Aggregate

Demand and
the Multiplier
Dr. Shylajan, C.S
Topics of Discussion
 Aggregate Demand
 The Downward-Sloping Aggregate
Demand Curve
 Shifts in Aggregate Demand
 Keynesian Theory of Output
Determination
 The Meaning of Equilibrium
 Output Determination by Consumption
and Investment (Simple economy)
 Aggregate Demand
 Aggregate Demand is the total demand
for goods and services in the economy.

 It depends on the aggregate price level

 Aggregate Supply curve shows the price

level associated with each level of output
 Why AD downward sloping?
Why AD Downward
sloping?
 The level of aggregate demand declines as the
overall price level in the economy rises.
(assuming other things constant)

 Aggregate Demand and Aggregate supply

interact to determine equilibrium price and
output.

 Movements along the Aggregate Demand and

Shifts of Aggregate Demand :Why?
Shifts in Aggregate
Demand
 1. Due to change in policy variables

Due to change in variables such as

money supply, tax policy, government
expenditures etc

 2. Due to exogenous variables

(Foreign output, war, etc for instance)
Aggregate Demand
 Our focus is on aggregate demand as
the determinant of the level of output

 Prices are given and constant

 We need to know how given policy

actions shift the aggregate demand
curve at a given level of prices.
(Graph)
Simple Economy
 In a simple economy aggregate demand is
the sum of the demand for consumption
and investment goods.

 It is the amount of goods people want to

buy

 Investment demand (I) is assumed constant

or independent of income or interest rate.
Determination of Equilibrium
Income and Output in a Simple
Economy (Keynesian Theory)
 No government, no trade

Output is at its equilibrium when planned Aggregate

Demand (C + I) is equal to actual output (Y)
AD = C +I

Y = AD

Quantity of output produced (Y) is exactly equal to the quantity

demanded (AD)
Determination of Equilibrium
Income and Output in a Simple
Economy
 At the equilibrium level of output,
firms are selling as much as they
produce, people are buying the
amount they want to purchase.

 So there is no inventory problem.

Deriving the Aggregate Demand Schedule
and Equilibrium Output
C  1 0 0  .7 5 Y I  25
Deriving the Planned Aggregate Demand Schedule and Finding Equilibrium. The
Figures in Column 2 are Based on the Equation C = 100 + .75Y.
(1) (2) (3) (4) (5) (6)
PLANNED UNPLANN
AGGREGAT AGGREGATE ED
E AGGREGATE PLANNED EXPENDITURE ) INVENTO EQUILIBRIUM
OUTPUT CONSUMPTION INVESTMENT C+I RY ?
(INCOME) (C) CHANGE (Y = C + I)
(Y) Y (C + I)

100 175 25 200  100 No

200 250 25 275  75 No
400 400 25 425  25 No
500 475 25 500 0 Yes
600 550 25 575 + 25 No
800 700 25 725 + 75 No
1,000 850 25 875 + 125 No
Output Determination by
Consumption and Investment

Aggregate output :Y

Planned aggregate
expenditure or AD: C + I
Equilibrium: Output = AD
Equilibrium: Y = C + I
Meaning of Equilibrium
income and output
 Output is at its equilibrium level when
aggregate demand (AD) is equal to
output (Y).
 What is AD? It is consumption
spending plus investment spending

AD = C + I where C=a+bY
= (a + bY) + I
= (a + I) + bY
Meaning of Equilibrium
income and output
 (a + I) is autonomous or independent
of level of income.
 But aggregate demand also depends
on the level of income (bY)
 Bcoz, consumption demand increases
with income (bY)
 At equilibrium, Y = AD
Y= (a + I) + bY
 Meaning of Equilibrium
income and output
 Solve for equilibrium output (Yo)

Y- bY = (a +I)

Yo = 1/ (1-b) * (a +I)………………….(1)

 Where b = marginal propensity to consume or MPC

 (a + I ) is autonomous spending
Finding Equilibrium
Output in a simple economy- An
Example

(1) Y  C  I
Y  1 0 0  .7 5 Y  2 5
(2) C  1 0 0  .7 5 Y
(3) I  25 Y  .7 5 Y  1 0 0  2 5
Y  .7 5 Y  1 2 5
By substituting (2) and
(3) into (1) we get:
.2 5 Y  1 2 5
125
Y   500
Y  1 0 0  .7 5 Y  2 5 .2 5
Finding Equilibrium
Output in a simple economy-
Graphically

 Keynesian Cross and equilibrium

income
The slope of the consumption
function measures which of
the following?

1. Marginal propensity to consume

2. Average propensity to consume
3. Aggregate level of consumption
4. Marginal propensity to save
5. Average propensity to save
Find the equilibrium
income when
investment demand is
300 and the
consumption function
is C = 10 + .8 Y.
Compute Y when MPC
increases to 0.90
At the equilibrium level of
real GDP, which of the
following is true?
1. Unplanned inventory
investment is positive

2.Unplanned inventory
investment is negative
3.Aggregate output equals
aggregate expenditure

4.Aggregate output plus

consumption spending equals
aggregate expenditures

5.Aggregate output plus saving

equals aggregate expenditure
Topics of Discussion

 The Investment Multiplier

 The Multiplier in the AS-AD Framework
 Aggregate Demand by Introducing the
Government Sector
 Determination of Equilibrium Income
with Government Sector
 Determination of Equilibrium Income in
an Open Economy
 The Paradox of Thrift
The Simple Multiplier
Model
 It is the change in equilibrium output when
autonomous demand increases by one unit.

 Multiplier k = 1/ (1-MPC)
 Multiplier = 1/ MPS

 Larger the MPC , the larger the multiplier

 To study why output fluctuates, the concept of

multiplier is important.
The Multiplier
 An increase in autonomous spending
raises the equilibrium level of income

 The increase in income is a multiple of

the increase in autonomous spending

 The larger the MPC, the larger the

multiplier (verify with previous
example)
The Multiplier in the AS-
AD Framework
 In a multiplier model, we use
Consumption plus Investment
approach to determine equilibrium
output.

 Equilibrium output is achieved when

aggregate expenditure (C+I) equals
real GDP (Y)
The Multiplier in the AS-
AD Framework

 In AS-AD framework, it is achieved

when downward sloping Aggregate
Demand Curve cuts the upward
sloping Aggregate Supply curve
(Graph)
Aggregate Demand by Introducing the
Government Sector (Fiscal policy in the
multiplier model)

 How government’s fiscal policies affect output?

 What is Fiscal Policy?

By Government taxation
By Government spending (Govt purchase)
By Transfer Payments

How government spending and taxation

programmes affect output?
Aggregate Demand by Introducing
the Government Sector

 Now we have

GDP = C + I + G +NX

Consumption expenditure
Gross private domestic investment
Government purchase of goods and services
Net exports
Determination of Equilibrium
Income with Government
Sector
 Assume we have a closed economy
 So we have GDP = C + I + G
 Total spending is C + I + G
 Equilibrium output is determined when
aggregate spending equals real GDP.
 At this point, total planned spending
exactly equals total planned output.
Determination of Equilibrium
Income with Government
Sector
 Three models:

1. With government spending (G)

2. Taxation (Lump sum tax as well as
proportional tax)
3. Transfer Payments (TR)
Impact of Taxation on
Aggregate Demand
 The increase in taxes will lower
disposable income
 Consumption schedule shifts
downwards
 Government taxation tend to
reduce aggregate demand and the
level of GDP
Determination of Equilibrium
Income in an Open Economy

GDP = C + I + G + NX
We have Exports and Imports
Exports = X
Imports =M
Net Exports (NX) = X - M
Determination of Equilibrium
Income in an Open Economy
 What are the determinants of Exports?
 Exports are exogenously given
 What are the determinants of Imports?
 Imports depend mostly on income of the
economy (Y)
 There is also an autonomous import which
is independent of income or any other
variables
Determination of Equilibrium
Income in an Open Economy
 Hence, Import function is
M = mo +mY
 Where mo is autonomous import

 Where m is marginal propensity to

import. That is, change in import for a
change in income, Y
 Determination of Equilibrium
Income in an Open Economy
 Case 1:Given the consumption function ©,
Investment, Government purchase, without tax
and transfer payments, Export, and Import
function how do we determine equilibrium level of
income?
 Case 2: Now given the consumption function, Tax
rate, Transfer payments, Investment, Government
purchase, Export, and Import function how do we
determine equilibrium level of income?
Determination of Equilibrium
Income in an Open Economy
 Consumption is a function of
disposable income
 C = a + bYd
 Where Yd = (Y – tY)
 Where tY is Proportionate tax rate
 TR is Government Transfer Payments
 C = a + b (Y - tY + TR)
Determination of Equilibrium
Income in an Open Economy
 AD = C + Io + Go + (Xo – M)
 Where C =a+bY
 M =Mo +mY
 Now we can estimate equlilibrium
income for a four sector model.
 Equilibrium is at Y = AD
 The Paradox of Thrift
 More saving looks beneficial to individuals.

 But if everybody starts saving without spending on

consumption, it will reduce demand for goods and then
output or income will get reduced and later saving will be
badly affected.

 The paradox of thrift implies that more savings could harm

the economy as a whole, especially during recession or
depression.

 Japan battles with paradox of thrift?

Summary