ECN 202: Principles of Macroeconomics Nusrat Jahan Lecture-10 Aggregate Demand and Aggregate Supply

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

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

Disposable IncomeConsumption

 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 Disposable Income Consumption Expenditure Marginal Propensity to Consume Average Propensity to Consume Net Saving Marginal Propensity to Save Average Propensity to Save

 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. Total Spending I C C+I MA 45° GDP E

 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. Total Spending I C C+I+G MA 45° GDP E C+I G B

 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. Total Spending I C C+I+G M A 45° GDP E C+I C+I+G+NX G NX BC

 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.

 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

 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 Y AD AD’ AD” AS AS’ AS”

 Two Causes of Economic Fluctuations Shift in Aggregate Demand Shift in Aggregate Supply