Macroeconomics
December 17 2011
Aggregate Demand and
Supply

2
Aggregate Demand and Aggregate Supply

»Some countries are rich and some are not!
»Aggregate Demand and Aggregate Supply
a...
Aggregate Demand and Aggregate Supply

»Aggregate Supply (AS) curve describes, for
each given price level, the quantity of...
Aggregate Demand and Aggregate Supply

»Difference in the micro and macro economic
concepts of demand and supply

»Equilib...
Aggregate Supply curve

»Classical Supply curve:
»Vertical – indicating that the same
amount of goods will be supplied
wha...
Aggregate Supply curve

»Classical Supply curve:
»Potential GDP
»Shift of vertical AS curve
»Does potential GDP grow over ...
Aggregate Supply curve

» Keynesian Supply curve:
» Horizontal– indicating that firms will supply
whatever amount of goods...
Aggregate Demand curve

»AD curve shows the combination of the price
level and level of output at which the goods
and mone...
AD in Alternative Supply assumptions

»Equilibrium under Keynesian case
»Given perfectly elastic supply, shifting AD
to th...
Supply side economics

»Some supply-side policies:
»Removing regulations, maintaining an
efficient legal system, technolog...
Income, Spending,
Multiplier

12
Introduction

»Attempt to answer the most fundamental
question of – Why does output fluctuate?

»Uneven growth observed
»R...
AD and Equilibrium Output

»Aggregate Demand is the total amount of
goods demanded in the economy

»AD = C + I + G + NX
»O...
Consumption function and AD

»Major part of AD is Consumption
»Other components of AD?
»Link between consumption and incom...
Consumption function, Saving and AD
−
»What do C, C and c mean?

»What is Marginal Propensity to Consume?
»Increase in con...
Consumption function, Saving and AD

»Budget Constraint?
»S ≡ Y – C
»Relationship between Consumption, Income,
Saving and ...
Consumption, AD and Autonomous Spending

»Removing the assumption in the real world
scenario!

»Another assumption of all ...
Equilibrium Income and Output

»Aggregate demand schedule is a vertical
addition of all components

»The equilibrium level...
Formula for equilibrium output

»Y = AD
»Substituting for AD with Autonomous
spending?

»Equilibrium level of income and o...
Savings and Investment

»In equilibrium, planned investment equals
saving, assuming that there is no G or NX

»What do the...
Multiplier

»By how much does a Re. 1 increase in A
raise the equilibrium level of output and
income?

»The Multiplier tab...
Multiplier

»The 3 most critical observations from a
multiplier effect
−
»An increase in autonomous demand (A)
leads to an...
Government Sector

»What are people’s expectations from the
Government during booms and troughs?

»What is the primary sou...
Government Sector

»Fiscal policy is the government’s policy
regarding the level of government
purchases, level of transfe...
Equilibrium Income and Taxes

»Equilibrium Income with YD:
−
»Y0 = A/1-c(1-t)

»Effect of taxes on the multiplier
»Automat...
Government Sector - Recap

»Government Purchases and transfer
payments act like increases in autonomous
spending in their ...
Budget

»Is there a reason to fear government budget
deficit?

»Budget surplus is the excess of the
government’s revenues,...
Some key terms to recall

» Aggregate

»

Demand

» Automatic
stabilizer

» Budget constraint
» Budget
surplus/deficit

» ...
Case Discussion – Should
Energy be Subsidized?

30
Case Analysis

»What are subsidies?
»Financial assistance given to energy
companies

»Direct Assistance – Grants, Tax
brea...
Case Analysis

»Reasons
»Primary: Access to poorer sections of the
society

»Secondary: Keeping the prices under
control

...
Case Analysis – Effects/Impacts of subsidies

»Short-term and long-term impacts:
»Cost Angle:
»Per unit cost of generating...
Case Analysis – Some statistics
Year

Countries/Economies

1992

$ 230 bn

Global

1997

$ 58 bn

US and 20 largest
countr...
Case Analysis – Arguments FOR subsidies

»Essential for all economic activities
(subsidized kerosene, LPG, electricity…)

...
Case Analysis – Arguments AGAINST subsidies

»Leads to increased consumption
»Irresponsible usage of energy
»Leads to fast...
Case Analysis – Arguments AGAINST subsidies

»Majority of the subsidies flows into nuclear
power

»High cost of insurance ...
Subsidies – Renewable Resource
FOR

»Social Costs will
come down

»Cleaner fuel
»Reduced health care
costs

»Tariff arrang...
Points for discussion

»Impact of subsidies on economy
»Who are the beneficiaries and who pays for
them?

»Are subsidies e...
Questions???
Have a happy Sunday!
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Macroeconomics 17 dec

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Macroeconomics 17 dec

  1. 1. Macroeconomics December 17 2011
  2. 2. Aggregate Demand and Supply 2
  3. 3. Aggregate Demand and Aggregate Supply »Some countries are rich and some are not! »Aggregate Demand and Aggregate Supply answer questions about equilibriums in goods, money market, unemployment, GDP levels etc »Provides a “big picture” view of the economy »Describes the overall relationship between overall price level and output 3
  4. 4. Aggregate Demand and Aggregate Supply »Aggregate Supply (AS) curve describes, for each given price level, the quantity of output firms are willing to supply »Aggregate Demand (AD) curve shows the combinations of the price level and level of output at which the goods and money markets are simultaneously in equilibrium 4
  5. 5. Aggregate Demand and Aggregate Supply »Difference in the micro and macro economic concepts of demand and supply »Equilibrium state of AS and AD »Shift in AD curve »Shift in AS curve 5
  6. 6. Aggregate Supply curve »Classical Supply curve: »Vertical – indicating that the same amount of goods will be supplied whatever be the price level »Assumption: Labor market equilibrium »Long term possibility »Why should supply curve be vertical in long run? Recall how it was in microeconomics! 6
  7. 7. Aggregate Supply curve »Classical Supply curve: »Potential GDP »Shift of vertical AS curve »Does potential GDP grow over time? »Changes in potential GDP do not depend on the price level »Potential GDP changes very little over time 7
  8. 8. Aggregate Supply curve » Keynesian Supply curve: » Horizontal– indicating that firms will supply whatever amount of goods is demanded at the existing price level » Assumption: Unemployment » Why should supply curve be horizontal in the short run? » Short-run price stickiness » Price level does not depend on GDP - inflation 8
  9. 9. Aggregate Demand curve »AD curve shows the combination of the price level and level of output at which the goods and money markets are simultaneously in equilibrium »Expansionary policies’ effects? »Do consumer and investor confidence have an effect on AD? »Depends on real money supply »AD curve slopes downwards and shifts 9
  10. 10. AD in Alternative Supply assumptions »Equilibrium under Keynesian case »Given perfectly elastic supply, shifting AD to the right will increase output but leave the equilibrium price level unchanged »Equilibrium under Classical case »Given perfectly inelastic supply, shifting AD to the right results in an increase in the price level but no change in output 10
  11. 11. Supply side economics »Some supply-side policies: »Removing regulations, maintaining an efficient legal system, technological progress »What is the effect of cutting tax rates? »Does it have an effect on AD or AS? »Only supply-side policies permanently increase output 11 »AS and AD in the long run
  12. 12. Income, Spending, Multiplier 12
  13. 13. Introduction »Attempt to answer the most fundamental question of – Why does output fluctuate? »Uneven growth observed »Relationship between output and spending »Spending  Output and Income  Spending »Spending and output feedback leads to an increase in Aggregate Demand 13
  14. 14. AD and Equilibrium Output »Aggregate Demand is the total amount of goods demanded in the economy »AD = C + I + G + NX »Output at its equilibrium level is when Y = AD »What happens when Y is > or < than AD at any point in time? »Concept of unplanned inventory investment or disinvestment 14
  15. 15. Consumption function and AD »Major part of AD is Consumption »Other components of AD? »Link between consumption and income »Assumption to start with – No G or NX »Relationship between consumption and income is described by the consumption function and denoted by − »C = C + cY 15
  16. 16. Consumption function, Saving and AD − »What do C, C and c mean? »What is Marginal Propensity to Consume? »Increase in consumption per unit increase in income ~ out of a Re. 1 increase in income, a fraction of it goes towards consumption »If only a fraction of it spent on consumption, what happens to the remaining? Mathematical notation? 16
  17. 17. Consumption function, Saving and AD »Budget Constraint? »S ≡ Y – C »Relationship between Consumption, Income, Saving and Aggregate Demand − »S ≡ −C + (1-c)Y »How would you interpret the role of MPC and MPS here? »Saving is an increasing function of income 17 (Example)
  18. 18. Consumption, AD and Autonomous Spending »Removing the assumption in the real world scenario! »Another assumption of all other components being autonomous. How will the Y curve be denoted? »Concept of Disposable Income and its role in the consumption function (YD = Y – TA + TR) »What will be the new consumption function 18 and AD?
  19. 19. Equilibrium Income and Output »Aggregate demand schedule is a vertical addition of all components »The equilibrium level of income is such that aggregate demand equals output, which in turn equals income »Refer to the 45◦ line and where it intersects − − the A and C curve »At that level of output, planned spending 19 precisely matches production
  20. 20. Formula for equilibrium output »Y = AD »Substituting for AD with Autonomous spending? »Equilibrium level of income and output equation: − »Y0 = A/(1-c) »From the equation, what are the things that would equilibrium output higher? 20
  21. 21. Savings and Investment »In equilibrium, planned investment equals saving, assuming that there is no G or NX »What do the distances between the curves in the graph signify? »What uses is income put to? »Y = C + S and Y = C + I »Including G and NX; Y = C + TA – TR »I = S + (TA – TR – G) - NX 21
  22. 22. Multiplier »By how much does a Re. 1 increase in A raise the equilibrium level of output and income? »The Multiplier table − »∆ AD = ∆ A / (1-c) »Multiplier indicates how much would be the amount spent on demand/consumption for every Re. 1 the autonomous spending rises ~ 1/(1-c) 22
  23. 23. Multiplier »The 3 most critical observations from a multiplier effect − »An increase in autonomous demand (A) leads to an increase in equilibrium income »The increase in income is a multiple of the increase in A − »The larger the MPC, the larger the multiplier 23
  24. 24. Government Sector »What are people’s expectations from the Government during booms and troughs? »What is the primary source of income for the Government? »Government purchases of goods and services is a critical part of AD »Taxes and transfers – R’ship amongst output, income and Disposable Income (YD) 24
  25. 25. Government Sector »Fiscal policy is the government’s policy regarding the level of government purchases, level of transfers and the tax structure (recall budget surplus) »Assumptions regarding G and TR »How can we substitute in our consumption function? »MPC for income and MPC for YD – Difference 25 »AD function with Disposable Income
  26. 26. Equilibrium Income and Taxes »Equilibrium Income with YD: − »Y0 = A/1-c(1-t) »Effect of taxes on the multiplier »Automatic Stabilizers »Any mechanism in the economy that automatically controls the change in output to a change in autonomous demand – Examples? 26
  27. 27. Government Sector - Recap »Government Purchases and transfer payments act like increases in autonomous spending in their effects on income »Role of proportional income tax and its impact on Disposable Income »Automatic stabilizers »A reduction in transfers lowers output »What do you think is the role of fiscal 27 policy?
  28. 28. Budget »Is there a reason to fear government budget deficit? »Budget surplus is the excess of the government’s revenues, taxes over its total expenditures, consisting of purchasing goods and services and transfer payments »Define budget deficit »How does fiscal policy impact budgets? 28
  29. 29. Some key terms to recall » Aggregate » Demand » Automatic stabilizer » Budget constraint » Budget surplus/deficit » Consumption 29 function Disposable Income » Fiscal policy » MPC » MPS » Multiplier
  30. 30. Case Discussion – Should Energy be Subsidized? 30
  31. 31. Case Analysis »What are subsidies? »Financial assistance given to energy companies »Direct Assistance – Grants, Tax breaks/ exemptions (have a direct impact on price) »Indirect Assistance – R&D support, Government encouragement for innovations 31
  32. 32. Case Analysis »Reasons »Primary: Access to poorer sections of the society »Secondary: Keeping the prices under control »Variants of Energy Subsidies »Cash transfer, Reduced rate loans, quotas, trade restrictions, preferential tax treatment 32
  33. 33. Case Analysis – Effects/Impacts of subsidies »Short-term and long-term impacts: »Cost Angle: »Per unit cost of generating energy was higher for renewable resource »Social cost of removing subsidies is high »Social Angle: »Pollution costs/Climate change »Greenhouse effect 33
  34. 34. Case Analysis – Some statistics Year Countries/Economies 1992 $ 230 bn Global 1997 $ 58 bn US and 20 largest countries outside OECD 1999 $95 bn 8 of the largest developing economies 2001 €17.2 bn EU 2005 34 Amount $250 bn Non-OECD countries
  35. 35. Case Analysis – Arguments FOR subsidies »Essential for all economic activities (subsidized kerosene, LPG, electricity…) »Direct impact on inflation »If prices of fuel increase, cost of transporting vegetables goes up! »Politics – think vote bank! »Cross subsidies 35
  36. 36. Case Analysis – Arguments AGAINST subsidies »Leads to increased consumption »Irresponsible usage of energy »Leads to faster depletion of a precious resource »Distorted costs and prices »Failure in determining actual cost of production of non-renewable resource »Environmental damage 36
  37. 37. Case Analysis – Arguments AGAINST subsidies »Majority of the subsidies flows into nuclear power »High cost of insurance coverage »Nuclear waste disposal costs »Hampers growth of renewable resources »Discourages research and innovation »Does it actually benefit the underprivileged? Can it be diverted? 37
  38. 38. Subsidies – Renewable Resource FOR »Social Costs will come down »Cleaner fuel »Reduced health care costs »Tariff arrangements 38 AGAINST »Capital costs of establishing renewable resource plants »A few types may have adverse ecological impact
  39. 39. Points for discussion »Impact of subsidies on economy »Who are the beneficiaries and who pays for them? »Are subsidies essential? »Does renewable/non-renewable make a difference? »Would developing/developed countries make a difference? 39 »Should renewable energy be promoted?
  40. 40. Questions???
  41. 41. Have a happy Sunday!

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