Aggregate demand &supply

1. AGGREGATE DEMAND & SUPPLY
1.CONSUMPTION FUNCTION
2.INVESTMENT FUNCTION
3. MULTIPLIER

2. AGGREGATE DEMAND
Total spending in an economy by
households,business,government and
foreigners
AD = C+I+G+X-M
C = CONSUMPTION
I = INVESTMENT
G = GOVT SPENDING
X-M = NET EXPORTS

3. Factors affecting AD:
2.MONEY
3.TAXES
4.PRICES
5.TRADE
Aggregate Demand
Output
Price
Aggregate demand is a downward sloping curve because as price
increases , real balances i.e. nominal balances / prices falls which implies
that Aggregate Demand falls.

4. Autonomous consumption (autonomous consumer spending) C
which depends upon:
consumer nominal wealth
consumer expectations and confidence concerning job
security and future income
money supply
autonomous taxes
Planned investment spending I, which depends upon:
real interest rates (i.e., changes in interest rates not caused
by changes in the price level)
business profit expectations or the expected rate of return
business taxes
money supply
Government spending G:
Net export spending X-M:
Shifts of Aggregate demand curve:

5. AGGREGATE SUPPLY
How much output would be willingly produced and sold,
given prices and costs ?
Increase in labor and capital have led to a vast increase in
the economy’s potential capacity to produce, shifting the
aggregate supply curve to the right.
In the long run, the as becomes the primary determinant
of growth.

6. 2.PRICES
3.COST
4.POTENTIAL OUTPUT
5.TECHNOLOGY
Aggregate Supply
Output
Price
Factors affecting Aggregate Supply

7. Aggregate Demand-Supply
Output
Price
Agg Demand
Agg Supply

8. AS-AD Framework
Intersection between AS-AD Curves, will
give us the four Macro variables
1.Prices
2.Output
3.Employment
4.Foreign trade
 Equilibrium output or actual output may
not be the full employment output.

9. Putting AD and AS together
Prices
output
AS
Y
f
AD
Y
1In this situation, the economy
would be operating at less than
capacity, there would be
unemployment and the economy
might be growing only slowly.
AD 1
Y
2
A shift in the AD curve to AD1
as a result of a change in any
or all of the factors affecting
AD would increase growth,
reduce unemployment but at
a cost of higher inflation (a
trade-off)

10. Supply Side Policies:
These include reduced taxes to increase
motivation, efficiency, better technology.
The shift of the supply curve will increase
output but reduce prices.
Reaganomics followed Supply side policies.

11. Consumption Function:
C= a +bY
a= Autonomous consumption
bY = induced consumption
b = marginal propensity to consume
Mpc = slope of the consumption
function- it indicates the change in
consumption due to a change in
income.

12. mpc and mps
The mirror image of mpc is mps.
The increase in income is distributed between
consumption and savings
Hence mpc +mps =1
If there are taxes, consumption is a function
of disposable income.
Hence C =f (Y
D
)
Y
D
= Disposable income = Y-T where T =
taxes.

13. Mpc and mps
Mpc = dc/dy
b = change in c due to a change in y
Hence b greater than or equal to zero.
Average propensity to consume –
Apc =C/Y. If Y is very low apc may be
greater than 1.

14. 45 degree model
cons
income
C=a+bY
45Degree line
Intersection with 45degree line
gives y=c

15. 45 degree model
Income
Consumption
45'
C
C+I
C+I+G

16. multiplier
The slope of the aggregate demand line is
approximately equal to the marginal
propensity to consume because none of the
other three major components of aggregate
demand depends strongly on national
income. Government purchases, investment
spending, and net exports are all more-or-
less independent of the level of national
income. They are considered autonomous.

17. MULTIPLIER
Y= C+I+G
Y is an endogenous variable whereas I and G
are autonomous or exogenous variable.
When any autonomous variable increase the
effect on the eqm output is by a multiplied
amount.
The size of the multiplier depends on mpc.

18. multiplier
The aggregate demand line on the income-
expenditure diagram slopes upward because
consumption is higher when national income
is higher. The slope of the aggregate demand
line--the amount by which aggregate demand
increases for every dollar increase in national
income--is approximately equal to the
marginal propensity to consume.

19. Shift of Investment Function:

20. Multiplier:
Y = C + I, where C = a + bY
Eq. 1.: Y = a + bY + I
Suppose I changes by DI such that
Y changes by DY. The new
equilibrium is:
Eq. 2.: Y + DY = a + b(Y + DY) + I
+ DI
Eq. 2.: Y + DY = a + bY + bDY + I
+ DI

21. MULTIPLIER
Eq. 2.: Y + DY = a + bY + bDY + I
+ DI
Eq. 1.: Y = a + bY + I
DY = bDY + DI
DY - bDY = DI
 (1 – b )DY = DI
 DY = [ 1/(1 – b )] DI

22. Multiplier:
DY = [ 1/(1 – b )] DI
1/(1 – b ) is the investment
multiplier.
We can say, then, that if
investment spending increases by
DI, then the equilibrium level of
income will increase by 1/(1 – b )
times that increase

23. multiplier
Notice that with a high MPC, this
economy is sensitive to even a small
change in investment spending.

24. The size of the multiplier depends on the
marginal propensity to consume: the higher
the marginal propensity to consume, the
higher the multiplier. A higher marginal
propensity to consume means that a larger
share of any increase in incomes is then
spent on consumption. A higher marginal
propensity to consume means that the
aggregate demand line--the line representing
total spending as a function of income--is
steeper.

25. A steeper aggregate demand line
means that even a small upward (or
downward) shift in it will have a large
effect on where it crosses the 45
degree income-expenditure line, and
thus a large effect on national income.
This is what we call a large value of the
multiplier.

26. Limitations of the Multiplier:
The process is subject to the availability of
consumer goods
Investments have to be repeated at regular
intervals to make the multiplier work.
Mpc has to remain constant
No time lags between income receipts and
spending
Assumption of involuntary employment

27. Accelerator Model:
The accelerator principle states that an
increase in capital stock is a function of
the increase in output(demand) and the
accelerator coefficient.
I = α (Yt – Yt-1)
Where α = acceleration coefficient or
capital output ratio.

28. Assumptions:
It operates only if the existing capital
equipment in the economy is fully
utilized.
 firms increase their production capacity
to meet the increase in demand without
looking at the time period.
Capital output ratio is fixed- no
technological changes

29. There is no ceiling on investment.
An increase in the rate of growth of output is
accompanied by net investment. Replacement
investment is not explained by this principle.
output Required stock
of capital
Net investment
30 60 -
40 80 20
60 120 40
70 140 20
80 160 20
95 190 30
95 190 0
90 180 -10

30. limitations
If there is excess capacity in an industry
there is no investment required.
Lumpiness of capital
In case of an output decline investment
should fall but only to the extent of
depreciation.
Ignores the gestation period

31. Other factors which affect investment
are profitability of investment,
availability of funds,etc.
Full capacity requirement is not always
satisfied.
Acceleration principle is used to explain
the shape of business cycles.