ECN 202: Principles of MacroeconomicsNusrat Jahan

Lecture-10

Aggregate Demand and Aggregate Supply

There is a very close relationship between Income, Consumption and Saving.

Saving = Income-Consumption

To understand the way Consumption and Saving affects National Income we need to understand the following tools-

Consumption FunctionSaving Function

Consumption Function:Consumption Function is the relationship between Income and Consumption

Break-even Point- It is the level of income for which Income=Consumption Non-Income Determinants of ConsumptionWealthExpectation about InflationReal Interest Rate

Savings Function:Savings Function is the relationship between Income and Saving. It can be derived from the Consumption Function

Disposable Income Consumption100 150200 220300 300400 380500 450600 520

100 200 300 400 500 6000

100

200

300

400

500

600

700

Consumption 520

Break-even point

45° 600

Consumption Function

Inco

me

100 200 300 400 500 600

-60

-40

-20

0

20

40

60

80

100Saving Function

Marginal Propensity to Consume (MPC): The extra amount that people consume when they receive an extra dollar of disposable income.

Marginal Propensity to Save (MPS): The fraction of an extra dollar of disposable income that goes to extra saving.

MPC + MPS = 1Average Propensity to Consume (APC): The percentage of income spent.

Average Propensity to Save (APS): The percentage of Income saved.APC + APS = 1

Disposable

Income

Consumption

Expenditure

Marginal

Propensity to

Consume

Average

Propensity to

Consume

Net Saving Marginal

Propensity to

Save

Average

Propensity to

Save

1000 11001

1.1 -1000

-0.1

2000 2100 1.05 -100 -0.05

0.9 0.1

3000 3000 1 0 0

0.7 0.3

4000 37000.5

0.92 3000.5

0.075

5000 4200 0.84 800 0.16

0.3 0.7

6000 4500 0.75 1500 0.25

Output Determination by Consumption and Investment (Two Sector Model)

Aggregate Expenditure for a closed- private economy = C + IgIn Equilibrium, GDP= C+ IgIf GDP>C+Ig then, production will go down and GDP will come back to equilibriumIf GDP<C+Ig then, production will increase and GDP will come back to equilibrium.

Tot

al S

pen

din

g

I

C

C+I

MA

45°

GDP

E

Output Determination by Consumption, Investment and Governement Expenditure (Three Sector Model)

Aggregate Expenditure for a closed- mixed economy = C + Ig+GIn Equilibrium, GDP= C+ Ig+GIf GDP>C+Ig+G then, production will go down and GDP will come back to equilibriumIf GDP<C+Ig+G then, production will increase and GDP will come back to equilibrium.

Tot

al S

pen

din

g

I

C

C+I+G

MA

45°

GDP

EC+I

G

B

Output Determination by Consumption, Investment,Governement Expenditure (Four Sector Model)Aggregate Expenditure for an open- mixed economy = C + Ig+G+NXIn Equilibrium, GDP= C+ Ig+G+NXIf GDP>C+Ig+G+NX then, production will go down and GDP will come back to equilibriumIf GDP<C+Ig+G+NX then, production will increase and GDP will come back to equilibrium.

Tot

al S

pen

din

g

I

C

C+I+G

MA

45°

GDP

E

C+I

C+I+G+NX

G

NX

B C

The MultiplierThe multiplier is the number by which the change in expenditure must be multiplied in order to determine the resulting change in output/GDP.

The Basic Model of Economic Fluctuations Aggregate Demand and Aggregate Supply

Two variables are used to develop a model to analyze the short-run fluctuations.

The economy’s output of goods and services measured by real GDP.

The overall price level measured by the CPI or the GDP deflator.

Economists use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

The aggregate-demand curve shows the quantity of goods and services that households, firms, and the government want to buy at each price level.

The aggregate-supply curve shows the quantity of goods and services that firms choose to produce and sell at each price level.

The Aggregate Demand Curve

The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

Why the Aggregate Demand Curve might shift?

Shifts arising from Consumption InvestmentGovernment ExpenditureNet Export

Why the Short-Run Aggregate-Supply Curve Might Shift

Labor Capital Natural Resources. Technology. Expected Price Level

P

Y

AD

AD’

AD”

ASAS’

AS”

Two Causes of Economic Fluctuations

Shift in Aggregate Demand

Shift in Aggregate Supply