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Aggregate Demand - Aggregate
Supply Equilibrium
The Fixed-Price Keynesian Model: An Economy Below
Full – Employment
Focus on the Demand Side
Factors that Affect AD
Consumption ≈ 68% of gdp– INCOME– Wealth Price– Interest Rates Price– Expectations
• Future Income• Future Prices
– Demographics– Taxes
Investment ≈ 17% of gdp– Interest Rates Price– Technology– Cost of Capital Goods– Capacity Utilization– Expectations!!!
AD = C + I + G + NXGovernment Spending
≈ 18% of gdpNet Exports ≈ - 3% of gdp
– Foreign Income– Domestic INCOME– Foreign Prices– Domestic Prices– Exchange Rates
– Foreign Interest Rates– Domestic Interest Rates
– Government Policy– Tariffs, Quotas, etc.– Gov’t Procurement
Consumption and Disposable Income 1947-2002
Simple Consumption FunctionIgnore depreciation, taxes, etc. for the time beingThen DI = Y = Aggregate Income = Real GDP
C = a + bY is a straight line with slope b.
a is autonomous autonomous consumptionconsumption.
The slope, b, is the marginal marginal propensity to consumepropensity to consume (MPCMPC).
0 < MPC < 1. MPC is C/Y, the amount by
which consumption changes for each dollar change in Y
C
Aggregate Income Y
a
C
Y
MPC = C/Y = b
Saving Function and
Autonomous Shifts in
Consumption and in Saving
Investment Spending (I)• Capital goods have a long life.• Capital goods take time to build.• Capital goods involve large expenditure.• The present value of a capital good
depends on the income it generates over a long time horizon.– Businesses must form expectations
about future conditions and profitability.– Investment is inherently risky.
• Investment expenditure tends to be erraticerratic.
Investment as a Function of Current IncomeInvestment depends more on expectations of the future than on what’s happening now.
The Aggregate Expenditures FunctionAE = C + I + G + NXG + NX
Real GDP (Output)
Agg
rega
te p
lan
ned
expe
ndit
ure
400
500
600
700
0 300 400 500 600 700
45o line: AE = Y
Total Expenditure
Reduce Output,Reduce Employment
Increase Output,increase Employment
Movement to EquilibriumMovement to Equilibrium
Equilibrium Real GDP: mpc = .75(1)
RealGDP(Y)
(2)
Consumption(C)
(3)Planned
Investment(I)
(4)Gov’t
Spending(G)
(5)Net
Exports(NX)
(6)Aggregate
Expenditures(AE)
(7)Unplanned Change in Inventories
(8)Change in Real
GDP
0 100 25 0 0 125 -125 Up
100 175 25 0 0 200 -100 Up
Equilibrium Real GDP: mpc = .75(1)
RealGDP(Y)
(2)
Consumption(C)
(3)Planned
Investment(I)
(4)Gov’t
Spending(G)
(5)Net
Exports(NX)
(6)Aggregate
Expenditures(AE)
(7)Unplanned Change in Inventories
(8)Change in Real
GDP
0 100 25 0 0 125 -125 Up
100 175 25 0 0 200 -100 Up
200 250 25 0 0 275 -75 Up
300 325 25 0 0 350 -50 Up
Equilibrium Real GDP: mpc = .75(1)
RealGDP(Y)
(2)
Consumption(C)
(3)Planned
Investment(I)
(4)Gov’t
Spending(G)
(5)Net
Exports(NX)
(6)Aggregate
Expenditures(AE)
(7)Unplanned Change in Inventories
(8)Change in Real
GDP
0 100 25 0 0 125 -125 Up
100 175 25 0 0 200 -100 Up
200 250 25 0 0 275 -75 Up
300 325 25 0 0 350 -50 Up
400 400 25 0 0 425 -25 Up
500 475 25 0 0 500 0 No chg
Equilibrium Real GDP: mpc = .75(1)
RealGDP(Y)
(2)
Consumption(C)
(3)Planned
Investment(I)
(4)Gov’t
Spending(G)
(5)Net
Exports(NX)
(6)Aggregate
Expenditures(AE)
(7)Unplanned Change in Inventories
(8)Change in Real
GDP
0 100 25 0 0 125 -125 Up
100 175 25 0 0 200 -100 Up
200 250 25 0 0 275 -75 Up
300 325 25 0 0 350 -50 Up
400 400 25 0 0 425 -25 Up
500 475 25 0 0 500 0 No chg
700 625 25 0 0 650 50 Down
Equilibrium Real GDP: mpc = .75(1)
RealGDP(Y)
(2)
Consumption(C)
(3)Planned
Investment(I)
(4)Gov’t
Spending(G)
(5)Net
Exports(NX)
(6)Aggregate
Expenditures(AE)
(7)Unplanned Change in Inventories
(8)Change in Real
GDP
0 100 25 0 0 125 -125 Up
100 175 25 0 0 200 -100 Up
200 250 25 0 0 275 -75 Up
300 325 25 0 0 350 -50 Up
400 400 25 0 0 425 -25 Up
500 475 25 0 0 500 0 No chg
600 550 25 0 0 575 25 Down
700 625 25 0 0 650 50 Down
Equilibrium Real GDP: mpc = .75(1)
RealGDP(Y)
(2)
Consumption(C)
(3)Planned
Investment(I)
(4)Gov’t
Spending(G)
(5)Net
Exports(NX)
(6)Aggregate
Expenditures(AE)
(7)Unplanned Change in Inventories
(8)Change in Real
GDP
0 100 25 0 0 125 -125 Up
100 175 25 0 0 200 -100 Up
200 250 25 0 0 275 -75 Up
300 325 25 0 0 350 -50 Up
400 400 25 0 0 425 -25 Up
500 475 25 0 0 500 0 No chg
600 550 25 0 0 575 25 Down
700 625 25 0 0 650 50 Down
Equilibrium Output (Y) & Spending (AE)and
Autonomous Spending Multiplier
Polish your algebraPolish your algebraY = C + I = {100 + .75 Y} + 25
Y = 125 + . 75 Y
Y - .75 Y = (1 - .75)Y = (1 – mpc) Y = 125
.25 Y = 125
= Autonomous Spending
Y = (1/.25) 125 = 4 x 125 = 500In general,
Y = Autonomous Spending/(1 – mpc)
= Autonomous Spending/mps
=AutonomousSpend/{marginal propensity to leak}
Spending Multiplier
• The spending multiplier measures the change in equilibrium income (real GDP) produced by change in autonomous expenditures:
ΔY/ΔI
By how many dollars does real GDP change for every dollar change in autonomous
expenditures?
MPS
1
leakages
1Multiplier
Multiplier at Work
Introduce Government Spending: mpc = .75(1)
RealGDP(Y)
(2)
Tax(T)
(3)Disposable
Income(Yd)
(4)ConsumptionC=100+.75 Yd
(C)
(5)Planned
Investment(I)
(6)Gov’t
Spending(G)
(7)Aggregate
Expenditure(AE)
(8)Change in Real GDP
0 0 0 100 25 50 175 Up
100 0 100 175 25 50 250 Up
200 0 200 250 25 50 325 Up
300 0 300 325 25 50 400 Up
400 0 400 400 25 50 475 Up
500 0 500 475 25 50 550 UP
Introduce Government Spending: mpc = .75(1)
RealGDP(Y)
(2)
Tax(T)
(3)Disposable
Income(Yd)
(4)ConsumptionC=100+.75 Yd
(C)
(5)Planned
Investment(I)
(6)Gov’t
Spending(G)
(7)Aggregate
Expenditure(AE)
(8)Change in Real GDP
0 0 0 100 25 50 175 Up
100 0 100 175 25 50 250 Up
200 0 200 250 25 50 325 Up
300 0 300 325 25 50 400 Up
400 0 400 400 25 50 475 Up
500 0 500 475 25 50 550 UP
600 0 600 550 25 50 625 UP
Introduce Government Spending: mpc = .75(1)
RealGDP(Y)
(2)
Tax(T)
(3)Disposable
Income(Yd)
(4)ConsumptionC=100+.75 Yd
(C)
(5)Planned
Investment(I)
(6)Gov’t
Spending(G)
(7)Aggregate
Expenditure(AE)
(8)Change in Real GDP
0 0 0 100 25 50 175 Up
100 0 100 175 25 50 250 Up
200 0 200 250 25 50 325 Up
300 0 300 325 25 50 400 Up
400 0 400 400 25 50 475 Up
500 0 500 475 25 50 550 UP
600 0 600 550 25 50 625 UP
700 0 700 625 25 50 700 No Change
Now add a tax (leakage): mpc = .75(1)
RealGDP(Y)
(2)
Tax(T)
(3)Disposable
Income(Yd)
(4)ConsumptionC=100+.75 Yd
(C)
(5)Planned
Investment(I)
(6)Gov’t
Spending(G)
(7)Aggregate
Expenditure(AE)
(8)Change in Real GDP
200 50 150 212.50 25 50 287.50 Up
300 50 250 287.50 25 50 362.5 Up
400 50 350 362.50 25 50 437.50 Up
500 50 450 437.50 25 50 512.50 UP
700 50 650 587.50 25 50 662.50 DOWN
Now add a tax (leakage): mpc = .75(1)
RealGDP(Y)
(2)
Tax(T)
(3)Disposable
Income(Yd)
(4)ConsumptionC=100+.75 Yd
(C)
(5)Planned
Investment(I)
(6)Gov’t
Spending(G)
(7)Aggregate
Expenditure(AE)
(8)Change in Real GDP
200 50 150 212.50 25 50 287.50 Up
300 50 250 287.50 25 50 362.5 Up
400 50 350 362.50 25 50 437.50 Up
500 50 450 437.50 25 50 512.50 UP
600 50 550 512.50 25 50 587.50 DOWN
700 50 650 587.50 25 50 662.50 DOWN
Now add a tax (leakage): mpc = .75(1)
RealGDP(Y)
(2)
Tax(T)
(3)Disposable
Income(Yd)
(4)ConsumptionC=100+.75 Yd
(C)
(5)Planned
Investment(I)
(6)Gov’t
Spending(G)
(7)Aggregate
Expenditure(AE)
(8)Change in Real GDP
200 50 150 212.50 25 50 287.50 Up
300 50 250 287.50 25 50 362.5 Up
400 50 350 362.50 25 50 437.50 Up
500 50 450 437.50 25 50 512.50 UP
550 50 500 475.00 25 50 550.00 NO Change
600 50 550 512.50 25 50 587.50 DOWN
700 50 650 587.50 25 50 662.50 DOWN
Government Spending Multiplier:
ΔY/ΔG = 1/(1 – mpc) = 1/mps
= 1/(1 - .75) = 1/.25 = 4 in our example
Tax Multiplier:
Y = C + I + G = a + mpc (Y – T) + I + G
(1 – mpc) Y = a + I + G – mpc T
Y = {1/(1-mpc)}{a + I + G – mpc T}
When tax is increased
ΔY = {1/(1-mpc)}{ - mpc ΔT}
ΔY/ ΔT = {- mpc/mps} ΔT
= - .75/.25 = - .75 x 4 = - 3 in our example