2.2. Aggregate Demand and Aggregate Supply

As economists we want to be able to model what is happening in an economy - particularly in the macro-economy. This enables us to analyze what causes changes in the economy at the macro level and to develop appropriate policies to achieve our macro goals.In managing a country's economy, governments are usually aiming to:

Maintain high levels of employment or full employment Maintain price stability - low and consistent levels of inflation Maintain a satisfactory balance of payments Maintain high levels of economic growth

There will always be trade-offs between these macroeconomic goals, because it can be difficult to maintain all of them at once; governments will, as a result, face decisions on acceptable levels for each target.

In trying to understand the various macroeconomic problems a country might face, and the policies that its government may adopt in response, it is useful to look at one of the most common theoretical frameworks for analyzing the macro-economy; those of aggregate demand and supply. These are similar to the concepts of demand and supply that we considered in Section 1, but with the addition of the word 'aggregate'. Aggregate means 'the sum of', so we are now looking at total demand and supply in the whole economy, instead of demand and supply of goods and services in individual markets.

The AD/AS modelThe AD/AS model is central to macro-economic analysis, because it focuses on the determination of the equilibrium level of real output and the level of prices.Using AD and AS curves, allows us in a relatively simple way, to illustrate complex inter-relationships and linkages, that are characteristic of market economies.

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What are the differences between the AD/AS model and the D&S model?

Figure 1 Demand and supply and AD/AS compared

Aggregate Demand

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 four components of GDP (Y) contribute to the aggregate demand for goods and services.

Y = C + I + G + NX

Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX)

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1. Consumption (C):The spending by households on goods and services, with the exception of purchases of new housing.

2. Investment (I):The spending on capital equipment, inventories, and structures, including new housing.

3. Government Purchases (G):This is the spending on goods and services by local, state, and federal governments. Does not include transfer payments because they are not made in exchange for currently produced goods or services.

4. Net Exports (NX):Export revenue minus import expenditure.

Components of US real GDP

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The relative growth of consumption 1950 - 2010

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Reasons for why the AD curve has a negative slope

1. The Price Level and Consumption: Pigou’s Wealth EffectA decrease in the price level makes consumers feel wealthier, which in turn encourages them to spend more. This increase in consumer spending means larger quantities of goods and services demanded.

2. The Price Level and Investment: Keynes’ Interest Rate EffectThe lower the price level, the less money households need to buy goods and services. When the price level falls, households try to reduce their holdings of money by lending some out (either in financial markets or through financial intermediaries). As households try to convert some of their money into interest-bearing assets, the interest rate will drop. Lower interest rates encourage borrowing by firms that want to invest in new plants and equipment and by households who want to invest in new housing. Thus, a lower price level reduces the interest rate, encourages greater spending on investment goods, and therefore increases the quantity of goods and services demanded.

3. The Price Level and Net Exports: Mundell-Fleming Exchange-Rate Effect

A lower price level in the United States lowers the U.S. interest rate. American investors will seek higher returns by investing abroad, increasing U.S. net capital outflow. The increase in net capital outflow raises the supply of dollars, lowering the real exchange rate. U.S. goods become relatively cheaper to foreign goods. Exports rise, imports fall, and net exports increase. Therefore, when a fall in the U.S. price level causes U.S. interest rates to fall, the real exchange rate depreciates, and U.S. net exports rise, thereby increasing the quantity of goods and services demanded.

All three of these effects imply that, all else equal, there is an inverse relationship between the price level and the quantity of goods and services demanded.

See also - http://web.sis.edu.hk/Departments/EcoBus/macroeconomics_11/media/adcurve.html

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Causes of shifts in the AD Curve

The downward slope of the aggregate demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. Many other factors, however, affect the quantity of goods and services demanded at any given price level. When one of these other factors changes, the aggregate demand curve shifts.

A change in factors affecting any one or more components of aggregate demand, households (C), firms (I), the government (G) or overseas consumers and business (X) changes planned aggregate demand and results shift in the AD curve.

Consider the diagram below, which shows an inward shift of AD from AD1 to AD3 and an outward shift of AD from AD1 to AD2. The increase in AD might have been caused for example by a fall in interest rates or an increase in consumers’ wealth because of rising house prices.

Aggregate demand from the perspective of Hong Kong

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1. Shifts Arising from Consumption

If consumers in Hong Kong become more concerned with saving for retirement (negative change in consumer confidence) and reduce current consumption, aggregate demand will decline.

If the government cuts direct (income tax) & indirect (goods and services) taxes, it encourages people to spend more, resulting in an increase in aggregate demand.

An rise in house prices or the value of shares increases consumers’ wealth and allow an increase in borrowing to finance consumption increasing AD

Other factors include a change in interest rates and the level of household indebtedness.

2. Shifts Arising from Investment

Suppose that the computer industry introduces a faster line of computers and many firms decide to invest in new computer systems. This will lead to an increase in aggregate demand.

If firms become pessimistic about future business conditions, they may cut back on investment spending, shifting aggregate demand to the left.

An investment tax credit increases the quantity of investment goods that firms demand, which results in an increase in aggregate demand.

An increase in the supply of money lowers the interest rate in the short run. This leads to more investment spending, which causes an increase in aggregate demand.

Other factors include access to technology and the level of corporate indebtedness.

3. Shifts Arising from Government Purchases

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If LegCo/government decides to reduce purchases of medical and pharmaceutical products, aggregate demand will fall.

If the Hong Kong government decides to purchase more fire-fighting equipment, aggregate demand will shift to the right.

4. Shifts Arising from Net Exports

When Europe experiences a recession, it buys fewer Hong Kong goods & services, which lowers net exports. Aggregate demand will shift to the left.

If the exchange rate of the U.S. dollar increases which appreciates the Hong Kong dollar, Hong Kong goods & services become more expensive to foreigners. Net exports fall and aggregate demand shifts to the left.

Another factor that can affect net exports is the level of protectionism in the economies of Hong Kong’s trading partners.

Aggregate Supply

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

In the long run, the aggregate-supply curve is vertical In the short run, the aggregate-supply curve is upward sloping

Short run aggregate supply (SRAS) shows total planned output in the economy when prices can change but the prices and productivity of all factor inputs e.g. wage rates and the state of technology are held constant.

Long run aggregate supply (LRAS): LRAS shows total planned output when both prices and average wage rates can change – it is a measure of a country’s potential output and the concept is linked strongly to that of the production possibility frontier.

Short-run Aggregate Supply

Why does the short-run aggregate supply curve slope upwards (positive slope)

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i. Sticky-Wage Theory: Short-run aggregate-supply curve slopes upward because nominal wages are slow to adjust, or are “sticky” in the short-run. To some extent, the slow adjustment of nominal wages is attributable to long-term contracts between workers and firms that fix nominal wages. Because wages do not adjust immediately to the price level, a lower price level makes employment and production less profitable, so firms reduce the quantity of goods and services they supply.

ii. Sticky-Price Theory: Short-run aggregate-supply curve slopes upward because the prices of some goods and services are slow to adjust, or are “sticky” in the short-run. To some extent, the slow adjustment the prices of some goods and services because they are costs to adjusting prices menu costs. is attributable to long-term contracts between workers and firms that fix nominal wages. Because not all prices adjust instantly to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-desired prices, and these higher-than-desired prices depress sales and induce firms to reduce the quantity of goods and services they produce.

iii. The Misperception Theory: Changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output. They mistakenly believe that their relative prices have fallen. Example: workers may notice a fall in their nominal wages before they notice a fall in the prices of the goods they buy. They may infer that the reward to working is temporarily low and respond by reducing the quantity of labor they supply. A lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied.

See also - http://web.sis.edu.hk/Departments/EcoBus/macroeconomics_11/media/srascurve.html

Shifts in the aggregate supply curve

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Shifts in the SRAS curve can be caused by the following factors:

1. Changes in unit labour costs: Unit labour costs are defined as wage costs adjusted for the level of productivity. For example a rise in unit labour costs might be brought about by firms agreeing to pay higher wages or a fall in the level of worker productivity. 2. Commodity prices: Changes to raw material costs and other components e.g. the world price of oil, copper, aluminium and other inputs in many production processes will affect a firm’s costs. These costs might be affected by a change in the exchange rate, which causes fluctuations in the prices of imported products. A fall (depreciation) in the exchange rate increases the costs of importing raw materials and component supplies from overseas. 3. Government taxation and subsidy: Changes to producer taxes and subsidies levied by the government as part of their fiscal policy – for example an increase in taxes on producers designed to meet the government’s environmental objectives will cause higher costs and an inward shift in the short run aggregate supply curve.

Alternative views of the long run aggregate supply curve

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Monetarist/New Classical In the long run, the ability of an economy to produce goods and services to meet demand is based on the level of production technology and the availability of factor inputs. A production function for a country is often written as follows:

Y*t = f (Lt, Kt, Mt)

Y* is an aggregate measure of potential output in a given economy T is the time period under consideration L represents the quantity and ability of labour input available to the

production process K represents the available capital stock, i.e. machinery, buildings and

infrastructure M represents the availability of natural resources and materials for

production i.e. land

LRAS is determined by the stock of a country’s productive resources and also by the productivity of factor inputs (labour, land and capital). Changes in the state of technology also affect the potential level of real national output. Hence, the price level does not affect these variables in the long run.

The long-run aggregate-supply curve is vertical at the natural rate of output. This level of production is also referred to as potential output or full-employment

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output. Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve.

The shifts may be categorized according to the various factors in the classical model that affect output.

Shifts arising • Labor• Capital• Natural Resources• Technological Knowledge

Keynesian long run aggregate supply curve The Keynesian AS curve assumes that prices and wages are fixed until full employment is reached; over the ‘Keynesian range’ there is spare capacity in the economy, the price level is stable, and real output can expand as a result of increases in AD without any inflationary pressure.

Beyond full employment, any changes in AD will bring about higher price levels. The Keynesian view of AS was adapted to show an ‘intermediate range’ where both unemployment and inflation could occur together.

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The adapted Keynesian AS curve is more realistic, and highlights the trade-offs that can occur between the price level and unemployment.

Source: http://www.economicsonline.co.uk/Managing_the_economy/Aggregate+supply.html

Shifting the LRAS over the long-term (Monetarist/New-Classical)

Changes in the price level do not affect the level of aggregate supply in the long run. Therefore, the long-run aggregate supply curve, labeled LRAS, is a vertical line at the potential level of real GDP. For instance, the price level was 109 in 2009, and potential real GDP was $13.9 trillion. If the price level had been 119, or if it had been 99, long-run aggregate supply would still have been a constant $13.9 trillion. Each year, the long-run aggregate supply curve shifts to the right, as the number of workers in the economy increases, more machinery and equipment are accumulated, and technological change occurs.

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The fundamentals of increasing long run aggregate supply

These all relate to the supply-side of the economy1. Expanding the labour supply - e.g. by improving incentives for people to search for and accept new jobs as they become available2. Increase the productivity of labour and capital – e.g. by investment in training and an increase in the size of the capital stock3. Increase the occupational and geographical mobility of labour to reduce certain types of unemployment for example the level of structural unemployment4. Expand the capital stock – i.e. increase the level of capital investment and research and development spending by firms5. Increase business efficiency by promoting greater competition within and between markets.6. Stimulate a faster pace of invention and innovation – this will promote lower production costs and improvements in the dynamic efficiency of the economy

Equilibrium in the AD/AS Model

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Short-run equilibrium

In the short run, real GDP and the price level are determined by the intersection of the aggregate demand curve and the short-run aggregate supply curve.

In the figure, real GDP is measured on the horizontal axis, and the price level is measured on the vertical axis by the GDP deflator. In this example, the equilibrium real GDP is $14.0 trillion, and the equilibrium price level is 100.

An increase in aggregate demand

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Consider what happens to this short-run aggregate market with an increase in aggregate demand. Suppose, for example, that the country’s central bank undertakes a bit of expansionary monetary policy, which causes a decline in interest rates, which then prompts the household and business sectors to increase consumption and investment expenditures. The result of this action is a rightward shift of the AD curve.

The result of this rightward AD curve shift is that a new short-run equilibrium is achieved at a higher price level (11) and a larger amount of real production ($110 billion). This result is comparable to that for a standard market. An increase in market demand results in a higher equilibrium price and a larger equilibrium quantity. The key difference, of course, is that this "market" is the aggregate product market for the entire economy and not the market for a specific good.

A comparative static analysis of the original equilibrium and the new equilibrium is useful and important. However, it is also instructive to dissect the adjustment process.

First, the AD curve shifts rightward due to the increase in consumption and investment expenditures induced by lower interest rates. This "extra" aggregate demand creates an imbalance in the aggregate market. At the existing price level (which has NOT yet changed), producers are willing and

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able to sell $100 billion worth of real production. Buyers, however, are now willing and able to purchase more, something like $120 billion worth of real production. This creates economy-wide product market shortages.

Second, motivated to satisfy this extra demand and to fill these shortages, producers increase production. In the short run they can do so, even if the original real production level is full employment, by tapping into frictional and structural unemployment and paying resources higher prices that create a temporary imbalance in real resource prices, which leads to an increase in the quantity of resources supplied. These actions, however, cause product prices and the price level to rise.

Third, with the rising price level, producers are able to increase real production, but buyers are induced to decrease aggregate expenditures. The combination of producers increasing real production and buyers decreasing aggregate expenditures act to reduce the existing economy-wide product market shortages. In fact, as long as economy-wide product market shortages persist, producers increase production, which causes the price level to rise, which then decreases aggregate expenditures. Eventually the rising real production and falling aggregate expenditures meet at the new short-run equilibrium price level of 11 and real production of $110 billion.

Source: http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=aggregate+demand+increase,+short-run+aggregate+market

Other possible scenarios

Decrease in aggregate demand - http://web.sis.edu.hk/Departments/EcoBus/macroeconomics_11/media/changeequiladleft.html

Decrease in short-run aggregate supply - http://web.sis.edu.hk/Departments/EcoBus/macroeconomics_11/media/changeequilasleft.html

Increase in short-run aggregate supply - http://web.sis.edu.hk/Departments/EcoBus/macroeconomics_11/media/changeequilasright.html

Long-Run Equilibrium in the Monetarist/New Classical Model

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Long-run equilibrium is found where the aggregate-demand curve intersects with the long-run aggregate-supply curve. Output is at its natural rate. Also at this point, perceptions, wages, and prices have all adjusted so that the short-run aggregate-supply curve intersects at this point as well.

The Effects of a Shift in Aggregate Demand

Pessimism causes household spending and investment to decline. This will cause the aggregate demand curve to shift to the left. In the short run, both output and the price level fall. This drop in output means that the economy is in a recession.

It is possible that policymakers may want to eliminate the recession by boosting government spending or increasing the money supply. Either way, these policies could shift the aggregate demand curve back to the right. However, even if policymakers do nothing, the economy will eventually move back to the natural rate of output.

People will correct the misperceptions, sticky wages, and sticky prices that cause the aggregate-supply curve to be upward sloping in the short run. The expected price level will fall, shifting the short-run aggregate-supply curve to the right.

In the long run, the decrease in aggregate demand can be seen solely by the drop in the equilibrium price level. Thus, the long-run effect of a change in aggregate

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demand is a nominal change (in the price level) but not a real change (output is the same).

The Effects of a Shift in Aggregate Supply

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Firms experience a sudden increase in their costs of production. This will cause the short-run aggregate-supply curve to shift to the left. (Depending on the event, long-run aggregate supply may also shift. We will assume that it does not.)In the short run, output will fall and the price level will rise. The economy is experiencing stagflation (a period of falling output and rising prices).

Policymakers will have a more difficult time with this situation. Policymakers can shift the aggregate-demand curve, but cannot simultaneously offset the drop in output and the rise in the price level. If they increase aggregate demand, the recession will end, but the price level will be permanently higher.

If policymakers do nothing, price expectations will adjust, causing the short-run aggregate-supply curve to shift back to the right.

Case Study – Supply-side shock due to rise in oil prices

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Panel (a) shows that a supply shock, such as a large increase in oil prices, will cause a recession and a higher price level in the short run. The recession caused by the supply shock increases unemployment and reduces output.

In panel (b), rising unemployment and falling output result in workers being willing to accept lower wages and firms being willing to accept lower prices. The short-run aggregate supply curve shifts from SRAS2 to SRAS1. Equilibrium moves from point B back to potential GDP and the original price level at point A.

Equilibrium in the Keynesian Model

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In the Keynesian model, there is no distinction between the long run and short run so macroeconomic equilibrium is possible at all levels of income. Y1 to YFE in the Figure above show four different possibilities:

Y0 shows the economy in recession – low levels of national income, high unemployment and excess capacity in the economy. Clearly not politically desirable and most likely to lead to government intervention to stimulate aggregate demand.

Assuming, for the sake of simplicity, that government has implemented stimulatory measures such as increased government spending, aggregate demand has increased to AD1 and the economy has moved towards the full employment level of income – income is rising and unemployment is falling. As factors become increasingly scarce and supply-side bottlenecks set in, inflation rises also.

At YFE all available factors are being used and any further increase in aggregate demand – to AD3 and beyond – is purely inflationary. Output capacity simply cannot meet demand beyond YFE as no additional factors can be employed.

Deflationary (recessionary) gap

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Assume an initial equilibrium at full employment (YFE) and that households expect property prices to fall (Figure below). The perceived future loss of wealth causes households to hold back on consumption and AD falls (AD0 to AD1). The gap (often referred to as a negative output gap) between YFE and Y1 is a deflationary gap.

Inflationary (expansionary) gap

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If, however, at YFE households expect property prices to rise and the income effect of this causes AD to increase (AD0 to AD1 in Figure above) the effect would be inflationary. Since the economy is operating at full employment and no more available factors exist, there is no increase in real output and an inflationary gap is created.

Effects of an increase in AD at low and high levels of income An increase in aggregate demand at very low levels of income (recessionary gap) might not create inflationary pressure at all since there is an abundance of factors, excess capacity and firms have unsold stocks. This is shown in Figure below where aggregate demand increases from AD0 to AD1 and there is an increase in real GDP but no increase in the price level. Accordingly, when the economy is at the full employment level, any increase in aggregate demand (AD3 to AD4) leads solely to inflation and no increase in output.

Possibility of equilibrium below full employment in the long run

Definition: “Inflationary gap”When de facto output in terms of macro equilibrium is above potential output, there is a positive output gap – an inflationary gap.

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The Keynesian model assumes that high unemployment, excess capacity in firms, high levels of stocks and wage stickiness all contribute to perfectly elastic supply at low levels of income. Furthermore, markets are inherently unstable and do not necessarily clear immediately. A key element in Keynesian theory is precisely that markets are imperfect, e.g. labour and goods markets do not necessarily clear in the short run. There are built-in market imperfections such as stickiness in labour prices, unions and general unwillingness of workers to accept lower wages in recessions.

Thus, while the basic equilibrium output of AS=AD is attained at below full employment levels, other markets – notably the labour market – need not be in equilibrium. The view is therefore that equilibrium can occur and be maintained at below the full employment level even in the long run – resulting in the prescription that government intervention on the demand side is necessary for full employment to be attained. If governments do not intervene to move the economy towards full employment, it is quite possible for the economy to remain at Y0 for an indeterminate period. This is a pivotal argument for Keynesian economists in the Keynesian – new-classical debate.

Source: http://goodbadecon.com/uploads/3/1/1/6/3116093/ch_45_-_equil_in_keynesian_model_-_2.2.pdf

Questions

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1: Explain why the aggregate demand curve is downward sloping.

2: Draw a short-run aggregate supply curve that is upward sloping (has a positive slope) i.e. increases as the national income rises.(a) Explain why the curve has this shape.(b) Now draw a long-run aggregate supply curve that intersects a short run AS curve. What is the relationship between SRAS and LRAS?

3: There are several determinants of aggregate supply that can cause the aggregate supply curve to shift. (a) Describe those determinants and give an example of a change in each.(b) Draw and label an aggregate supply diagram that illustrates the effect of the change in each determinant.

4: Draw and carefully label an aggregate demand and supply diagram with initial equilibrium at P0 and Y0.(a) Using the diagram, explain what happens when AD falls.(b) How is the short run equilibrium different from the long run equilibrium?

5: Table 3 shows aggregate demand and aggregate supply schedules for the United Kingdom.

Price level (GDP deflator)

Real GDP demanded (billions of 1995 £)

Real GDP supplied (billions of 1995 £)

90 800 650100 775 700110 750 750120 725 800130 700 850

(a) Plot the aggregate demand curve(b) Plot the aggregate supply curve(c) What is the macroeconomic equilibrium?(d) If potential GDP in the United Kingdom is £800 billion, what is the type of macroeconomic equilibrium?

6: The US economy is at full employment when the following events occur:

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A deep recession hits the world economy, and real GDP in the rest of the world decreases

The world oil price tumbles

(a) Explain the effect of each event separately on aggregate demand and aggregate supply in the United States.(b) Explain the combined effect of the two events on the US price level and real GDP.

7: What shifts in aggregate demand or aggregate supply would cause each of the following conditions for an economy?(a) The price level rises, and the real GDP rises (b) The price level falls, and the real GDP rises (c) The price level falls, and the real GDP falls (d) The price level rises, and the real GDP falls(e) The price level falls, and the real GDP remains the same (f) The price level remains the same, and the real GDP rises

9: Suppose aggregate demand increases, causing an increase in national income but no change in the price level. Using an AD/AS diagram, illustrate and explain how this could occur.

10: Use an AD/AS diagram to illustrate and explain how each of the following will affect the equilibrium price level and national income:(a) Consumers expect a recession(b) Foreign income rises(c) Foreign price levels fall(d) Government spending increases(e) Workers expect higher future inflation and negotiate higher wages now.(f) Technological improvements increase productivity.

The Keynesian Multiplier (HL only)

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The Multiplier effect is defined as the additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Government purchases are said to have a multiplier effect on aggregate demand. Each dollar spent by the government can raise the aggregate demand for goods and services by more than a euro.

For example: In order words a €20 bn injection by the Hong Kong Government should lead to a more than €20 bn rise in national income.

MARGINAL PROPENSITY TO CONSUME (MPC):

demand.shift in aggregateeffect can amplify the2. . . . but the multiplier multipliermultiplier

demand by €20 billion . . . of €20 billion initially increases aggregate1. An increase in government purchases

AD3

AD2

€20 billion

AD1Aggregate demand,

0

LevelPrice

OutputQuantity of

The Multiplier Effect

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This is the proportion of each additional euro of household income that is used for consumption expenditure. The marginal propensity to consume (MPC) indicates what the household sector does with extra income. The MPC indicates the portion of additional income that is used for consumption expenditures. If, for example, the MPC is 0.75, then 75 percent of extra income goes for consumption.

The MPC Formula

The standard formula for calculating marginal propensity to consume (MPC) is:

MPC = Change in Consumption/Change in income

Consumption Schedule

The marginal propensity to consume is calculated by dividing the change in consumption in the second column by the change in income in the first column. Beginning at the top of the schedule, household income increases from $0 to $1 trillion. This $1 trillion change in income induces a change in consumption from $1 trillion to $1.75 trillion, a change of $0.75 trillion.

Running the numbers through the MPC formula gives:

MPC = 0.75/1.00 = 0.75

Now calculate the MPC for all the other values

While the MPC is not necessarily constant at for all changes in income (in fact, the MPC tends to decline at higher income levels), most analysis of consumption

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generally works with a constant MPC. It tends to make subsequent calculations for things like the multiplier a lot easier.

The Multiplier Process

The multiplier measures the magnified change in aggregate production (gross domestic product) resulting from a change in an autonomous variable (such as investment expenditures).

The magnified change occurs because a change in production (such as what occurs when investment expenditures purchase capital goods) generates income, which then induces consumption. However, the resulting consumption is also an expenditure on production, which generates more income, which induces more consumption. This next round of consumption also triggers a change in production, which generates even more income, and which induces even more consumption.

And on it goes, round after round. The end result is a magnified, multiplied change in aggregate production initially triggered by the change investment, but amplified by the change in consumption.

The MPC enters into the process because it determines how much consumption is induced with each change in production and income. If the MPC is greater, then the multiplier process is also greater as more consumption is induced with each round of activity.

This connection between the multiplier process and the marginal propensity to consume is illustrated in the standard formula for a basic expenditures multiplier:

Simple Multiplier Formula

Multiplier = 1/ 1-MPC

Calculate the value of the simple multiplier if MPC = 0.75; MPC = 0.8

Average Propensity to Consume (APC)

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Average propensity to consume is the proportion of household income used for consumption expenditures. It is found by dividing consumption by income.

APC = Consumption/income

Rather than the CHANGE in consumption divided by the CHANGE in income, the APC measures TOTAL consumption divided by TOTAL income. In particular, the APC indicates how the household sector divides up total income. If, for example, the APC is 0.9, then 90 of the income received by the household sector is used for consumption. Moreover, whereas the MPC is constant, the APC actually changes from one income level to the next.

MARGINAL PROPENSITY TO SAVE (MPS)

The marginal propensity to save is the proportion of each additional euro of household income that is used for saving. The marginal propensity to save (MPS) indicates what the household sector does with extra income. The MPS indicates the portion of additional income that is used for saving. If, for example, the MPS is 0.25, then 25 percent of extra income goes for saving.

The MPS Formula

The standard formula for calculating marginal propensity to save (MPS) is:

MPS = change in savings/change in income

Saving Schedule

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The marginal propensity to save is calculated by dividing the change in saving in the second column by the change in income in the first column. Beginning at the top of the schedule, household income increases from $4 to $5 trillion. This $1 trillion change in income induces a change in saving from $0 trillion to $0.25 trillion, a change of $0.25 trillion.

Running the numbers through the MPS formula gives:

MPS = 0.25/1 = 0.25

While the MPS is not necessarily constant at for all changes in income (in fact, the MPS tends to increase at higher income levels), most analysis of saving generally works with a constant MPS.

This connection between the multiplier process and the marginal propensity to save is illustrated in the standard formula for a basic expenditures multiplier:

Multiplier = 1/ MPS

Calculate the value of the simple multiplier if MPS = 0.25; MPC = 0.20

Average Propensity to Save

The marginal propensity to save is one of two measures of the relation between saving and income. The other is average propensity to save (APS). Average propensity to save is the proportion of household income used for saving. It is found by dividing saving by income.

The formula for calculating average propensity to save (APS) looks a lot like that for the MPS, but with important differences:

APS = Savings/income

Rather than the CHANGE in saving divided by the CHANGE in income, the APS measures TOTAL saving divided by TOTAL income. In particular, the APS indicates how the household sector divides up total income. If, for example, the APS is 0.1, then 10% of the income received by the household sector is used for saving. Moreover, whereas the MPS is constant, the APS actually changes from one income level to the next.Question

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In a two-sector economy, mps = 0.20, I = €5000m and Y = €25000m

(a)Assuming investment remains constant, what is the equilibrium level of saving, and what is the value of the multiplier?

(b) If investment were to increase by €1000m, what would be the new equilibrium level of national income?

Other Leakages from the Circular Flow of Income

The Marginal rate of Taxation (MRT)

Taxation is another leakage from the circular flow of income. The marginal rate of taxation is the proportion of each additional euro of household income that is used to pay the fiscal authorities.

MARGINAL PROPENSITY TO IMPORT (MPM)

The change in imports purchased from foreign countries induced by a change in income or production (national income or gross domestic product). The marginal propensity to import (MPM) indicates the extent to which imports are induced by changes in income or production. If, for example, the MPM is 0.1, then each dollar of extra income in the economy induces 10 cents of imports.

While exports are unrelated to domestic income or production, imports purchased from the foreign sector are induced by the level of domestic income and production. As household consumption is induced by income, so too are imports. When the household sector receives more income, it increases consumption expenditures, part of which is used to purchase imports. More income, means more consumption and more imports.

Of course, imports also consist of investment expenditures by the business sector and government purchases by the government sector. Both of these are induced by income and production, as well. And both of these are used to purchase imports.

Hence, imports are induced by domestic income and production. However, because imports are subtracted from exports to derive net exports, an induced increase in imports means an induced decrease in net exports.

The MPM Formula

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The standard formula for calculating marginal propensity to import (MPM) is:

MPM = change in import expenditure/change in income

The imports line is positively sloped, indicating that greater levels of income generate greater imports from the foreign sector. The net exports line is negatively sloped, indicating that greater levels of income generate lower net exports.

The multiplier process with induced consumption is augmented by induced imports. The change in production and income generated by the autonomous change in investment induces changes in both consumption AND IMPORTS. However, because imports reduce net exports, the increase in consumption expenditures on production are partially offset by the decrease in net exports. The resulting change production is less than what it would be without induce imports i.e. imports is a leakage from the circular flow of income.

Thus in a four-sector economy, the multiplier is calculated either as:

1/1-MPC or 1/(mps + mrt + mpm)

Question

(1) Out of every extra €10 of income, a community saves €2, spends €1.50 on foreign goods and services, and the government takes €1.50 in taxation. What is the value of the multiplier? Utilise both formuli to arrive at your answer.

The Crowding-Out Effect

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Fiscal policy may not affect the economy as strongly as predicted by the multiplier. An increase in government purchases causes the interest rate to rise. A higher interest rate reduces investment spending.

This reduction in aggregate demand that results when a fiscal expansion increases the interest rate is called the crowding-out effect. The crowding-out effect tends to dampen the effects of fiscal policy on aggregate demand.

Conclusion

When the government increases its purchases by $20 billion, the aggregate demand for goods and services could rise by more or less than $20 billion, depending on whether the multiplier effect or the crowding-out effect is larger.

Questions

$20 billion

r2

demand . . . purchases increases aggregate1. When an increase in government

AD3

AD2

aggregate demand.initial increase inpartly offsets the4. . . . which in turn

(b) The Shift in Aggregate Demand

Aggregate demand, AD1

LevelPrice

0of OutputQuantity

D2M

money demand . . . spending increases2. . . . the increase in

rate . . .

interest

equilibrium

the

increases

3. . . . which

(a) The Money Market

supplyMoney

MDMoney demand,

r

RateInterest

0by the Fed

Quantity fixedof MoneyQuantity

Figure 5 The Crowding-Out Effect

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1: Fill in the blanks in the following table:

Income ($)

Consumption Saving MPC MPS APC APS

1000 400 0.602000 900 11003000 1400 0.504000 2100

2: What is the level of savings if:(a) Disposable income is $500 and consumption is $450(b) Disposable income is $1200 and the APS is 0.90(c) The MPC equals 0.90, disposable income rises from $800 to $900, and saving is originally $120 when income equals $800

3: What is the marginal propensity to consume if:(a) Consumption increases by $75 when disposable income rises by $100(b) Consumption falls by $50 when disposable income falls by $100(c) Saving equals $20 when disposable income equals $100 and saving equals $40 when disposable income equals $300.

4: An economy has no imports or taxes, the MPC is 0.80, and real GDP is $150 billion. If businesses increase investment by $5 billion, calculate: (a) The Multiplier(b) The change in real GDP(c) The new level of real GDP(d) Explain why real GDP increases by more than $5 billion.

5: An economy has no imports or taxes. The marginal propensity to consume is 0.60, and real GDP is $100 billion. If investment decreases by $10 billion, calculate:(a) Multiplier(b) The change in real GDP(c) The new level of real GDP(d) Explain why real GDP decreases by more than $10 billion.

6: Suppose economists observe that an increase in government spending of €10 billion raises the total demand for goods and services by €30 billion.

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(a) If these economists ignore the possibility of crowding out, what would they estimate the marginal propensity to consume (MPC) to be?

(b)Now suppose that economists allow for crowding out. Would their new estimate of MPC be larger or smaller than their initial one?

7: Suppose that the government reduces taxes by €20 billion, that there is no crowding out, and that the marginal propensity to consume is 0.75.

(a)What is the initial effect of the tax reduction on aggregate demand?(b) What additional effects follow this initial effect? What is the total

effect of the tax cut on aggregate demand? (think in terms of consumption patterns and nature of tax cut: temporary or permanent)

(c)How does the total effect of this €20 billion tax cut compare to the total effect of a €20 billion increase in government purchases?

8: A country has a marginal propensity to save of 0.1, a marginal rate of tax of 0.1 and a marginal propensity to import of 0.2. What is the value of the multiplier?

9: Suppose government spending increases. Would the effect on aggregate demand be larger if the central bank took no action in response or if the central bank were committed to maintaining a fixed interest rate?

10: Explain: The government spends €3 billion to buy police cars. Explain why aggregate demand might increase by more than €3 billion. Explain why aggregate demand might increase by less than €3 billion.

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