The total quantity of aggregate output (real GDP) that all buyers (consumers, firms, the government, and foreigners) want to buy at different price levels, ceteris paribus.
AD curve shows relationship between real GDP demanded & price level, ceteris paribus.
The negative slope is a result of:
Consumer confidence – how optimist consumers are about the future
Interest rate changes
Wealth changes
Personal income tax changes
Household indebtedness changes – how much $ people owe from taking out loans
Changes in business confidence are the level of optimism businesses have regarding future sales.
Interest rate changes
Improvements in technology –
stimulate investment spending: rightward shift
Business tax changes
Corporate indebtedness changes
Legal/institutional changes – some economies don’t offer credit to small businesses
Political priorities changes
Changes in economic priorities: attempts to change AD
Changes in national income cannot cause AD curve shifts because the real GDP axis also represents national income.
Don’t confuse the wealth effect (resulting from price level change) with the factor that affects AD shifts (no price level changes).
Short run in macroeconomics – period of time where prices are constant/inflexible and don’t change much, especially in labor costs.
Long run in macroeconomics – period of time where prices are flexible and changes with changes in the price level.
Aggregate supply (AS) – total quantity of goods/ services produced in an economy over a time period at different price levels.
Short-run aggregate supply (SRAS) curve – when resource prices remain constant, the relationship between price level and real GDP is shown.
There is a positive slope because.
1.) If wages increase, cost of production rises: leftward shift2.) If wages decrease, cost of production decreases: rightward shift
1.)If non-labor resource prices rise: leftward shift
2.)If non-labor resource prices decrease: rightward shift
1.) increase in tax: leftward shift
2.) Decrease in tax: rightward shift
1.) Increase in subsidies: rightward shift
2.) Decrease in subsidies: leftward shift
1.) Events that cause a decrease in output: leftward shift
2.) Events that cause increase in output: rightward shift
Equilibrium level of output (real GDP) is where AD intersects AS. In the short-run, it is where AD intersects SRAS.
In the above diagram, Ys is the equilibrium level of real GDP and Ple is the equilibrium price level.
The equilibrium leveI of real GDP can determine unemployment:
At PI1 excess real GDP supplied. At Pl2 excess real GDP demanded.
There are 3 types of short-run macroeconomic equilibrium positions, defined in relation to the economy’s potential output (Yp), which represents the level of real GDP where there is full employment.
1.) The monetarist/new classical model builds from 19th century classical economists. Key principles:
2.) Monetarist approach to AS differs on short run and long run.
3.) The long run relationship is the long run aggregate supply (LRAS). The LRAS curve is vertical at Yp (potential GDP).
4.) The LRAS curve is vertical because in the short run, if the price level increases when other inputs are constant, the quantity of output moves upward along the curve. However, in the long run the input prices increase by the same amount.
5.) In the long run, according to the monetary/new classical model output gaps cannot persist.
6.) In the figure to the right, a recessionary gap has formed because AD1 falls to AD2. However, in the long run the fall in price level is matched by decrease in resource prices which shifts the SRAS curve to the right. The gap has disappeared though the price level has fallen.
7.) In the lower figure, an inflationary gap has formed because AD2 to AD1. In the long run wages also increase, so SRAS curve shifts to the left resulting at point c. The gap disappeared but the price level increased.
8.) In the monetarist/new classical point of view, gaps are removed in the long run. The economy moves towards equilibrium. Changes in AD can affect real GDP only in the short run. In the long run the only impact of an AD change is the price level, so AD increase in the long run can be inflationary.
Section I: Real GDP low, price level constant as GDP increases. Lots of unemployment in spare capacity.
Section II: Real GDP and price level increases but spare capacity soon decreases. Only way to increase output is to sell at a higher price. Full employment level.
Section III: AS curve becomes vertical, real GDP cannot increase and the price level increases rapidly.
Recessionary gap – The AD curve (AD1) intersects at the horizontal section, less than the potential GDP.
Inflationary gap – The AD curve (AD3) intersects at the vertical section, greater than the potential GDP.
Full employment equilibrium – AD2 curve, which intersects the potential GDP YP.
These terms, inflationary and deflationary gaps are Keynesian concepts. Potential output and natural unemployment are monetarist concepts.
The Keynesian perspective says that recessionary gaps can happen for a long time, until the gov’t helps with specific ways to allow it to come out.
It is a short-run analysis and they don’t accept the idea that the economy can move into the long-run and that it tends to full employment equilibrium.
In the Keynesian model, AD increase doesn’t always cause a price level Increase. From a monetarist point of view, an increase in AD results in an increase in price level.
1.) These factors shift the AS curve to the right. Their opposites shift the curve to the left.
2.) Rightward shifts correspond to long-term growth (increase in potential output). Short term economic growth does not cause this.
3.) In the monetarist/new classical model, factors that shift the LRAS curve shift the SRAS curve over the long term.
4.) Events with a temporary effect on aggregate supply can shift the SRAS curve temporarily without shifting the LRAS curve.
It is the ratio of change in national income (real GDP) arising from a change in government spending.
Multiplier (K) = Change in real GDP / Initial change in expenditure
Note: If K>1, change in GDP > change in expenditure
Marginal Propensity to consume (MPC):- Change in consumption due to change in income.
Marginal Propensity to save (MPS):- Fraction of additional income saved.
Marginal Propensity to tax (MPT):- Fraction of additional income taxed.
Marginal Propensity to import (MPM):- Fraction of additional income spent on imported goods and services.
Note: Formula: MPC + MPS + MPT + MPM = 1
Multiplier = 1 / 1 – MPC or 1 / MPS + MPT + MPM
The value of the multiplier is given by 1 / 1 – MPC, which is equivalent to 1 / MPS + MPT + MPM. Therefore, if we know MPC, we can calculate the multiplier’s value.
Conclusion: Larger the MPC, the greater the multiplier. Smaller the leakages, greater the multiplier.
The full effect of the multiplier can be experienced only when the price level is constant. If the price level is increasing, the greater the price level increases, the smaller is the size of the multiplier effect.
Desired Consumption: It is the expenditure, consumer desires to make on final goods and services. It depends on consumer’s real income.
Note: Consumption Function: It is the ‘C’ line, representing consumption spending. It has a constant slope, given by dC/dY.
This slope is known as Marginal Propensity to Consume (MPC), which means the change in consumption due to change in income.
Autonomous spending: Spending which is independent of income.
Induced Spending: Spending which is dependent on income.
In the figure below, Ye = Equilibrium point. At Y1 Consumption > real GDP produced. Hence, firm’s inventories are sold, thus providing firms with the signal to increase production causing real GDP to increase to Ye.
At Y2, Consumption < real GDP produced. Hence, the firm’s stock is lying idle, signaling a cut down on production, so real GDP falls to Ye.
Note: Equilibrium point is Ye where desired saving (leakages) = Desired investment (injection)
Adding Government (G) and Foreign sector (exports X- imports M or Xn =net exports)
G and Xn both are autonomous (independent of income).
Note: ‘X’ is an injection which increases desired spending. While ‘M’ is a leakage which reduces desired spending.
If X>M, spending increases. If X<M spending decreases.
Aggregate expenditure represents total desired spending (C+I+G+Xn) When aggregate expenditure = Real GDP, Economy is in equilibrium.
Each point on the aggregate demand curve corresponds to a particular price level where the amount of output buyers want to buy is just that output that generates the spending needed to buy the output
The Keynesian cross model and output gaps
In the Keynesian cross model, equilibrium can occur at any level of output and there is nothing to guarantee that the equilibrium level of output will be the same as potential output. Recessionary (deflationary) gaps or inflationary gaps may persist indefinitely.
Recessionary gap (Ye < Yp): At Ye, there exists unemployment and recession. Actual equilibrium output is less than the potential output and unemployment > natural rate of unemployment.
Inflationary gap (Ye > Yp): At Ye, unemployment < natural rate of unemployment and actual output > potential output.
The multiplier is a Keynesian concept showing the power of increased spending to induce a larger increase in real GDP when the economy is in recession and is not experiencing upward pressure on the price level.
Relationship between multiplier and MPC: larger the MPC, larger the multiplier.
Note: MPC is the slope of the aggregate expenditure function (F), because larger the slope of F, larger the multiplier and steeper the aggregate expenditure function and vice versa.
When MPC = 0, multiplier (1/ 1-MPC) is 1.
Because MPC is 0, this indicates that all of the increased income is saved and that nothing is spent.