitive to:
      - the real interest rate 
           . Lower real interest rate = more investment (AD->)
           . Higher real interest rate = less investment (AD<-)
      - expected returns 
           . Higher expected returns = more investment
           . Lower expected returns = less investment
           . Especial returns are influenced by 
                 - expectation of future profitability 
                 - technology 
                 - degree of excess capacity (Existjng stock of capital)

Govt spending
• more govt spending (AD->)
• less govt spending (AD<-)

Net exports 
• nets exports are sensitive to:
    -exchange rate (international value of $)
        . Strong $ = more imports and fewer exports (AD<-)
        . Weak $ = fewer imports and more exports (AD->)
     - relative income 
         . Strong foreign Economies = more exports 
         . Week foreign economies = less exports

*Aggregate Supply*
-Long Run Aggregate Supply (LRAS) - the period of time where input prices are completely flexible and adjust to changes in the price level.
-the level of real GDP supplied is independent of price level.
-It marks the level of full employment in the economy. (FE, Yf, Y' = full employment)
-Analogous to PPC
-Since input prices are flexible in long run, changes in price level do not change firms real profits and therefore don't change firms level of output.
-LRAS is vertical at the economy's level of full employment. 

-Short Run Aggregate Supply (SRAS) - Period of time where input prices are sticky and don't adjust to changes in the price level
-the level o real GDP supplied is directly related to the price level.
-because input prices are sticky in the short run, the SRAS is upward slopping. 
-an increase in SRAS is seen as a shit to the right ---> and decrease to the left <---
-the key to understanding shifts in SRAS is per unit cost production
-per unit cost production = total input cost

Determinants of SRAS: (affect unit production cost)

1. Input Prices
2. Productivity
3. Legal - Institutional Environment: taxes and subsidies

• Taxes (money to government) on business increase per unit production cost, shits SRAS <----
• Subsidies (money from government) to business reduce per unit production cost, shifts SRAS ---->

Domestic Resource Prices:

-wages (75% of all business costs)

-cost of capital 

-raw materials (commodity prices)

Foreign Resource Prices:

-Strong money: lower foreign resource prices

-Weak money: higher foreign resource prices

Market Power: Monopolies and cartels that control the price of those resources.

-Increase in resource prices: SRAS <----

-Decrease in resource prices: SRAS ---->

Productivity = total output/total inputs

More productivity = lower unit production cost ---->

Lower productivity = higher unit production cost <----

Government Regulation: creates a cost o compliance = SRAS <----

Deregulation: reduces compliance cost = SRAS ---->

Full Employment – Equilibrium exists where AD interests 

SRAS and LRAS at the same point.

Recessionary Gap - exists when equilibrium occurs below full employment output.

-AD decrease shifts to the left 

Inflationary Gap- exists when equilibrium occurs                    beyond full employment output.

-AD increases shifts to the right

Interest Rates and Investments Demand

Money spent on expenditures on:

o   New plants ( factories )

o   Capital equipment ( machinery )

o   Technology ( hardware and software )

o   New homes

o   Inventories ( goods sold by producers )

·         How do a business make investment decisions?

o   Cost / Benefits Analysis

·         How does a business determine benefits?

o   Expected rate of return

·         How does a business count the cost?

o   Interest Cost

·         How does a business determine the amount of investment they undertake?

o   Compare expected rate of return to interest cost

§  If expected return > interest cost, then invest

§  If expected return < interest cost, do not invest

Real ( r% ) vs. Nominal ( i% )  (pie)inflation

What’s the difference?

·         Nominal is observable rate of interest. Real subtracts out inflation (pie%) and only known ex post facto.

How to compute the real interest rate

r%= i% - pie%

What determines cost of an investment decision?

·         Real interest rate ( r%)

What is the shape of investment demand slope?

·         Downward sloping

Why?

·         When interest rates are high, few investments are profitable. When interest rate are low, more investments are profitable.

*The Investment Demand Curve*

Cost of production 

- lower cost shifts ID ---->

-Higher cost shifts ID <----

Business Taxes

-lower business taxes shift ID ---->

-higher business taxes shift ID <----

Technological Change

• New technology ---->
• Lack of technology <----

Stock of Capital

• If an economy is low on capital then ID shifts ---->
• If it has much capital then ID shifts <----

Expectations 

• positive expectations shift ID ---->
• negative expectations shift ID <----

LRAS: represents a point on an economics production possibilities curve and it is a vertical line at an output level that represents the quantity of goods and services a nation can produce over a sustained period using all of its productive resources as efficiently as possible.

-always at full employment

-does not change as price level changes

-shifts outward if there is a change in technology, resource, or there is economic growth. 

Three Schools of Economics:

Classical:	Keynesian:	Monetary:
People- Adam Smith, John B. Say, David Ricardo, Afford Marshall. Savings (leakage) Investment (injection) -says competition is good -invisible hand (market runs itself) -concept of laissez-faire -Say’s law: supply creates its own demand -whatever output is produced will be demanded -the economy is always at or close to full employment -In the long run the economy will balance out at FE -Trickle-down effect: help the rich first, then the rest -savings increase with interest rates -prices and wages are flexible downward -AS determines output -AS = AD at full equilibrium	People- John Maynard Keynes -congress savers does not equal investors -competition is flawed -AD is the key, not As demand creates its own supply therefore AD creates its own output -savings are inverse to interest rates -leaks causes constant recessions and savings too -ratchet effects and sticky wages block Say's law -since there is no mechanism capable of full employment, in the long run we are dead the economy is not always close to or at full employment -fiscal policy, add stabilizers, use expansionary and contractionary policies	People - Allan Greenspan -Ben Bernanke -congress can't time the policy options -voters won't allow contractionary options -easy and tight money -we can change the required reserves if needed -buy and sell bonds through open market operation -we can use the interest rate to change the discount rate and federal fund rate.