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 = Y – C 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) + bY= A + bYwhere A – part of AD independent of income or autonomous
Contd….
In equilibrium, withoutG and NXY = ADY = A + bYY = (1 / 1-c) A Planned I = S
AD = Y
AD = A + cY
C = a + cY
a
A
E
AD
Y
I
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 = ADdY = dADdAD = dA + cdY
dA – change in autonomous spendingdY – change in income
dY = dA + cdYdY = (1/1-c) dAα = 1 / 1 – c – multiplierLarger the MPC, greater the multiplier
Graphical derivation
AD = Y
AD1 = A1 + cY
A
A1
E
AD
Y
dA
AD = A + cY
Y1Y0
Government spending Governments affect AD in two ways
G – government spending Taxes and transfers affecting YD
Consumption now depends on YD and not Y 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
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 = α = 1 / 1–c(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
AD
P
Y
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 long-term 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
PAS
Y
Equilibrium
AS
Y
AD
P
E
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