ECON 2105 1nd Edition Lecture 12 Outline of Last Lecture I. Multiplier Effect II. Chain Reaction of Multiplier EffectIII. Practice IV. More practice V. What drives investment spending?VI. Inventories and unplanned investment spendingOutline of Current Lecture I. Actual Investment Spending II. Aggregate Demand and Price Level III. Wealth Effect IV. Interest Rate Effect V. Exchange Rate Effect (Trade Effect) VI. Shifts on the AD curve Current LectureModule 17 Aggregate Demand: Introduction and Determinants I. Actual Investment Spending - Actual investment spending = I (planned) + I (unplanned) - Say, firms underestimated their sales- Which means sales > expected sales These notes represent a detailed interpretation of the professor’s lecture. GradeBuddy is best used as a supplement to your own notes, not as a substitute.- Firms will sell from inventory - Therefore, inventory spending will fall  I (unplanned < 0 - A reduction in inventories  negative investment spending - In equilibrium…. I (unplanned) = 0 (inventory is at desired level, still have products in inventory but the amount they want) and I = I (planned) - In good times inventory should go down - Next period production should go up to replace what was sold from the inventory - If the economy is bad, (you produce enough be no one is buying, less than expected sales) sales are lower, unsold products will be added to inventory. This will increase I (unplanned) = ^inventories - So I > I (planned), next period production will go down - I (unplanned) = In good times it is negative and in bad times it is positive - I (planned) = in good times its higher than actual investment II. Aggregate Demand and the Price Level - Aggregate demand in the economy- measures overall demand for US GDP.AD= C + I (planned) + G + X – IM o Households o Agent in production process - Companies, firms, stores, o Government - How about the role of aggregate prices (P) in the level of aggregate demand in the economy?- Aggregate demand curve: the relationship between the aggregate price level and the quantity of aggregate output demanded by households, businesses, the government, and the rest of the world. (negative demand curve) - Higher price level = lower total demand- A movement down the AD curve leads to a lower aggregate price level and higher aggregate output - Recall: GDP = C + I + G + X − IM- Why does a rise in the aggregate price level reduce C, I, and X − IM? - Why does the AD curve slope downward?III. Wealth Effect - The wealth effect: A higher aggregate price level reduces the purchasing power of households’ wealth and reduces consumer spending (real wealth falls)- Wealth: money in the bank, bonds, stocks, retirement accounts, houses, etc. - Hidden assumption: people try to restore their wealth when it goes down, vice versa. - How consumers will respond to change in wealth - When prices go up, real wealth falls and buying power of your wealth fallso If this happens people will adjust their consumption and consume less o Consumer spending goes down, aggregate demand goes down IV. Interest Rate Effect - The interest rate effect: A higher aggregate price level makes households hold more money (transactional money demand) and leads to a rise in interest rates (and a fall in investment spending and consumer spending).- When the prices rise, people tend to carry more cash, so we have less money in the banking sector. Banks, then need to offer good interest on deposits to attract more money into the banking sector. - At higher interest rate, people tend to save more and consume less. - At higher interest rate, firms tend to reduce their investment spending. - Interest rate high, lower investment spending will be o If the aggregate price level rises, the purchasing power of the money we are holding begins to decrease. Consumers respond to this by holding more money, or by selling assets like bonds. A decrease in the quantity of money available for lending to other borrowers tends to increase the interest rate. o Higher interest rates decrease investment spending by firms and consumption spending by households. So through the interest rate effect, higher price levels lower the quantity of aggregate output demanded.VII. Exchange Rate Effect (Trade Effect) - Prices go up, exports goes down, aggregate demand goes down - Prices go up, imports go up, aggregate demand falls VIII. Shifts on the AD curve - What happens when something changes spending patterns at every price level?- The aggregate demand curve shifts because of changes in:o expectations. When expectations go up people will buy more o wealth.  shock to stock market, housing marketo Size of the existing stock of physical capital.  investment spending, if there is an increase in physical stock there will be less investment spending o government policies.  G spending goes up will directly affect demand  Fiscal policy  tax cut, C indirect  Monetary policy  rate, indirect - CHANGES IN WEALTH: A MOVEMENT ALONG VS. A SHIFT OF THE AGGREGATE DEMAND CURVE- Q: Which is it: Does a change in wealth move us along the AD curve (wealth effect) or shift it?- A: it depends on the source of the change in wealth.o If it’s a change in price level that affects our wealth, it’s a movement along the AD. Example: Rapid inflation shrinks our wealth.o If it’s a change in something else that affects our wealth, it’s a shiftin the AD. Example: The housing market crashes.- Impact in inflation expectation (pie^e) is to increase, What will happen toAD curve? o You will have to pay more in the future o Consumer spending now will rise o Positive demand shock o What will happen to exantc real interest rate? If there is a increasein pie^e, then exantc real interest rate falls - Show the impact of the government default (if the debt limit will not be increased) on AD curve.o Interest rate will rise o Government spending will decrease o Investment spending will go down o Because of pessimism investment spending will go down and consumer spending will go down, saving will go up o Total demand will fall - Increase in tax cuts on AD Curve o Will increase our disposable income (YD goes up = Y + TR- T) o C goes up = A +MPC x YD goes up o AD goes up = C goes up + I + G + X – IM - Show the impact of the “fiscal cliff” (if it had not been avoided ) (cuts on government spending) on