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 0 + bY

This equation states that consumption is a function of income, and it represents a simple explanation of consumption behavior of individuals.

C

0 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 < 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 0 + bY) = -C 0 + (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.

A graphical illustration of the consumption function; C = C 0 + bY

C

C 0 b 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’ ’Permanent’

income.

and

‘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 0 and the two other variables r and Y.

• 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 0 + bY + I(r) Y = (C0 + I) (1 – b) = 1 (C 0 + I) 1 - b

• This means that when either of the exogenous elements of expenditure, C 0 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

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,

investment expenditure.

the level of income has changed by more that the change in

AD = C+I N M O

45

Ya Yb Total national income Y Y=Y (C+1) ’ (C+1)

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

(the inverse of the marginal propensity to save)

1 - b

• 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; Y = 1 (C 0 – 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 0 + b(Y - T) + I + G + X – m(Y - T) Y = 1 (C 0 + I + G + X – (b - m)T 1 – (b - m)

• 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.