AGGREGATE DEMAND &
2. INVESTMENT FUNCTION
Total spending in an economy by
AD = C+I+G+X-M
C = CONSUMPTION
I = INVESTMENT
G = GOVT SPENDING
X-M = NET EXPORTS
Factors affecting AD:
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.
Shifts of Aggregate demand curve:
Autonomous consumption (autonomous consumer spending) C
which depends upon:
consumer nominal wealth
consumer expectations and confidence concerning job
security and future income
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
Government spending G:
Net export spending X-M:
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
Intersection between AS-AD Curves, will
give us the four Macro variables
Equilibrium output or actual output may
not be the full employment output.
Putting AD and AS together
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
In this situation, the economy
would be operating at less than
capacity, there would be
unemployment and the economy
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.
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
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 =
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
Intersection with 45degree line
45 degree model
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-orless independent of the level of national
income. They are considered autonomous.
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
The size of the multiplier depends on mpc.
The aggregate demand line on the incomeexpenditure 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.
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
Eq. 2.: Y + ∆Y = a + b(Y + ∆Y) +
I + ∆I
Eq. 2.: Y + ∆Y = a + bY + b∆Y +
I + ∆I
I + ∆I
Y + ∆Y = a + bY + b∆Y +
= a + bY
∆Y - b∆Y = ∆I
(1 – b )∆Y = ∆I
∆Y = [ 1/(1 – b )] ∆I
∆Y = [ 1/(1 – b )] ∆I
1/(1 – b ) is the investment
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
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
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
Limitations of the Multiplier:
The process is subject to the availability of
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
Assumption of involuntary employment
The accelerator principle states that an
increase in capital stock is a function of
the increase in output(demand) and the
I = α (Yt – Yt-1)
Where α = acceleration coefficient or
capital output ratio.
It operates only if the existing capital
equipment in the economy is fully
firms increase their production capacity
to meet the increase in demand without
looking at the time period.
Capital output ratio is fixed- no
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.Required stock Net investment
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
Ignores the gestation period
Other factors which affect investment
are profitability of investment,
availability of funds,etc.
Full capacity requirement is not always
Acceleration principle is used to explain
the shape of business cycles.