Download Macroeconomics

Macroeconomics
Chapter 12
AGGREGATE DEMAND
Prepared by: Abdullah Al-Otaibi
Aggregate demand: is the total value of goods and services demanded
in an economy.
Aggregate supply: is the total value of goods and services supplied in
an economy.
Say’s Law:
• Say (1767-1832) is a well-respected French businessman and
scholar, he advocates the benefits of free markets, and outlines his
controversial ‘law of markets’, which is known as ‘Say’s Law’.
• Say’s Law is the summary of the idea that ‘supply creates its own
demand’ for the economy as a whole.
• Say’s Law states that aggregate demand in an economy could
neither exceed nor fall below aggregate supply in that economy.
• The implication of this ‘law’ is that any fluctuations in the levels of
output and employment in the economy should be only temporary
and self-reversing.
• Thus, the economy is ‘self-correcting’ and any situation of
unemployment should quickly revert to full employment.
Say’s Law critics:
John Maynard Keynes (1883-1946):
• Say’s law and its economic implications were criticized by Keynes.
These criticisms were generated from suffering of the Great
Depression of the 1930’s which was one of the most disruptive
economic crises in history, that resulted in mass unemployment and
greatly reduced levels of GDP in the major Western countries.
• Keynes presented a new way of analyzing the economy, the theory
of ‘aggregate demand’.
• In Keynes’s vision there was no self-correcting property in the
economy that would solve economic downturns.
• In his theory, the level of employment depends on the level of
aggregate demand, which he claimed could settle at any level.
• As a result, the equilibrium level of employment in the economy
could also be at any level between zero and full employment.
• Keynes concluded that full employment represents just
one particular outcome of an economic system, and that
other levels of employment could also result and could
coexist with unused productive capacity.
• According to Keynes’s perception, aggregate demand for
goods and services underlies the determination of total
income and employment in the economy.
The determinants of aggregate demand in a closed
economy with no government sector:
• A causal explanation of what determines national income
and employment must start with a study of what
determines the planned level of expenditure in an
economy. In other words, it should begin with an analysis
of aggregate demand.
There are four major components of aggregate
demand:
• Consumption demand,
• Investment demand,
• Government demand,
• And net foreign demand (export demand – import
demand).
• We assume what is called a ‘closed economy’, the one with no foreign
trade, and government expenditure.
• So that, we concentrate on examining the determinants of the first two
components of the aggregate demand, consumption and investment
demand.
Consumption demand:
• Consumption demand consists of the expenditures that households plan
to make on both durable and non-durable goods, and on services.
• Durable goods: are those commodities, such as cars and computers,
that generate benefits for their owners over a substantial period of time.
• Non durable goods: are those commodities, such as food and clothes,
which are consumed or used over a relatively short time period.
• Services: are those commodities, such as a medical check-up or the
teaching of a class, that have the characteristic of having to be
consumed at the same time as they are produced.
• Consumption demand and its fluctuations are an
essential part of the explanation of booms and
recessions.
• Keynes assumed that planned consumption demand C
depends on Y the level of current disposable income of
households.
• Disposable income: is the income that households can
spend, that is = total income + transfers – taxes.
• In this case disposable income = total income, because
we are assuming a simple model with no government
expenditures or taxation.
• In Microeconomics, market demand was a function
principally of relative prices, while in the Keynesian
model consumption demand is a function principally of
current incomes.
• The key idea of Keynes is ‘Consumption depends on
income’ can summarized by the following equation;
C = C + bY
This equation states that consumption is a function of
income, and it represents a simple explanation of
consumption behavior of individuals.
C is ‘autonomous consumption’, that is expenditure which
does not depend on households’ income. So it is
expenditure that households will undertake even if they
have no income.
b ‘marginal propensity to consume’ that tells us the extent to
which a marginal change in income is associated with a
marginal change in consumption. It’s value assumed to be
positive but less than one unity.
0
0
0<b<1
• Anything that the household does not spend is saved,
and hence the consumption function indicates that some
part of any additional increment of income is saved,
then.
Savings = Y – C
so that, the saving function of the economy is;
S = Y – (C + bY)
= -C + (1-b)Y
(1-b) is called the marginal propensity to save of the
economy, it tells us the extent to which a marginal
change in income is associated with a marginal change
in savings.
0
0
A graphical illustration of the consumption function;
C = C + bY
0
C
b
C
0
0
Disposable income (Y)
The Nobel prize winning economist Franco
Modigliani pointed out that:
• (a) income varies over a person’s life.
• (b) people use saving and borrowing to smooth
their consumption over their lifetimes.
• Thus he concluded that, consumption demand
should depend not only on current income but
also on their future prospects for income.
• Modigliani’s life-cycle hypothesis:
individuals will pay regard to their lifetime income
prospects when making consumption and saving
decisions.
• Modigliani argued that most people
do not want a major decline in the
standard of living when they retire.
This means that during his/her
working years this individual would
save part of his/her income and
accumulate wealth. After retirement
he/she would then use the income
saved (dissaving) and wealth to keep
enjoying his/her pattern of
consumption.
A graphical illustration of the life-cycle hypothesis
wealth
C
Saving
dissaving
Time
retirement begins
death
• The life-cycle hypothesis
suggests that people will tend to
save little over the full course of
their lifetime, but that savings are
used to shift consumption from
periods when income is relatively
high to periods when income is
expected to be relatively low.
Another Nobel prize winning economist, Milton Friedman,
proposed a similar theory of consumption.
• He suggested distinguishing between ‘Transitory’ and
’Permanent’ income.
• ‘Transitory’ income: is the part of income received in one
period that is not expected to recur in the future.
• ‘Permanent’ income: is the part of income that is expected
to go on year after year.
• The ‘permanent-income’ hypothesis:
He maintained that only permanent income should enter in
the consumption function since saving and borrowing are
used to smooth the effects of changes in transitory income.
Thus, transitory income would be ignored in the demand for
consumption since the long-term for permanent income are
not changed.
Investment demand
• Investment consists of spending by firms and
households to increase their captial.
• Firms make two types of investment spending;
1- (Fixed investment):
capital inputs
2- (inventory investment):
finished output in
storage or work in progress.
• Household’s investment spending
New residences
• When firms make investment decisions they have to
forecast the flow of future income that a project is likely
to generate. Thus, most of the changes in the level of
income when a country experiences a boom or
recession are thought to be due to a decline in, or a
recovery of, investment demand.
• There are two factors that firms are likely to consider
when they plan investments.
• (1)- The cost of financing investment.
Interest rate
on bank loans
• (2)- The expected returns on the projects they plan to
invest in.
• The link between investment demand and the rate of
interest on bank loans (r) can be expressed as an
investment function
I = I (r)
If the interest rate or the cost of borrowing is low relative
to the returns they expect from the investment, firms will
go ahead with the investment and so increases the
demand for investment. vice versa.
The basic model of income determination:
• In constructing a model of income determination,
we distinguish between exogenous and
endogenous variables.
• Exogenous variables: are those variables that
are considered fixed, that is determined outside
the model.
• Endogenous variables: are those variables that
are determined within that particular model.
• In an economic model the exogenous variables
determine the endogenous variables.
Income determination in a closed economy
with no government sector:
• For combining aggregate demand within a simple and
closed economy, the following assumptions are considered
for simplicity;
(1) we are considering a closed economy, that is net foreign
demand is zero, and government investment is not
considered
(2) investment demand is a function of the interest rate
alone.
(3) aggregate demand is the combination of consumption
demand C and investment demand I.
• AC = C + I
• AC = C0 + bY + I(r)
• This equation tells us the variables that are directly
capable of influencing the level of aggregate demand.
Thus, it states that aggregate demand depends on a
constant or exogenous term C and the two other
variables r and Y.
0
• The equilibrium level of income arises when the plans for
aggregate demand can be fulfilled, so that the level of
output (income) is equal to the level of aggregate
demand, or
Y = AD
Y = C + bY + I(r)
0
Y = (C0 + I)
(1 – b)
=
1
(C + I)
1-b
0
• This means that when either of the exogenous elements
of expenditure, C or I, changes by a certain amount,
income changes by 1
times that amount.
1–b
This is a bigger change in income that the original change
in exogenous expenditure because 1 – b is the marginal
propensity to save 0 < b < 1 , so 1
is greater that 1.
1–b
0
The following graph illustrates;
(1)- The aggregate demand in the economy against the
level of income.
(2)- Every point on the diagonal 45 line represents the
equilibrium condition. “The equilibrium condition is to
have equality between aggregate demand and
aggregate supply (total national income),”
(3)- If we suppose that the investment expenditure
increases by MN. The aggregate demand schedule
shifts upward by the extent of the increase in
investment expenditure, from (C + 1) to (C + 1)
(4)- The equilibrium level of income increases from Ya to
Yb. And, the total increase in income is the
distance MO.
(5)- we notice that MO > MN, which means that, the level
of income has changed by more that the change in
investment expenditure.
AD = C+I
Y=Y
(C+1)’
(C+1)
N
M
O
Ya
Yb
45
Total national income Y
The multiplier process:
• The ratio MO/MN (the increase in income divided by the
increase in investment expenditure) is referred to a the
‘Keynesian multiplier’.
• It measures by how much you have to multiply an
increase in ‘Autonomous Expenditure’ to work out the
corresponding increase in income.
• Autonomous Expenditure: is expenditure on
consumption, investment or by the government that
happens independent of the level of national income.
• The multiplier =
1
1-b
(the inverse of the marginal propensity to save)
• As a result of that, we can represent the multiplier as the
following:
MO = 1
MN
(1 - b)
• The multiplier is based on the assumption that all
changes in aggregate demand are translated into
corresponding changes in the level of output.
• Thus, The multiplier is defined as the ratio of the change
in real GDP resulting from a change in an autonomous
(exogenous) component of the aggregate demand (for
example, investment demand or autonomous
consumption expenditure).
Multiplier =
change in real GDP
change in autonomous component of AD
Extending the model: Government spending and an
open economy:
• Government demand G are another important
component of aggregate demand. It is taken to be as an
exogenous policy variable, that is the value of the
variable is taken as a fixed value G. So
G=G
• Governments finance these expenditures through the
imposition of taxes T, which reduces disposable income
with households, but government spending adds to
aggregate demand.
• If the level of taxes is exogenous, we can write T = T
• The level of equilibrium income (Y = AD) in the case of
government spending;
1
(C – bT + I + G)
1–b
• The level of equilibrium income in the case of open
economy (with imports and exports) as an additional
influences on aggregate demand;
Y = AD
Y = AD = C + b(Y - T) + I + G + X – m(Y - T)
Y=
0
0
Y=
1
(C + I + G + X – (b - m)T
1 – (b - m)
0
• There is an extra leakage (imports) from the circular flow
of income, so the multiplier is now 1
which is
1-(b-m)
smaller than in the case of the closed economy.
Employment, Unemployment and the real wage:
The scope for government policy:
• A role for government intervention in the economy is
suggested in this simple model to secure full employment
because aggregate income and employment ultimately
depend on the level of aggregate demand.
• Government can intervene to increase or decrease
aggregate demand directly by their spending actions, or
indirectly by trying to influence interest rates in the
economy.
Fiscal policy: is the taxation and spending activities of
governments.
By raising the level of aggregate demand in the economy
the government would in effect be increasing the demand
for labor in the economy. As a consequence, employment
and income in the economy can increase as a result of an
expansion of government expenditure.
• When investment expenditure is low, government
spending can stimulate aggregate demand and restore
employment through three limits.
• First, it takes time to decide on and implement changes
in the level of public expenditure. For example, statistics
must be collected in order to take the rational decision,
then, approval for changes in public expenditure have to
be secured through parliament.
• The second limit arises from the funding of an increase
in government expenditure which would generally
involve an increased budget deficit (or smaller surplus).
• The third limit is the concern that an increase in
government expenditure stimulates demand to a level
which exceeds the capacity of the economy to supply.
When demand is high relative to capacity, there can be
problems of inflation developing.
Monetary policy:
• Monetary policy, in the form of changing interest rates,
can be used o influence the level of aggregate demand
in the economy.
• The central bank sets the interest rate on loans.