Chapter 2 Aggregate Demand and Aggregate Supply

MACROECONOMICS

Introduction to Economics

contents

Equilibrium of a National Economy

Aggregate Demand and Consumption Expenditure

Investment Expenditure

Government Expenditure and Net Export

Derivation of Aggregate Demand Curve

Derivation of Aggregate Supply Curve

2.1

2.2

2.3

2.4

2.5

2.6

2.1 Equilibrium of a National Economy

•in the market of a certain commodity, an equilibrium is reached at the intersection of demand and supply curves

•how about the case of an equilibrium of a national economy? → an equilibrium is reached at the intersection of aggregate

demand(AD) and aggregate supply(AS) curves

•aggregate demand curve : how much commodities are demanded for each price level for the economy as a whole

•aggregate supply curve : how much commodities are supplied at each price level for the economy as a whole

Aggregate Demand and Aggregate Supply Curves

2.1 Equilibrium of a National Economy

• since there are many different kinds of commodities, it is difficult to measure total demand or supply of the economy as a whole

• to solve this problem, we assume a (hypothetical) representative commodity when we derive aggregate demand and aggregate supply curves horizontal axis : quantity of the representative commodity vertical axis : price of the representative commodity

• But in effect, horizontal axis : national income(GDP) vertical axis : price level

Equilibrium of the Market

2.1 Equilibrium of a National Economy

• an equilibrium is reached at the intersection of two curves

Shift of Aggregate Demand and Aggregate Supply Curves

2.1 Equilibrium of a National Economy

ex) an increase in the demand for our products in foreign markets

- a rightward shift of aggregate demand curve

an increase in aggregate

demand - GDP increases and price level rises

ex) a sudden rise in crude oil price

- a leftward shift of aggregate supply curvea decrease in

aggregate supply - GDP decreases and price level rises

⇒ stagflation

Shift of Aggregate Demand and Aggregate Supply Curves

2.1 Equilibrium of a National Economy

2.2 Aggregate Demand and Consumption Expenditure

- sum of the expenditures of households, firms, government and foreign sector

aggregate demand

- components of aggregate demand

•consumption expenditure of households(C )

•investment expenditure of firms(I )

•government expenditure(G )

•net export(Xn )

- component which is the largest in size is 𝑪(consumption expenditure)

Consumption Expenditure

2.2 Aggregate Demand and Consumption Expenditure

consumption and consumption expenditure could be different due to the existence of durable consumer goods, but we use them interchangeably

•consumption expenditure

in general, consumption expenditure by households constitutes more than 50% of aggregate demand the most important determinant of consumption expenditure is the size of income (more income ⇒more consumption)

•disposable income and consumption expenditure- strictly speaking, consumption expenditure is determined by the size of disposable income

Disposable Income and Consumption Expenditure

2.2 Aggregate Demand and Consumption Expenditure

data: The Bank of Korea (2014), Economics Statistics System

Consumption Function

2.2 Aggregate Demand and Consumption Expenditure

• the relationship between disposable income(Yd ) and consumption expenditure(C ) can be expressed by the following consumption function

• marginal propensity to consume (MPC )

- if disposable income increases by 1 dollar and consumption expenditure increases by b dollar, we say MPC is b

MPC=𝐶Yd

= b

C = a + bYd

(a > 0 , 0 < b < 1 )

Consumption Curve and MPC

2.2 Aggregate Demand and Consumption Expenditure

•consumption curve shows the relationship between disposable income and consumption

•marginal propensity to consume has a constant value(b )

Other Factors Affecting Consumption Expenditure

2.2 Aggregate Demand and Consumption Expenditure

(1) wealth- wealth effect : a rise in prices of stocks and houses ⇒ an increase in wealth ⇒ an increase in consumption expenditure

(2) price level- real balance effect : a change in price level causes a change in real value of

assets whose nominal value is fixedex) a rise in price level ⇒ a decrease in the real value of assets whose nominal value is fixed ⇒ a decrease in consumption expenditure

Other Factors Affecting Consumption Expenditure

2.2 Aggregate Demand and Consumption Expenditure

(3) interest rate- a rise in interest rate ⇒ people may reduce consumption expenditure

and increase saving- but many empirical studies figure out that the impact of interest rate on

consumption and saving is not that strong

(4) future income- someone who expects an increase in future income can increase current

consumption expenditure even though there is no increase in current income

2.3 Investment Expenditure

• the proportion of investment expenditure in aggregate demand is not so

large as consumption expenditure

• but it is quite variable depending on economic conditions ⇒main cause of

business cycles

• we should know exactly what investment means

- in macroeconomics, investment means firms’ expenditure on capital

goods which are newly produced domestically

- total stock of capital increases by the amount of investment

Various Types of Investment

2.3 Investment Expenditure

• fixed investment

- purchase of production facilities such as machines, equipment,

vehicles and construction of factories, bridges and roads

• inventory investment

- an increase in the stock of inventory is considered an inventory

investment

Criterion of Investment

2.3 Investment Expenditure

• a firm decides to make an investment if expected return from it is greater than its cost

• returns form an investment project materialize as the stream of future incomes

• therefore we should calculate the present value of future income and compare it with

cost

• through the process of discounting, we can calculate the present value of future

income ⇒ discount rate

• strictly speaking, discount rate and interest rate are different from each other

• but interest rate is used as discount rate in many cases

Criterion of Investment

2.3 Investment Expenditure

• suppose discount rate is r and expected returns from a certain investment project for next three years are R1, R2, R3

• we can calculate the present value of the stream of future incomes like this;

• if it costs C to carry out the investment project and PVR > C holds, it is worthwhile to carry out the investment project

•determinants of investment

(1) interest rate : negative(−) relation(2) expected return(3) easiness of mobilizing investment funds

PVR=R11+r +

R2(1+r )²

+R3

(1+r )³

2.4 Government Expenditure and Net Export

• total value of government purchase of goods and services in a year

• limited to the purchase of final goods and services produced in that year

• should be distinguished from fiscal expenditurewhich means the total expenditure of government including transfer payments

• government expenditure is considered a kind of policy variables

government expenditure

Net Export

2.4 Government Expenditure and Net Export

• net export = export – import- aggregate demand includes only the expenditure on domestically

produced commodity (expenditure on imports excluded)

- therefore net export could become a component of aggregate demand

• in most countries, the proportion of net export in aggregate demand is

relatively small

Changes in Export, Import and Net Export (as % of GDP)

2.4 Government Expenditure and Net Export

Determinants of Net Export

2.4 Government Expenditure and Net Export

(1) size of national income

• positive(+) relation between own national income and import- an increase in (own) national income ⇒ increases in

consumption and investment ⇒ increases in importation of consumption goods and investment goods

• the size of export is affected by the level of foreign national income • an increase in own national income ⇒ a decrease in net export• an increase in foreign national income ⇒ an increase in net export

Determinants of Net Export

2.4 Government Expenditure and Net Export

(2) relative level of domestic prices and foreign prices

• if domestic inflation rate is higher than foreign inflation rate, net export will decrease

• changes in exchange rate also affect net export

(1) domestic and foreign national income

conclusion : determinants of net export are

(2) domestic and foreign price level

(3) exchange rate

2.5 Derivation of Aggregate Demand Curve

• aggregate demand is composed of consumption expenditure, investment expenditure, government expenditure and net export

• what happens to these components of aggregate demand if price level rises?

(1) consumption expenditure decreases due to real balance effect

(2) a rise in domestic price level ⇒ a decrease in export and an increase in import ⇒ net export decreases

• a rise in price level ⇒ a decrease in aggregate demand ⇒downward sloping aggregate demand curve

Aggregate Demand Curve

2.5 Derivation of Aggregate Demand Curve

Shift of Aggregate Demand Curve

2.5 Derivation of Aggregate Demand Curve

• when we draw aggregate demand curve, we assume that there is no change in variables other than price level

• aggregate demand curve shifts if there is a change in any of such variables

ex) an increase in export → at price level of P0 , aggregate demand increases from Y0 to Y1 →aggregate demand curve shifts rightward from AD0 to AD1

• if there is a decrease in any component of aggregate demand, aggregate demand curve will shift to the left

Shift of Aggregate Demand Curve

2.5 Derivation of Aggregate Demand Curve

Shift of Aggregate Demand Curve

2.5 Derivation of Aggregate Demand Curve

• an increase in either consumption expenditure, investment expenditure or

government expenditure independently of price level change ⇒ rightward

shift of aggregate demand curve

• when the economy is in a recession, we can revitalize it by expanding

aggregate demand

• expansionary policies are meant to shift aggregate demand to the right

(1) fiscal policy : changes in government expenditure or tax revenue

(2) monetary policy : changes in money supply or interest rate

2.6 Derivation of Aggregate Supply Curve

•profit from producing one more unit of a commodity

= price of the product – additional cost of production

• when we derive aggregate supply curve, we assume that all variables

other than price level remain unchanged

• a rise in price level → a rise in the price of the commodity, but no

change in additional cost → an increase in profit

• such an increase in profit will result in an increase in production →

upward sloping aggregate supply curve

Aggregate Supply Curve

2.6 Derivation of Aggregate Supply Curve

Shift of Aggregate Supply Curve

2.6 Derivation of Aggregate Supply Curve

• if there is a change in variables other than price level, aggregate

supply curve will shift

ex) a rise in wage → an increase in production cost

→ a decrease in profit → production will decrease

→ a decrease in aggregate supply

• at the price level of P0, aggregate supply will decrease from Y0 to Y1

→ leftward shift of aggregate supply curve

Shift of Aggregate Supply Curve

2.6 Derivation of Aggregate Supply Curve

Shift of Aggregate Supply Curve

2.6 Derivation of Aggregate Supply Curve

• if there is an increase in the availability of labor or capital, aggregate

supply curve will shift to the right

• even though there is no increase in the availability of labor or capital,

aggregate supply curve will shift to the right if productivity improves

due to innovation or other reasons

• but these kinds of rightward shifts take a lot of time usually

• in contrast, a leftward shift of the curve caused by a rise in wage or the

prices of raw materials does not take that much time

Equilibrium of a National Economy

2.6 Derivation of Aggregate Supply Curve

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