Aggregate Demand and Aggregate Supply: Classical and Keynesian ApproachDr. Shylajan, C.S

Topics of DiscussionAggregate Demand The Downward-Sloping Aggregate Demand CurveShifts in Aggregate DemandAggregate SupplyClassical TheorySays LawShort run and long run Aggregate supply curve

Topics of DiscussionLabour market equilibrium under classical and Keynesian modelsKeynesian Theory of Output DeterminationThe Meaning of Equilibrium under Keynesian modelOutput Determination by Consumption and Investment (Simple economy)

AD & AS: Classical and Keynesian ApproachAggregate Demand is the total demand for goods and services in the economy.It depends on the aggregate price levelAggregate Supply curve shows the price level associated with each level of output.AS is the level of total national output that will be produced at each level of price, other things held constant.

Why AD Downward sloping?

The level of aggregate demand declines as the overall price level in the economy rises. (assuming other things constant). Why?

Aggregate Demand and Aggregate supply interact to determine equilibrium price and output (Real GDP)

Movements along the Aggregate Demand and Shifts of Aggregate Demand

Shifts in Aggregate Demand1. Due to change in policy variables

Due to change in variables such as money supply, tax policy, government expenditures etc

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

Aggregate DemandOur focus is on aggregate demand as the determinant of the level of output

Prices are given and constant

We need to know how given policy actions shift the aggregate demand curve at a given level of prices.

Short run vs Long run Aggregate Supply

Because the firms that supply goods and services have flexible prices in the long run but sticky prices in the short-run, the AS relationship depends on the time horizon.

Classical modelThe classical model describes how the economy behaves in the long run.We derive Long Run AS from the classical model.The amount of output produced depends on the fixed amounts of capital (K) and labor (L) and on the available tecnologyY= F(K, L)

Classical modelAccording to Classical model, output does not depend on the price level. Hence a vertical Long Run AS curve.In the long run, the intersection of the AD curve with its vertical AS curve determines the price level.Please note that if the AS curve is vertical, then changes in AD affects prices, but not output. (Graph)

Says Law of MarketsThe classical economy:- The prices and wages are flexible.Hence the economy is stableThe economy moves automatically and quickly to its full-employment output equilibriumNo need for government interventionBusiness cycles are temporary

Says lawJ B SayOverproduction is impossibleSupply creates its own demandClassical model:-output is determined by AS, and AD affects only the price levelPeople can buy whatever the firms produce. Hence no oversupply

Says lawNo role for ADChanges in the fiscal policy, investment, monetary policy or other spending factors no impact on output or employmentPrices and wages adjust quickly and flexibly to maintain full employmentChanges in AS leads to changes in real output (Graph)Failure of Classicalism was clear during Great Depression of 1930s with huge unemployment

Says lawThe classical model and vertical AS curve applies only in the long runIn the short run, prices are stickyHence SR AS curve is not verticalIn the short run, price level is fixed and firms are willing to sell as much as their customers are willing to buy

Says lawThe short run equilibrium of the economy is the intersection of the AD curve and the horizontal AS curve. Hence, changes in AD do affect the level of output. For instance, by increasing spending by investors we can increase output without increasing over all price. (Graph)

Labor market equilibriumDemand for labor functionSupply of labor functionEquilibrium in the labour marketClassical Model: Wage flexibility and full employmentKeynesian model: Sticky wages and prices

Labor market equilibriumThe demand for a factor of production reflects the marginal productivity of that output.Why demand for labour curve is downward sloping? The supply of labor: labour supply refers to the number of hours that the population desires to work in gainful activities.

Keynesian Income Determination : Simple EconomyIn a simple economy aggregate demand is the sum of the demand for consumption and investment goods.

It is the amount of goods people want to buy

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

Determination of Equilibrium Income and Output in a Simple Economy (Keynesian Theory)No government, no tradeOutput is at its equilibrium when planned Aggregate Demand (C + I) is equal to actual output (Y)AD = C +I

Y = AD

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

Determination of Equilibrium Income and Output in a Simple EconomyAt the equilibrium level of output, firms are selling as much as they produce, people are buying the amount they want to purchase.

So there is no inventory problem.

Deriving the Aggregate Demand Schedule and Equilibrium Output

Deriving the Planned Aggregate Demand Schedule and Finding Equilibrium. The Figures in Column 2 are Based on the Equation C = 100 + .75Y.(1)(2)(3)(4)(5)(6) AGGREGATE OUTPUT (INCOME) (Y) AGGREGATE CONSUMPTION (C) PLANNED INVESTMENT(I)PLANNED AGGREGATE EXPENDITURE ) C + IUNPLANNED INVENTORY CHANGE Y - (C + I) EQUILIBRIUM? (Y = C + I)10017525200- 100No20025025275- 75No40040025425- 25No500475255000Yes60055025575+ 25No80070025725+ 75No1,00085025875+ 125No

Output Determination by Consumption and Investment

Aggregate output :Y Planned aggregate expenditure or AD: C + I Equilibrium: Output = ADEquilibrium: Y = C + I

Meaning of Equilibrium income and outputOutput is at its equilibrium level when aggregate demand (AD) is equal to output (Y).What is AD? It is consumption spending plus investment spending

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

Meaning of Equilibrium income and output(a + I) is autonomous or independent of level of income.But aggregate demand also depends on the level of income (bY)Bcoz, consumption demand increases with income (bY)At equilibrium, Y = AD Y= (a + I) + bY

Meaning of Equilibrium income and outputSolve for equilibrium output (Ye)

Y- bY = (a +I)

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

Where b = marginal propensity to consume or MPC

(a + I ) is autonomous spending

Finding EquilibriumOutput in a simple economy- An ExampleBy substituting (2) and (3) into (1) we get:

Finding EquilibriumOutput in a simple economy- Graphically

The slope of the consumption function measures which of the following?1. Marginal propensity to consume2. Average propensity to consume3. Aggregate level of consumption4. Marginal propensity to save5. Average propensity to save

Find the equilibrium income when investment demand is 300 and the consumption function is C = 10 + .8 Y

At the equilibrium level of real GDP, which of the following is true?Unplanned inventory investment is positive

2.Unplanned inventory investment is negative

3.Aggregate output equals aggregate expenditure

4.Aggregate output plus consumption spending equals aggregate expenditures

5.Aggregate output plus saving equals aggregate expenditure

Topics of DiscussionThe Investment MultiplierThe Multiplier in the AS-AD FrameworkAggregate Demand by Introducing the Government Sector Determination of Equilibrium Income with Government SectorDetermination of Equilibrium Income in an Open Economy The Paradox of Thrift

The Simple Multiplier ModelIt is the change in equilibrium output when autonomous demand increases by one unit.

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

Larger the MPC , the larger the multiplier

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

The Multiplier

An increase in autonomous spending raises the equilibrium level of income

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

The larger the MPC, the larger the multiplier

The Multiplier in the AS-AD FrameworkIn a multiplier model, we use Consumption plus Investment approach to determine equilibrium output.

Equilibrium output is achieved when aggregate expenditure equals real GDP

The Multiplier in the AS-AD FrameworkIn AS-AD framework, it is achieved when downward sloping Aggregate Demand Curve cuts the upward sloping Aggregate Supply curve

Aggregate Demand by Introducing the Government Sector (Fiscal policy in the multiplier model)

How governments fiscal policies affect output?

What is Fiscal Policy?

By Government taxationBy Government spendingBy Transfer Payments

How government spending and taxation programmes affect output?

Aggregate Demand by Introducing the Government SectorNow we have GDP = C + I + G +NXConsumption expenditureGross private domestic investmentGovernment purchase of goods and servicesNet exports

Determination of Equilibrium Income with Government Sector

Assume we have a closed economySo we have GDP = C + I + GTotal spending is C + I + GEquilibrium output is determined when aggregate spending equals GDP.At this point, total planned spending exactly equals total planned output.

Determination of Equilibrium Income with Government SectorThree models:

1. With government spending (G)2. Tax (as a fraction of income, tY)3.Tax as lump sum4. Transfer Payments (TR)

Impact of Taxation on Aggregate DemandThe increase in taxes will lower disposable income Then C=a+bYd where Yd=Y+TR-tYConsumption schedule shifts downwardsGovernment taxation tend to reduce aggregate demand and the level of GDP

Determination of Equilibrium Income in an Open Economy

GDP = C + I + G + NXWe have Exports and ImportsExports = XImports =MNet Exports (NX) = X - M

Determination of Equilibrium Income in an Open EconomyWhat are the determinants of Exports?Exports are exogenously givenWhat are the determinants of Imports?Imports depend mostly on income of the economy (Y)There is autonomous import which is independent of income or any other variables

Determination of Equilibrium Income in an Open EconomyHence, Import function is M = mo +mYWhere mo is autonomous import

Where m is marginal propensity to import. That is, change in import for a change in income, Y

Determination of Equilibrium Income in an Open Economy

Given the consumption function, Tax rate, Transfer payments, Investment, Government spending, Export, and Import function how do we determine equilibrium level of income?

Determination of Equilibrium Income in an Open EconomyConsumption is a function of disposable incomeC = a + bYdWhere Yd = (Y tY+TR)Where tY . Proportionate tax rateTR is Government Transfer Payments C = a + b (Y - tY + TR)

Determination of Equilibrium Income in an Open EconomyAD = C + I + G + (X M)

Equilibrium is at Y = AD

Numerical problems

The Paradox of Thrift

More saving looks beneficial to individuals.

But if everybody starts saving without spending on consumption, it will reduce demand for goods.

The paradox of thrift implies that more personal savings could harm the economy as a whole, especially during recession or depression.

Japan battles with paradox of thrift?

Thanks

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