ECN 202: Principles of Macroeconomics
Nusrat Jahan
Lecture-9
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 Function
Saving 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 Consumption
Wealth
Expectation about Inflation
Real Interest Rate
Savings Function:
Savings Function is the relationship between Income and Saving. It can be derived
from the Consumption Function
Disposable Income
100
200
300
400
500
600
Consumption
150
220
300
380
450
520
Consumption Function
Income
700
600
45°, 600
500
Consumption, 520
400
300
Break-even
point
200
100
0
100
200
300
400
500
600
Saving Function
100
80
60
40
20
0
-20
-40
-60
100
200
300
400
500
600
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 = 1
Average Propensity to Consume (APC): The percentage of income spent.
Average Propensity to Save (APS): The percentage of Income saved.
APC + APS = 1
Disposable
Income
Consumptio
n
Expenditure
1000
1100
Marginal
Propensity
to
Consume
Average
Propensity
to
Consume
Net
Saving
1.1
-100
1
2000
2100
1.05
3000
0
0.92
4200
300
4500
0.075
0.5
0.84
800
0.3
6000
0
0.3
0.5
5000
-0.05
0.1
1
3700
-0.1
-100
0.7
4000
Average
Propensity
to Save
0
0.9
3000
Marginal
Propensity
to Save
0.16
0.7
0.75
1500
0.25
Output Determination by Consumption and Investment (Two Sector Model)
Aggregate Expenditure for a closed- private economy = C + Ig
In Equilibrium, GDP= C+ Ig
If GDP>C+Ig then, production will go down and GDP will come back to equilibrium
If GDP<C+Ig then, production will increase and GDP will come back to equilibrium.
45°
Total Spending
C+I
E
C
I
A
M
GDP
Output Determination by Consumption, Investment and Governement
Expenditure (Three Sector Model)
Aggregate Expenditure for a closed- mixed economy = C + Ig+G
In Equilibrium, GDP= C+ Ig+G
If GDP>C+Ig+G then, production will go down and GDP will come back to
equilibrium
If GDP<C+Ig+G then, production will increase and GDP will come back to
equilibrium.
45°
C+I+G
Total Spending
E
C+I
C
G
I
A
B
M
GDP
Output Determination by Consumption, Investment,Governement Expenditure
(Four Sector Model)
Aggregate Expenditure for an open- mixed economy = C + Ig+G+NX
In Equilibrium, GDP= C+ Ig+G+NX
If GDP>C+Ig+G+NX then, production will go down and GDP will come back to
equilibrium
If GDP<C+Ig+G+NX then, production will increase and GDP will come back to
equilibrium.
45°
Total Spending
E
C+I+G+NX
C+I+G
C+I
NX
C
G
I
A
B
C
M
GDP
The Multiplier
The 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?
P
Shifts arising from
Consumption
Investment
Government Expenditure
Net Export
AD’
AD
AD”
Y
Why the Short-Run Aggregate-Supply Curve Might Shift
Labor
Capital
Natural Resources.
Technology.
Expected Price Level
AS’
AS
AS”
Two Causes of Economic Fluctuations
Shift in Aggregate Demand
Shift in Aggregate Supply