Aggregate demand and aggregate supply

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

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

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

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

Consumption and savings

S=YC 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

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

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

Consumption, planned investment 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) + cY = A + cY where A part of AD independent of income or autonomous

Contd.
AD E AD = Y AD = A + cY C = a + cY

A I a

In equilibrium, without G and NX Y = AD Y = A + cY Y = (1 / 1-c) A

Y

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

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 = 1 / 1 c multiplier Larger the MPC, greater the multiplier

Graphical derivation
AD E AD = Y AD1 = A1 + cY AD = A + cY

A1 A

dA

Y0

Y1

Government spending

Governments affect AD in two ways

G government spending Taxes and transfers affecting YD 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

Consumption now depends on YD and not Y

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 = = 1 / 1c(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

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

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

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

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 longterm 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

AS curve

Represents the quantity of goods and services firms choose to produce and sell at each price level
P

AS

Equilibrium
P AS

AD Y