Derivation of Aggregate Demand;

Interrelations between product, Money

and Labor Market

Qazi Subhan

Summary

From product market, IS Curve is derived and from

money market LM Curve is derived
With the intersection of IS and LM, Aggregate Demand
would be determined
From Labor Market, we can derive Aggregate Supply
with the help of production function.
At That point where Aggregate Demand and Aggregate
Supply are making intersection, that is the point of
determination for GENERAL EQUILIBRIUM for the
economy which shows the relationship between General
Price Level and GNP or National Income

Introduction to Aggregate Demand

To capture the concept of Aggregate

demand, following markets should be
discussed

Product Market

Money Market

Labor Market

Product Market

Product market is concerned with the supply

and demand of consumer goods.
But in Macro economics, National Income
identity
equation;
Y=C+I+G+(X-M)
is
depicting the goods market for the whole
economy.
All the elements of the equation are
concerned with the transaction of tangible
goods.

Technically

Y = C + I + G +X-M is considered as goods

Market because in it, all the components of
aggregate expenditure, goods are involved. So any
change in mentioned components would cause a
change in Aggregate Demand.

From Product Market, we can derive IS

(Investment Saving) Curve for the derivation of
Aggregate Demand.

Derivation of IS Curve from product

market

IS (Investment Saving) curve shows negative

relation between rate of interest and national
income.
According to this approach, as rate of interest
increases, Investment would come down. With
decrease in Investment, total national income
would come down due to decrease in economic
activities.

Shifting factors of IS Curve

Consumption

Government Expenditure

Exports

Imports

Taxes

Money Market

Money market consists of two market forces

which are involved for the determination of rate
of interest and quantity of money. Market forces
are as follows:
Money Demand
Money supply
Money Demand
The people are demanding money for three
purposes;

Money Demand for daily Transactions

Money Demand for Precaution

Money Demand for Speculation

Money Supply

Money supply is defined as M1, M2 and M3

M1= Currency + Demand Deposits

M2=M1+Money market mutual funds +

Time Deposits + Postal Deposits

M3= M2-Postal deposits

Normally, Money Supply is in the hand of central

bank so it is generally kept fixed in the analysis.

Derivation of LM Curve from Money

Market

Liquidity of Money (LM) curve can be derived

from money market.
As national income increases, the people are
demanding more money for speculation and
ultimately the rate of interest will increase.
LM curve shows positive relation between
rate of interest and national income

Shifting Factors of LM Curve

There are two shifting factors of LM Curve

Money Supply

As Money Supply increases, LM Curve Shift to

rightward

Inflation

With an increase in inflation, real money balance

(M/P) would decrease which will cause to shift the
LM Curve to left ward.

Derivation of Aggregate Demand from Product

and Money Market

With the intersection of product and money

market or (with IS and LM), Aggregate
Demand would be determined.

Aggregate demand shows negative relation

between price and national income.

The downward-sloping AD curve

An increase in the
P
price level causes
a fall in real money
balances (M/P ),
causing a
decrease in the
demand for goods
& services.

AD

Shifting Factors of Aggregate Demand

Consumption

Government Expenditure

Exports

Imports

Taxes

Money Supply

Shifting the AD curve

P

An increase in
the money
supply shifts the
AD curve to the
right.

AD2
AD1

Derivation of Aggregate Supply

Labor Market

For derivation of Aggregate Supply, we require two

things; Labor Market and Production Function.
In labor market, wages and employment level has been
determined with the help of two market forces
Labor Demand

Labor Supply
Labor Demand
Labor demand has negative relation with wage
because as wage increases, cost of production would
increase. As cost of production increases, it implies that
the firm would reduce the demand for labor. Briefly,
there is reciprocal relationship between wage and labor
demand

Labor Supply

With intersection of labor demand and labor

supply, wage and employment level has been
determined
Labor supply has positive relation with wage.
As wage increases, the incentives for the
labor would increase and more people are
willing to offer their services at high wage rate
to any organization.

Derivation of Aggregate supply from Labor

Market

Aggregate Supply can be derived from labor

market and production function.
As employment increases, output will amplify.
An increase in output will cause to increase in
GNP because GNP is the value of total
product which has been produced by one
nation in a specified time period.
The labor market is related to aggregate
supply through production function.

Interrelations between Labor Market and

Production Function

Aggregate supply is determined with the help

of labor market and production function
Q = f (K, L)
In the labor market, two variables have been
determined; wage, employment level

They are linked with production function

through labor.

As employment increases, labor supply

would increase which increases output. With
an increase in output, overall national income
would increase as can be seen in the next
slide.

To understand this, lets look at the sources of economic growthwhere

does production come from?
is a function of

Real GDP

Y F A, K , L
Productivity Capital

Employment

Therefore, we should be able to break down economic growth into its individual
components
Real GDP
Growth

Capital
Growth

%Y %A %K %L
Productivity
Growth

Employment
Growth

Shift in Aggregate Supply

Labor Supply

Labor Demand

Production Techniques

Labor Intensive technology

Capital Intensive Technology
Neutral Technology

Demand Management Policies

Fiscal Policy

Monetary Policy

Exchange Rate Policy

Fiscal Policy

Definition

Objectives of Fiscal policy

Tools of Fiscal Policy

Kinds of Fiscal Policy

Application of tools of fiscal policy to

Economic situation.

Definition

Fiscal Policy means that policy which is

formulated by the government to achieve its
objectives with the help of its tools.

Objectives

Economic Growth
Price stability
Employment Opportunities

Tools Of Fiscal Policy

Government Expenditure
Taxes

Direct Tax
Indirect Tax

Kinds of Fiscal Policy

Contractionary Fiscal Policy (Tax and G )

Expansionary Fiscal Policy (G and Tax )

Application of Fiscal Policy to the

Economy

Business Cycles

To Product Market

To Money Market

To Labor Market

Monetary Policy

Definition

Objectives of Monetary policy

Tools of Monetary Policy

Kinds of Monetary Policy

Application of tools of Monetary policy to

Economic situation.

Definition
Monetary Policy is designed by State Bank to
stabilize the economy with the monetary tools
Objectives

To improve the economic growth

To stabilize the prices

To increase employment opportunities

Tools of Monetary Policy

Bank Rate

Required Reserve Ratio (RRR)

Open Market Operation (OMO)

Types of Monetary Policy

There are two types

Expansionary Monetary Policy

Bank Rate decrease

RRR decrease
Purchase of Public shares

Contractionary Monetary Policy

Bank Rate Increase

RRR Increase
Sale of Public shares

Application of Monetary Policy

Money Market

Product Market

Labor Market

Business Cycle