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AGGREGATE DEMAND & SUPPLY 1. CONSUMPTION FUNCTION 2. INVESTMENT FUNCTION 3. MULTIPLIER

Aggregate demand &supply

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AGGREGATE DEMAND &SUPPLY

AGGREGATE DEMAND & SUPPLYCONSUMPTION FUNCTIONINVESTMENT FUNCTION3. MULTIPLIER

AGGREGATE DEMANDTotal spending in an economy by households,business,government and foreignersAD = C+I+G+X-MC = CONSUMPTIONI = INVESTMENTG = GOVT SPENDINGX-M = NET EXPORTS

Factors affecting AD:

MONEYTAXESPRICESTRADE Aggregate demand is a downward sloping curve because as price increases , real balances i.e. nominal balances / prices falls which implies that Aggregate Demand falls.

Chart1

5.4881163609

4.9658530379

4.4932896412

4.0656965974

3.6787944117

3.328710837

3.0119421191

2.7253179303

2.4659696394

2.2313016015

2.0189651799

1.8268352405

1.6529888822

1.4956861922

1.3533528324

1.2245642825

1.1080315836

1.0025884372

0.9071795329

0.8208499862

0.7427357821

Output

Price

Aggregate Demand

Sheet1

PQ

10.50.5

60.0833333333

110.0454545455

160.03125

210.0238095238

260.0192307692

310.0161290323

360.0138888889

410.012195122

460.0108695652

510.0098039216

560.0089285714

65.4881163609

74.9658530379

84.4932896412

94.0656965974

103.6787944117

113.328710837

123.0119421191

132.7253179303

142.4659696394

152.2313016015

162.0189651799

171.8268352405

181.6529888822

191.4956861922

201.3533528324

211.2245642825

221.1080315836

231.0025884372

240.9071795329

250.8208499862

260.7427357821

Sheet2

Sheet3

Autonomous consumption (autonomous consumer spending) C which depends upon:consumer nominal wealth consumer expectations and confidence concerning job security and future income money supply autonomous taxes Planned investment spending I, which depends upon:real interest rates (i.e., changes in interest rates not caused by changes in the price level) business profit expectations or the expected rate of return business taxes money supply Government spending G:Net export spending X-M: Shifts of Aggregate demand curve:

AGGREGATE SUPPLY

How much output would be willingly produced and sold, given prices and costs ?

Increase in labor and capital have led to a vast increase in the economys potential capacity to produce, shifting the aggregate supply curve to the right.

In the long run, the as becomes the primary determinant of growth.

PRICESCOSTPOTENTIAL OUTPUT TECHNOLOGYFactors affecting Aggregate Supply

Chart2

9.110594002

10.0687635374

11.1277046425

12.2980155558

13.5914091423

15.0208301197

16.6005846137

18.3464833381

20.2759998342

22.4084453517

24.765162122

27.3697369586

30.2482373221

33.4294722114

36.9452804947

40.8308495628

45.1250674972

49.8709122741

55.1158819032

60.9124698035

Output

Price

Aggregate Supply

Sheet1

PQ

69.110594002

710.0687635374

811.1277046425

912.2980155558

1013.5914091423

1115.0208301197

1216.6005846137

1318.3464833381

1420.2759998342

1522.4084453517

1624.765162122

1727.3697369586

1830.2482373221

1933.4294722114

2036.9452804947

2140.8308495628

2245.1250674972

2349.8709122741

2455.1158819032

2560.9124698035

Sheet1

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

Output

Price

Aggregate Supply

Chart1

65.85739633139.110594002

59.59023645510.0687635374

53.919475694111.1277046425

48.788359168912.2980155558

44.145532940613.5914091423

39.944530043815.0208301197

36.143305429516.6005846137

32.703815164118.3464833381

29.59163567320.2759998342

26.775619217822.4084453517

24.227582159424.765162122

21.922022886327.3697369586

19.835866586630.2482373221

17.948234306733.4294722114

16.240233988436.9452804947

14.694771390440.8308495628

13.296379003545.1250674972

12.031061246749.8709122741

10.886154394755.1158819032

9.850199834960.9124698035

Agg Demand

Agg Supply

Output

Price

Aggregate Demand-Supply

Sheet2

PQ

Agg DemandAgg Supply

665.85739633139.110594002

759.59023645510.0687635374

853.919475694111.1277046425

948.788359168912.2980155558

1044.145532940613.5914091423

1139.944530043815.0208301197

1236.143305429516.6005846137

1332.703815164118.3464833381

1429.59163567320.2759998342

1526.775619217822.4084453517

1624.227582159424.765162122

1721.922022886327.3697369586

1819.835866586630.2482373221

1917.948234306733.4294722114

2016.240233988436.9452804947

2114.694771390440.8308495628

2213.296379003545.1250674972

2312.031061246749.8709122741

2410.886154394755.1158819032

259.850199834960.9124698035

Sheet3

Sheet1

PQ

69.110594002

710.0687635374

811.1277046425

912.2980155558

1013.5914091423

1115.0208301197

1216.6005846137

1318.3464833381

1420.2759998342

1522.4084453517

1624.765162122

1727.3697369586

1830.2482373221

1933.4294722114

2036.9452804947

2140.8308495628

2245.1250674972

2349.8709122741

2455.1158819032

2560.9124698035

Sheet1

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

0

Output

Price

Aggregate Supply

Chart1

65.85739633139.110594002

59.59023645510.0687635374

53.919475694111.1277046425

48.788359168912.2980155558

44.145532940613.5914091423

39.944530043815.0208301197

36.143305429516.6005846137

32.703815164118.3464833381

29.59163567320.2759998342

26.775619217822.4084453517

24.227582159424.765162122

21.922022886327.3697369586

19.835866586630.2482373221

17.948234306733.4294722114

16.240233988436.9452804947

14.694771390440.8308495628

13.296379003545.1250674972

12.031061246749.8709122741

10.886154394755.1158819032

9.850199834960.9124698035

Agg Demand

Agg Supply

Output

Price

Aggregate Demand-Supply

Sheet2

PQ

Agg DemandAgg Supply

665.85739633139.110594002

759.59023645510.0687635374

853.919475694111.1277046425

948.788359168912.2980155558

1044.145532940613.5914091423

1139.944530043815.0208301197

1236.143305429516.6005846137

1332.703815164118.3464833381

1429.59163567320.2759998342

1526.775619217822.4084453517

1624.227582159424.765162122

1721.922022886327.3697369586

1819.835866586630.2482373221

1917.948234306733.4294722114

2016.240233988436.9452804947

2114.694771390440.8308495628

2213.296379003545.1250674972

2312.031061246749.8709122741

2410.886154394755.1158819032

259.850199834960.9124698035

Sheet3

AS-AD FrameworkIntersection between AS-AD Curves, will give us the four Macro variables PricesOutputEmploymentForeign trade

Equilibrium output or actual output may not be the full employment output.

Putting AD and AS togetherPricesoutputASYfADY1In this situation, the economy would be operating at less than capacity, there would be unemployment and the economy might be growing only slowly.AD 1Y2A shift in the AD curve to AD1 as a result of a change in any or all of the factors affecting AD would increase growth, reduce unemployment but at a cost of higher inflation (a trade-off)

Supply Side Policies:

These include reduced taxes to increase motivation, efficiency, better technology.

The shift of the supply curve will increase output but reduce prices.

Reaganomics followed Supply side policies.

Consumption Function:C= a +bYa= Autonomous consumptionbY = induced consumptionb = marginal propensity to consumeMpc = slope of the consumption function- it indicates the change in consumption due to a change in income.

mpc and mpsThe mirror image of mpc is mps. The increase in income is distributed between consumption and savingsHence mpc +mps =1If there are taxes, consumption is a function of disposable income.Hence C =f (YD)YD = Disposable income = Y-T where T = taxes.

Mpc and mpsMpc = dc/dyb = change in c due to a change in yHence b greater than or equal to zero.Average propensity to consume Apc =C/Y. If Y is very low apc may be greater than 1.

45 degree modelconsincomeC=a+bY45Degree lineIntersection with 45degree line gives y=c

45 degree model

Chart1

051015

15.610.615.6

26.211.216.2

36.811.816.8

47.412.417.4

581318

68.613.618.6

79.214.219.2

89.814.819.8

910.415.420.4

10111621

1111.616.621.6

1212.217.222.2

1312.817.822.8

1413.418.423.4

15141924

1614.619.624.6

1715.220.225.2

1815.820.825.8

1916.421.426.4

20172227

2117.622.627.6

2218.223.228.2

2318.823.828.8

2419.424.429.4

25202530

2620.625.630.6

2721.226.231.2

2821.826.831.8

2922.427.432.4

30232833

3123.628.633.6

3224.229.234.2

3324.829.834.8

3425.430.435.4

35263136

3626.631.636.6

3727.232.237.2

3827.832.837.8

3928.433.438.4

40293439

4129.634.639.6

4230.235.240.2

4330.835.840.8

4431.436.441.4

45323742

4632.637.642.6

45'

C

C+I

C+I+G

Income

Consumption

Sheet1

45'CC+IC+I+G

0051015

115.610.615.6

226.211.216.2

336.811.816.8

447.412.417.4

5581318

668.613.618.6

779.214.219.2

889.814.819.8

9910.415.420.4

1010111621

111111.616.621.6

121212.217.222.2

131312.817.822.8

141413.418.423.4

1515141924

161614.619.624.6

171715.220.225.2

181815.820.825.8

191916.421.426.4

2020172227

212117.622.627.6

222218.223.228.2

232318.823.828.8

242419.424.429.4

2525202530

262620.625.630.6

272721.226.231.2

282821.826.831.8

292922.427.432.4

3030232833

313123.628.633.6

323224.229.234.2

333324.829.834.8

343425.430.435.4

3535263136

363626.631.636.6

373727.232.237.2

383827.832.837.8

393928.433.438.4

4040293439

414129.634.639.6

424230.235.240.2

434330.835.840.8

444431.436.441.4

4545323742

464632.637.642.6

Sheet2

Sheet3

multiplierThe slope of the aggregate demand line is approximately equal to the marginal propensity to consume because none of the other three major components of aggregate demand depends strongly on national income. Government purchases, investment spending, and net exports are all more-or-less independent of the level of national income. They are considered autonomous.

MULTIPLIERY= C+I+GY is an endogenous variable whereas I and G are autonomous or exogenous variable.When any autonomous variable increase the effect on the eqm output is by a multiplied amount.The size of the multiplier depends on mpc.

multiplier

The aggregate demand line on the income-expenditure diagram slopes upward because consumption is higher when national income is higher. The slope of the aggregate demand line--the amount by which aggregate demand increases for every dollar increase in national income--is approximately equal to the marginal propensity to consume.

Shift of Investment Function:

Multiplier:Y = C + I, where C = a + bYEq. 1.: Y = a + bY + ISuppose I changes by I such that Y changes by Y. The new equilibrium is: Eq. 2.: Y + Y = a + b(Y + Y) + I + I Eq. 2.: Y + Y = a + bY + bY + I + I

MULTIPLIER Eq. 2.: Y + Y = a + bY + bY + I + IEq. 1.: Y = a + bY + I Y = bY + IY - bY = I (1 b )Y = I Y = [ 1/(1 b )] I

Multiplier:Y = [ 1/(1 b )] I1/(1 b ) is the investment multiplier.We can say, then, that if investment spending increases by I, then the equilibrium level of income will increase by 1/(1 b ) times that increase

multiplierNotice that with a high MPC, this economy is sensitive to even a small change in investment spending.

The size of the multiplier depends on the marginal propensity to consume: the higher the marginal propensity to consume, the higher the multiplier. A higher marginal propensity to consume means that a larger share of any increase in incomes is then spent on consumption. A higher marginal propensity to consume means that the aggregate demand line--the line representing total spending as a function of income--is steeper.

A steeper aggregate demand line means that even a small upward (or downward) shift in it will have a large effect on where it crosses the 45 degree income-expenditure line, and thus a large effect on national income. This is what we call a large value of the multiplier.

Limitations of the Multiplier:The process is subject to the availability of consumer goodsInvestments have to be repeated at regular intervals to make the multiplier work.Mpc has to remain constantNo time lags between income receipts and spendingAssumption of involuntary employment

Accelerator Model:The accelerator principle states that an increase in capital stock is a function of the increase in output(demand) and the accelerator coefficient.I = (Yt Yt-1)Where = acceleration coefficient or capital output ratio.

Assumptions:It operates only if the existing capital equipment in the economy is fully utilized. firms increase their production capacity to meet the increase in demand without looking at the time period.Capital output ratio is fixed- no technological changes

There is no ceiling on investment.An increase in the rate of growth of output is accompanied by net investment. Replacement investment is not explained by this principle.

outputRequired stock of capitalNet investment3060-408020601204070140208016020951903095190090180-10

limitationsIf there is excess capacity in an industry there is no investment required.Lumpiness of capitalIn case of an output decline investment should fall but only to the extent of depreciation.Ignores the gestation period

Other factors which affect investment are profitability of investment, availability of funds,etc.Full capacity requirement is not always satisfied.Acceleration principle is used to explain the shape of business cycles.