Aggregate Demand and Economic The Problem of Leakages

Fluctiations
As we discuss the ins and outs of stabilization
policy, there are two stylized facts that you
need to keep in mind.
Stylized Fact 1 : During an economic
contraction, unemployment rises, while in a
recovery or expansion, unemployment falls.
Arthur M. Okun estimated that a 1% drop in
the unemployment rate was associated with When households save rather than spend part
an approximately 3% boost to real GDP. of their incomes, a leakage happens.
Stylized Fact 2 : If an economic expansion is When firms spend on investment goods, an
very strong, it tends to leads to an increase injection happens.
in the inflation rate.
The following situations represent an
economy in equilibrium
1) If amount that households want to save is
equal to the amount that firms want to invest
2) leakages = injections (S=II)
3) Y=AD

If the leakages exceed the injections,

1) leakages > injections
2) S > II
3) Y > AD
Great Depression : The biggest downturn in U.S.
history. Production dropped dramatically from Here, Classicals and Keynesians present
1929 to 1930 and unemployment was over 25%. solutions for the situation of leakages >
injections.
Aggregate Demand
What households and firms intend to spend on
consumption and investment.
Aggregate Demand = Consumption +
Intended Investment (AD = C + II)
The Classical Solution to Leakages interest rate falls. As a result, fall in investment
Banks help people to earn interest. Therefore was balanced by a decrease in saving.
people prefer the banks for their saving instead
The Keynesian Model
of under a mattress. In this market, households
In the model of Keynes, there are two
are the suppliers of loanable funds and firms are
consumption components.
the demanders of loanable funds.

C is autonomous consumption and mpc is the
marginal propensity.

C is the consumption value when the income

is equal to zero.

at an any point on
the table

If interest rate is high, gain is more. If interest

The Keynesian Model
rate is low, gain is less. As the interest rate
increases, saving is appealing.

What does the solution tell us?

The horizontal axis measures income (Y) while

the vertical axis measures consumption (C). The
consumption function is the autonomous
consumption (starts from 20). The slope of the
Firms decided to invest less. The demand for
consumption function line is equal to mpc. And
loanable funds curve shifts leftward and interest
also there is a line 45 degree. This line tells us
rate fall to 3%. And now, firms can have cheaper
what happen if people consumed all their
interest rate so part of drop in investment will be
income instead of saving part of it. So this line
reserved. And also, households prefer to save
expresses the consumption = income. And also
less and prefer to consume more due to the
the vertical distance between the 45 degree line
and consumption function expresses how much
people save.
The Factors that cause to change on the
consumption function
- Wealth. If people feel wealthier, even if their
incomes don't change; they can consume more.
- If people feel less confident about the future,
they may tend to consume less.
- Government policies. A leader of a country can
encourage people to spend or save.
Consumption function starts from autonomuos
consumption. We know that AD=C+II so
aggregate demand function starts from 80. The
distance difference between consumption line
and aggregate demand line is equal to intended
investment.
Shifting up or down on the Graph
As autonomuous consumption or autonomuous
investment changes, the AD shifts up or down.
For example, when II increases to 140;

The Difference between the Classican Model

and Keynesian Model
Classical model assumes that people made
decisions about saving or spending according to
interest rate. But Keynesian model never
mention the interest rate at all because
according to Keynesian Model, the effects of
interest rate are uncertain on the saving.

The Aggregate Demand on the Graph

The Possibility of Unintended Investment example, 80 falling on the II is equal to 400
Investment = Intended Investment + Excees falling on the output.
Inventory or Depletion
We can calculate how the falling on the intended
Y = C + I
investment affect the falling on the output and
AD = C + II
aggregate demand with multiplier.
so Y - AD = Excees Inventory Accumulation(-)
or Depletion(+)
Y = multiplier x II

in this equation,
Y is the changing on the output and aggregate
demand
II is the decreasing value on the intended
investment
multiplier is 1/(1-mpc)

For example, mpc=0.8 and there is a 80 falling

on the inteded investment.
Y=5.(-80)=-400

-400 is the falling value on the output and

aggregate demand.

On the graph, When income is equal to 800, AD is

equal to 720 so income exceeds to aggregate
demand. Therefore, 870-720=80 unintended
inventories.

The Multiplier

If Intended investment decreases, output and

aggregate demand decreases more. For