Aggregate demand and supply


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Aggregate demand and supply

  1. 1. Aggregate demand and aggregate supply
  2. 2. 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
  3. 3. 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
  4. 4. 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
  5. 5. 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
  6. 6. 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
  7. 7. 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
  8. 8. 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
  9. 9. Consumption, plannedinvestment 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 + bY where A – part of AD independent of income or autonomous
  10. 10. Contd….AD AD = Y E AD = A + cY C = a + cY In equilibrium, withoutA G and NX I Y = AD Y = A + bYa Y = (1 / 1-c) A Planned I = S Y
  11. 11. 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
  12. 12. Derivation Y = AD dY = dAD dAD = dA + cdY dA – change in autonomous spending dY – change in income dY = dA + cdY dY = (1/1-c) dA α = 1 / 1 – c – multiplier Larger the MPC, greater the multiplier
  13. 13. Graphical derivationAD AD = Y E AD1 = A1 + cY AD = A + cY A1 dAA Y Y0 Y1
  14. 14. 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
  15. 15. 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
  16. 16. 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
  17. 17. 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 P AD Y
  18. 18. 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
  19. 19. 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
  20. 20. AS curve Represents the quantity of goods and services firms choose to produce and sell at each price level P AS Y
  21. 21. Equilibrium P AS E AD Y