1. Macroeconomics
December 17 2011

2. Aggregate Demand and
Supply
2

3. Aggregate Demand and Aggregate Supply
»Some countries are rich and some are not!
»Aggregate Demand and Aggregate Supply
answer questions about equilibriums in
goods, money market, unemployment, GDP
levels etc
»Provides a “big picture” view of the
economy
»Describes the overall relationship between
overall price level and output
3

4. Aggregate Demand and Aggregate Supply
»Aggregate Supply (AS) curve describes, for
each given price level, the quantity of output
firms are willing to supply
»Aggregate Demand (AD) curve shows the
combinations of the price level and level of
output at which the goods and money
markets are simultaneously in equilibrium
4

5. Aggregate Demand and Aggregate Supply
»Difference in the micro and macro economic
concepts of demand and supply
»Equilibrium state of AS and AD
»Shift in AD curve
»Shift in AS curve
5

6. Aggregate Supply curve
»Classical Supply curve:
»Vertical – indicating that the same
amount of goods will be supplied
whatever be the price level
»Assumption: Labor market equilibrium
»Long term possibility
»Why should supply curve be vertical in
long run? Recall how it was in
microeconomics!
6

7. Aggregate Supply curve
»Classical Supply curve:
»Potential GDP
»Shift of vertical AS curve
»Does potential GDP grow over time?
»Changes in potential GDP do not depend
on the price level
»Potential GDP changes very little over
time
7

8. Aggregate Supply curve
» Keynesian Supply curve:
» Horizontal– indicating that firms will supply
whatever amount of goods is demanded at
the existing price level
» Assumption: Unemployment
» Why should supply curve be horizontal in the
short run?
» Short-run price stickiness
» Price level does not depend on GDP - inflation
8

9. Aggregate Demand curve
»AD curve shows the combination of the price
level and level of output at which the goods
and money markets are simultaneously in
equilibrium
»Expansionary policies’ effects?
»Do consumer and investor confidence have
an effect on AD?
»Depends on real money supply
»AD curve slopes downwards and shifts
9

10. AD in Alternative Supply assumptions
»Equilibrium under Keynesian case
»Given perfectly elastic supply, shifting AD
to the right will increase output but leave
the equilibrium price level unchanged
»Equilibrium under Classical case
»Given perfectly inelastic supply, shifting
AD to the right results in an increase in
the price level but no change in output
10

11. Supply side economics
»Some supply-side policies:
»Removing regulations, maintaining an
efficient legal system, technological
progress
»What is the effect of cutting tax rates?
»Does it have an effect on AD or AS?
»Only supply-side policies permanently
increase output
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»AS and AD in the long run

12. Income, Spending,
Multiplier
12

13. Introduction
»Attempt to answer the most fundamental
question of – Why does output fluctuate?
»Uneven growth observed
»Relationship between output and spending
»Spending  Output and Income 
Spending
»Spending and output feedback leads to an
increase in Aggregate Demand
13

14. AD and Equilibrium Output
»Aggregate Demand is the total amount of
goods demanded in the economy
»AD = C + I + G + NX
»Output at its equilibrium level is when Y =
AD
»What happens when Y is > or < than AD at
any point in time?
»Concept of unplanned inventory investment
or disinvestment
14

15. Consumption function and AD
»Major part of AD is Consumption
»Other components of AD?
»Link between consumption and income
»Assumption to start with – No G or NX
»Relationship between consumption and
income is described by the consumption
function and denoted by
−
»C = C + cY
15

16. Consumption function, Saving and AD
−
»What do C, C and c mean?
»What is Marginal Propensity to Consume?
»Increase in consumption per unit increase in
income ~ out of a Re. 1 increase in income,
a fraction of it goes towards consumption
»If only a fraction of it spent on consumption,
what happens to the remaining?
Mathematical notation?
16

17. Consumption function, Saving and AD
»Budget Constraint?
»S ≡ Y – C
»Relationship between Consumption, Income,
Saving and Aggregate Demand
−
»S ≡ −C + (1-c)Y
»How would you interpret the role of MPC
and MPS here?
»Saving is an increasing function of income
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(Example)

18. Consumption, AD and Autonomous Spending
»Removing the assumption in the real world
scenario!
»Another assumption of all other components
being autonomous. How will the Y curve be
denoted?
»Concept of Disposable Income and its role in
the consumption function (YD = Y – TA +
TR)
»What will be the new consumption function
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and AD?

19. Equilibrium Income and Output
»Aggregate demand schedule is a vertical
addition of all components
»The equilibrium level of income is such that
aggregate demand equals output, which in
turn equals income
»Refer to the 45◦ line and where it intersects
−
−
the A and C curve
»At that level of output, planned spending
19
precisely matches production

20. Formula for equilibrium output
»Y = AD
»Substituting for AD with Autonomous
spending?
»Equilibrium level of income and output
equation:
−
»Y0 = A/(1-c)
»From the equation, what are the things that
would equilibrium output higher?
20

21. Savings and Investment
»In equilibrium, planned investment equals
saving, assuming that there is no G or NX
»What do the distances between the curves
in the graph signify?
»What uses is income put to?
»Y = C + S and Y = C + I
»Including G and NX; Y = C + TA – TR
»I = S + (TA – TR – G) - NX
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22. Multiplier
»By how much does a Re. 1 increase in A
raise the equilibrium level of output and
income?
»The Multiplier table
−
»∆ AD = ∆ A / (1-c)
»Multiplier indicates how much would be the
amount spent on demand/consumption for
every Re. 1 the autonomous spending rises
~ 1/(1-c)
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23. Multiplier
»The 3 most critical observations from a
multiplier effect
−
»An increase in autonomous demand (A)
leads to an increase in equilibrium income
»The increase in income is a multiple of the
increase in A
−
»The larger the MPC, the larger the
multiplier
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24. Government Sector
»What are people’s expectations from the
Government during booms and troughs?
»What is the primary source of income for the
Government?
»Government purchases of goods and
services is a critical part of AD
»Taxes and transfers – R’ship amongst
output, income and Disposable Income (YD)
24

25. Government Sector
»Fiscal policy is the government’s policy
regarding the level of government
purchases, level of transfers and the tax
structure (recall budget surplus)
»Assumptions regarding G and TR
»How can we substitute in our consumption
function?
»MPC for income and MPC for YD – Difference
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»AD function with Disposable Income

26. Equilibrium Income and Taxes
»Equilibrium Income with YD:
−
»Y0 = A/1-c(1-t)
»Effect of taxes on the multiplier
»Automatic Stabilizers
»Any mechanism in the economy that
automatically controls the change in
output to a change in autonomous
demand – Examples?
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27. Government Sector - Recap
»Government Purchases and transfer
payments act like increases in autonomous
spending in their effects on income
»Role of proportional income tax and its
impact on Disposable Income
»Automatic stabilizers
»A reduction in transfers lowers output
»What do you think is the role of fiscal
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policy?

28. Budget
»Is there a reason to fear government budget
deficit?
»Budget surplus is the excess of the
government’s revenues, taxes over its total
expenditures, consisting of purchasing
goods and services and transfer payments
»Define budget deficit
»How does fiscal policy impact budgets?
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29. Some key terms to recall
» Aggregate
»
Demand
» Automatic
stabilizer
» Budget constraint
» Budget
surplus/deficit
» Consumption
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function
Disposable
Income
»
Fiscal policy
»
MPC
»
MPS
»
Multiplier

30. Case Discussion – Should
Energy be Subsidized?
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31. Case Analysis
»What are subsidies?
»Financial assistance given to energy
companies
»Direct Assistance – Grants, Tax
breaks/ exemptions (have a direct
impact on price)
»Indirect Assistance – R&D support,
Government encouragement for
innovations
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32. Case Analysis
»Reasons
»Primary: Access to poorer sections of the
society
»Secondary: Keeping the prices under
control
»Variants of Energy Subsidies
»Cash transfer, Reduced rate loans,
quotas, trade restrictions, preferential tax
treatment
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33. Case Analysis – Effects/Impacts of subsidies
»Short-term and long-term impacts:
»Cost Angle:
»Per unit cost of generating energy was
higher for renewable resource
»Social cost of removing subsidies is high
»Social Angle:
»Pollution costs/Climate change
»Greenhouse effect
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34. Case Analysis – Some statistics
Year
Countries/Economies
1992
$ 230 bn
Global
1997
$ 58 bn
US and 20 largest
countries outside OECD
1999
$95 bn
8 of the largest
developing economies
2001
€17.2 bn
EU
2005
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Amount
$250 bn
Non-OECD countries

35. Case Analysis – Arguments FOR subsidies
»Essential for all economic activities
(subsidized kerosene, LPG, electricity…)
»Direct impact on inflation
»If prices of fuel increase, cost of
transporting vegetables goes up!
»Politics – think vote bank!
»Cross subsidies
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36. Case Analysis – Arguments AGAINST subsidies
»Leads to increased consumption
»Irresponsible usage of energy
»Leads to faster depletion of a precious
resource
»Distorted costs and prices
»Failure in determining actual cost of
production of non-renewable resource
»Environmental damage
36

37. Case Analysis – Arguments AGAINST subsidies
»Majority of the subsidies flows into nuclear
power
»High cost of insurance coverage
»Nuclear waste disposal costs
»Hampers growth of renewable resources
»Discourages research and innovation
»Does it actually benefit the underprivileged?
Can it be diverted?
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38. Subsidies – Renewable Resource
FOR
»Social Costs will
come down
»Cleaner fuel
»Reduced health care
costs
»Tariff arrangements
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AGAINST
»Capital costs of
establishing
renewable resource
plants
»A few types may
have adverse
ecological impact

39. Points for discussion
»Impact of subsidies on economy
»Who are the beneficiaries and who pays for
them?
»Are subsidies essential?
»Does renewable/non-renewable make a
difference?
»Would developing/developed countries
make a difference?
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»Should renewable energy be promoted?

40. Questions???

41. Have a happy Sunday!