Aggregate Demand - Macro

Aggregate Demand and Keynesian
Economics
One of the central questions in macroeconomics is why output fluctuates
around its potential level. Growth is highly uneven. In business cycle booms
and recessions, output rises and falls relative to the trend of potential output.
Over the last 30 years there have been five recessions, in which output
declined relative to trend or, as in 2008, fell drastically—and then recoveries,
in which output rose relative to trend.
The Great Depression
1929-1933
Great Depression of 1930s
• The Great Depression was the greatest and longest economic recession in
modern world history that ran between 1929 and 1941.
• Investing in the speculative market in the 1920s led to the stock market crash in
1929, which wiped out a great deal of nominal wealth.
• Most historians and economists agree that the stock market crash of 1929 wasn't
the only cause of the Great Depression.
• During the Great Depression, US unemployment rate rose from virtually 0% in
1929 to a peak of 25.6% in May 1933. This was the equivalent of 15 million
people unemployed.
• The unemployment rate remained in double figures until America’s entry in the
Second World War in 1941.
John Maynard Keynes
1936
Chapter Outline
• Understand the factors that determine the aggregate demand curve
(AD curve)
• See how shocks to the Aggregate demand affect output and income
• Identify tools that policymakers use to achieve certain outcomes
• Introduce the IS Curve
Aggregate Demand
• The Keynesian Model is important to understand the determination of output in an
economy.
• Aggregate Demand is the total amount of goods and services demanded in the economy
• Output is at its equilibrium level when the quantity of output produced is equal to the
quantity demanded.
𝑌 = 𝐴𝐷 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
• When AD (the amount people want to buy) is not equal to output,
there is unplanned inventory (IU) .
IU = Y – AD
• If output is greater than aggregate demand, there is unplanned
inventory investment, IU > 0.
• As excess inventory accumulates, firms cut back on production until
output and aggregate demand are again in equilibrium. Conversely, if
output is below aggregate demand, inventories are drawn down until
equilibrium is restored.
Consumption Function and Aggregate
Demand
• With the concept of equilibrium output firmly defined, we now focus on
the determinants of aggregate demand, and particularly on
consumption demand.
• For simplicity, we omit the government and foreign trade, therefore
setting both G and NX equal to zero.
• In practice, the demand for consumption goods is not constant but,
rather, increases with income: Families with higher incomes consume
more than families with lower incomes, and countries where income is
higher have higher levels of total consumption.
• The relationship between consumption and income is described by the
consumption function .
The consumption function
• The consumption function is defined as
: The subsistence consumption level when income is 0

: The marginal propensity to consume. This is interpreted as the increase
in consumption when income increases
Consumption and Saving
• 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
• We can compute the savings function, from the consumption function
Substituting the consumption function obtained previously in the above equation;

CONSUMPTION, AGGREGATE DEMAND, AND
AUTONOMOUS SPENDING
• We have specified one component of aggregate demand, consumption demand, and its
link to income.
• We now add investment, government spending and taxes, and foreign trade to our
model.
• We assume that each is autonomous, that is, determined outside the model and
specifically assumed to be independent of income.
• Here we just assume that investment is , government spending is , taxes are ,
transfers are , and net exports are . Consumption now depends on disposable income
YD,
YD
• Aggregate demand is the sum of the consumption function,
investment, government spending, and net exports. Continuing to
assume that the government sector and foreign trade are exogenous,
-(-)+]+
• Now, total output is a function of consumption, investment, gov.

spending, and net exports
Equilibrium Income and Output
• At a point before 𝑌𝑜, demand exceeds production, and hence inventory
is negative.
• To cater to the exceeding demand, firms increase production.
• Thus, income starts to adjust from a point before 𝑌𝑜 to 𝑌𝑜.
• If the economy is above 𝑌𝑜, production exceeds demand, and hence
excess inventory is accumulated
• To cater 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 𝑌𝑜
to 𝑌_𝑜
Equilibrium Output
• The 45-degree line (Y=AD) resembles equilibrium in the goods and
services market
Some insights
• The position of the aggregate demand schedule is characterized by its
slope, c (the marginal propensity to consume), and intercept,
(autonomous spending).
• Given the intercept, a steeper aggregate demand function—as would
be implied by a higher marginal propensity to consume—implies a
higher level of equilibrium income.
• Similarly, for a given marginal propensity to consume, a higher level of
autonomous spending, a larger intercept—implies a higher equilibrium
level of income.
• Thus, the equilibrium level of output is higher the larger the marginal
propensity to consume, c , and the higher the level of autonomous
spending, .
The Multiplier
• By how much does a $1 increase in autonomous spending raise the equilibrium level of
income?
• Since, in equilibrium, income equals aggregate demand, it would seem that a $1
increase in (autonomous) demand or spending should raise equilibrium income by $1.
• As income increases by INR 1 – induced spending increases through increased
consumption
• Consumption increases by MPC times the total increase in income – which increases
aggregate demand
• Now production increases to meet this extra AD, which in turn increases income and
consumption by 𝑀𝑃𝐶(𝑀𝑃𝐶∆𝐴)
• This process keeps on continuing, and hence we see that an initial increase in
autonomous spending has a ripple/multiplied effect on total income
• Think of a simple economy with two individuals
• Individual A spends INR 1000 as an initial boost in expenditure. This
money goes to person B.
• Assume that the MPC is constant (=0.5). Individual B now spends
0.5(1000) in the economy, and this money is now income to individual
A
• Individual A has the same MPC, and now consumes 0.5 times
(0.5*1000) as consumption which becomes income for individual B
• The cycle repeats – individual B has a consumption expenditure of 0.5
times (0.5*0.5*1000)
• Thus, the total income generated in the economy is 1000 + 0.5*1000
+ (0.5)(0.5)*1000 + (0.5*0.5*0.5)*1000
Income = 1000 [ 1 / (1- (0.5))] = 2000
/ = 1/ (1 – c) Autonomous spending multiplier
Importance of multiplier
• We see that the multiplier depends on the marginal propensity to consume
• Higher the MPC, higher will be the multiplier, since it increases the induced
demand in the economy
• Multiplier shows the change in output when there is a change in any component
of autonomous spending
• It also denotes 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
• Example: If there is a 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
Graphing multiplier effect
• Initial eq – Point E
• Autonomous spending increases by
• AD is higher than output, and firms produce

more to meet the demand
• Eq output moves to Y’ where the gap between

demand and output reduces to FG (due to mpc)
• Final eq is reached at E’, with final output at
• The change in output depends on (1) MPC; (2)

level of autonomous spending

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Aggregate Demand and Keynesian

: The subsistence consumption level when income is 0

Substituting the consumption function obtained previously in the above equation;

• Now, total output is a function of consumption, investment, gov.

• Autonomous spending increases by

• AD is higher than output, and firms produce

• Eq output moves to Y’ where the gap between

• Final eq is reached at E’, with final output at

• The change in output depends on (1) MPC; (2)

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