ECN 202: Principles of Macroeconomics Nusrat Jahan Lecture-10

1. ECN 202: Principles of MacroeconomicsNusrat JahanLecture-10 Aggregate Demand and Aggregate Supply

2. There is a very close relationship between Income, Consumption and Saving. • Saving = Income-Consumption • To understand the way Consumption and Saving affects National Income we need to understand the following tools- • Consumption Function • Saving Function

3. Consumption Function: • Consumption Function is the relationship between Income and Consumption • Break-even Point- It is the level of income for which Income=Consumption • Non-Income Determinants of Consumption • Wealth • Expectation about Inflation • Real Interest Rate • Savings Function: • Savings Function is the relationship between Income and Saving. It can be derived from the Consumption Function

6. Marginal Propensity to Consume (MPC): The extra amount that people consume when they receive an extra dollar of disposable income. • Marginal Propensity to Save (MPS): The fraction of an extra dollar of disposable income that goes to extra saving. • MPC + MPS = 1 • Average Propensity to Consume (APC): The percentage of income spent. • Average Propensity to Save (APS): The percentage of Income saved. • APC + APS = 1

7. Output Determination by Consumption and Investment (Two Sector Model) • Aggregate Expenditure for a closed- private economy = C + Ig • In Equilibrium, GDP= C+ Ig • If GDP>C+Ig then, production will go down and GDP will come back to equilibrium • If GDP<C+Ig then, production will increase and GDP will come back to equilibrium. 45° C+I E Total Spending C I GDP A M

8. Output Determination by Consumption, Investment and Governement Expenditure (Three Sector Model) • Aggregate Expenditure for a closed- mixed economy = C + Ig+G • In Equilibrium, GDP= C+ Ig+G • If GDP>C+Ig+G then, production will go down and GDP will come back to equilibrium • If GDP<C+Ig+G then, production will increase and GDP will come back to equilibrium. 45° C+I+G E C+I Total Spending C G I GDP A B M

9. Output Determination by Consumption, Investment,Governement Expenditure (Four Sector Model) • Aggregate Expenditure for an open- mixed economy = C + Ig+G+NX • In Equilibrium, GDP= C+ Ig+G+NX • If GDP>C+Ig+G+NX then, production will go down and GDP will come back to equilibrium • If GDP<C+Ig+G+NX then, production will increase and GDP will come back to equilibrium. 45° E C+I+G+NX C+I+G C+I NX Total Spending C G I M GDP A B C

10. The Multiplier • The multiplier is the number by which the change in expenditure must be multiplied in order to determine the resulting change in output/GDP. The Basic Model of Economic Fluctuations Aggregate Demand and Aggregate Supply • Two variables are used to develop a model to analyze the short-run fluctuations. • The economy’s output of goods and services measured by real GDP. • The overall price level measured by the CPI or the GDP deflator. • Economists use the model of aggregate demand and aggregate supply to explain short-run fluctuations in economic activity around its long-run trend.

11. 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. • The Aggregate Demand Curve • The four components of GDP (Y) contribute to the aggregate demand for goods and services. • Y = C + I + G + NX

12. Why the Aggregate Demand Curve might shift? • Shifts arising from • Consumption • Investment • Government Expenditure • Net Export • Why the Short-Run Aggregate-Supply Curve Might Shift •  Labor •  Capital •  Natural Resources. •  Technology. •  Expected Price Level P AD’ AD AD” Y AS’ AS AS”

13. Two Causes of Economic Fluctuations •  Shift in Aggregate Demand •  Shift in Aggregate Supply