G) in Russia’s GNP and the USA’s GDP.

5. If real GDP fell by 6% and the population declined by 3% in the same year:

a) real GDP per capita decreased;

b) real GDP per capita increased and nominal GDP decreased;

c) nominal GDP has not changed;

d) prices fell by 3%.

6. The British company’s production of sneakers in Russia:

a) increases both GDP and GNP;

b) increase the UK’s GDP;

c) increases the UK’s GNP;

d) will not increase either of them.

7. The purchase of a new house by a family will affect the size of:

a) net exports;

b) public expenditure;

c) private investment;

d) expenses for the purchase of consumer durable goods.

What is not used in determining national income (NI)?

a) corporate profits;

b) transfer payments;

c) rental income;

d) salary.

What is personal disposable income?

a) accrued wages;

b) total income received (wages and other income));

c) real income;

d) total income received less tax and non-tax mandatory payments.

10. To move from gross national product (GNP) to net national product (NNP), you must:

a) add to net investment expenses;

b) deduct net investment from GNP;

c) deduct depreciation of fixed assets from GNP;

d) add depreciation to GNP.

Numerical tasks

Write an appropriate equation and use it to compute the answer.

1. In 2016, nominal GDP in the US was $16,560 billion, and real GDP was $13,800 billion. What was the price deflator in that year?

2. GDP increased from 500 billion to 600 billion. The GDP Deflator increased from 125 to 150. How does it affect the value of real GDP?

The economy’s GDP

Suppose you are given the following data for an economy (in millions of $):

• Personal consumption                              1,000

• Home construction                              100

• Increase in inventories                              40

• Equipment purchases by firms                 60

• Government purchases                             100

• Social Security payments to households  40

• Government welfare payments                100

• Exports                                                     50

• Imports                                                     150

What is the economy’s GDP? What components from the list above are included?

4. Compute GDI from the data below (in millions of $). Assume that GDP equals GNP for this problem (i.e. all factor incomes are earned and paid in the domestic economy).

Employee compensation	700
Social Security payments to households	40
Welfare payments	100
Profits	200
Rental income	50
Net interest	25
Depreciation	50
Indirect taxes	175

5. Suppose a dairy farm produces raw milk, which it sells for $1,000 to a dairy. The dairy produces cream, which it sells for $3,000 to an ice cream manufacturer. The ice cream manufacturer uses the cream to make ice cream, which it sells for $7,000 to a grocery store. The grocery store sells the ice cream to consumers for $10,000. Compute the value added at each stage of production, and compare this figure to the final value of the product produced.Report your results in a table.

Goods	Produced by	Purchased by	Price	Value added
Milk
Cream
Ice cream
		Final Value
		Sum of Values Added

 

6. What impact would each of the following have on real GDP? Would economic well-being increase or decrease as a result?

1. On average, people in a country decide to increase the number of hours they work by 5%.
2. Spending on homeland security increases in response to a terrorist attack.
3. The price level and nominal GDP increase by 10%.

7. All other things unchanged, compare the position of a country’s expected production possibility curve and the expected position of its LRAS curve if:

1.Its labor force increases in size by 3% per year compared to 2% per year.

2.Its saving rate falls from 15% to 10%.

3.It passes a law making it more difficult to fire workers.

4.Its level of education rises more quickly than it has in the past.

 

Chapter 3. Aggregate Demand and Aggregate Supply

Unit 3.1 Aggregate Demand

Learning objectives

1. Define potential output, also called the natural level of GDP.

2. Define aggregate demand, represent it using a hypothetical aggregate demand curve, and identify and explain the three effects that cause this curve to slope downward.

3. Distinguish between a change in the aggregate quantity of goods and services demanded and a change in aggregate demand.

4. Use examples to explain how each component of aggregate demand can be a possible aggregate demand shifter.

5. Explain what a multiplier is and tell how to calculate it

Firms face four sources of demand: households (personal consumption), other firms (investment), government agencies (government purchases), and foreign markets (net exports). Aggregate demand is the relationship between the total quantity of goods and services demanded (from all the four sources of demand) and the price level, all other determinants of spending unchanged. The AD curve is a graphical representation of aggregate demand

The Slope of the AD Curve

We will use the price deflator as our measure of the price level; the aggregate quantity of goods and services demanded is measured as real GDP. The table in Figure Aggregate Demand gives values for each component of aggregate demand at each price level for a hypothetical economy. Various points on the AD curve are found by adding the values of these components at different price levels. The AD curve for the data given in the table is plotted on the graph. At point A, at a price level of 1.18, $11,800 billion worth of goods and services will be demanded; at point C, a reduction in the price level to 1.14 increases the quantity of goods and services demanded to $12,000 billion; and at point E, at a price level of 1.10, $12,200 billion will be demanded.

Figure Aggregate Demand

An AD curve shows the relationship between the total quantity of output demanded (measured as real GDP) and the price level (measured as the price deflator). At each price level, the total quantity of goods and services demanded is the sum of the components of real GDP, as shown in the table. There is a negative relationship between the price level and the total quantity of goods and services demanded, all other things unchanged.

The negative slope of the AD curve suggests that it behaves in the same manner as an ordinary demand curve. But we cannot apply the reasoning we use to explain downward-sloping demand curves in individual markets to explain the downward-sloping AD curve. There are two reasons for a negative relationship between price and quantity demanded in individual markets. First, a lower price induces people to substitute more of the good whose price has fallen for other goods, increasing the quantity demanded. Second, the lower price creates a higher real income. This normally increases quantity demanded further.

Neither of these effects is relevant to a change in prices in the aggregate. When we are dealing with the average of all prices – the price level – we can no longer say that a fall in prices will induce a change in relative prices that will lead consumers to buy more of the goods and services whose prices have fallen and less of the goods and services whose prices have not fallen. The price of corn may have fallen, but the prices of wheat, sugar, tractors, steel, and most other goods or services produced in the economy are likely to have fallen as well.

Furthermore, a reduction in the price level means that it is not just the prices consumers pay that are falling. It means the prices people receive – their wages, the rents they may charge as landlords, the interest rates they earn – are likely to be falling as well. A falling price level means that goods and services are cheaper, but incomes are lower, too. There is no reason to expect that a change in real income will boost the quantity of goods and services demanded – indeed, no change in real income would occur. If nominal incomes and prices all fall by 10%, for example, real incomes do not change.

Why, then, does the AD curve slope downward?

One reason for the downward slope of the aggregate demand curve lies in the relationship between real wealth (the stocks, bonds, and other assets that people have accumulated) and consumption (one of the four components of aggregate demand). When the price level falls, the real value of wealth increases – it has more purchasing power. For example, if the price level falls by 25%, then $10,000 of wealth could purchase more goods and services than it would have if the price level had not fallen. An increase in wealth will induce people to increase their consumption. The consumption component of aggregate demand will thus be greater at lower price levels than at higher price levels. The tendency for a change in the price level to affect real wealth and thus alter consumption is called the wealth effect; it suggests a negative relationship between the price level and the real value of consumption spending.

A second reason the AD curve slopes downward lies in the relationship between interest rates and investment. A lower price level lowers the demand for money, because less money is required to buy a given quantity of goods. What economists mean by money demand will be explained in more detail in a later chapter. But, as we learned in studying demand and supply, a reduction in the demand for something, all other things unchanged, lowers its price. In this case, the ‘something’ is money and its price is the interest rate. A lower price level thus reduces interest rates. Lower interest rates make borrowing by firms to build factories or buy equipment and other capital more attractive. A lower interest rate means lower mortgage payments, which tends to increase investment in residential houses. Investment thus rises when the price level falls. The tendency for a change in the price level to affect the interest rate and thus to affect the quantity of investment demanded is called the interest rate effect. John Maynard Keynes, a British economist whose analysis of the Great Depression and what to do about it led to the birth of modern macroeconomics, emphasized this effect. For this reason, the interest rate effect is sometimes called theKeynes effect.

A third reason for the rise in the total quantity of goods and services demanded as the price level falls can be found in changes in the net export component of aggregate demand. All other things unchanged, a lower price level in an economy reduces the prices of its goods and services relative to foreign-produced goods and services. A lower price level makes that economy’s goods more attractive to foreign buyers, increasing exports. It will also make foreign-produced goods and services less attractive to the economy’s buyers, reducing imports. The result is an increase in net exports. The international trade effect is the tendency for a change in the price level to affect net exports.

Taken together, then, a fall in the price level means that the quantities of consumption, investment, and net export components of aggregate demand may all rise. Since government purchases are determined through a political process, we assume there is no causal link between the price level and the real volume of government purchases. Therefore, this component of GDP does not contribute to the downward slope of the curve.

In general, a change in the price level, with all other determinants of aggregate demand unchanged, causes a movement along the AD curve. A movement along an AD curve is a change in the aggregate quantity of goods and services demanded. A movement from point A to point B on the AD curve is an example. Such a change is a response to a change in the price level.

Changes in Aggregate Demand

Aggregate demand changes in response to a change in any of its components. An increase in the total quantity of consumer goods and services demanded at every price level, for example, would shift the AD curve to the right. A change in the aggregate quantity of goods and services demanded at every price level is a change in aggregate demand, which shifts the AD curve. Increases and decreases in aggregate demand are shown in Figure Changes in Aggregate Demand.

Figure Changes in Aggregate Demand

An increase in consumption, investment, government purchases, or net exports shifts the aggregate demand curve AD ₁ to the right as shown in Panel (a). A reduction in one of the components of aggregate demand shifts the curve to the left, as shown in Panel (b).

What factors might cause the AD curve to shift? Each of the components of aggregate demand is a possible aggregate demand shifter. We shall look at some of the events that can trigger changes in the components of aggregate demand and thus shift the AD curve.

Aggregate demand shifters:

· Changes in Consumption

· Changes in Investment

· Changes in Government Purchases

· Changes in Net Exports

Consumption

a) Consumer confidence

Several events could change the quantity of consumption at each price level and thus shift aggregate demand. One determinant of consumption is consumer confidence. If consumers expect good economic conditions and are optimistic about their economic prospects, they are more likely to buy major items such as cars or furniture. The result would be an increase in the real value of consumption at each price level and an increase in aggregate demand. In the second half of the 1990s, sustained economic growth and low unemployment fueled high expectations and consumer optimism. Surveys revealed consumer confidence to be very high. That consumer confidence translated into increased consumption and increased aggregate demand. In contrast, a decrease in consumption would accompany diminished consumer expectations and a decrease in consumer confidence, as happened after the stock market crash of 1929. The same problem has plagued the economies of most Western nations in 2008 as declining consumer confidence has tended to reduce consumption.

b) Tax policy

Another factor that can change consumption and shift aggregate demand is tax policy. A cut in personal income taxes leaves people with more after-tax income, which may induce them to increase their consumption. For example, the US government cut taxes in 1964, 1981, 1986, 1997, and 2003; each of those tax cuts tended to increase consumption and aggregate demand at each price level.

c) Transfer payments

Transfer payments such as welfare and Social Security also affect the income people have available to spend. At any given price level, an increase in transfer payments raises consumption and aggregate demand, and a reduction lowers consumption and aggregate demand.

Investment

a) Firms’ expectations

Investment is the production of new capital that will be used for future production of goods and services. Firms make investment choices based on what they think they will be producing in the future. The expectations of firms thus play a critical role in determining investment. If firms expect their sales to go up, they are likely to increase their investment so that they can increase production and meet consumer demand. Such an increase in investment raises the aggregate quantity of goods and services demanded at each price level; it increases aggregate demand.

b) Interest rates

Changes in interest rates also affect investment and thus affect aggregate demand. We must be careful to distinguish such changes from the interest rate effect, which causes a movement along the AD curve. A change in interest rates that results from a change in the price level affects investment in a way that is already captured in the downward slope of the AD curve; it causes a movement along the curve. A change in interest rates for some other reason shifts the curve. We examine reasons interest rates might change in another chapter.

c) Tax policy

Investment can also be affected by tax policy. For example, a reduction in the tax rate on certain capital gains when the owner of an asset, such as a house or a factory, sells the asset for more than its purchase price. The lower capital gains tax could stimulate investment, because the owners of such assets know that they will lose less to taxes when they sell those assets, thus making assets subject to the tax more attractive.

Government Purchases

Any change in government purchases, all other things unchanged, will affect aggregate demand. An increase in government purchases increases aggregate demand; a decrease in government purchases decreases aggregate demand. For example, reductions in defense spending in the wake of the collapse of the Soviet Union in 1991 tended to reduce aggregate demand. Similarly, increased defense spending for the wars in Afghanistan and Iraq increased aggregate demand. Dramatic increases in defense spending to fight World War II accounted in large part for the rapid recovery from the Great Depression.

Net Exports

a) Foreign incomes

A change in the value of net exports at each price level shifts the AD curve. A major determinant of net exports is foreign demand for a country’s goods and services; that demand will vary with foreign incomes. An increase in foreign incomes increases a country’s net exports and aggregate demand; a slump in foreign incomes reduces net exports and aggregate demand. For example, several major U.S. trading partners in Asia suffered recessions in 1997 and 1998. Lower real incomes in those countries reduced U.S. exports and tended to reduce aggregate demand.

b) Exchange rates

Exchange rates also influence net exports, all other things unchanged. A country’s exchange rate is the price of its currency in terms of another currency or currencies. A rise in the U.S. exchange rate means that it takes more Japanese yen, for example, to purchase one dollar. That also means that U.S. traders get more yen per dollar. Since prices of goods produced in Japan are given in yen and prices of goods produced in the United States are given in dollars, a rise in the U.S. exchange rate increases the price to foreigners for goods and services produced in the United States, thus reducing U.S. exports; it reduces the price of foreign-produced goods and services for U.S. consumers, thus increasing imports to the United States. A higher exchange rate tends to reduce net exports, reducing aggregate demand. A lower exchange rate tends to increase net exports, increasing aggregate demand.

c) Foreign price levels

Foreign price levels can affect aggregate demand in the same way as exchange rates. For example, when foreign price levels fall relative to the price level in the United States, U.S. goods and services become relatively more expensive, reducing exports and boosting imports in the United States. Such a reduction in net exports reduces aggregate demand. An increase in foreign prices relative to U.S. prices has the opposite effect.

d) Various countries’ trade policies

The trade policies of various countries can also affect net exports. For example, a policy by Japan to increase its imports of goods and services from India, for example, would increase net exports in India.

The Multiplier

A change in any component of aggregate demand shifts the AD curve. Generally, the AD curve shifts by more than the amount by which the component initially causing it to shift changes.

Suppose that net exports increase due to an increase in foreign incomes. As foreign demand for domestically made products rises, a country’s firms will hire additional workers or perhaps increase the average number of hours that their employees work. In either case, incomes will rise, and higher incomes will lead to an increase in consumption. Taking into account these other increases in the components of aggregate demand, the AD curve will shift by more than the initial shift caused by the initial increase in net exports.

The multiplier is the ratio of the change in the quantity of real GDP demanded at each price level to the initial change in one or more components of aggregate demand that produced it:

Multiplier = Δ in real GDP demanded at each price level / initial Δ of any component of AD

We use the capital Greek letter delta (Δ) to mean ‘change in’. In the aggregate demand–aggregate supply model (AD-AS model) in this chapter, it is the number by which we multiply an initial change in aggregate demand to obtain the amount by which the AD curve shifts as a result of the initial change. In other words, we can use the following equation to solve for the change in real GDP demanded at each price level:

Δ in real GDP demanded at each price level = multiplier × initial Δ in any component of AD

Key concepts

1. Potential output is the level of output an economy can achieve when labor is employed at its natural level. When an economy fails to produce at its potential, the government or the central bank may try to push the economy toward its potential.

2. The AD curve represents the total of consumption, investment, government purchases, and net exports at each price level in any period. It slopes downward because of the wealth effect on consumption, the interest rate effect on investment, and the international trade effect on net exports.

3. The AD curve shifts when the quantity of real GDP demanded at each price level changes.

4. The multiplier is the number by which we multiply an initial change in aggregate demand to obtain the amount by which the AD curve shifts at each price level as a result of the initial change