aggregate demand and supply

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Aggregate Demand and Supply (Keynesian Model):

Aggregate Demand and Supply (Keynesian Model) Nitish Kumar Arya M.A. Economics Banaras Hindu University Varanasi 221005

Aggregate Demand:

Aggregate Demand The level of economic activity (measured in terms of GDP) fluctuate in both short as well as long run The aggregate quantity of goods and services bought in the economy during any given period depends on the level of total spending and the prices of different goods and services The level of aggregate demand determines the level of employment (utilization of labour, capital and other inputs)

Aggregate Demand Function:

Aggregate Demand Function AD is equal to total amount spent in the economy at a given price level Y = C+I+G+ (X-M) for four sector economy Y = C+I+G for three sector economy Y = C+I for two sector economy AD=Y Aggregate demand curve slope downward (like an ordinary demand curve)

Equilibrium Output:

Equilibrium Output Equilibrium level of output is that level of output at which the quantity of output produced equals quantity demanded AD as defined earlier (AD=Y) need not be equilibrium output Reasons: AD is in the ‘ex-ante’ whereas AD (or Y or NI) is ex-post AD speaks of that quantity people want to buy whereas Y what they bought Y measures output in an accounting sense whereas AD is an economic concept (desired and planned)

Equilibrium Output:

Equilibrium Output Equilibrium level of output is that level of output at which the total desired spending on goods and services (desired aggregate demand) is equal to the actual level of output (Y). All other concepts introduced below are in the ex-ante sense (what is desired) and not in the ex-post sense (what actually done) We are aware that Y (of national income) is equal to aggregate spending (from the spending side of national accounts GDP=private consumption spending+investment in fixed capital formation+government consumption+net exports)

What Determines Aggregate Spending?:

What Determines Aggregate Spending? Remember individuals, firms, government and net exports are the components of the aggregate spending (AE = C+I+G (X-M)) Autonomous and induced spending - are those that do not depend on current domestic incomes Private Spending by definition there are only two possible uses of disposable income; consumption and saving. So when each individual decides how much to put to one use, he or she has automatically decided how much to put to the other use

Private Spending - Consumption Function:

Private Spending - Consumption Function The term consumption function describes the relationship between private consumption and the variables that influence it. In the simplest theory, consumption is determined primarily by current personal disposable income Average Propensity to Consume (APC) is total consumption spending divided by total disposable income APC = -------- C Yd

Consumption Function:

Consumption Function Marginal Propensity to Consume (MPC) relates the change in consumption to the change in disposable income. Remember APC measures the proportion of DI that households desire to spend on consumption MPC measures the proportion of any increment to DI that households desire to spend on consumption

Consumption Function:

Consumption Function Observe that APC = 1 (where DI is 500 and Consumption is 500) MPC is greater than zero but less than unity, meaning that incremental income is more than incremental consumption

Consumption Function:

Consumption Function C 500 1000 1500 2000 DI 500 1000 1500 2000 C Positive slope of C is MPC 45 degree line

Saving Function:

Saving Function APS is the proportion of DI that households want to save APS = S/Y MPS relates to change in total desired saving to the change in DI If MPC is 0.8 the MPS should be 0.2 Therefore, MPC+MPS = 1 Similarly APC+APS = 1 Because income is either spent or saved

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0 -100 250 500 -500 500 1000 1500 2000 S

Saving Function:

Saving Function Remember households save to accumulate wealth which can be used at a later date higher interest rates will generally lead to lower consumer spending

Desired Investment Spending:

Desired Investment Spending Other things being equal, the higher is the real interest rate, higher is the cost of borrowing money for investment purposes and less is the amount of desired investment spending. This relationship is most easily understood if we disaggregate investment into three parts inventory accumulation residential house building and business fixed capital formation

Factors Responsible for Change in AD:

Factors Responsible for Change in AD Change in income Rate of Interest Government Policy Change in Exchange Rate Change in Expected Rate of Inflation Change in Business Expectations

Factors Responsible for Change in Aggregate Supply:

Factors Responsible for Change in Aggregate Supply Change in cost of production supply shock or disturbances Investment spending and technological changes Availability of raw materials Supply of labour Human capital Incentives

Aggregate Supply Function:

Aggregate Supply Function Aggregate Supply is the total output of goods and services that firms wish to produce, assuming that they can sell all they wish to sell at the going price level AS curve relates the quantity of output supplied to the price level AS curve drawn for given input prices is positively sloped because unit costs rise with increasing output and because rising product prices make it profitable to increase output

Macroeconomic Equilibrium:

Macroeconomic Equilibrium At the combination of GDP and price level given by the intersection of the AS and AD curves are spending (demand) behaviour and production (supply) activity consistent AS AD Eo Real GDP Price Level

What is Multiplier?:

What is Multiplier? Multiplier measures the magnitude of the change in GDP in response to a change in autonomous spending when price level is constant Simple multiplier measures the horizontal shift in the AD curve in response to a change in autonomous spending An increase in desired aggregate spending increases equilibrium GDP by multiple of the initial increase in autonomous spending Multiplier is the ratio of change in GDP to change in autonomous spending

Understanding Multiplier:

Understanding Multiplier Assumption: marginal propensity to spend out of National Income is 0.80 Suppose the autonomous spending (a large company decides to spend Rs.100 crores on new factories, NI increases initially by same amount Workers (those involved in creating new factories) who receive Rs.100 crores will spend Rs.80 crores This new income, in turn induces Rs.64 crores of third round spending In other words, each additional round of spending creates new income (and output)