AGGREGATE DEMAND
• Growth is highly uneven
• There has been multiple recessions and
depressions that the economy has gone
through.
INTRODUCTION
• The Great Depression of 1930s, the recent
financial crisis 2008
• What causes such fluctuations??
• Keynes proposed a model that shows how
shocks to the Aggregate Demand (AD) affect
Output and Income
• Keynes identified AD as the key variable in any
economy
• Aggregate Demand is the total amount of
goods and services demanded in the
economy
AGGREGATE
DEMAND
• AD is determined as the sum of C, I, G, NX
𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
• Output is at equilibrium when AD equals
to output produced
𝑌 = 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
• When AD is not equal to output, there is
unplanned inventory (IU)
𝐼𝑈 = 𝑌 − 𝐴𝐷
DISEQUILIBRIUM
• When IU > 0, firms are essentially producing
more that what is demanded, this causes
unplanned inventory investment
• This would induce the firms to cut production in
the next period
• When IU < 0, firms are essentially producing less
that what is demanded, this causes unplanned
inventory disinvestment
• The relation b/w consumption and income
is described by the consumption function
CONSUMPTION
FUNCTION
• The consumption function is defined as:
𝐶 = 𝐶 + 𝑐𝑌
0 < 𝑐 < 1; 𝐶 > 0
• 𝐶: The subsistence consumption level
when income is 0
• 𝑐: The Marginal Propensity to Consume
(MPC)
• This is interpreted as the increase in
consumption when income increases
• If the value of 𝑐 is 1, then what is earned is
what is spent. However, when c is less than 1,
then the remaining income is saved
MARGINAL
PROPENSITY TO
CONSUME
• We can compute the savings function, from the
consumption function
𝑆 =𝑌−𝐶
𝑆 = 𝑌 − 𝐶 − 𝑐𝑌
𝑆 = −𝐶 + (1 − 𝑐)𝑌
• (1 − 𝑐): Marginal Propensity to Save (MPS)
• Consumption function shows the link between
income and consumption
• Now we include the other components of AD
CONSUMPTION,
AD, AND
AUTONOMOUS
SPENDING
• We assume that the remaining variables are
autonomous, i.e., it is not a function of income
• When there are taxes (TA) and transfer payments
(TR)our consumption would depend on
disposable income
𝑌𝐷 = 𝑌 − 𝑇𝐴 + 𝑇𝑅
𝐶 = 𝐶 + 𝑐𝑌𝐷 = 𝐶 + 𝑐(𝑌 − 𝑇𝐴 + 𝑇𝑅)
CONSUMPTION,
AD, AND
AUTONOMOUS
SPENDING
𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
𝐴𝐷 = 𝐶 + 𝑐 𝑌 − 𝑇𝐴 + 𝑇𝑅 + 𝐼 + 𝐺 + 𝑁𝑋
𝑌 = 𝐴 + 𝑐𝑌
Where, 𝐴 = 𝐶 − 𝑐 𝑇𝐴 − 𝑇𝑅 + 𝐼 + 𝐺 + 𝑁𝑋
Keynesian Cross
EQUILIBRIUM
INCOME AND
OUTPUT
• At a point before 𝑌0 , demand exceeds production,
and hence inventory is negative.
• To cater to the exceeding demand, firms increase
production.
EQUILIBRIUM
INCOME AND
OUTPUT
• Thus, income starts to adjust from a point before
𝑌0 to 𝑌0 .
• If the economy is above 𝑌0 , production exceeds
demand, and hence excess inventory is
accumulated
• Due to the excess inventory firms reduce
production, lay off workers, and reduces
production expenses
• Thus, income starts to fall and adjusts from a point
to the right of 𝑌0 to 𝑌0
• The 45-degree line (Y=AD) resembles equilibrium in
the goods and services market
𝐴𝐷 = 𝐴 + 𝑐𝑌
𝑌 =𝐴+𝑐
𝐴
𝑌𝑜 =
(1 − 𝑐)
EQUILIBRIUM
INCOME AND
OUTPUT
• The AD is a function of slope of consumption function
and the autonomous expenditure part
• Steeper AD curve means that the MPC is high
• If autonomous expenditure increases, the AD curve
shifts upwards and the equilibrium income increases
• The equilibrium level of output is higher when MPC is
large and/or autonomous spending is high
MULTIPLIER
• If some component of expenditure increases what
would be the effect on the level of income and
output in the economy??
• Suppose autonomous expenditure increases by
Rs. 10 would the equilibrium level of income also
increase by 10?
• Think of a simple economy with two individuals
• Individual A spends INR 1000 as an initial boost in
expenditure
• This money will go to individual B
MULTIPLIER
• Assume the B’s MPC is 0.5, so B would now spend
500 (0.5 ∗ 1000)
• This money is now A’s income.
• If A’s MPC is also 0.5, A would spend 250 from this
income
• The cycle would repeat
• Total income generated in the economy is
MULTIPLIER
1000 + 0.5 ∗ 1000 + 0.5 0.5 ∗
1000 + 0.5 ∗ 0.5 ∗ 0.5 ∗ 1000...
Income = 1000[1/(1-0.5)]= 2000
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝐷𝑒𝑚𝑎𝑛𝑑
𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒 𝑖𝑛 𝑃𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛
𝑇𝑜𝑡𝑎𝑙 𝐼𝑛𝑐𝑟𝑒𝑎𝑠𝑒
Δ𝐴
Δ𝐴
Δ𝐴
𝑐Δ𝐴
𝑐Δ𝐴
(1 + 𝑐)Δ𝐴
𝑐 2 Δ𝐴
𝑐 2 Δ𝐴
(1 + 𝑐 + 𝑐 2 )Δ𝐴
sf
MULTIPLIER
…
∆𝑌 = 1 + 𝑐 + 𝑐 2 + ⋯ ∆𝐴
∆𝑌
1
=
∆𝐴 1 − 𝑐
Multiplier
GRAPHING
THE
MULTIPLIER
EFFECT
• Initial eq – Point E
• Autonomous spending increases by ∆𝐴
• AD is higher than output, and firms produce more to
meet the demand
GRAPHING
THE
MULTIPLIER
EFFECT
• Equilibrium output moves to Y’ where the gap between
demand and output reduces to FG (due to MPC)
• Final equilibrium is reached at E’, with final output at
𝑌𝑂′
• The change in output depends on
• MPC
• Level of autonomous spending
• Multiplier depends on the MPC
• It tells us the change in output when there is a change in
any component of autonomous spending
WHY IS
MULTIPLIER
IMPORTANT
• It suggests that the final change in output will be much
greater than the initial change in spending
• This is important in explaining any kind of economic
fluctuations in the economy
• Consider a case of loss in investor confidence in the
economy, this would reduce autonomous spending,
bringing down the AD curve, which would reduce
income, and reduce consumer spending even more
thereby reducing total income even further down in the
economy
MULTIPLIER
AND
GOVERNMENT
SECTOR
• During slowdowns government is expected to take
measures to revive the economy
• What can the government do?
• Fiscal policy is government policy with regard to:
oGovernment expenditure
oTransfers
oTax structure
• When government increases its spending, the AD curve
shifts up (comes under autonomous spending)
• By how much does income increase?
GOVERNMENT
EXPENDITURE
MULTIPLIER
• Higher G – higher income – leads to higher
consumption of goods and services – further leads to
higher income
• Assume expenditure rises by ∆𝐺 → income rises by ∆𝐺
→ consumption rises by c ∆𝐺 → this increase in
income again increases consumption by c* c ∆𝐺 → and
the cycle continues
∆𝑌 = ∆𝐺 + 𝑐∆𝐺 + 𝑐 2 ∆𝐺 + 𝑐 3 ∆𝐺 + ⋯
Item
GOVERNMENT
EXPENDITURE
MULTIPLIER
Change
Initial Change in
Govt Purchases
∆𝐺
First Change in
Consumption
𝑀𝑃𝐶∆𝐺
Second Change in
Consumption
𝑀𝑃𝐶 2 ∆𝐺
Cumulative
Change
∆𝐺
∆𝐺
+ 𝑀𝑃𝐶∆𝐺
∆𝐺
+ 𝑀𝑃𝐶∆𝐺
+ 𝑀𝑃𝐶 2 ∆𝐺
…
𝑇ℎ𝑢𝑠, 𝑡𝑜𝑡𝑎𝑙 𝑐ℎ𝑎𝑛𝑔𝑒 𝑑𝑢𝑒 𝑡𝑜 𝑎 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑔𝑜𝑣𝑒𝑟𝑛𝑚𝑒𝑛𝑡
𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒
∆𝑌/ ∆𝐺 = 1/ (1 − 𝑐)∆𝑌 = ∆𝐺(1 + 𝑐 + 𝑐^2 + ⋯ )
GOVERNMENT
EXPENDITURE
MULTIPLIER
WITH TAXES
• In the previous model we did not include any taxes in
the disposable income component of consumption
• How will the value of multiplier change when we take
into account taxes?
• Assume that a proportional tax is paid by consumers
• The consumption function is 𝐶 = 𝐶 + 𝑐 𝑌 + 𝑇𝑅 − 𝑡𝑌
• Assume government expenditure, investment, and net
exports is autonomous
GOVERNMENT
EXPENDITURE
MULTIPLIER
WITH TAXES
• The AD function takes the form
𝐴𝐷 = 𝐶 + 𝑐 𝑌 + 𝑇𝑅 − 𝑡𝑌 + 𝐼 + 𝐺 + 𝑁𝑋
𝑌 =𝐴+𝑐 1−𝑡 𝑌
𝐴
𝑌=
[1 − 𝑐 1 − 𝑡 ]
• The presence of tax lowers the value of the multiplier
for a given MPC
• Thus, presence of taxes flattens the AD curve and
reduces the multiplier as it decreases induced
consumption
IMPLICATION
OF A FISCAL
POLICY
CHANGE
• When government spending increases, the autonomous
spending increases, and the AD curve shifts upwards
• The economy moves from a point E to a point E ′
increasing income and output from 𝑌𝑜 to 𝑌 ′
• This change in income is calculated as
∆𝑌 = ∆𝐺 + 𝑐(1 − 𝑡)∆𝑌
1
∆𝑌 =
∆𝐺
1 − 𝑐(1 − 𝑡)
IMPLICATION
OF A FISCAL
POLICY
CHANGE
∆𝑌
1
=
∆𝐺 1 − 𝑐(1 − 𝑡)
• The effect of the multiplier has reduced compared to
when there was no tax
• Now the consumption multiplier becomes 𝑐(1 − 𝑡).
• Remember, tax is considered to be a leakage in the
system
• Take an example of C = 0.8, t = 0.25
• Without the tax, the government expenditure multiplier
is
1
1
𝑘 =
=
=5
1−𝑐
1 − 0.8
EFFICIENCY
OF
MULTIPLIER
• With the tax, the government expenditure multiplier
becomes
1
𝑘 =
1−𝑐 1−𝑡
1
=
= 2.5
1 − ( 0.8 ∗ 0.75)
= 2.5
• Thus, we notice that the prevalence of the tax rates has
a dampening effect on the multiplier
• What happens when the tax rate is increased?
TRANSFER
PAYMENT
MULTIPLIER
• Can the government pursue a fiscal policy using a
transfer payment?
• What will be the transfer payment multiplier?
MULTIPLIER
• https://www.ies.gov.in/pdfs/Seminar_Paper_EshaSw
aroop.pdf
• Automatic stabilizers is a mechanism in an economy
which naturally – without any intervention – reduces
the amount by which output changes in response to a
change in demand
AUTOMATIC
STABILIZERS
• These automatic stabilizers come into force when an
economy is under a boom or a recession in a business
cycle
• Swings in investment demand have smaller effect on
output when automatic stabilizers are in place
• When investor confidence is too low and investor
sentiment is pessimistic, the reduction is output is
mitigated through the proportional income tax –
which reduces the multiplier
• Income Taxes
AUTOMATIC
STABILIZERS
o Under a boom – income increases – taxes increase
– the increase in AD is lower – consumption is
moderated
o Under a recession – income decreases – taxes
decreases – consumption falls but moderated –
decrease in AD is lower
• Unemployment Benefit
• At the beginning of the fiscal year, the government
plans its budget for the next fiscal year.
• In this annual budget, the two main economic
variables of importance to the government is
• Spending on various services
GOVERNMENT
BUDGET
• Taxation from individuals and firms
• Most governments today (especially developing
ones) run in a deficit. This means that their revenue
stream is lower than expenditure
• What effect does the budget have on output and
growth?
BUDGET
SURPLUS
• The excess of government taxes, revenues over its
expenditures is the budget surplus
• A negative budget surplus (BS) denotes a budget
deficit
𝐵𝑆 = 𝑇𝐴 − 𝐺 − 𝑇𝑅
• Re-writing the above equation in terms of disposable
income, we get
𝐵𝑆 = 𝑡𝑌 − 𝐺 − 𝑇𝑅
• Budget surplus/deficit depends on income, and
government spending
• What happens to the budget deficit (BD) if government
expenditure increases
• G increases – BD increases (G – T > 0)
EFFECTS OF
FISCAL
POLICY
CHANGES
ON BUDGET
DEFICIT
• G increases – AD increases – Y increases – tax increases –
BD could decline
• Change in BD = Change in G – change in T
∆𝐵𝐷 = ∆𝐺 − ∆𝑇
∆𝑇 = 𝑡∆𝑌
∆𝑌
1
∆𝑇 = 𝑡∆𝐺
= 𝑡∆𝐺
∆𝐺
1−𝑐 1−𝑡
𝑡
∆𝐵𝐷 = ∆𝐺 1 −
1−𝑐 1−𝑡
= ∆𝐺
1−𝑐 1−𝑡
1−𝑐 1−𝑡
• This is unambiguously positive – thus as G increases – the
budget deficit increases
• Balanced budget: govt. purchases equal tax receipts
• Government increases its purchases and makes an
equivalent increase in taxes
• Suppose ∆ 𝐺 = ∆𝑇, no change in other expenditures
• What happens to income in this case?
BALANCED
BUDGET
MULTIPLIER
𝑌 = 𝐴+𝐺+𝑐 𝑌−𝑇
∆𝑌 = ∆𝐺 + 𝑐 ∆𝑌 − ∆𝑇 = ∆𝐺 + 𝑐∆𝑌 − 𝑐∆𝑇
= ∆𝐺 + 𝑐∆𝑌 − 𝑐∆𝐺
∆𝑌 1 − 𝑐 = ∆𝐺 1 − 𝑐
∆𝑌 1 − 𝑐
=
=1
∆𝐺 1 − 𝑐
• There is no multiplier effect – this is called the balanced
budget multiplier
• Full employment is defined as that level of output
where the economy has achieved its potential output
• Let this potential output be defined as 𝑌 ∗
FULL
EMPLOYMENT
BUDGET
SURPLUS
• Then the full employment budget surplus is
𝐵𝑆 ∗ = 𝑡𝑌 ∗ − 𝐺 − 𝑇𝑅
• The difference between actual and full employment
budget surplus is defined as
𝐵𝑆 ∗ − 𝐵𝑆 = 𝑡(𝑌 ∗ − 𝑌)
• The only difference is income tax collection
• This difference is the cyclical component of the budget
Suppose the consumption function is given by C = 100 +
0.8 Y , while investment is given by I = 50.
a) What is the equilibrium level of income in this
case?
b) What is the level of saving in equilibrium?
PROBLEM
c) If, for some reason, output is at the level of 800,
what will the level of involuntary inventory
accumulation be?
d) If I rises to 100, what will the effect be on the
equilibrium income?
e) What is the value of the multiplier, here?
a. 𝐴𝐷 = 𝐶 + 𝐼 = 100 + (0.8)𝑌 + 50 =
150 + (0.8)𝑌
The equilibrium condition is Y = AD
𝑌 = 150 + 0.8 𝑌 ⇒ 0.2 𝑌 = 150 ⇒ 𝑌
= 5 ∗ 150 = 𝟕𝟓𝟎
PROBLEM:
SOLUTION
b. 𝑆 = 𝑌 – 𝐶
𝑆 = 𝑌 − 100 + 0.8 𝑌 = − 100 +
0.2 𝑌
𝑆 = − 100 + (0.2)750 = − 100 + 150 = 50
S = I, which means that the equilibrium condition is
fulfilled.
PROBLEM:
SOLUTION
c. If the level of output is Y = 800, then AD = 150 +
(0.8)800 = 150 + 640 = 790
The amount of involuntary inventory accumulation is
𝑈𝐼 = 𝑌 − 𝐴𝐷 = 800 − 790 = 10
d) 𝐴𝐷′ = 𝐶 + 𝐼′ = 100 + (0.8)𝑌 + 100 =
200 + (0.8)𝑌
For equilibrium: 𝑌 = 𝐴𝐷′
𝑌 = 200 + (0.8)𝑌 ⇒ (0.2)𝑌 = 200 ⇒ 𝑌
= 5 ∗ 200 = 𝟏𝟎𝟎𝟎
PROBLEM:
SOLUTION
e) Multiplier is 5
Note: This solution for (d) can also be arrived at by using
the multiplier formula:
△ 𝑌 = (𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟)(△ 𝐼) ⇒△ 𝑌 = 5 ∗ 50 = 250
New income: 𝑌` = 750 + 250 = 1000
Suppose the consumption function is given by C 100 +
0.9 Y , while investment is given by I = 50.
a. What is the equilibrium level of income in this case?
PROBLEM
b. Suppose I = 100. What is the new effect of
equilibrium income?
c. Does this change in investment level have a higher or
lower effect on income than when C = 100 + 0.8Y