<h5 id="41-aggregate-demand-and-its-components">4.1 Aggregate Demand and its components</h5> <ul> <li>Aggregate demand is the total demand for final goods and services in an economy.</li> <li>It has components like consumption, investment, government spending, and net exports.</li> <li>Consumption and investment can be planned values (ex-ante) or actual values (ex-post).</li> <li>Ex-ante consumption is what people plan to consume, and ex-ante investment is what producers plan to add to their inventory.</li> <li>Ex-post measures represent actual values of these items as measured by the economic activities in a certain year.</li> <li>Understanding the planned values of different components of aggregate demand is crucial for determining income.</li> </ul> <p>======</p> <h5 id="411-consumption">4.1.1. Consumption</h5> <ul> <li>Consumption demand is primarily determined by household income.</li> <li>The consumption function, C=Ć + cY, describes the relationship between consumption and income. <ul> <li>Ć represents autonomous consumption, which is consumption that is independent of income.</li> <li>cY represents induced consumption, which shows the dependence of consumption on income.</li> </ul> </li> <li>The marginal propensity to consume (MPC) is the rate of change in consumption with respect to income and is denoted by c.</li> <li>The marginal propensity to save (MPS) is the rate of change in savings with respect to income and is denoted by s, where s = 1 - c.</li> <li>The average propensity to consume (APC) is consumption per unit of income, and the average propensity to save (APS) is savings per unit of income.</li> </ul> <p>======</p> <h5 id="412-investment">4.1.2. Investment</h5> <ul> <li>Investment is the addition to the stock of physical capital and changes in inventory.</li> <li>Investment goods, such as machines, are part of the final goods, not intermediate goods.</li> <li>Investment decisions by producers depend on the market rate of interest.</li> <li>For simplicity, it’s assumed that firms plan to invest the same amount every year.</li> <li>The ex ante investment demand can be written as I=$\bar{I}$, where $\bar{I}$ is a positive constant representing the autonomous investment in the economy in a given year.</li> </ul> <p>======</p> <h5 id="42-determination-of-income-in-two-sector-model">4.2 Determination of Income in Two-sector Model</h5> <ul> <li>In an economy without a government, ex ante aggregate demand for final goods is $AD = \bar{C} + \bar{I} + c.Y$.</li> <li>When the final goods market is in equilibrium, $Y = \bar{C} + \bar{I} + c.Y$ simplifies to $Y = \bar{A} + c.Y$, where $\bar{A} = \bar{C} + \bar{I}$ is the total autonomous expenditure.</li> <li>The term $Y$ in the equation represents the ex ante output or the planned supply of final goods, while the right-hand side denotes ex ante or planned aggregate demand for final goods.</li> <li>Inventory investment can be negative or positive, and it can occur due to planned or unplanned reasons, leading to a difference between planned $Y$ and actual $C+I$.</li> <li>With the introduction of a government, the fiscal variables Tax ($T$) and Government Expenditure ($G$) affect the aggregate demand for final goods and services, leading to $Y = \bar{C} + \bar{I} + G + c(Y-T)$.</li> </ul> <p>======</p> <h5 id="43-determination-of-equilibrium-income-in-the-short-run">4.3 Determination of Equilibrium Income in the Short Run</h5> <ul> <li>In microeconomic theory, demand and supply curves determine the equilibrium price and quantity.</li> <li>In macroeconomic theory, the price level is fixed at the first stage of determining equilibrium.</li> <li>This is justified by the assumption of an economy with unused resources, where additional output can be produced without increasing marginal cost.</li> <li>Hence, the price level does not vary even if the quantity produced changes.</li> <li>This is also a simplifying assumption that will be changed in later stages.</li> </ul> <p>======</p> <h5 id="431-macroeconomic-equilibrium-with-price-level-fixed">4.3.1 Macroeconomic Equilibrium with Price Level Fixed</h5> <ul> <li>The Consumption Function can be represented as $C = \bar{C} + cY$, where $\bar{C}$ is the autonomous expenditure and $c$ is the marginal propensity to consume.</li> <li>The Investment Function is represented as a horizontal line at a height equal to $\bar{I}$ above the horizontal axis, indicating that I is autonomous and remains constant regardless of the level of income.</li> <li>The Aggregate Demand Function shows the total demand (consumption + investment) at each level of income. It is obtained by vertically adding the consumption and investment functions.</li> <li>The Aggregate Supply is assumed to smoothly move up or down, represented by a $45^{\circ}$ line, indicating that whatever is the level of GDP, that much will be supplied and the price level has no role to play.</li> <li>The Equilibrium is shown by the point where ex ante aggregate demand is equal to ex ante aggregate supply. In algebraic terms, it is represented as $Y = \frac{\bar{C} + \bar{I}}{(1-c)}$.</li> </ul> <p>======</p> <h5 id="432-effect-of-an-autonomous-change-in-aggregate-demand-on-income-and">4.3.2 Effect of an Autonomous Change in Aggregate Demand on Income and</h5> <ul> <li>The equilibrium level of income is dependent on aggregate demand.</li> <li>A change in aggregate demand can occur due to changes in consumption or investment.</li> <li>Consumption can change due to variations in the intercept($\bar{C}$) or slope($c$) of the consumption function.</li> <li>Investment, assumed autonomous (not dependent on income), can be influenced by factors such as credit availability and interest rates.</li> <li>An increase in autonomous investment shifts the aggregate demand line upwards, leading to a new equilibrium point with higher output and aggregate demand. This results in a multiplier effect on the equilibrium values of aggregate demand and output.</li> </ul> <p>======</p> <h5 id="433-the-multiplier-mechanism">4.3.3 The Multiplier Mechanism</h5> <ul> <li> <p>The text presents the concept of the investment multiplier in an economic model. The multiplier is the ratio of the total increment in equilibrium value of final goods output to the initial increment in autonomous expenditure. It is expressed as 1/(1-c) where c is the marginal propensity to consume.</p> </li> <li> <p>The Paradox of Thrift is a consequence of this model. If the marginal propensity to save (1-c) increases, the total value of savings in the economy does not increase but may either decline or remain unchanged.</p> </li> <li> <p>An example is given of an exogenous shift in people’s expenditure pattern, causing a decrease in aggregate demand and a reduction in output. The process of adjustment to a new equilibrium is described, with successive rounds of reduction in output and income.</p> </li> <li> <p>The total decrease in the value of output and aggregate demand is shown to be 150, which is the new equilibrium output when the marginal propensity to consume has decreased.</p> </li> <li> <p>The line representing aggregate demand shifts downwards when the marginal propensity to save increases, reducing the slope of the line. This is depicted in Fig. 4.8.</p> </li> </ul> <p>======</p> <h5 id="44-some-more-concepts">4.4 Some More Concepts</h5> <ul> <li>The equilibrium output in an economy is determined by the equality of actual output (Y) and aggregate demand (AD), but this does not necessarily mean full employment.</li> <li>Full employment is achieved when all factors of production are fully employed in the production process.</li> <li>Equilibrium does not signify full employment of resources; it only means that the level of income in the economy will not change even with unemployment.</li> <li>If the equilibrium level of output is less than the full employment level, it leads to deficient demand and declining prices in the long run.</li> <li>If the equilibrium level of output is more than the full employment level, it leads to excess demand and rising prices in the long run.</li> </ul> <p>======</p>