DEMAND FOR GOODS & SERVICES & LOANABLE FUNDS

4 Introduction
 As shown in the circular flow of economic activity, year-to-year changes in economic activity
can be analyzed through the interaction of production, income, and aggregate expenditures
(Demand).
 Because expenditures determine output, output determines income (Wages & Rent), and income
determines expenditures, we can measure total economic activity as total income, total
expenditures (C+I+G+NX), or the total final value of all new goods and services produced
(GDP).
 In this section, we will focus on the idea that GDP is driven by demand and assume firms
decide how much to produce based on that demand. We will simply assume that if there is
excess demand, firms will increase production and sell the goods at the same price. If there is
excess supply, firms will cut back production. We assume for now that prices are fixed
(Horizontal Short Run Aggregate Supply Curve). Later we will relax this assumption and look
at the production decisions of firms in the short and long run.
 To analyze aggregate demand, we will work with the following equation that shows
output/income (GDP) is equal to the sum of expenditures by economic agents.
 Y=C+I+G+NX
 We have already identified that total expenditure in the economy is comprised of 4 components
and we will look at each one individually to both model them and discuss the factors that drive
them. Y=income or output (GDP)=
o Consumption (56%)
o Investment (20%)
o Government Spending (26%)
o Net Export (-2%)

4.1 Consumption & Private Savings

 Households decide how much of their income they want to spend today on goods and services
(consumption) and how much of their income they want to save for future consumption. This is
one of the most fundamental economic decisions as it sets the stage for the amount of funds to
supplied to the financial markets (savings) and the amount of expenditures in the goods market
(consumption). Because decisions to spend more today (assuming no change income) require
that savings decreases by the same amount (Y=C+S), we will look at both consumption and
savings together.
 Consumption expenditures are separated into:
o Durable (Cars, appliances, furniture)
o Non-durable goods (Food) and
o Services (haircuts, financial planning).
 “The fundamental psychological law, upon which we are entitled to depend with great
confidence both a priori from our knowledge of human nature and from the detailed facts of
experience, is that men are disposed, as a rule and on average, to increase their
consumption, as their income increases, but not by as much as the increase in their income”.
(Keynes)
 The basic assumption of the above quote is that individuals have a preference for savings and a
preference for how much they will spend today (consumption). Some people may have stronger
preferences for saving whereas others may have a stronger preference for consuming today.
 Therefore, every additional dollar in income will be allocated by the consumer between
consumption and savings depending on their preference. These preferences are represented by
the consumer’s Marginal Propensity to Consume (MPC) and the consumer’s Marginal
Propensity to Save (MPS). The MPC measures how much of their additional income goes to
consumption, and the MPS measures how much of their income goes to savings.
 The Marginal Propensity to Consume (MPC) measures the % of every dollar of additional
∆C
income that an individual decides to spend on consumption ( MPC= ). Naturally,
∆Y D
whatever the individual does not spend on consumption will be saved. Therefore, we can also
∆S
calculate the Marginal Propensity to Save (MPS= ¿. Taken together, the MPS and MPC
∆Y D
must equal 1 as there are only two options for individuals, spend or save.
o MPS+ MPC=1 ∆C=MPC*∆Y ∆S=MPS*∆Y
∆C ∆S
o MPS=1−MPC MPC= MPS=
∆Y ∆Y
 Including imports as part of the decision of households to consume, we also have the marginal
propensity to import. As such we have,
∆M
o MPS+ MPC + MPM =1 MPM = ∆M=MPM*∆Y
∆Y
 The primary factors affecting consumption are:
o Disposable Income
o Expected Future Income (Include Expectations)
o Wealth
o Price Level
o Interest Rate
4.1.1 Consumption Function:
 C=C A +mpc∗(Y −T )C=C A +mpc ( Y )−mpc(T )
 C=−S A + mps∗(Y −T ) S=−S A +mps ( Y )−mps(T )
 C = autonomous consumption + the marginal propensity to consume * disposable income.
 CA=Autonomous Consumption Expenditure: the amount of consumption that is independent
of disposable income. This is the amount consumption that is independent of current income
and is related to what we need to consume to survive and consumption based on future income
and household wealth.
 Our consumption function states that total consumption is comprised of autonomous
consumption (not dependent on income: even if income is zero we must consume for survival
by borrowing) plus the amount of income that the consumer decides to spend on consumption,
which is represented by the MPC multiplied by disposable income. Disposable income is net
income after taxes (Y-T=YD). The government takes part of our income through taxes.
 Taxes are technically a leakage, but because governments either spend the money or save in the
financial markets, introducing Government spending in total expenditures makes it a transfer.

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 The consumer’s total gross income will therefore be split between C, S, and T.
∆Y ∆C ∆S
o = + → 1=MPC+ MPS
∆Y ∆Y ∆Y
 According to Keynes, the MPC must be less than 1 and greater than 0.
 Total income (Y )=Conusmption+ Savings+ Taxes
o Y =C +T + S
o ∆ Y =∆ C+ ∆ S+∆ T
 Total income (Y )−Taxes=Conusmption+ Savings
o ∆ Y −∆ T =∆C +∆ S
 Disposable Income=Total income(Y )−Taxes
o ∆ Y D =∆ Y −∆ T
 Disposable income=Consumption+ Savings
o ∆ Y D =∆ C−∆ S
 What we see here is that an increase in income leads to an increase in both consumption and
savings. If we hold income constant, an increase in consumption must be met by a decrease in
savings, and an increase in savings must be met by a decrease in consumption. However,

4.1.2 Graphing Consumption & Private Savings

 The graph on the right shows the relationship between disposable income and consumption.
What we see is that at income of zero, the consumer consumes
Ca.
 Disposable Income: As shown, the primary driver of
consumption is disposable income, which is gross income less
taxes and includes any transfer payments from the government.
Because we are measuring income on the graph, as income
changes and drives changes in consumption, we move along the
curve.
o YDC & YDC
 Starting at zero income (Ca), as income increases, we see that
consumption moves to point K and as income increases further, we
move to point C. The slope of the line measures how much
consumption increases when income goes up or down. The slope of
the line measures ∆C/∆Y, which means the slope equals the MPC.
 A 45-degree line from the origin in a graph plots all the points
where the distance to the Y-axis equals the distance to the X-axis.
This means that along the 45-degree line consumption equals income. Until we include other
variables of expenditures, we will assume that consumption is the only expenditure. Therefore,
total production equals total consumption in equilibrium.
 We will also graph the relationship between savings and income. As we know, higher income
also leads to higher savings, and we also know that total income is split between consumption
and savings.
 Starting at point K, we see that income is at Y and total consumption is at C. You will also
notice that this point is on the 45-degree line, which means total income equals total
consumption (0 savings). In the bottom graph, point K is on the axis showing zero savings.

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 To the left of point K, we can see that consumption is above the 45-degree line, which means
consumption is greater than incomenegative savings
(borrowing). The savings curve goes below the x-axis showing
negative savings.
 To the right of Point K, say point D, we can see that
consumption is below the 45-degree line, which means savings
is positive and consumption is less than income.
 Assuming that there is an increase in income from Y to Y’, we
know that this will cause an increase in consumption. However,
we also know that as long as the MPC is less than 1, some % of
every extra dollar of income will go towards savings
(∆Y*MPS=∆S).
 As income increases from Y to Y’, we see that consumption
increases from C to C1 represented by the movement from point
K to D. We move along the curve because the variable that caused the change in consumption
(income) is measured on the x-axis. You will also notice that point K is below the 45-degree
line showing that total consumption is less than total income, which means there is positive
savings.

 Looking at the graphs on the right we see the following:

 Starting at Point K, an increase in consumption with no change
in income causes the consumption to shift upward (C-C’) from
point K to D which corresponds to a decrease in savings (S-
S’)movement from k to d. (Holding income constant
↑C→↓S)
 A decrease in consumption starting at point K in the top graph
moves the consumption line from C to C’’ (K to F), which
corresponds with an increase in savings from S to S’’ (k to f
bottom graph).
 Point H, K, and G in the top right graph corresponds with points
h, k, and g in the bottom right graph. Because H, K, and G are
points of consumption that are on the 45-degree line (Y=C),
savings must be zero as shown in the bottom graph (points h, k, and g are all on the axis at 0
savings). This would be the case if the MPC=1.

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4.1.3 Factors Affecting Consumption and Private Savings

 Disposable Income: As shown, the primary driver of

consumption is disposable income, which is gross income
less taxes and includes any transfer payments from the
government. Remember, because income is measured on
the axis, the increase in income represents a movement
along the curve. The same principles apply to savings.

 Wealth: The value of the individual’s wealth is determined by the difference

between their assets and liabilities. Assets are anything of
value owned by the individual and liabilities are anything
owed by the individual. On average, individuals with
higher wealth will more likely than not, spend more than
individuals with less wealth. When the price of stocks
you own increases, you are more likely to spend more of
your income (less savings needed to reach future
consumption target). Since income is unchanged, we
know that the increase in consumption will be accompanied by a decrease in savings. This
makes sense because the more wealth you have, the less is your need to save for future income.
As your wealth decreases, we would likely see a decrease in consumption and an increase in
savings.
o ↑W→↑C & WC
 Overall Price Level: The overall price level in the economy affects the purchasing power of
both income and wealth; however, when the overall price level increases so do wages and
income, as such, as the price level increases the real value of wealth decreases, but real income
stay the same. This would affect consumption in the same way as a decrease in wealth.
 ↑P→↓Real Wealth (Wealth/P)→↓C & P(Wealth/P)C
 ↑P→↓Real Wealth (Wealth/P)→S & P(Wealth/P)S

4.1.4 Prices & Consumption:

 Although it seems intuitive that higher prices would lead to lower consumption based on the
law of demand (PQ), at the macro level higher prices do not directly affect consumption.
We can see this from our circular flow of economic activity.
 Output=Income=Expenditures
 P*Y = Wages = C+I+G+NX
 Increases in prices would increase nominal output leading to an increase in nominal income.
The nominal income will then lead to higher expenditures. As such, higher prices will have
no effect on real output, income, and expenditures.
W W
 Real Wage= ∆ Real Wage=0
P P

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 Expected Future Income: The decision to save or
spend is partly based on the individual’s future
consumption needs. Since the individual saves to
support (defer consumption) future consumption, the
more an individual expects to earn in the future, the
less he/she must save today. As a result, increases in
expected future income will likely lead to higher
consumption today and less savings. Similarly, if I
expect to poor in the future, I would probably
decrease consumption today and save more.
o IFC & IFC
o IFS & IFS
 Expectations: Consumer expectations about the future and about the overall health play an
important role through what is called consumer confidence. Higher confidence about the
economy increases consumers expectations about income (both current and future), the stability
of their job, and about finding profitable job opportunities in the economy rather quickly (new
jobs or advancement in their current job). As such, when consumer confidence increases, or
consumers have more positive expectations they are willing to spend more and as a result save
less. There is less of a need for precautionary savings. Therefore, positive expectations will
increase consumption, and negative expectations will decrease consumption.
 Interest Rate: Interest rates affect consumption through two channels. First, interest rates affect
the cost of borrowing to finance purchases of some consumer goods (durables). In this situation,
higher interest rates will reduce consumption for those that finance consumption by borrowing.
Another way to think about this is that households that carry debt will see their interest
payments increase and will have less income for consumption. On the other hand, for lenders or
savers, the higher interest rate will lead to more interest income (a higher return to saving and
less of need to save for future income). This would lead to a decrease in savings and an increase
in consumption. As such, the effects of
higher interest rates on savers could
either increase or decrease
consumption. Research shows that
higher interest rates lead to increases in
savings and decreases in consumption.
Therefore, we assume that higher
interest rates will decrease
consumption.
o iCost of Borrowing/Lower
Income C & S
o iCost of Borrowing/Higher
Income C & S

4.2 Investment:
 There are three categories of investment spending:
o Fixed Investment: planned spending by firms on equipment and structures and planned
spending on new residential housing.

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o Residential Investment: includes all expenditures on new housing by individual’s and
landlords.
o Planned Inventory Investment: spending by firms on additional holdings of raw materials,
parts, and finished goods, it is calculated as the change in these holdings in a given year.
o Beginning of the Year Ford has 100K cars ($20k each) total inventory of 2B. End
of the year, total inventory 3B. The change in inventory investment is 1B.
 When constructing the aggregate expenditure model, we use planned investment rather than
actual investment. Since firms usually produce goods and services before they are purchased
and store them as inventories, and since inventories are included in investment, firms must set a
level of planned investment. (Planned Inventory)
 Essentially, firms will have a planned amount of inventories. When there is an increase in
inventories, firms did not sell as much as they thought they would. Since inventories not sold
are counted as investment, the excess supply of goods and services represents an increase in
investment.
o Inventories IP<IA
o Inventories IP>IA
 If a firm has unplanned inventory investment, it will cut production to keep from accumulating
inventory. On the other hand, an unplanned decrease in inventories will signal to the firm to
increase production.
o Inventories IP<IAProduction (Y)
o Inventories IP>IAProduction (Y)
 Adjusting production to eliminate unplanned inventory investment plays a key role in the
determination of aggregate output.
 An important point to keep in mind about investment (we will look more deeply into this later)
is that all investment is derived from savings.

4.2.1 Changes in Investment:

 Income: Investment spending by firms is not directly related total
income. As such, when we graph income and investment, investment
is a horizontal line.

 Interest Rate: Keynes considered the cost of borrowing to be the key

factor in determining planned investment. Although the level of investment in the economy
depends on many different variables, the primary variable affecting the level of investment by
firms, households and the government is the cost of borrowing funds.
 The real interest rate represents the cost of borrowing funds for firms. If firms are using retained
earnings (profits) to finance investment, then the real interest rate will represent the opportunity
cost of those funds.
 When deciding to invest, economic agents compare the return on the investment with the cost of
borrowing. As long as the return is greater than the cost, agents will increase investment. If the
returns are less than the cost, agents will decrease investment. The return on investments is
called the marginal productivity of capital (MPK)

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 A rise in the real interest rate (cost of borrowing) will decrease the number of investment
projects that yield a positive return to the firm and will cause a decrease investment.
 Economic agents will borrow funds for investment when the benefits of the investment project
are greater than the costs of acquiring the funds because the transaction
will lead to increased profit and utility.
 Since the real interest rate measures the cost of borrowing, when the
interest rate rises, the cost of borrowing increases and some
investments that were previously profitable will no longer be profitable
and agents will decrease their level of investment. On the other hand, a
decrease in the interest rate will lead to some projects that were not
previously profitable, to become profitable, and as a result, agents will
increase investment.
 rI & rI:
 Financial Frictions (FF): Directly related to the ability of firms to
borrow is the degree of financial frictions within the financial markets.
When firms apply to banks for loans, banks undertake a significant
process to evaluate the creditworthiness of the firm and evaluate the
likelihood that the funds will be properly used. In other words, banks
want to make sure that firms are going to pay back the funds and that
the firm will use the funds for the intended purpose. During the internet
boom of the late nineties, accounting scandals resulted in banks not
trusting firm’s financial statements which are the primary method for
evaluating much of the health and ability to repay of the firm. As such,
even though interest rates were low and firms wanted to borrow, banks were less willing to lend
due to the issues with financial statements. In the 2008 financial crisis, banks became skeptical
of how risk was being measured and there was a general increase in uncertainty in the markets.
This resulted in difficulties for firms with respect to accessing and getting loans.
o FFI
o FFI
 MPK: (Rate of Return on Projects)
o MPK (Positive Shocks)Inv
o MPK (Positive Shocks)Inv
o Expected Future Output or Positive ShockMPK
o Expected Future Output or Negative ShockMPK
 Expectations:
o Like consumption, Keynes believed there was a part of investment not explained by
interest rates. This part of investment is based on expectations about the economy. If firms
believe the economy will expand, they expect future profits to be higher and increase
investment. On the other hand, if firms believe that we are heading into a recession, they
will probably decrease investment. This provides an indirect link to output/income. Higher
outputhigher salesexpected future higher profitInv. However, we assume no
relationship between current output and investment to keep things somewhat simple.
 Taxes:

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 o Higher taxes reduce the after-tax profit to firms from investment projects. As a result, firms
will require a higher rate of return. Therefore, some projects that were profitable before the
increase in taxes are no longer profitable and as such, firms decrease their level of
investment.
 Cash Flow:
o Higher profits lead to greater cash flows, which allows firm to finance greater investment.

4.3 Government Spending:

 Governments receive income through taxes and the use taxes to purchase goods and services, to
purchase factors of production, to make transfer payments
(transfer payments are the opposite of taxes as they increase
the households disposable income) to households in the form
pensions and welfare payments.
 Taxes=Government Spending + Transfer Payments.
 We usually assume that taxes (T) used in disposable income is
net of transfer paymentsTaxes=Government Spending.
o If T>GGovernment (public) SavingsBudget Surplus
o If T<GGovernment Savings (public) or BorrowingBudget Deficit
 We will simplify our model by assuming that bot Gt and T are fixed.
 G&T are fixed by the government. As income increases in the economy government will collect
more taxes and increase government spending accordingly. This ensures leakages equals
injections for the funds transferred to the government.

4.4 Net Exports

 Net exports represents a more complicated component of aggregate expenditure as it deals with
the part of domestic agent’s consumption of foreign goods and services and the part of foreign
agent’s consumption of domestic goods and services.
 Net exports equals total exports (amount of domestic goods purchased by foreigners) minus
imports (amount of foreign goods purchased by domestic agents). Factors affecting imports and
exports are basically the same as domestic consumption. In other words, the decision to buy
foreign goods and services for consumption is the same as domestic consumption with two
other factors added: Foreign Prices and the Exchange Rate.
 Net exports equal the quantity of output sold to foreigners (exports) less the amount of domestic
expenditure spent on foreign produced goods and services. NX=Exports-Imports.

4.4.1 Price of Foreign Goods and The Exchange Rate

 The first important point to see with respect to foreign goods is that once a Canadian has
decided to buy a good, the choice between buying domestically or from foreign firms is based
on the difference between Canadian and foreign prices. If an individual can get the good
cheaper in a foreign country, they would purchase the good through imports.
 Net exports is complicated because we have to deal with two prices when estimating the cost of
a foreign good. First, we have the foreign price of the good (PF) which is stated in foreign
currency. Let’s assume that you want to buy a chocolate bar from Europe. The price of the
chocolate bar will be stated in terms of Euros. For example, assume the price of a chocolate bar
is 2 Euros.

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 In order to buy the chocolate bar, we have to covert Canadian dollars into Euros. Therefore, the
price of foreign goods is based on the actual price foreign firms set and the price of buying
Euros.
 The price of one currency in terms of another is called the exchange rate.
Can $
 ¿ of Canadian $ Per Euro=R= → if R=7.5→it costs $7.5 for 1 Euro
Euro
1 Euro 1
 ¿ of Foreign Dollars Per Canadian $= = → if R=7.5→it costs =0.13it costs
R Can $ 7.5
0.13 Euros for 1 Canadian dollar.
 As we can see, there are two ways to state the exchange rate, R which equals $ per unit of
foreign currency or 1/R which is units of foreign currency per Canadian $. Exchange rates are
usually quoted with both terms. Different textbooks use different versions. We will use R for
our purposes: Canadian $ per unit of foreign currency.
 When textbooks use units of foreign currency per $ (1/R) they usually call it E.
 The price of foreign currency is referred to as the exchange rate. It tells us how many Canadian
dollars we have to give up to buy 1 Euro. If the exchange rate between the Euro and dollar is 2,
we need two Canadian dollars per Euro. If the good costs 2 Euros and the exchange rate is 2, we
would need 4 Canadian dollars to buy the chocolate bar.
 Therefore, the price of foreign goods in Canadian $ is equal to the following:
P F∗Can $
P=P F∗R= Foriegn Price∗Number of Canadian $ Per Euro
Euro
 Therefore, when deciding to import a good rather than buy domestically, Canadians will
compare the domestic price of the good with the foreign price of the good converted into
Canadian dollars based on the exchange rate ( P F∗R ).
 The only real difference between imports and exports is who is buying and selling the goods.
Imports are purchased by Canadians and produced by foreigners, whereas exports are purchased
by foreign residents but produced by Canadian firms.
 Therefore, for foreigners, the price of our goods is given by
1
o Foreign Price of Canadian Goods P F =P*
R

 Consumption & Prices: Although changes in prices of Canadian goods do not affect
consumption (discussed above) because higher prices result in higher income leaving real
income unchanged, when either Canadian prices or foreign price change, there is an effect on
imports and exports. The effect is based on changes in relative prices. I buy domestically when
it is cheaper here relative to foreign countries, and I buy foreign goods when Canadian prices
are higher relative to foreign prices.
 If foreign prices increase (or Canadian prices decrease), we will buy less foreign goods and
more domestic goods because the price of Canadian goods has become relatively cheaper.
When foreign prices decrease relative to Canadian prices, we will buy more foreign goods.
 Canadian Price of Foreign Goods P= PF *R

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 F 1
 Foreign Price of Canadian Goods P =P*
R

Changes in R
 RAppreciation →When R decreases, it takes less Canadian $ to buy one unit of foreign
currency.
o Canadian Price of Foreign Goods PF *↓ R  Foreign goods become cheaper for
CanadiansImports.
1
o Foreign Price of Canadian Goods P* ↑  Canadian Goods become more expensive
↓R
for foreignersExports.
 RDepreciation →When R increases, it takes more Canadian $ to buy one unit of foreign
currency.
o Canadian Price of Foreign Goods PF *↑ R  Foreign goods become more expensive for
CanadiansImports.
1
o Foreign Price of Canadian Goods P* ↓  Canadian Goods become cheaper for
↑R
foreignersExports.
 When the Canadian dollar appreciates (R), foreign goods become cheaper and Canadians buy
more foreign goods and decrease consumption of domestic goodsImports. At the same time,
foreigners buy less Canadian goods and more domestic goodsExports
o Appreciation (R)Exports & ImportsNX
 When the Canadian dollar depreciates (R), foreign goods become more expensive and
Canadians buy less foreign goods and increase consumption of domestic goodsImports. At
the same time, foreigners buy more Canadian goods and less domestic goods Exports
o Depreciation (R)Exports & ImportsNX

4.6 Real Exchange Rate

 As discussed, when deciding to buy foreign or domestic goods, the consumer will compare
prices of goods in the two countries. The consumer will have to convert the foreign to Canadian
dollars to make the comparison. The foreign price of the good in dollars is given by R∗PF , and
of course, the price of the Canadian good (P) is already measured in Can $.
o If R∗PF > P Foreign Goods are Cheaper
o If R∗PF < P Doemstic Goods are Cheaper
o If R∗PF =PForeign Goods are the Same Price as Domestic Goods
R∗P F
 Real Exchange Rate=e= This equation shows how many units of the foreign
P
good the consumer could get per unit of domestic good. It is the real exchange rate.
o When measuring the difference between prices in two countries, we can use the
P F∗R
ratio of relative prices:
P

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 o This equation takes the foreign price level and multiplies it by R, which gives us
the foreign price in terms of domestic currency (Euro prices in terms of Canadian
dollars).
o It then divides the Euro price in terms of Canadian dollars by Canadian prices.
Therefore, if the ratio is greater than 1, then Euro prices are higher than Canadian
prices measured in Canadian dollars. Equal to 1 and the price levels are the same
when measured in the same currency. Less than 1 means the Euro prices in terms
of Canadian dollars is less than the Canadian price level.
o Example:
o Let’s assume that the exchange rate between the Canadian dollar ($) and the Euro is 2$ per €
(R=2), the price of a Liter of oil is $3 in Canada, and the price of Liter of oil in Europe is 9
Euros.
o Is the price of oil the same in Canada and Europe?
o Price Oil in Europe in Canadian $= R∗PF =2∗9 € =$18
o The cost of a liter of oil in Europe measured in Canadian $ is 18. 18 Canadian $ can be turned
into 9 Euros, which will buy you one unit of oil.
o Next, if we divide by 3the number of $ one would require to get a liter of oil in Canada.
2∗9 18
o e= = =6. This means that one unit of foreign good is equivalent in value to 6 units
3 3
of the same good in Canada
o Canadian residents can buy oil in Canada for $3 or in Europe for $18. Naturally Canadian
residents would choose domestic goods over foreign goods. On the other hand, foreign
residents can buy oil in their own country for 9 euros or could exchange 1.5 euros for $3 and
buy in Canada.
1 3 3 1
o Inverting the real exchange rate = = = This means that we can get 1/6 of a unit of
e 2∗9 18 6
foreign good with one unit of domestic goods.
 e=# of foreign goods per domestic good.
1
 =# of domestic goods per foreign good.
e
F
R∗P
 e= =1If the ratio of R*PF (the price of foreign goods in terms of $) to domestic
P
prices is equal to 1, then goods are the same price in Europe and Canada when measured in the
same currency. One Canadian good can be exchanged for one European good.
R∗P F
 e= >1If the ratio of R*PF (the price of foreign goods in terms of $) to domestic prices
P
is greater than 1, then goods are more expensive in Europe. More than one Canadian good is
needed to be exchanged for one European good.
R∗P F
 e= <1If the ratio of R*PF (the price of foreign goods in terms of $) to domestic prices
P
is less than 1, then goods are more expensive in Canada. Less than one Canadian good can be
exchanged for one European good

 e>1Foreign prices are greater than domestic.

 e<1Foreign prices are less than domestic prices.

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 e=1Foreign prices are equal to domestic prices

R∗P F
 The higher the real exchange rate, the higher the countries net exports will be. e=
P
o e: (Either an R (Dep $), PF, or P)Domestic Consumption & Imports
& ExportsNX
o e: (Either an R (App $) or PF, or P)Domestic Consumption &
Imports & ExportsNX

 High eForeign goods are relatively expensiveDomestic Consumption & Imports &
Exports
 Low eForeign goods are relatively cheapDomestic Consumption & Imports &
Exports

4.6.1 Purchasing Power Parity:

 If a good costs more in Europe, Canadians could profit by buying the good in Canada (lower
price) and selling it in Europe at the higher price.
 On the same note, if a good is cheaper in Europe, Canadians could buy the good in Europe at
the lower price and sell in Canada at a higher price earning a profit.
 The return on importing and exporting goods has two parts: the difference in price of the goods,
and the gain or loss on the foreign exchange transaction.
P F∗R
 If >1Forign Price > Domestic PriceBuy Canadian Goods (P) and sell them in
P
Europe for PF.
o In this situation, you buy the goods at P, ship them to Europe and sell at P F.
Because you sold them at PF, you will have to convert your return back into
dollars. P F∗R =Return in Can $
o This will require you to sell foreign currency(S€).
 If the return to selling goods in Europe ( P F∗R ¿ is greater than the cost or price of a good in
Canada, then the Canadian will earn a return by buying Canadian goods, selling them in Europe
and exchanging the Euros for Canadian $ (S€).
o Increasing the supply of Euros will cause R to decrease.
F
 P ∗R> P Buy goods in Canada and sell goods in Europe. This will lead to an increase in the
supply of €R  until P F∗R=P.

P F∗R
 if <1 Domestic Price > Foreign Price < Buy European Goods (PF) and sell them in
P
Canada for P.
o In this situation, you first buy Euros and then purchase the goods in Europe
P F∗R . You then ship the goods to Canada and sell at P.
o This will require you to buy foreign currency(D€).
 If the return to selling goods in Europe ( P F∗R ¿ is lower than the price of the goods in Canada,
then the Canadian will earn a return by buying Euros, buying European goods, and selling them
in Canada.

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 o Increasing the Demand of Euros will cause R to increase.
F
 P ∗R< P Buy goods in Europe and sell goods in Canada. This will lead to an increase in the
Demand of €R P F∗R=P

 Therefore, the prices of all goods should be the same around the world when measured in the
P F∗R
same currency. This is called the purchasing power parity ( =1 ¿. When exchanging
P
money into different currencies, you should be able to buy the same basket of goods in all
countries.
 Originally, the PPP was brought back into use to estimate the equilibrium exchange rates at
which countries could return to the gold standard after disruptions of international trade and the
large changes in commodities prices after WW1.
 According to the PPP, the equilibrium exchange rate is set to where the price of a good is the
same in two countries in terms of the same currency. Either price will be equivalent in terms of
dollars or in terms of Euros. This is the Law of One Price.
o R∗P F
e=
P
e∗P
o The formula for the real exchange rate can be written as R=
PF
P
o When e=1 and the PPP holds, R= .
PF
 If we assume that prices are constant in this analysis, changes in the real exchange rate will be
proportional to changes in the nominal exchange rate. The real and nominal exchange rate move
together.
R∗P F R= e∗P
 e= 
P PF

4.4.2 Imports
 When we purchase goods and services from other countries, our income is being injected
into their circular flow. If we take some of our income and spend it in Europe, that portion
of income is a leakage out of the domestic economy and will lead to a decrease in domestic
income.
 Imports allow a country to spend/consume more than it produces because the
expenditures are not flowed through the circular flow. If the expenditures were spent in
the domestic economy, we know they would translate into higher income.
 Because imports represent domestic consumption on foreign goods, there are two
variables that determine the quantity of imports purchased: foreign price of goods in
terms of domestic currency and consumer’s disposable income.
 Because imports are a function of income (imports are part of household’s consumption
decisions), as the consumer’s income increases they will consume more of both domestic
goods and foreign goods.
 Because imports represent a leakage out of the economy, unlike domestic consumption,
imports will not cause domestic income to increase. Since we now have two leakages that
increase with income (savings & imports) our multiplier is going to change.

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 In a closed economy we know that MPS+MPC=1: every dollar of income must be either
saved or consumed, with MPC representing the amount of income spent on domestic
goods. Since consumers can purchase foreign goods, which does not represent spending
on domestic goods, we now have MPS+MPC+MPM=1.
 In our closed economy analysis we had two ways of representing the multiplier:
1 1
o ∨
1−mpc mps
 Because the multiplier tells us how much domestic income increases when there is an
autonomous change in spending on domestic output (MPC measures changes in
domestic consumption from changes in income), our multiplier does not change when
1
measured as .
1−mpc
1
 However, if are measuring the multiplier using MPS, it now becomes to
mps+mpm
show the additional leakage (imports) that does not enter the income stream.
Income:
 YM & YM
∆M
 =Marginal Propensity to Import (MPM)
∆Y
 Income (Output): Higher income leads to increased consumption, which includes consumption
of foreign goods. Therefore, higher Income increases imports
and lower income decreases imports.
 Total spending on imports in Canandian $ equals the quanity
times the foreign price level times the exchnage rate. (Q*P F*R)
 Similar to the MPC, we also have the marginal propensity
∆M
to import: MPM= =Marginal Propensity to Import
∆Y
(MPM) which shows the relationship between changes in income and changes in imports. As
shown the graph, as income increases, Canadians buy more foreign goods and services.
 We can now expand our understanding of the MPC and MPS with the inclusion foo the MPM.
As discussed, every dollar of income must be either saved or consumed, which gave us:
o MPC+MPS=1
 However, we can now write this as
o MPC+MPM+MPS=1
 Therefore, our MPC which measures change in income and change in domestic consumption,
will now be lower as we include imports. Because imports are spent on foreign output, we do
not want to include them as part of Canadian consumption expenditures.
o YM YM

4.4.2.1 Imports & Changes in AE

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 As imports increase, aggregate
expenditures decrease because
imports represent spending on foreign
output.
o MC MC
 Therefore, increases in imports would
shift our consumption line down, and
decreases in imports would shift our
consumption line upward.
 It is important to note that when we include imports as part of income, our MPC decreases. This
causes the slope of the consumption line to flatter in an open economyAs income increases,
part of it is spent on imports, part on savings, and part on consumption.
 When we purchase goods and services from other countries, our income is being injected into
their circular flow. If we take some of our income and spend it in Europe, that portion of income
is a leakage out of the domestic economy and will lead to a decrease in domestic expenditures.

4.4.3 Exports
 Exports represent foreign consumption of our goods.
Therefore, exports become part of aggregate
expenditures on domestic goods and services. Exports
represent an injection into our circular flow. However,
exports are not a function of Canadian income or output
because Canadian income and output flows to domestic
residents for expenditures and not foreign residents.
 Therefore, when we graph exports with Canadian
income/output, it is a straight line.
 Similar to the relationship between Canadian imports of foreign goods and Canadian income,
foreign imports of Canadian goods (Exports) are a function of foreign income. If foreign
income grows, they buy more domestic and foreign goods. Therefore, as foreign income
increases, Canadian exports will increase.
o YFX YFX

4.5 Net Exports & Aggregate Expenditures

 Net exports is the difference between exports and imports. Net exports are an important
macroeconomic variable because exports represent an injection (expenditure) into the Canadian
economy (foreigners buying Canadian output) and imports represent a leakage as Canadians
buy foreign produced output.
o Imports: Canadian Income is leaked into foreign countries circular flow.
o Exports: Foreign income is injected into the Canadian circular flow.
 Therefore, the difference represents the net injection into the economy. If NX is positive, the
economy is receiving an injection, and if NX is negative the economy is experiencing a leakage.
 Calculating Import Expenditures:
o The amount of money Canadians spend on imports is based on the foreign price
(quoted in foreign prices) multiplied by the quantity of imports (Q).

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 o In order to get the expenditures into Canadian dollars, we multiply the
expenditures in foreign currency by R.
o M =R∗( P F∗Q)
 Real Import expenditures:
o Because aggregate expenditure is in real terms, we can now divide the total
amount of expenditures by the Canadian price level to see how many goods we
are giving up for these imports.

o R∗(P F∗Q) Imports in real terms.

M= =¿
P
o Setting
R∗P F =e
P
o M=e*Q

4.5.1 Determinants of Net Exports

 The three most important variables that influence net exports are the relative price level between
two countries, relative growth rates in output (income), and the exchange rate.
o NX=Imports and/or Exports
o NX=Imports and/or Exports

 Prices: Higher domestic inflation (prices) relative to the

foreign country would mean that Canadian prices are rising
faster than foreign prices. It is important to note that if the
price levels of the two countries are increasing or decreasing
at the same rate, both imports and exports will change by the
same amount leaving Net Exports unchanged.
 Canadian Prices relative to Foreign prices: Imports &
ExportsNX
 Canadian Prices relative to Foreign prices: Imports &
ExportsNX
 Foreign Price Level:
o PFM & XNX
o PFM & XNX
 Domestic Price Level:
o PM & XNX
o PM & XNX
 Exchange Rate: When the Canadian dollar appreciates (R), foreign goods become cheaper
and Canadians buy more foreign goods and decrease consumption of domestic
goodsImports. At the same time, foreigners buy less Canadian goods and more domestic
goodsExports
 When the Canadian dollar depreciates (R), foreign goods become more expensive and
Canadians buy less foreign goods and increase consumption of domestic goodsImports. At
the same time, foreigners buy more Canadian goods and less domestic goodsExports

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 o Appreciation (R)Exports & ImportsNX
o Depreciation (R)Exports & ImportsNX
 Income: When domestic income rises imports increase and when foreign income rises exports
increase. If domestic income rises faster than foreign income, imports will increase leading to a
decrease in net exports. On the other hand, if foreign income is growing faster than Canadian
income, exports will rise leading to higher net exports. Again, is they rise by the same amount,
there should be no change in Net Exports.
 Domestic Income:
o YM & No Change in XNX
o YM & No Change in XNX
 Foreign Income:
o YFX & No Change in MNX
o YFX & No change in MNX

Variable Change Effect Rational

Income Y MNX Higher income increases individual’s purchases of
Y MNX all G&S including foreign: ∆M=∆Y*MPM.
Foreign Income YF XNX ∆X=∆YF*MPMF
YF XNX
Domestic Price Level P M,XNX PP>R*PFForeign Goods are relatively
P M,XNX cheaper.
Foreign Price Level PF M,XNX PFP<R*PFDomestic goods are relatively
PF M,XNX cheaper.
Increased Preferences for PrefD M,XNX
Domestic Goods
Increased Preferences for PrefF M,XNX
Foreign Goods
Exchange Rate (R) RDepreciation $ M,XNX Depreciation makes foreign goods more expensive
RAppreciation $ M, XNX relative to domestic goods for both domestic and
foreign residents

4.5.1 Net Exports & the Real Exchange Rate

 As we have shown, R or PF leads to a higher price of foreign goods in terms of Canadian $
and P leads to foreign goods being more expensive relative to Canadian (Canadian goods
became cheaper.

o With e=
R∗P F , we can say that an increase in e leads to lower imports and
P
higher exports.
 As we have shown, R or PF leads to a lower price of foreign goods in terms of Canadian $
and P leads to foreign goods being cheaper relative to Canadian
(Canadian goods became more expensive).

o With e=
R∗P F , we can say that an de crease in e
P
leads to higher imports and lower exports.

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  e: (Either an R (Dep $), PF, or P)Domestic Consumption & Imports &
ExportsNX
 e: (Either an R (App $) or PF, or P)Domestic Consumption & Imports &
ExportsNX
 Changes in domestic or foreign income will shift the NX curve.
o YMNX (Shift NX Down) & YMNX (Shift NX up)
o YFXNX (up) & YFXNX (down)

16.4 NX & Income

 Measuring NX on the Y-axis and Income on the X-
axis, we can see that as income increases, NX declines
(YMNX).
 For this graph, an increase in R, PF, or P would shift
the NX curve upward at every level of doemstic
income showing higher exports and less imports for a
given level of income.
 On the other hand, decreaes in R, PF, or P, would
shift the NX curve downward for each level of income
reflecting the higher imports and lower exports.

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