Lecture 5

1. Lecture 5

2. Change in Real GDP Change in Real GDP Change in investment spending Change in Spending The Multiplier Equation The multiplier of investment describes the impact of an initial increase in investment on real GDP. It shows how much real GDP changes when there is a change in investment. Multiplier = Derive the formula: The marginal propensity to save may be expressed as: MPS = ΔS/ΔY Because DS must be equal to DI for equilibrium to be restored, we can substitute DI for DS and solve: • MPS=ΔI/ΔY ΔY=ΔI/MPS ΔY/ΔI= 1/MPS So = ΔY/ΔI = Multiplier= 1/MPS ,or

3. Aggregate Expenditure • Aggregate expenditure is the total amount the economy plans to spend in a given period. There are four components in aggregate expenditure which consumption, investment, government expenditure and net export. • AE= C+ I + G + NX

4. Equilibrium Aggregate Output (Income) • Equilibrium occurs when there is no tendency for change. Equilibrium occurs when planned aggregate expenditure is equal to aggregate output/GDP. • In the figure below the point E shows the equilibrium where AE cuts the 45 degree line. At the equilibrium aggregate expenditure is equal to aggregate output/GDP. That is Y=AE

5. Breaking Down Aggregate Expenditure • We start the discussion by the simplest aggregate expenditure model which is the two sector closed economy. • Two sector or private ( no govt) closed economy: In this model we just include consumption expenditure and investment expenditure. • AE= C + I

6. Three sector model/ closed economy (no trade) : Here we bring government in the aggregate expenditure model. So we will consider tax ( T) and government expenditure ( G). As we have tax in the economy so we need to use disposable income instead of income. So we have the following equation: • AE= C (Y-T) + I + G where C ( Y-T) shows that consumption is a function of disposable income.

7. Four sector model/Open Economy: This is the complete model where we consider international trade ( export and import) and that is why this model is called open economy. So this model has four components: Consumption ( C), Investment ( I), Govt. Expenditure ( G) and Net export ( NX). So we can write • AE= C (Y –T)+ I + G + NX

8. Consumption function MathematicallyAE Model • Consumption function is expressed as equation: • C = 100 + 0.5Y • One part here is fixed to 100 that does not depend on the value of Y; that is called “autonomous consumption”. • Slope co-efficient of other part (0.5) is called the MPC

9. Two sector model (AE = C + I) • Aggregate expenditure (AE) in the is composed of consumption (C) and investment (I). • Let’s use the same consumption function: C = 100 + 0.5Y and I = 100 • Here, AE function could be presented as equation: • AE = C + I = 100 + 0.5Y + 100 = 200 + 0.5Y • It shows a relationship between income (Y or GDP) and expenditure (AE) in a privately closed economy

10. Equilibrium in two sector model • We know that equilibrium will occur at a situation where aggregate output/GDP is equal to aggregate expenditure. So we have Y = AE • We want to find the value of equilibrium GDP (Y) • So we have two equation: • AE = 200 + 0.5Y* and • Y = AE • So from these two equations we get • Y* = 200 + 0.5Y* Y* – 0.5Y* = 200 0.5Y* = 200 Y* = 400

11. Three sector model, AE = C + I + G • Now we bring government in our model. The government has two effects on our model: • The government raises tax revenues (T) by taxing on household incomes • Government make purchases (G) of goods and services

12. Equilibrium in three sector model • Consumption is depended on disposable income YD= (Y – T ) • C = 100 + 0.5(Y-50) • Let T = G = 50 with I = 100. • AE function in a three sector economy: AE = C ( Y-T) + I + G AE = 100 + 0.5(Y – 50) + 100 + 50 AE = 100 + 0.5Y – 25 + 100 + 50 = 225 + 0.5Y SO we have AE= 225 + 0.5Y And at the equilibrium we have Y=AE. So we can write Y= 225 + 0.5Y • Y* - 0.5Y* = 225 or 0.5Y* = 225 or Y* = 450

13. Four sector AE model • In four sector model, AE constitutes with • Consumption (C) • Investment (I) • Government expenditure (G) • Net Exports (NX) • Let’s assume we have the same consumption function as before in the three sector model: C = 100 + 0.5 (Y – T) • Let NX = 50 with I = 100, T = G = 50. • Find the equilibrium aggregate output / GDP

14. Equilibrium in Four sector model • Equation of AE function in a four sector model: AE = C + I + G + NX AE = 100 + 0.5(Y – 50) + 100 + 50 + 50 AE = 100 + 0.5Y – 25 + 100 + 50 + 50 = 275 +0.5Y So AE= 275 +0.5Y And at equilibrium Y=AE So we can write Y* = 275 + 0.5Y* • Solving for Y*, we get: Y* = 550

15. Different Aggregate Expenditure Model • In a two sector or private ( no govt) closed economy: AE = C(Y) + I • In a closed economy (no trade) or three sector model: AE = C(Y - T) + I + G • In an open economy or four sector model: AE = C(Y – T) + I + G + NX

16. Aggregate Demand and Aggregate Supply • 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.

17. THE AGGREGATE-DEMAND CURVE • The four components of GDP (Y) contribute to the aggregate demand for goods and services. Y = C + I + G + NX

18. P P2 1. A decrease Aggregate in the price demand level . . . Y Y2 2. . . . increases the quantity of goods and services demanded. The Aggregate-Demand Curve... Price Level Quantity of 0 Output

19. Shifts in the Aggregate-Demand Curve • The downward slope of the aggregate demand curve shows that a fall in the price level raises the overall quantity of goods and services demanded. • Many other factors, however, affect the quantity of goods and services demanded at any given price level. When one of these other factors changes, the aggregate demand curve shifts. • There will be a shift of the aggregate demand curve if there is a change in factor other than price level. Such as • Consumption ↑ because of ↑ in consumer confidence • Investment ↑ because of ↑ in business confidence • Government Purchases ↑ because of ↑ in Military, Medicare expenditure • Net Exports ↑ because of ↑ in Rest of the world’s income

20. Price Level D2 Aggregate demand, D1 Y2 Quantity of Output Shifts in the Aggregate Demand Curve P1 0 Y1

21. Short-run aggregate supply P P2 2. . . . reduces the quantity 1. A decrease of goods and services in the price supplied in the short run. level . . . Y2 Y The Short-Run Aggregate-Supply Curve Price Level Quantity of 0 Output

22. Aggregate supply Equilibrium price level Aggregate demand Equilibrium output Equilibrium occurs at the intersection of Aggregate Demand and Aggregate Supply curves Price Level Quantity of 0 Output

23. Difference between long run and short run • Short Run: Short run is defined as a situation where some factors are fixed. Example: in short run production function land can be fixed. That means we cannot change the amount of land in our production process. • Long Run: Long run is defined as a situation where all factors are variable. Example: in long run production function we can change the amount of land. That means we can increase or decrease the amount of land that we are using in production process.

24. THE AGGREGATE-SUPPLY CURVE • In the long-run, aggregate-supply curve is vertical. • The change in price level does not affect the aggregate quantity supplied in the long run and that is why it is vertical. Reason of vertical long run aggregate supply: The long-run, aggregate-supplycurve is vertical at the point of natural level of output/GDP. The natural level of GDP is defined as the level of GDP that arises when the economy is fully employing all of its available input resources. That means we are fully utilizing our input resources, so an increase in price level will not increase the aggregate output.

25. Long-run aggregate supply P P2 2. . . . does not affect 1. A change the quantity of goods in the price and services supplied level . . . in the long run. The Long-Run Aggregate-Supply Curve Price Level Quantity of 0 Natural level Output of output