aggregate demand and the multiplier-iv

8/8/2019 Aggregate Demand and the Multiplier-IV

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AggregateAggregate

Demand andDemand andthe Multiplier the Multiplier

Dr. Shylajan, C.S Dr. Shylajan, C.S



Topics of D iscussionTopics of D iscussion

Aggregate Demand Aggregate DemandThe DownwardThe Downward- -Sloping AggregateSloping AggregateDemand CurveDemand CurveShifts in Aggregate DemandShifts in Aggregate DemandKeynesian Theory of Output Keynesian Theory of Output DeterminationDeterminationThe Meaning of EquilibriumThe Meaning of EquilibriumOutput Determination by ConsumptionOutput Determination by Consumption

and Investment (Simple economy)and Investment (Simple economy)



Aggregate D ema nd Aggregate D ema nd Aggregate Demand is the total demand Aggregate Demand is the total demandfor goods and services in the economy.for goods and services in the economy.

It depends on the aggregate price levelIt depends on the aggregate price level

Aggregate Supply curve shows the price Aggregate Supply curve shows the pricelevel associated with each level of output level associated with each level of output

Why AD downward sloping?Why AD downward sloping?



Why AD Downw ar d Why AD Downw ar d slopin g?slopin g?

The level of aggregate demand declines asThe level of aggregate demand declines asthe overall price level in the economy rises.the overall price level in the economy rises.

(assuming other things constant)(assuming other things constant)

Aggregate Demand and Aggregate supply Aggregate Demand and Aggregate supplyinteract to determine equilibrium price andinteract to determine equilibrium price and

output.output.

Movements along the Aggregate DemandMovements along the Aggregate Demandand Shifts of Aggregate Demand :Why?and Shifts of Aggregate Demand :Why?



S h if t s in Aggregate S h if t s in Aggregate

Dema ndDema nd1 .1 . Due to change in policy variablesDue to change in policy variables

Due to change in variables such asDue to change in variables such asmoney supply, tax policy, government money supply, tax policy, government expenditures etcexpenditures etc

2.2. Due to exogenous variablesDue to exogenous variables(Foreign output, war, etc for instance)(Foreign output, war, etc for instance)



Aggregate Dema nd Aggregate Dema nd

Our focus is on aggregate demand asOur focus is on aggregate demand asthe determinant of the level of output the determinant of the level of output

Prices are given and constant Prices are given and constant

We need to know how given policyWe need to know how given policyactions shift the aggregate demandactions shift the aggregate demandcurve at a given level of prices.curve at a given level of prices.(Graph)(Graph)



S im pl e Econo m yS im pl e Econo m y

In a simple economy aggregate demand isIn a simple economy aggregate demand isthe sum of the demand for consumptionthe sum of the demand for consumption

and investment goods.and investment goods.

It is the amount of goods peopleIt is the amount of goods people want towant tobuybuy

Investment demand (I) is assumed constant Investment demand (I) is assumed constant or independent of income or interest rate.or independent of income or interest rate.



Determ in at ion of Eq uilib r iu m Determ in at ion of Eq uilib r iu m I nco me a nd Ou t pu t in a S im pl e I nco me a nd Ou t pu t in a S im pl e Econo m y (Ke yn e si a n Th e o ry)Econo m y (Ke yn e si a n Th e o ry)

N o g ov er n me n t , no tra d eN o g ov er n me n t , no tra d e

Ou t pu t is at it s e q uilib r iu mOu t pu t is at it s e q uilib r iu m when plannedwhen planned Aggregate Demand (C + I) is equal to actual Aggregate Demand (C + I) is equal to actualoutput (Y)output (Y)

AD = C +I AD = C +I

Y = AD Y = AD

Quantity of output produced (Quantity of output produced ( Y Y)) is exactlyis exactlyequal to the quantity demanded (equal to the quantity demanded ( AD AD))



Determ in at ion of Eq uilib r iu m Determ in at ion of Eq uilib r iu m I nco me a nd Ou t pu t in a S im pl e I nco me a nd Ou t pu t in a S im pl e Econo m yEcono m y

At the equilibrium level of output, At the equilibrium level of output,firms are selling as much as theyfirms are selling as much as theyproduce, people are buying theproduce, people are buying theamount they want to purchase.amount they want to purchase.

So there is no inventory problem.So there is no inventory problem.



Der ivin g t h e Aggregate Dema nd S ch e dul e Der ivin g t h e Aggregate Dema nd S ch e dul e a nd Eq uilib r iu m Ou t pu ta nd Eq uilib r iu m Ou t pu t

C Y ! 100 75. I ! 2 5

Der ivin g t h e P la nn e d Aggregate Dema nd S ch e dul e a nd Findin g Eq uilib r iu m . Th e Der ivin g t h e P la nn e d Aggregate Dema nd S ch e dul e a nd Findin g Eq uilib r iu m . Th e

Fig u re s in C olu m n 2 are Ba s e d on t h e Eq u at ion Fig u re s in C olu m n 2 are Ba s e d on t h e Eq u at ion C C = 100 + .75= 100 + .75Y Y..(1 )(1 ) (2 )(2 ) (3 )(3 ) (4 )(4 ) (5 )(5 ) (6 )(6 )

AGGR EGAT AGGR EGATEE

OUTPU TOUTPU T(INCOME ) (INCOME )

((Y Y))

AGGR EGATE AGGR EGATECON S UMP TIONCON S UMP TION

((C C ))

PL ANNE DPL ANNE DINVE S TMENTINVE S TMENT

PL ANNE DPL ANNE D AGGR EGATE AGGR EGATE

EXPEN DI TURE )EXPEN DI TURE )CC ++ II

UNPL ANNUNPL ANNEDED

INVEN TOINVEN TORY RY

CH ANGECH ANGEY Y ((C C ++ II ))

EQUILIB RI UMEQU I LI BRI UM??

(( Y Y = C + I )= C + I )

100100 175175 2525 200200 100100 NoNo

200200 250250 2525 275275 7575 NoNo

400400 400400 2525 42 542 5 2525 NoNo500500 475475 2525 500500 00 Yes Yes

600600 550550 2525 575575 + 2 5+ 2 5 N oNo

800800 700700 2525 7 257 25 + 75+ 75 N oNo1 ,0001 ,000 850850 2525 875875 + 1 25+ 1 25 N oNo



Ou t pu t Determ in at ion b y Ou t pu t Determ in at ion b y Consu m p t ion a nd I nv e s tme n tConsu m p t ion a nd I nv e s tme n t

Aggregate output : Aggregate output :Y Y

Planned aggregatePlanned aggregateexpenditure or AD:expenditure or AD: C C ++ II

Equilibrium: Output = ADEquilibrium: Output = ADEquilibrium:Equilibrium: Y Y == CC ++ II



Mea nin g of Eq uilib r iu m Mea nin g of Eq uilib r iu m

inco me a nd ou t pu tinco me a nd ou t pu tOutput is at its equilibrium level whenOutput is at its equilibrium level whenaggregate demand (AD) is equal toaggregate demand (AD) is equal tooutput (Y).output (Y).What is AD? It is consumptionWhat is AD? It is consumptionspending plus investment spendingspending plus investment spending

AD = C + I AD = C + I where C=a+bY where C=a+bY = (a + bY) + I= (a + bY) + I= (a + I) + bY = (a + I) + bY




inco me a nd ou t pu tinco me a nd ou t pu t(a + I)(a + I) is autonomous or independent is autonomous or independent of level of income.of level of income.But aggregate demand also dependsBut aggregate demand also dependson the level of incomeon the level of income ((bY bY))BcozBcoz, consumption demand increases, consumption demand increases

with income (with income (bY bY))At e q uilib r iu m, Y = AD At e q uilib r iu m, Y = AD Y= ( a + I ) + Y= ( a + I ) + b Yb Y




inco me a nd ou t pu tinco me a nd ou t pu tSolve for equilibrium output (Solve for equilibrium output (Yo Yo))

Y Y-- b Yb Y = ( a +I )= ( a +I )

Yo Yo = 1/ (1= 1/ (1- -b ) * ( a +I ) .(1 )b ) * ( a +I ) .(1 )

Where b = marginal propensity to consume or MPCWhere b = marginal propensity to consume or MPC

(a + I ) is autonomous spending(a + I ) is autonomous spending



Findin g Eq uilib r iu mFindin g Eq uilib r iu mOu t pu t in a si m pl e e cono m yOu t pu t in a si m pl e e cono m y-- An An Ex am pl eEx am pl e

Y Y ! 100 75 2 5.

Y C I ! (1)

C Y ! 100 75.(2)

I ! 2 5(3)

By substituting (2) and(3) into (1) we get:

Y Y ! 100 75 2 5.

Y Y ! .75 100 2 5

Y Y !.75 1 2 5

.2 5 1 2 5Y !

Y ! !1 2 5

2 5500

.



Findin g Eq uilib r iu mFindin g Eq uilib r iu mOu t pu t in a si m pl e e cono m yOu t pu t in a si m pl e e cono m y--Gra p h ic a llyGra p h ic a lly

Keynesian Cross and equilibriumKeynesian Cross and equilibriumincomeincome



Th e slop e of t h e consu m p t ion Th e slop e of t h e consu m p t ion func t ion mea su re s w h ic h of func t ion mea su re s w h ic h of t h e followin g?t h e followin g?

1 . Marginal propensity to consume1 . Marginal propensity to consume2. Average propensity to consume2. Average propensity to consume3. Aggregate level of consumption3. Aggregate level of consumption4. Marginal propensity to save4. Marginal propensity to save5 . Average propensity to save5 . Average propensity to save



Find t h e e q uilib r iu m Find t h e e q uilib r iu m inco me w h e n inco me w h e n inv e s tme n t d ema nd is inv e s tme n t d ema nd is

300 a nd t h e 300 a nd t h e consu m p t ion func t ion is consu m p t ion func t ion is C = 10 + .8 Y.C = 10 + .8 Y.Co m pu te Y w h e n MP C Co m pu te Y w h e n MP C inc rea s e s t o 0.90inc rea s e s t o 0.90



At t h e e q uilib r iu m leve l of At t h e e q uilib r iu m leve l of rea l GDP , w h ic h of t h e rea l GDP , w h ic h of t h e followin g is tr u e?followin g is tr u e?

1 .1 . Unplanned inventoryUnplanned inventoryinvestment is positiveinvestment is positive

2.Unplanned inventory2.Unplanned inventoryinvestment is negativeinvestment is negative



3.Aggregate output equals3.Aggregate output equals

aggregate expenditureaggregate expenditure

4.Aggregate output plus4.Aggregate output plus

consumption spending equalsconsumption spending equalsaggregate expendituresaggregate expenditures

5 .Aggregate output plus saving5 .Aggregate output plus savingequals aggregate expenditureequals aggregate expenditure



Topics of DiscussionTopics of Discussion

The Investment MultiplierThe Investment MultiplierThe Multiplier in the ASThe Multiplier in the AS- -AD Framework AD Framework

Aggregate Demand by Introducing the Aggregate Demand by Introducing theGovernment SectorGovernment SectorDetermination of Equilibrium IncomeDetermination of Equilibrium Income

with Government Sectorwith Government SectorDetermination of Equilibrium Income inDetermination of Equilibrium Income inan Open Economyan Open Economy

The Paradox of Thrift The Paradox of Thrift



Th e S im pl e Mul t ipli er Th e S im pl e Mul t ipli er

Mod e lMod e lIt is the change in equilibrium output whenIt is the change in equilibrium output whenautonomous demand increases by one unit.autonomous demand increases by one unit.

Multiplier k = 1/ (1Multiplier k = 1/ (1 --MPC)MPC)Multiplier = 1/ MPSMultiplier = 1/ MPS

Larger the MPC , the larger the multiplierLarger the MPC , the larger the multiplier

To study why output fluctuates, the concept To study why output fluctuates, the concept of multiplier is important.of multiplier is important.



Th e Mul t ipli erTh e Mul t ipli er

An increase in autonomous spending An increase in autonomous spendingraises the equilibrium level of incomeraises the equilibrium level of income

The increase in income is a multiple of The increase in income is a multiple of the increase in autonomous spendingthe increase in autonomous spending

The larger the MPC, the larger theThe larger the MPC, the larger themultiplier (verify with previousmultiplier (verify with previousexample)example)



Th e Mul t ipli er in t h e ASTh e Mul t ipli er in t h e AS --

AD Frame wo rk AD Frame wo rkIn a multiplier model, we useIn a multiplier model, we use

Consumption plus Investment Consumption plus Investment approach to determine equilibriumapproach to determine equilibriumoutput.output.

Equilibrium output is achieved whenEquilibrium output is achieved whenaggregate expenditure (C+I) equalsaggregate expenditure (C+I) equalsreal GDP (Y)real GDP (Y)



Th e Mul t ipli er in t h e ASTh e Mul t ipli er in t h e AS --

AD Frame wo rk AD Frame wo rk

In ASIn AS--AD framework, it is achieved AD framework, it is achievedwhen downward sloping Aggregatewhen downward sloping AggregateDemand Curve cuts the upwardDemand Curve cuts the upwardsloping Aggregate Supply curvesloping Aggregate Supply curve

(Graph)(Graph)



ggrega e ema n y n ro uc n g e ggrega e ema n y n ro uc n g e Go ver n me n t S e ct o r (F isc a l polic y in t h e Go ver n me n t S e ct o r (F isc a l polic y in t h e m ul t ipli er m od e l)m ul t ipli er m od e l)

H ow government s fiscal policies affect H ow government s fiscal policies affect output?output?

What is Fiscal Policy?What is Fiscal Policy?

By Government taxationBy Government taxationBy Government spending (By Government spending (Govt Govt purchase)purchase)By Transfer PaymentsBy Transfer Payments

H ow government spending and taxationH ow government spending and taxationprogrammesprogrammes affect output?affect output?



Aggregate Dema nd b y I n tr oducin g Aggregate Dema nd b y I n tr oducin g

t h e Go ver n me n t S

e ct o rt h e Go ver n me n t S

e ct o rNow we haveNow we have

GDP =GDP = C + I + G C + I + G + NX + NX

Consumption expenditureConsumption expenditureGross private domestic investment Gross private domestic investment

Government purchase of goods and servicesGovernment purchase of goods and servicesNet exportsNet exports



Determ in at ion of Eq uilib r iu m Determ in at ion of Eq uilib r iu m I nco me wi t h Go ver n me n t I nco me wi t h Go ver n me n t

S e ct o rS e ct o r Assume we have a closed economy Assume we have a closed economySo we have GDP = C + I + GSo we have GDP = C + I + GTotal spending is C + I + GTotal spending is C + I + GEquilibrium output is determined whenEquilibrium output is determined whenaggregate spending equals real GDP.aggregate spending equals real GDP.

At this point, total planned spending At this point, total planned spendingexactly equals total planned output.exactly equals total planned output.



Determ in at ion of Eq uilib r iu m Determ in at ion of Eq uilib r iu m I nco me wi t h Go ver n me n t I nco me wi t h Go ver n me n t S e ct o rS e ct o r

Three models:Three models:

1 . With government spending (G)1 . With government spending (G)2. Taxation (Lump sum tax as well as2. Taxation (Lump sum tax as well as

proportional tax)proportional tax)3. Transfer Payments (TR)3. Transfer Payments (TR)



I m p a c t of Ta xat ion on I m p a c t of Ta xat ion on

Aggregate Dema nd Aggregate Dema ndThe increase in taxes will lowerThe increase in taxes will lower

disposable incomedisposable incomeConsumption schedule shiftsConsumption schedule shiftsdownwardsdownwards

Government taxation tend toGovernment taxation tend toreduce aggregate demand and thereduce aggregate demand and thelevel of GDPlevel of GDP



Determ in at ion of Eq uilib r iu m Determ in at ion of Eq uilib r iu m I nco me in a n Op e n Econo m y I nco me in a n Op e n Econo m y

GDP =GDP = C + I + G + NXC + I + G + NX

We h ave Ex po rt s a nd We h ave Ex po rt s a nd I m po rt sI m po rt sEx po rt s = XEx po rt s = X

I m po rt s =MI m po rt s =MNet Ex po rt s (NX ) = XNet Ex po rt s (NX ) = X -- MM



Determ in at ion of Eq uilib r iu m Determ in at ion of Eq uilib r iu m

I nco me in a n Op e n Econo m yI nco me in a n Op e n Econo m yWhat are the determinants of Exports?What are the determinants of Exports?Exports are exogenously givenExports are exogenously givenWhat are the determinants of Imports?What are the determinants of Imports?Imports depend mostly on income of theImports depend mostly on income of theeconomy (Y)economy (Y)

There is also an autonomous import whichThere is also an autonomous import whichis independent of income or any otheris independent of income or any othervariablesvariables




I nco me in a n Op e n Econo m yI nco me in a n Op e n Econo m yH ence, Import function isH ence, Import function is

M = m o + m YM = m o + m YWhereWhere momo is autonomous import is autonomous import

WhereWhere mm is marginal propensity tois marginal propensity toimport. That is, change in import for aimport. That is, change in import for achange in income, Y change in income, Y




I nco me in a n Op e n Econo m yI nco me in a n Op e n Econo m yCase 1 :Given the consumption function ©,Case 1 :Given the consumption function ©,Investment, Government purchase, without Investment, Government purchase, without

tax and transfer payments, Export, andtax and transfer payments, Export, andImport function how do we determineImport function how do we determineequilibrium level of income?equilibrium level of income?Case 2: Now given the consumptionCase 2: Now given the consumptionfunction, Tax rate, Transfer payments,function, Tax rate, Transfer payments,Investment, Government purchase, Export,Investment, Government purchase, Export,and Import function how do we determineand Import function how do we determine

equilibrium level of income?equilibrium level of income?




I nco me in a n Op e n Econo m yI nco me in a n Op e n Econo m yConsumption is a function of Consumption is a function of disposable incomedisposable incomeC = a +C = a + bYdbYdWhere Yd = (Y Where Yd = (Y tY tY))WhereWhere tY tY is Proportionate tax rateis Proportionate tax rateTR is Government Transfer PaymentsTR is Government Transfer PaymentsC = a + b (Y C = a + b (Y - - tY tY + TR)+ TR)




I nco me in a n Op e n Econo m yI nco me in a n Op e n Econo m y AD = C + Io + Go + ( X o AD = C + Io + Go + ( X o M)M)Where C =Where C =a+bY a+bY M =Mo +M =Mo +mY mY Now we can estimateNow we can estimate equlilibriumequlilibriumincome for a four sector model.income for a four sector model.Equilibrium is at Y = ADEquilibrium is at Y = AD



Th e Para do x of Th r if tTh e Para do x of Th r if t

More saving looks beneficial to individuals.More saving looks beneficial to individuals.

But if everybody starts saving without spending onBut if everybody starts saving without spending on

consumption, it will reduce demand for goods andconsumption, it will reduce demand for goods andthen output or income will get reduced and laterthen output or income will get reduced and latersaving will be badly affected.saving will be badly affected.

The paradox of thrift implies that more savingsThe paradox of thrift implies that more savingscould harm the economy as a whole, especiallycould harm the economy as a whole, especiallyduring recession or depression.during recession or depression.

Japan battles with paradox of thrift?Japan battles with paradox of thrift?



S u mmar yS u mmar y

aggregate demand and the multiplier-iv

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