December 17 2011

Macroeconomics

2

Aggregate Demand and Supply

Aggregate Demand and Aggregate Supply

3

»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

Aggregate Demand and Aggregate Supply

4

»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

Aggregate Demand and Aggregate Supply

5

»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

Aggregate Supply curve

6

»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!

Aggregate Supply curve

7

»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

Aggregate Supply curve

8

»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

Aggregate Demand curve

9

»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

AD in Alternative Supply assumptions

10

»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

Supply side economics

11

»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

»AS and AD in the long run

12

Income, Spending, Multiplier

Introduction

13

»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

AD and Equilibrium Output

14

»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

Consumption function and AD

15

»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−

Consumption function, Saving and AD

16

»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?

−

Consumption function, Saving and AD

17

»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

(Example)

−

Consumption, AD and Autonomous Spending

18

»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

and AD?

Equilibrium Income and Output

19

»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

precisely matches production

− −

Formula for equilibrium output

20

»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?

−

Savings and Investment

21

»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

Multiplier

22

»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)

−

Multiplier

23

»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

−

−

Government Sector

24

»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)

Government Sector

25

»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

»AD function with Disposable Income

Equilibrium Income and Taxes

26

»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?

−

Government Sector - Recap

27

»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

policy?

Budget

28

»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?

Some key terms to recall

29

» Aggregate

Demand

» Automatic

stabilizer

» Budget constraint

» Budget

surplus/deficit

» Consumption

function

» Disposable

Income

» Fiscal policy

» MPC

» MPS

» Multiplier

30

Case Discussion – Should Energy be Subsidized?

Case Analysis

31

»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

Case Analysis

32

»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

Case Analysis – Effects/Impacts of subsidies

33

»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

Case Analysis – Some statistics

34

Year Amount Countries/Economies

1992 $ 230 bn Global

1997 $ 58 bnUS and 20 largest

countries outside OECD

1999 $95 bn8 of the largest

developing economies

2001 €17.2 bn EU

2005 $250 bn Non-OECD countries

Case Analysis – Arguments FOR subsidies

35

»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

Case Analysis – Arguments AGAINST subsidies

36

»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

Case Analysis – Arguments AGAINST subsidies

37

»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?

Subsidies – Renewable Resource

38

»Social Costs will

come down

»Cleaner fuel

»Reduced health

care costs

»Tariff arrangements

FOR AGAINST

»Capital costs of

establishing

renewable resource

plants

»A few types may

have adverse

ecological impact

Points for discussion

39

»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?

»Should renewable energy be promoted?

Questions???

Have a happy Sunday!