AD and Multiplier

AD and The Multiplier

Dr. Mrutyunjay Dash

Aggregate Demand

The aggregate demand implies effective demand which equals actual expenditure. The aggregate effective demand means the aggregate expenditure made by the society per unit time, usually, one year.

It has two components:

I) aggregate demand for consumer goods

II) aggregate demand for capital goods

Thus AD=C+I

Consumption Expenditure

• Exogenous factors affecting consumption:– Tax rates

– Incomes – short term and expected income over lifetime

– Wage increases

– Credit

– Interest rates– Wealth

• Property

• Shares

• Savings

• Bonds

The Wealth Effect•Wealth effect – Financial and Physical AssetsArise in stock market value prompts people reorient their consumption spending.

Increased consumption

Less saving

More financial assets.

The International Effect

• International effect – as the price level falls net exports will rise.

Investment Expenditure• Spending on:

– Machinery

– Equipment

– Buildings

– Infrastructure

• Influenced by:

– Expected rates of return

– Interest rates

– Expectations of future sales

– Expectations of future inflation rates

The Interest Rate Effect

• The interest rate effect works as follows:

a decrease in the price level increase of real cash

banks have more money to lend interest rates fall

investment expenditures increase

The International Effect

• The international effect works as follows:

a decrease in the price level in the U.S. the fall in price of U.S. goods relative to

foreign goods U.S. goods become more competitive

internationally U.S. exports rise and U.S. imports fall

Aggregate Demand Schedule:

AD=C+I and C=a+bY where a is a constant showing C when Y =0 and b is the proportion of income consumed, i.e., b=∆C/ ∆Y.

AD=C+I=a+bY+I

DERIVATION OF AD FUNCTION:C=a+bYWhere a is a constant implying C when y=0 and b is the proportion of income consumed.b= ∆C/∆Y AD function:C+I=a+bY+IThe C+I schedule can be constructed on the basis of the following assumptions:C=50+0.5YI=Rs 50 BillionAD function would be C+I=50+0.5Y+50

AD Schedule

Income (Y) C=50+0.5Y I C+I Schedule

0 50 ` 50 100

50 75 50 125

100 100 50 150

150 125 50 175

200 150 50 200

250 175 50 225

The AD Curve

Pricelevel

Real output

Aggregate demand

P1

Y1

Wealth, interest rate, and international effects

Multiplier effect

Ye

P0

Y0

Pricelevel

Real output

P0

Y0

The Multiplier Effect

• Initial changes in expenditures set in motion a process in the economy that amplifies the initial effects.

• Multiplier effect – the amplification of initial changes in expenditures.


• The multiplier effect works as follows:

An increase in the price level in the U.S. U.S. exports fall and U.S. imports rise

U.S. firms lose sales and cut output U.S. incomes fall

U.S. households buy less U.S. firms cut back again and so on


• The multiplier effect amplifies the initial wealth, interest rate, and international effects, making the AD curve flatter than it would have been.

Aggregate Supply

• AS: AS refers to the total value of goods and services produced and supplied in an economy per unit of time. AS includes both consumer goods and producer goods.

In the Keynesian theory of income determination aggregate income equals consumption and savings.

Thus AS=C+S

Eqilibrium National Income: Rs 200 billion

If C+S[AS]>C+I[AD], then Firms produce goods and services worth more than required demand.

Over stock – reduction in production- cut in expenses on inputs

If C+S<C+I, Then

AD>AS

Expansion of pdn. Activities-generation of more income in the economy.

The AD Curve and the AE Curve

AE1D

esir

ed E

xpen

ditu

re

045o

AE0

Y2Y1

E2

E1

E0

AE2

Y0

AE = Y

Real National Income [GDP]

[i]. Aggregate expenditure

0 Y2 Y1

Y0

P2

P1

P0

AD

Pri

ce L

evel

E0

E1

E2

Real National Income (GDP)

[ii]. Aggregate Demand

Y0

The relationship between AE and AD curves

At each price level consistency between A. Desired Spending, Total output and Level of income at that output.

Consumption Function

As income increases consumption increases but not proportionately

C=f(Y)

APC [Average Propensity to consume]

It is the fraction of total income spent on consumption.

If C=100+0.75Y

APC=C/Y

MPC [Marginal Propensity to Consume]

Symbolically expressed as MPC (b)= ∆C/ ∆Y.

The range 0<b<1

b is always greater than 0 but less than 1.

Multiplier

• The theory of multiplier states that an original new investment will raise national income by more than the original investment.

• It is defined as the ratio of the change in income to the change in investment.

• Then K= ∆Y/ ∆I. As Y=C+I then ∆Y= ∆C+∆I. • Dividing both sides by ∆Y we get 1= ∆C/∆Y+ ∆I/∆Y.• ∆I/∆Y=1- ∆C/∆Y Or I/ ∆I/∆Y=1/I-MPC • K=1/1-b

1. The mpc through remains constant

2. The government activity concerning taxation is absent

3. There is autonomous investment in the economy.

4. There is no time lag.

Greater the saving co-efficient, greater is the leakage and smaller will be the magnitude of K, since K=1/mps and vice versa.

Leakages:•Debt cancellation•Idle deposits-Adv. Inv. Climate/restrictive credit policy•Liquidity preference•Financial investments :Sellers of shares may not spend the proceeds.•Net ImportsInflation: Investment after excess capicity

b is always greater than 0 but less than 1.If b=0, then K=1Income will increase only by an amount equivalent to an increase in investment

If b=1, then K=∞A small increment in investment will lead to an infinite increase in income.

Higher is the mpc greater will be the magnitude of K.

Higher is the mps lower will be the magnitude of K.

Comparative Static Multiplier:In a comparative static system, given the mpc and single dosage of investment ,the national income will be found to grow exponentially and the growth of income will follow a geometrical progression.

If b= ∆C/∆Y Then investment increases by an amount equal to ∆I, the increments in income will follow the folloeing pattern.

Y1= ∆I

Y2= ∆I +b∆I =(1+b) ∆I

Y3= ∆I +b∆I+ b2∆I=(1+b+b2) ∆IIf b = 0.5 and ∆I=100Here(1+b+b2+…………..+bn-1 forms a geometrical

progression. The sum of all the terms upto infinity can be determined through the expression S=a/1-r where S is the sum of all items of a G.P. upto infinity, a=initial term and r= common ratio.

S=1/1-b∆Y=1/1-b. ∆I

National Income Determination

AS=C+S

C+I

I

200 Income [Rs billion]

Exp

endi

ture

[Rs

billi

on]

200

50

200 Income [Rs billion]200 Income [Rs billion]200

E

C+I

C+I+ ∆I

Y=C+S

C

Income

CO

NS

UM

PT

ION

AN

D IN

VE

ST

ME

NT

Y1 Y2

Remarks of Higgins:The analysis of the Multiplier Theory conferred a new importance and new respectability on public investment policy; it was elevated from the rank of the last line of defence to major offensive strategy.

An increment in investment will generate an income several times more than the investment.

Digging of holes and filling them up.

Relevance of Investment Multiplier in UDCs: The magnitude of investment multiplier varies directly with

the magnitude of the marginal propensity to consume.Dr.V.K.R.V. Rao ReportThe existence of involuntary unemployment

Disguised Unemployment- Requirement of huge investment to relocate/no consideration of unemployment by the mass. Disguised unemployment: More labour force

Limitation : Fuller utilisation of gigantic labour force requires huge investment.Increase in investment leads to inflation.

Inelastic supply curve of output.[Agricultural Pdts(Inelastic). (Increased Inv.-increased demand-increased Price

Fear of over production and decline in prices.[lack of administered price]

Absence of Excess capacity

If idle capital equipment is available in ample measure a small injection of investment will set these idle machines into motion and lead to more output, income.UDCs: Excess capacity in terms of capital is negligible.[over utilisation]The expansion of output and employment in such a situation requires huge investment rather than a small injection of new investment.Supporters of Keynes: Utilisation of Surplus workforce/ Huge Investment.Inelastic supply of working capitalLack of banking and institutional finance.Critics: Strict Standards

Price level

AE = Y

The Simple Multiplier and Shifts in the AD Curve

Real GDP

[i]. Aggregate ExpenditureD

esir

ed E

xpen

dit

ure

0

45o

AE0

Y1

E0

Y0

AE1

A

E1

0 Y1Y0

P0

AD0

Pri

ce L

evel

E0 E1

AD1Y

Real GDP

[i]. Aggregate Demand

The simple multiplier and shifts in the AD curve

• A change in autonomous expenditure changes equilibrium GDP for any given price level, and the simple multiplier measures the resulting horizontal shift in the aggregate demand curve.

• The original AE curve is at AE0 with equilibrium at E0, GDP=Y0 and Price level=P0; the yield point E0 on AD0.

• AE0 shifts to AE1 because of an autonomous expenditure increase A, and GDP increases to Y1.

• With given price level P0, the AD curve shifts rightward to E1.

Y

SRAS

A Short-run Aggregate Supply Curve

Real GDP

Y0

P0

SRAS

Real GDP


Y0 Y1

P0

P1

SRAS

Real GDP


The short-run aggregate supply curve

• The SRAS curve is positively sloped.• The positive slope shows that with prices of labour and

other inputs given, total desired output and the price level will be positively associated.

• A rise in the price level from P0 to P1 will be associated with a rise in output supplied from Y0 to Y1.

• The slope of the SRAS curve is fairly flat at low levels of output and very steep at higher levels.

Y0

P0

SRAS

Macroeconomic Equilibrium

AD

E0

Pri

ce L

evel

0

Real GDP

Y0

P0

SRASAD

E0

Pri

ce L

evel

Y2Y1

P1

0

Real GDP



• Macroeconomic equilibrium occurs at the intersection of the AD and SRAS curves and determines the equilibrium values for GDP and the price level.

• Equilibrium occurs at E0 with GDP equal to Y0 and the price level P0.

• If the price level were P1, below P0, the desired output of firms would be Y1 but desired demand would be Y2, so desired spending would exceed desired production.

• Only at E0 are desired plans of producers and consumers consistent.

AE = Y

The AE Curve and the Multiplier When the Price Level Varies

Y0

P0

P1

SARS

Real GDP

E0

Pri

ce L

evel

AD0

Des

ired

Exp

end

itu

re

45o

AE0

E0

Real GDP 0 Y0

[i]. Aggregate demand


AE = Y

Y1Y0

P0

P1

SARS

Real GDP

E0

Pri

ce L

evel

AD0

Y’1

E’1

1[i]. Aggregate demand

Des

ired

Exp

end

itu

re

AE0

Y’1

E0

AE’1

A

E’1

1

Real GDP 0 Y0


45o


AE = Y

Y1Y0

P0

P1

SARS

Real GDP

AD1

E0

Pri

ce L

evel

E1

AD0

Y’1

E’1

2

1

Des

ired

Exp

end

itu

re

AE0

Y’1

E0

AE’1

A

E’1

E1

Y1

Y

2

1

AE1

Real GDP 0 Y0

45o

[i]. Aggregate demand



AD and Multiplier

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