Aggregate demand and aggregate supply

Keynesian theory General theory of employment, interest and money Level of output/income and employment depends

on level of aggregate demand Increase in aggregate demand – increase in output

– increase in employment – full employment Full employment output can be produced if there is

sufficient aggregate demand Inadequate aggregate demand leads to

unemployment

Concept of aggregate demand Total amount of goods and services demanded in

the economy AD = C + I + G + NX Actual and planned aggregate demand

Actual demand in accounting context Planned or desired demand in economic context

Equilibrium income/output when quantity of output produced = quantity of output demanded

In equilibrium, AD = C + I + G + NX = Y Y = AD means actual AD = planned AD at

equilibrium level of income/output

Consumption demand Keynes – psychological law of consumption – C

varies with the level of disposable income Franco Modigliani – life cycle theory of

consumption – individuals plan consumption over long periods to allocate it over entire lifetime – C as a function of wealth and labour income

Milton Friedman – permanent income theory of consumption – consumption related to longer term estimate of income called permanent income

Consumption function Demand for consumption goods depends mainly on

level of income in Keynesian analysis C = a + cY where a > 0 and 0 < c < 1 a – intercept representing minimum level of

consumption when income is zero c – slope of consumption function known as

marginal propensity to consume MPC – additional consumption out of additional

income – increase in C per unit increase in Y MPC = dC / Dy

Consumption and savings

S = Y – C S = Y – (a + cY) S = - a + (1 - c)Y (1 – c) – marginal propensity to save MPS = dS / dY Savings increase as income increases Paradox of thrift

Investment demand Investment is the flow of spending that adds to

physical stock of capital Gross and net investment Financial and real investment Planned and unplanned investment Induced and autonomous investment

Induced investment – depending on profit expectations / anticipated changes in demand and level of income / rate of interest

Autonomous investment – not depending on income or rate of interest – e.g. Government investment in infrastructure

Investment function

Keynesian investment function Volume of induced investment

depends on MEC – marginal efficiency of capital –

determined by expected income flow from capital asset and its purchase price

Market rate of interest

Consumption, planned investment and AD

Assuming planned investment spending constant and equal to I and also assuming G and NX equal to zero,

AD = C + I= (a + I) + bY= A + bYwhere A – part of AD independent of income or autonomous

Contd….

In equilibrium, withoutG and NXY = ADY = A + bYY = (1 / 1-c) A Planned I = S

AD = Y

AD = A + cY

C = a + cY

a

A

E

AD

Y

I

Multiplier

An increase in autonomous spending brings about more than proportionate increase in equilibrium level of income

Multiplier effect – known as investment or income multiplier

Ratio of change in income due to change in autonomous investment

Amount by which equilibrium output changes for change in autonomous aggregate demand by one unit

Derivation

Y = ADdY = dADdAD = dA + cdY

dA – change in autonomous spendingdY – change in income

dY = dA + cdYdY = (1/1-c) dAα = 1 / 1 – c – multiplierLarger the MPC, greater the multiplier

Graphical derivation

AD = Y

AD1 = A1 + cY

A

A1

E

AD

Y

dA

AD = A + cY

Y1Y0

Government spending Governments affect AD in two ways

G – government spending Taxes and transfers affecting YD

Consumption now depends on YD and not Y C = a + cYD = a + c (Y + TR – TA) TA = t Y C = a + cTR + c (1-t) Y Assuming that G and TR are constant,

AD = (a+ cTR+ I+ G) + c(1-t) Y = A + c(1-t) Y

Contd…. In equilibrium, Y = AD Y = A + c(1-t) Y Y [1-c(1-t)] = A where A = a+ cTR+ I+ G Y = A / 1-c(1-t) Multiplier in presence of taxes = α = 1 / 1–c(1-t) Government spending can increase A by the amount

of purchases G and by the amount of induced spending out of transfers bTR

Increased A will increase Y depending on the value of MPC and tax rate

When tax rates (t) are higher, value of multiplier is lower

Government budget Plan of the intended expenses and revenues of the

government Budget surplus = TA – G – TR BS = tY – G – TR At low levels of income, budget is in deficit, since

govt spending (G+TR) > tax collection (tY) At high levels of income, budgets are in surplus Budget deficits typically persist during recessions

when tax collections are low and transfers like unemployment allowances increase

AD curve Represents the quantity of goods and services households,

firms and government want to buy at each price level When prices fall

real wealth of households increases inducing more consumption

Interest rates fall inducing more investment Exchange rates depreciate inducing more exports

AD

P

Y

Aggregate supply Total amount of goods and services produced in the

economy over a specific time period Classical AS – vertical line indicating that same amount

of goods and services will be supplied irrespective of price level Assumption – labour market is always in equilibrium with full

employment Keynesian AS – horizontal line indicating that firms will

supply whatever amount of g & s is demanded at existing price level Assumption – unemployment leading to hiring labour at

prevailing wage rate In practice, AS is positively sloped lying between

Keynesian and classical AS

Contd…. Upwards sloping AS in the short run

Misperceptions – changes in price level can mislead the suppliers about individual markets in which they sell their output, resulting in changes in supply

Sticky wages – nominal wages are sticky or slow to adjust in the short run - slow adjustments can be due to long-term contracts or work/social norms When P falls, W/P (real wage) rises, increasing the real cost to the

firm, thus making employment and production less profitable Firms cut down on employment and production and thus on supply

Sticky prices – prices of some goods and services are slow in adjustment – they lag behind when overall price level declines thus affecting their demand – this induces firms to reduce supply in the short run

AS curve Represents the quantity of goods and services firms choose to

produce and sell at each price level

PAS

Y

Equilibrium

AS

Y

AD

P

E