AGGREGATE DEMAND & SUPPLY

1. CONSUMPTION FUNCTION2. INVESTMENT FUNCTION3. MULTIPLIER

AGGREGATE DEMAND

Total spending in an economy by households,business,government and foreigners

AD = C+I+G+X-M C = CONSUMPTION I = INVESTMENT G = GOVT SPENDING X-M = NET EXPORTS

Factors affecting AD:

1. MONEY2. TAXES3. PRICES4. TRADE

Aggregate Demand

Output

Pri

ce

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.

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 economy’s potential capacity to produce, shifting the aggregate supply curve to the right.

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

1. PRICES2. COST3. POTENTIAL

OUTPUT 4. TECHNOLOGY

Aggregate Supply

Output

Pric

e

Factors affecting Aggregate Supply

Aggregate Demand-Supply

Output

Pric

e Agg Demand

Agg Supply

AS-AD Framework

Intersection between AS-AD Curves, will give us the four Macro variables

1. Prices2. Output3. Employment4. Foreign trade

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

Putting AD and AS together

Prices

output

AS

Yf

AD

Y1In this situation, the economy would be operating at less than capacity, there would be unemployment and the economy might be growing only slowly.

AD 1

Y2

A 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 +bY a= Autonomous consumption bY = induced consumption b = marginal propensity to consume Mpc = slope of the consumption

function- it indicates the change in consumption due to a change in income.

mpc and mps The mirror image of mpc is mps. The increase in income is distributed

between consumption and savings Hence mpc +mps =1 If there are taxes, consumption is a

function of disposable income. Hence C =f (YD) YD = Disposable income = Y-T where T =

taxes.

Mpc and mps

Mpc = dc/dy b = change in c due to a change in

y Hence 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 model

cons

income

C=a+bY

45Degree line

Intersection with 45degree line gives y=c

45 degree model

Income

Co

nsu

mp

tio

n 45'

C

C+I

C+I+G

multiplier The 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.

MULTIPLIER

Y= C+I+G Y 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 + bY Eq. 1.: Y = a + bY + I Suppose 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

+ I Eq. 1.: Y = a + bY + I

Y = bY + I Y - bY = I (1 – b )Y = I Y = [ 1/(1 – b )] I

Multiplier: Y = [ 1/(1 – b )] I 1/(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

multiplier

Notice 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 goods Investments have to be repeated at

regular intervals to make the multiplier work.

Mpc has to remain constant No time lags between income receipts

and spending Assumption 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 = α (Yt – Yt-1) Where α = 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.output Required

stock of capital

Net investment

30 60 -

40 80 20

60 120 40

70 140 20

80 160 20

95 190 30

95 190 0

90 180 -10

limitations

If there is excess capacity in an industry there is no investment required.

Lumpiness of capital In 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.