UNIT 4

TOPIC 1: THE BUSINESS CYCLE

TOPIC 2: AGGREGATE EXPENDITURE
TOPIC 3: AGGREGATE DEMAND AND
SUPPLY MODEL
 The Business Cycle
• https://www.youtube.com/watch?feature=p
layer_detailpage&v=DmXvUz0qAtw
• https://www.youtube.com/watch?feature=p
layer_detailpage&v=6XpXsC-yNHI
The Business Cycle
 Four Phases of Business Cycle

Business Cycle (or Trade Cycle) is divided into the following four
phases :-

• Prosperity/Peak Phase : Expansion or Boom or Upswing of

economy.
• Downturn Phase : from prosperity to recession (upper turning
point).
• Recession/Depression Phase : Contraction or Downswing of
economy.
• Recovery Phase : from depression to prosperity (lower turning
Point).
 PEAK / Prosperity Phase
General level of activity is above average. When there is an expansion of output, income,
employment, prices and profits, there is also a rise in the standard of living. This period
is termed as Prosperity phase.
• The features of prosperity are :-
• High level of output and trade.
• High level of effective demand.
• High level of income and employment.
• Rising interest rates.
• Inflation.
• Large expansion of bank credit.
• Overall business optimism.
• A high level of MEC (Marginal efficiency of capital) and investment.
• Due to full employment of resources, the level of production is Maximum and
there is a rise in GNP (Gross National Product). Due to a high level of economic
activity, it causes a rise in prices and profits. There is an upswing in the
economic activity and economy reaches its Peak. This is also called as a Boom
Period.
 Downturn Phase
• The turning point from prosperity to depression is termed as downturn
Phase.

• During a downturn period, the economic activities slow down. When

demand starts falling, the overproduction and future investment plans
are also given up. There is a steady decline in the output, income,
employment, prices and profits. The businessmen lose confidence
and become pessimistic (Negative). It reduces investment. The banks
and the people try to get greater liquidity, so credit also contracts.
Expansion of business stops, stock market falls. Orders are cancelled
and people start losing their jobs. The increase in unemployment
causes a sharp decline in income and aggregate demand. Generally,
recession lasts for a short period.
 Recession/Depression Phase
• When there is a continuous decrease of output, income, employment, prices
and profits, there is a fall in the standard of living and depression sets in.
• The features of depression are :-
• Fall in volume of output and trade.
• Fall in income and rise in unemployment.
• Decline in consumption and demand.
• Fall in interest rate.
• Deflation.
• Contraction of bank credit.
• Overall business pessimism.
• Fall in MEC (Marginal efficiency of capital) and investment.
• In depression, there is under-utilization of resources and fall in GNP (Gross
National Product). The aggregate economic activity is at the lowest, causing a
decline in prices and profits until the economy reaches its Trough (low point).
 Recovery Phase
• The turning point from depression to expansion is termed as Recovery or
Revival Phase.

• During the period of revival or recovery, there are expansions and rise in
economic activities. When demand starts rising, production increases and this
causes an increase in investment. There is a steady rise in output, income,
employment, prices and profits. The businessmen gain confidence and become
optimistic (Positive). This increases investments. The stimulation of investment
brings about the revival or recovery of the economy. The banks expand credit,
business expansion takes place and stock markets are activated. There is an
increase in employment, production, income and aggregate demand, prices
and profits start rising, and business expands. Revival slowly emerges into
prosperity, and the business cycle is repeated.

• Thus we see that, during the expansionary or prosperity phase, there is

inflation and during the contraction or depression phase, there is a deflation.
 UNIT 4 IS:
MICROECONOMICS AND
MACROECONOMICS
 MICROECONOMICS

• Micro Small

• It is a study of individual economic

unit.
 Microeconomics
It studies the behaviors of individual:
• Households
• Firms
• Industries
• Product and factor markets
 MACROECONOMICS
• Macroeconomics is concerned with the study of
large- scale economic phenomena.
(examples: total income and employment,
inflation and growth).

• Studies the ‘ordinary business of life’ in the

aggregate; that is we look at the behavior of the
economy as a whole.

• Examines the problems relevant to aggregates

of firms and households rather than individual
firms and households.
Note: aggregate means ‘total’
 MICROECONOMICS
• It studies the behavior of these individual units
for example;
• How does an individual household decide to spend their
income? (consumption pattern)

• How does an individual firm decide what volume of

output to produce or what products to make?
(decision on production)

• How is the price of an individual product determined?

(DEMAND and SUPPLY)
 MACROECONOMICS
• The key variables in macroeconomics study include;
– the business cycles,
– total output in the economy
– economic growth
– the aggregate price level
– employment and unemployment
– inflation
– interest rates
– wages rates
– international trade
– foreign exchange.
ECONOMIC THEORIES STUDY THE 2 SCHOOL OF THOUGHTS

1. CLASSICAL THEORIES (now called New Classical Theories)

2. KEYNESIAN THEORIES.
 THE KEYNESIAN VIEW

In the short run, especially during recessions, economic output is strongly

influenced by aggregate demand (total spending in the economy). In the Keynesian
view, aggregate demand does not necessarily equal the productive capacity of the
economy; instead, it is influenced by a host of factors and sometimes behaves
erratically, affecting production, employment, and inflation. Keynesian economists
often argue that private sector decisions sometimes lead to inefficient
macroeconomic outcomes which require active policy responses by the public
sector, in particular, monetary policy actions by the central bank and fiscal policy actions
by the government, in order to stabilize output over the business cycle.
AGGREGATE EXPENDITURE

AE = C + Ip + G + (X – M)

OR

AE = C + Ip + G1 + G2 + (X – M)
 COMPONENTS OF AE
1. CONSUMPTION EXPENDITURE
• Personal Consumption expenditure can be
categorized as – expenditure on non durables,
durables and services.
• CONSUMPTION is the largest component of GDP
(Gross Domestic Product)
 COMPONENTS OF AE
2. INVESTMENT
• The second largest element of AE
• Aggregate INVESTMENT is the most
volatile component of GDP
Note: GDP and AE are not the same thing because the
INVESTMENT component of AE is planned investment (Ip). It
does not include inventories which are unsold stocks of goods.
Only if inventories is nil then AE = GDP.
 COMPONENTS OF AE
3. GOVERNMENT SPENDING
• The third largest component of AE
• Government spending includes all
federal, state and local government
expenditure on final goods and
services and investment in capital
equipment and infrastructure.
 COMPONENTS OF AE
4. NET EXPORTS (EXPORTS MINUS
IMPORTS)
• Net exports (X – M) was because
exports and imports are actually
consumption (goods and services) or
investment (capital spending) or
government items.
 THE DETERMINANTS OF AE
• Although economists are interested
in the size of these expenditure flows,
they are more concerned with why they
vary from year to year.
• Hence we need to explore the factors
that influence each of the components
of AE.
 Factors affecting
CONSUMPTION SPENDING
1. Level of disposable income (Yd)
2. The cost of credit (interest rates)
3. The stock of personal wealth
4. Consumer expectations/sentiment
5. Government economic policy; monetary
policy (affecting interest rates, fiscal policy
affects disposable income)
6. The distribution of income in the economy
7. Demographic and institutional factors
 Factors affecting
INVESTMENT SPENDING (Ip)
Investment is expenditure on producer or capital goods that are
used to produce final goods and services in the future. The level
of investment is a very important determinant of aggregate
demand and the overall health of the economy.

1.Risk :- investment rises and falls according to

perceived risk which the future entails, political
decisions, international events, changes in consumers
taste.
 Factors affecting
INVESTMENT SPENDING (Ip)
2. The rate of interest :- a major influence on investment decision.
Interest rates and the level of investment expenditure is inversely
related because interest rates is a cost /price of borrowing (as
interest rates increase, level of investment falls and vice versa)
and interest rates represent the opportunity cost of money where
firms have the choice of using money capital for new investment
of other alternatives, the opportunity cost of investment increases
when interest rates rise.

Note: nominal interest rates and real interest rates.

Nominal interest rate is the current price of borrowed money
Real interest rate takes the rate of inflation into account (more
important determinant of investment than nominal interest rate)
 Factors affecting
INVESTMENT SPENDING (Ip)
3. Business expectations
4. Profitability
5. Government policies: - influence investment
both directly and indirectly. Fiscal and
monetary policies affect investment levels
because of their influence on the general level
of economic activity.
 Factors affecting
GOVERNMENT SPENDING
Government spending is an injection. Examples of
government spending are wages and salaries for
public servants, production of public goods(health
service, education service, social welfare and national
defence)
1. The stability of the economy – managing economic
fluctuations.
2. The level of social expenditure – to reduce income
inequality.
3. The level of general expenditure – spending on
infrastructure for future economic growth
 Factors affecting
NET EXPORTS
1. The degree of overseas economic activity and the
level of world demand
2. The level of international competitiveness
3. The accessibility of world markets
4. Economic conditions within a country and the level
of domestic demand for imports
5. The nature of external policy (exchange rate, trade
barriers)
6. Terms of trade
 Why Investment (I) more volatile and less predictable than
Consumption (C)?

INVESTMENT (I) CONSUMPTION (C)

 RISKY  INCREASE AS DISPOSABLE
 DURABILITY OF INCOME INCREASE
CAPITAL EQUIPMENT
 PROFIT IS A MAJOR
DETERMINANT
 RATE OF GROWTH OF
SALE
 IRREGULAR
OCCURRENCE OF
MAJOR INNOVATIONS
Factors influencing aggregate • Disposable income (Yd)
consumption expenditure • Interest rates (r)
• Expectations
C • Availability of credit
• Stock of wealth

Factors influencing aggregate • Business expectations

planned investment • Interest rates (r)
• Level of past profits
Ip • Government policies

Factors influencing government • Determined in accordance with

expenditure government policy objectives e.g. social
policies, health, education.
G • Can be used to stabilize macroeconomic
fluctuations.

Factors influencing net exports • Domestic and overseas economic

activity
X-M • Tariffs, quotas, exchange rates and
terms of trade
 The 5-sector Model
Income (Y)

Households Firms
Consumption (C)

Savings (S) Investment (I)

Financial Sector

Government
Taxation (T) spending (G)
Government Sector

Imports (M) Exports (X)

Overseas Sector
LEAKAGES INJECTIONS
 The CIRCULAR FLOW OF INCOME MODEL
RESOURCES (REAL/PHYSICAL FLOW)

Income (Y)

Households Firms
Consumption (C)

Savings (S) GOODS & SERVICES Investment (I)

Financial Sector
Government
Taxation (T) spending (G)
Government Sector

Imports (M) Exports (X)

Overseas Sector
 Symbols
• Y = INCOME
• O = OUTPUT/PRODUCTION
• E = EXPENDITURE
 HOUSEHOLD INCOME
HOUSEHOLD INCOME
2 –SECTOR MODEL Y=C
3 - SECTOR MODEL Y=C+S
4 –SECTOR MODEL Y=C+S+T
5 - SECTOR MODEL Y=C+S+T+M

FOR EXAMPLE:
HOUSEHOLD INCOME = 60% CONSUMPTION + 20% SAVINGS + 10% TAXATION
+ 10% IMPORTS
Household income in 2-sector circular flow of income model
LEAKAGES / WITHDRAWALS
• SAVINGS (S)
• TAXATION (T)
• IMPORTS (M)
Household income payments on these items
reduces the spending power of households
and firms (both money and real flows)
 INJECTIONS
• INVESTMENT (I)
• GOVERNMENT SPENDING (G)
• EXPORTS (X)
These injections return money to the
circular flow
 GDP, AE & AD
• GDP = GROSS DOMESTIC PRODUCT
• AE = AGGREGATE EXPENDITURE
• AD = AGGREGATE DEMAND
GDP = C + I +G + (X-M)
(I stands for actual investment spending)
AE/AD = C + Ip + G + (X-M)
(Ip stands for planned investment)
 GDP
(GROSS DOMESTIC PRODUCT)
• A measure of total income or output of a country
• It is a money value of the flow of goods and services that arise
from the economic activity of a nation
• The statistical measure of national income is the GDP

C + I + G + (X – M) = TOTAL PRODUCTION =
TOTAL EXPENDITURE = TOTAL INCOME
 GDP
(GROSS DOMESTIC PRODUCT)
• TOTAL PRODUCTION (O)
• TOTAL EXPENDITURE/SPENDING(E)
• TOTAL INCOME(Y)
O = E =Y
(GNP = GROSS NATIONAL PRODUCT)
GNP > GDP
The GDP can be measured in 3 ways
Methods of measuring GDP
By output (Production Method)
By income (Income Method)
By expenditure (Expenditure
Method)
• The value of production approach
• Adds together the value of all goods and
services from 3 sectors; primary,
secondary and tertiary)
• The value of intermediate goods and
services are not included, because this will
involve ‘double counting’ (counting output
values twice or more)
• The income approach
• Adds together all the incomes earned by a
country’s citizen (wages, rent, interest and
profits), allowing for depreciation of capital
equipment, and net indirect taxes.
• The expenditure approach
• Adds together all money spent by private
citizens, firms and the government on final
goods and services, changes in stocks
held by firms and net exports (exports
minus imports) within a year.
 EQUILIBRIUM
TOTAL INCOME = TOTAL PRODUCTION = TOTAL EXPENDITURE
Y=O=E
TOTAL LEAKAGES/WITHDRAWALS = TOTAL INJECTIONS
S+T+M=I+G+X
AGGREGATE SUPPLY (AS) = C + S + T + M

AGGREGATE DEMAND (AD) = C + I +G + X

AGGREGATE DEMAND = AGGREGATE SUPPLY

AD = AS
C+S+T+M=C+I+G+X
TOTAL LEAKAGES/WITHDRAWALS (W) = TOTAL INJECTIONS (J)
W=J
Y = GDP = C + I + G + (X-M)
 DISEQUILIBRIUM
CHANGES IN LEAKAGE AND INJECTION
When S = I (no tendency for change in the circular flow

If S > I, C falls Production falls Employment falls

Income falls Savings falls

If S < I, C rises Production rises Employment rises

Income rises Savings rise

Whenever the S and I is in disequilibrium, the economy adjust itself to reach

a new equilibrium.
 The Keynesian
Expenditure Model
• Explains the importance of Aggregate
Expenditure (AE) in determining the level of
economic activity (output/spending).
• It is also known as the Expenditure model
and the Keynesian cross model.
• The economy will be in EQUILIBRIUM when
the level of AE is equal to AS (Aggregate
Supply i.e. when Total Spending = Total
Output)
 The 450 line

AD/AE
Y=E=O
The components of
AE/AD is
45-degree line represents
C + Ip + G +(X-M)
all combinations in which
AE = AS
Total output is equals to the
expected total receipts
(Income)

450
Income (Y)
 CONSUMPTION SPENDING (C)

• Largest component of GDP (AE/AD).

• Consumption spending is directly

proportional to total income.

C when Y ; Cwhen Y

There are 2 types of C spending;

Autonomous C and Induced C
What is Autonomous Consumption ?

• Part of total consumption, which is determined by

factors other than income.

• Household would still spend even if the level of

income were zero.

• If income is zero, household must dig into past

savings or go into debt – this is called ‘dis-savings’.
For example: Housing and car loan installment/monthly payments, house rental
Induced Consumption

• Part of consumption, which depends on the

level of income.

• As income rises, some proportion of

income will be spent on consumption.
 The Consumption Function
C = A + cY

C= total consumption
A= autonomous consumption
c = induced consumption
Y= level of Y

By substituting A = 1000 and cY = 3/4 , the equation would be;

C = 1000 + 3/4Y
Marginal Propensity to Consume (MPC)

• Proportion of any change in income, which is

spent on consumption.

• The fraction of each additional dollar of income

spent on consumption - can be expressed as;

MPC = C / Y
 Consumption (C) (cont.)

• Average Propensity to Consume (APC)

Proportion of total income, which is spent.

APC = C / Y
• MPC

Proportion of any change in income, which is

spent on consumption.
 The Consumption Function

AE Y=E=O/AE

Savings
Y>C
C = 1000 + 3/4Y

Break even at
1000 4000

45 line
Y<C
Y
Dis-saving
4000
 mpc

Autonomous C
 Video (Consumption function)
• https://www.youtube.com/watch?feature=p
layer_detailpage&v=v4M2CxK_aN4
 SAVINGS (S)
• Part of current income, which is not spent on
consumption.

• The Savings Function

Y = C+S
S = Y–C

S = 1/4Y – 1000
MPS

• proportion of any change in income, which is

saved.

• The extra savings generated by an additional

dollar of income - can be expressed as;

MPS = S / Y

MPS = 1 - MPC
APS

• the proportion of total income, which is

saved.
APS = S / Y
 The Saving Function
S
S = 1/4Y – 1000

-1000

MPC + MPS = 1

In this 3 sector economy model, income can only be spent on consumption or

saved, therefore MPS and MPC must always add up to 1.
 Savings function
• https://www.youtube.com/watch?feature=p
layer_detailpage&v=GDccB0JJOOo
 THE RELATIONSHIP
BETWEEN
THE CONSUMPTION AND
SAVINGS FUNCTION
 C 45 line

C = 1000 + 3/4Y

1000

Y
S

S = 1/4Y – 1000
Y
4000

-1000
When planned consumption is equal to
income;
C = Y, savings is zero

At income below 4000, savings is negative,

dis –savings

At income above 4000, savings is positive,

savings.
 INVESTMENT (I)

• The act of producing goods that are not for

immediate consumption (production for future
consumption) and it also includes capital goods
and additions to stock.

• Investment consist of:

– fixed capital equipment such as machinery, equipment,
plant, etc..

– stocks of finished or unfinished products.

 INVESTMENT (I) (cont.)
• Relationship between investment and AD :

AD > AS
There is unintended run down of stocks

AD < AS
There is unintended build up of stocks
 The Investment Function

AE Assume that all investment is autonomous

– does not vary with the level of income.

2000 I

Y
 GOVERNMENT SPENDING (G)

• The underlying aim of the government is directed

towards the social and economic well being of its
people.

• Under Keynesian model, we regard total government

spending as being autonomous – independent of
income.
 45 degree line and AE
• https://www.youtube.com/watch?feature=p
layer_detailpage&v=LP6rthgzqH4
Note: This Keynesian diagram includes all sectors within the economy (complex model)
 45 degree line
AE
M (imports)
AE

I+G+X

X
I +G
G
I
I

0 Y
Y1
(REAL GDP)
Note: all injections are autonomous: Autonomous Investment, Government Spending and Exports. That’s why the I function,
G function and X function are independent of any change in income. Imports can increase as income increase.
 The Multiplier
• An initial change in AD/AE can have a
greater final impact on equilibrium national
income.
• This is known as the multiplier effect and
it comes about because injections of
demand into the circular flow of income
stimulate further rounds of spending.
 The Multiplier
• Changes may occur in any components of aggregate
expenditure (AE)
• An initial autonomous change in any component of
AE can trigger the multiplier process.
• That is, any initial change in either,
a. Autonomous consumption
b. Autonomous investment
c. Autonomous government spending
d. Autonomous exports.
 The Multiplier
For example, an initial investment of $300m creates
new income, which is either spent or saved. The
proportion that is spent creates income for others in
the second time period, which is also either spent or
saved
Initial investment $300million

New income (Y1) New Income (Y2)

Spent 60%

Saved 40%
 The Multiplier Process
• Consider a �300 million increase in business investment. This will set
off a chain reaction of increases in expenditures. Those who produce
the capital goods that are ultimately purchased will experience an
increase in their incomes. If they in turn, collectively spend about 3/5
of that additional income, then �180m will be added to the incomes of
others.

• At this point, total income has grown by (�300m + (0.6 x �300m). The
sum will continue to increase as the producers of the additional goods
and services realize an increase in their incomes, of which they in turn
spend 60% on even more goods and services. The increase in total
income will then be (�300m + (0.6 x �300m) + (0.6 x �180m).

• The process can continue indefinitely. But each time, the additional
rise in spending and income is a fraction of the previous addition to
the circular flow.
 Let’s look at another example: refer to the table below

Y = C + S
NEW I PERIOD

$10M 1 10 = 6 + 4

2 6 = 3.6 + 2.4

3 3.6 = 2.16 + 1.44

4 2.16 = 1.3 + 0.86

TOTAL AFTER 4 TOTAL TOTAL TOTAL

PERIODS INCOME = C + S

21.76 = 13.06 + 8.7

TOTAL AFTER TOTAL TOTAL TOTAL

INFINITE INCOME = C + S
PERIODS

25 = 15 + 10

assumes MPC = 0.6

 The Multiplier Process
• Refer to the previous table:
• Perhaps a firm decides to spend $10 million building a new factory in town

• The initial(new) investment creates income for people who supply goods,
services and labour to build the factory.
• Those people then spend that income on goods and services elsewhere in
town-food, clothing, school fees, furniture etc.
• This increases the level of business activity in the town, and perhaps
employment as well.

• $10 million new Investment employment of resources (land,labour

capital) income Consumption spending (induced)
 The Multiplier Process
• To analyze the impact of new investment,
assume that prior to the building of the new
factory:
a. The level of income is $300 million
b. The economy is in equilibrium, with S = I at
$60million
c. The MPC is 0.6, so for every dollar of extra
income earned, the consumer will spend 60 cents
and save 40 cents
 The Multiplier Process
• The previous table shows that the progressive impact of the new
investment on the economy.
• After 4 periods of the income/spending cycle, $21.76m of extra
income has been created from the autonomous increase of $10m in
period 1.
• After an infinite number of spending rounds, an initial $10m has
created $25m extra income for the economy, that is:

total income = total consumption + total savings

$ 25m = $ 15m + $ 10m

At this point, note that the additional saving generated by new income
($10m) equals the initial new investment ($10m). That is S = I once
again and the economy has returned to equilibrium.
 The multiplier formula
• The multiplier formula examine the impact of the change in investment

k = 1___ OR k = __1_____
1 - MPC MPS

k = multiplier coefficient
MPC = marginal propensity to consume (assume to be 0.6)
MPS = marginal propensity to save (assume to be 0.4)

Therefore;

k = 1/ (1-0.6) OR k = 1/ 0.4

k = 2.5
This means if the economy’s MPC is 0.6, the final effect of
autonomous investment on the level of expenditure will be 2.5
times the initial change in investment
 Video : Multiplier process
• https://www.youtube.com/watch?feature=p
layer_detailpage&v=H3nyc8XHrQc
• https://www.youtube.com/watch?feature=p
layer_detailpage&v=Xg-0z5RWbAU
Using the Keynesian model to illustrate the multiplier principle. Initially, the economy
is in equilibrium with Y = 300 and S = I = 60. C = 240 (Y1 = C + S = 300)

45 degree
C + I + 10m
C+I
325

300

70 I + 10m
60
I

Y
300 325
 The Multiplier Process
• The diagram assumes no government and no trade, so AE = C + I
• Initial equilibrium occurs at Y = $300m. then firms decided to
increase investment by $10m.
• This created extra income in the economy, which gave consumers
extra spending power.
• The new equilibrium is at Y = $325m, S = I at $70m. The new
equilibrium occurs at a higher level of income.
• A small change in Investment has resulted in a multiplied change in
total income.
Y2 = C + S
$325M = 255M + 70M
 The size of the multiplier
• The community’s propensity to spend and save determines the
impact of any increase in investment.
• There is a direct relationship between the size of the MPC and
the size of the multiplier.
• The more willing that people are to spend any extra income
they receive, the higher the value of the multiplier, and the
greater the impact of any change in expenditure on the level of
economic activity.

MPC ; k
 How the multiplier process work in reverse?

• The multiplier process could also work in reverse, that is if

investment falls, the level of income in the economy falls by a
greater amount than the initial reduction in investment.
• Some examples are:
a. The closure of rail services in country areas
b. A drought which results in lower exports.

INVESTMENT PRODUCTION

EMPLOYMENT INCOME CONSUMPTION

 The multiplier process in reverse
• The multiplier effect works for falls in demand too. The
loss of an export order or the cancellation of a planned
investment project can have a negative multiplier
effect on the regional or national economy.

• A good example to use is the closure of a local factory,

perhaps the main employer in a town. The resulting
loss of employment can have severe negative effects
on average incomes and spending on the rest of the
community with further "knock-on" effects on
suppliers and retailers.
 Factors influencing the multiplier process
• The higher the propensity to consume (MPC), the greater is the
multiplier effect.
• The government can influence the size of the multiplier through
changes in direct taxes (MPT). For example, a cut in the basic rate of
income tax will increase the amount of extra income that can be spent
on further goods and services.
• Another factor affecting the size of the multiplier effect is the
propensity to purchase imports (MPM). If, out of extra income, people
spend money on imports, this demand is not passed on in the form of
extra spending on domestically produced output.
• The multiplier process also requires sufficient spare capacity in the
economy for extra output to be produced. If aggregate supply is
inelastic, the full multiplier effect is unlikely to occur, because
increases in AD will lead to higher prices rather than a full increase in
real national output. This is shown in the diagram below
 The Multiplier Process
• The concept of the multiplier process became
important in the 1930s when Keynes suggested it as
a means to achieving full employment.
• This demand-management approach, meant to help
overcome a shortage of business capital investment,
measured the amount of government spending
needed to reach a level of national income that
would prevent unemployment.
Another glimpse at the Keynesian Model
The two diagrams show that when S = I the economy is
in macroeconomic equilibrium. ( S = I = 5)
 The Keynesian Cross Model
• The Keynesian cross model is a simple model based on the circular flow
model. It is pretty easy to understand and is useful when one would like to
study more complicated models such as the AD-AS model.

• First off, let’s learn a little bit more about investment spending. There are two types of
investment: fixed investment (spending on factories, machines, etc.) and inventory
investment (spending on additional finished goods).
• The reason firms would like to hold a certain amount of finished goods is that they cannot
consistently and accurately predict demand. The sum of fixed investment and desired
inventory investment is called planned investment.
• However, firms almost always have to reluctantly increase or reduce their inventories due
to fluctuations in aggregate demand. This portion of investment is referred to as unplanned
[inventory] investment. It can be either positive or negative depending on the level of
demand. If unplanned inventory investment is positive, then firms are producing more than
what they can sell (there are goods that were produced but could not be sold and therefore
they were added into inventory and make unplanned inventory investment positive). They
will therefore cut production the following year. Similarly, if unplanned investment is
negative, then demand for goods is greater than what firms are producing and that creates
an incentive for them to produce more.

(Note: the word “investment” used here refers to planned investment unless otherwise noted.)
 The Keynesian Cross Model
Refer to the diagram in the previous slide
• Now we’re equipped with what we need, let’s look at an example of a Keynesian cross
diagram. Since output equals expenditure in equilibrium, the 45o line represents the
collection of all the points where the economy is in equilibrium. In the diagram, the
expenditure function that we deal with is E = 1000 + .5Y
• As seen from the diagram, the equilibrium level of output is at point A when output =
expenditure = 2000 (we get this by letting E = Y = 1000 + .5Y, then Y = 2000)

• If output is higher than the equilibrium level, say, at 2500, then the amount of output
produced (2500) is higher than the amount demanded (E = 1000 + .5*2500 = 2250) . Since
firms cannot sell all of their goods, there’s an increase in unplanned investment across all
firms, which prompts them to cut production in the following year. Therefore, the level of
output decreases gradually until it reaches equilibrium (the point at which unplanned
investment is 0)

• On the other hand, if actual output is less than the equilibrium level, then the amount of
output produced is less than the amount demanded. In this case, there is a depletion of
inventory which is equivalent to a negative unplanned investment. Firms will have the
incentive to produce more next year to meet demand and maintain the desired level of
inventory. Hence, output increases.
 Limitations of the Keynesian Model

• The multiplier might ignore foreign economic effects that are important for
countries with a large foreign trade sector.

• Consider a rise in UK investment some of which is spent on imports. This will

increase the national income of another economy and might therefore lead to
a further rise in UK exports. This would have further multiplier effects.

• Supply-side capacity of the economy

• We have assumed that an increase in aggregate demand does lead to a rise in

real national output. This is the case when the economy has the spare
capacity to meet the demand, but there are occasions when any further
increase in demand will create an inflationary gap.

• A further assumption is that interest rates remain constant - it may well be the
case that when aggregate demand is rising the central bank may take steps to
curb the growth of demand by raising official interest rates
 Multiplier Exercise Page 33
1. mpc = change in C/change in Y
= (225-150)/ (300-200) = 0.75
k = 1/1-mpc; k = 1/0.25 = 4
k = change in Y/ change in I
4 = change in Y/ 20 billion;
Change in Y = 80 ; therefore
Year3 Income is Year 2 Y + Change in Y
but since I fall by 20 billion thus 300 – 80 =
220
 Page 33
2. K = 1/(1- 0.8) = 5 bcos change in C/
change in spending i.e 80b/100b

3. K = 1/0.2 = 5 ;
Change in Y = k ( Change in I)
= 5 (3000) = 15000
4. Change in Y = k (Change in G)
250 = 2.5 (Change in G)
therefore the Change in G = 100
MILLIONNNNNNNNNNNNNNNNNNNNNN
 The Paradox of Thrift
• The paradox states that if everyone tries to save more money during
times of economic recession, then aggregate demand will fall and will
in turn lower total savings in the population because of the decrease
in consumption and economic growth. The paradox is, narrowly
speaking, that total savings may fall even when individual savings
attempt to rise, and, broadly speaking, that increase in savings may be
harmful to an economy
 The AD and AS model
• Keynesian model was used to show changes in AD,
and how it brings about changes in the levels of
production, income, employment and prices.
• The AD and AS model is used to illustrate the effect
of changes in both AD and AS, on the levels of
output (GDP), income, employment and prices
(inflation)
 Aggregate Demand
• https://www.youtube.com/watch?feature=p
layer_detailpage&v=adgqvtlUtMk
 Aggregate supply
• https://www.youtube.com/watch?feature=p
layer_detailpage&v=kdAQhvyco4s
 AD/AS MODEL
• https://www.youtube.com/watch?feature=p
layer_detailpage&v=v4dmUrUqvWs
• THE BASICS OF MACROECONOMICS
https://www.youtube.com/watch?feature=p
layer_detailpage&v=VRrD3BKUPxE
 Aggregate demand and Aggregate supply model

Three Curves in the AS/AD Model

(Before we begin, let's get familiar with the supply and demand
curves in this model)
There are three different curves in this model:
• The aggregate demand curve
• The short-run aggregate supply curve (SRAS for short)
• The long-run aggregate supply curve (LRAS for short)

Remember that wherever the short-run aggregate supply curve

intersects with the aggregate demand curve, this is where the
economy is now, and economists call it equilibrium. Now that
we've looked at the curves, let's see how Keynes' AS/AD Model
explains recessions and expansions.
 The AD-AS Model

Macroeconomic equilibrium is when AD = SRAS = LRAS

Aggregate Supply Curve: shows the level of real
domestic output that will be produced at each price
level. The AS curve is upward sloping because firms
are willing to produce more at a higher price level.
 Aggregate Supply (AS)
• Aggregate supply (AS) measures the volume
of goods and services produced within the
economy at a given price level.
• AS represents the ability of an economy to
deliver goods and services to meet demand
• The nature of this relationship will differ between the
long run and the short run
 Short run and Long run AS
• Short run aggregate supply (SRAS) shows total planned output when
prices in the economy can change but the prices and productivity of all
factor inputs e.g. wage rates and the state of technology are held constant.
• Long run aggregate supply (LRAS): LRAS shows total planned output
when both prices and average wage rates can change – it is a measure of a
country’s potential output and the concept is linked to the production
possibility frontier
• In the long run, the LRAS curve is assumed to be vertical (i.e. it does not
change when the general price level changes)
• In the short run, the SRAS curve is assumed to be upward sloping (i.e. it is
responsive to a change in aggregate demand reflected in a change in the
general price level)
 Short run AS
• The short-run aggregate supply curve is constructed assuming all aggregate
supply determinants remain unchanged. Should any of these determinants
change, the short-run aggregate supply curve shifts to a new position. The
short-run aggregate supply curve can either shift rightward (an increase in
aggregate supply) or leftward (a decrease in aggregate supply).
• Shifts of the short-run aggregate supply curve can be brought about by such
things as technology, changes in wages and other resource prices, or changes
in resource quantities.
• While changes in aggregate supply determinants and resulting shifts of the
short-run aggregate supply curve are less dramatic than changes affecting
aggregate demand, they DO change. In most cases the changes are slow and
steady, for example, the natural growth of the population.
• From time to time, however, shifts in the short-run aggregate supply curve are
more abrupt, such as higher energy prices during the 1970s. Perhaps most
important, shifts in the short-run aggregate supply are the mechanism that
automatically moves the aggregate market from short-run equilibrium to long-
run equilibrium.
 Aggregate Supply
• Aggregate supply includes consumer, capital, public, and
traded goods and is usually represented in economics by a
supply curve on a graph.
• Many things can change the amount of goods and service
supplied in an economy.
• A few of the determinants are size of the labour force, input
prices, technology, productivity, government regulations,
business taxes and subsidies, and capital.
• For example, as wages, energy, and raw material prices increase,
aggregate supply decreases, all else constant. Enhancements in
technology, increases in government subsidies, and better productivity
through training or education can cause increases in aggregate supply,
all else constant.
Three Ranges of Aggregate
Supply
Aggregate Supply:
...has three ranges:
1 – Keynesian Range
straight horizontal line

2 – Intermediate Range
upward sloping line

3 – Classical Range
straight vertical line
 KEYNESIAN RANGE
• Straight horizontal line
• Recession/depression level
• The economy operating well below full employment
• Easy to raise output without raising prices due to
high unemployment
 INTERMEDIATE
RANGE
• Upward-sloping line
• The economy is operating close to full-
employment output
 CLASSICAL RANGE
• Straight vertical line
• The economy is operating at full
employment and you see inflation on the
way
 FULL EMPLOYMENT
• In macroeconomics, full employment is a condition of the national
economy, where all or nearly all persons willing and able to work at the
prevailing wages and working conditions are able to do so. It is defined
either as 0% unemployment, literally, no unemployment or as the level
of employment rates when there is no cyclical unemployment
• Jobs for all that want them. This does not mean zero
UNEMPLOYMENT because at any point in time some
people do not want to work. Also, because some people
are always between jobs, there will usually be some
FRICTIONAL UNEMPLOYMENT.
• Most governments aim to achieve full employment.
• Usually when cyclical unemployment is zero
• Impossible to reach full employment without inflation
• The full employment objective is achieved at
unemployment rate of 5% and below
 Long run AS

•Long run aggregate supply is determined by the

1.productive resources available to meet
demand
2.productivity of factor inputs (labour, land and
capital).
3.Changes in technology also affect the
potential level of national output in the long
run.
Short run AS (SRAS) & Long run AS (LRAS)
 SRAS & LRAS
• In the short run, producers respond to higher demand (and
prices) by bringing more inputs into the production process
and increasing the utilization of their existing inputs. Supply
does respond to change in price in the short run - we move up
or down the short run aggregate supply curve.
• In the long run we assume that supply is independent of the
price level (money is said to be neutral) - the productive
potential of an economy (measured by LRAS) is driven by
improvements in productivity and by an expansion of the
available factor inputs (more firms, a bigger capital stock, an
expanding active labour force etc). As a result we draw the long
run aggregate supply curve as vertical.
Aggregate Demand

AD = C + I + G + (X-M)
 Aggregate demand
The Aggregate Demand Curve
The AD curve shows the relationship between the general price level and
real GDP.
 Changes in AD

The primary cause of shifts in the economy is aggregate demand

 Shifts in AD
There are many actions that will cause the aggregate demand curve to shift.

• When the aggregate demand curve shifts to the left, the total quantity
of goods and services demanded at any given price level falls. This
can be thought of as the economy contracting.

• The aggregate demand curve also can shift right as the economy
expands. When the aggregate demand curve shifts right, the quantity
of output demanded for a given price level rises. Therefore, a shift of
the aggregate demand curve to the right represents an economic
expansion. A shift of the aggregate demand curve to the right is
simply effected by the opposite conditions that cause it to shift to the
left.

The shifts in AD are brought about by changes in its components, Consumption spending,
Investment spending, Government spending, Export spending and import spending.
Macroeconomic equilibrium
 Macroeconomic equilibrium
• Long-run macroeconomic equilibrium requires that real GDP be equal to potential
GDP, and corresponds to a situation of full employment.
• That is, long-run macroeconomic equilibrium entails the economy being on its
vertical long-run supply curve. This contrasts with the short-run equilibrium
situation, in which real GDP may be less than or greater than (or equal to)
potential GDP.
Short-run equilibrium at a real GDP in excess of
potential GDP is called an above full-employment
equilibrium. The excess of real GDP over potential GDP
is called an inflationary gap.
Short-run equilibrium at a real GDP below the level of
potential GDP. This is called a below full-employment
equilibrium, and the difference between potential GDP
and real GDP is called a recessionary gap.
Changes in SRAS and AD
Changes in AD
Supply Shock
Review
 The AD and AS model
• Aggregate Supply-Aggregate Demand Model is a
macroeconomic model that explains the ups and
downs in output and prices. It's based on the theory
of John Maynard Keynes that was developed from
his observations during the Great Depression.
• The Aggregate Supply-Aggregate Demand model (or
AS/AD for short) is a combination of the Classical
Model, which describes how the economy is at full
employment in the long-run, and the Keynesian
Model, which describes how the economy falls into
recession (or experiences expansion) in the short-
run.
Changes in macroeconomic equilibrium

• According to the AS/AD Model, the economy

starts out at its long-run potential, which
economists call the full employment level of
output. During a recession, actual output
falls below potential output. In the short-run,
real GDP falls, and the general level of prices
falls. In the long-run, there is no change in
real GDP, and the general level of prices
falls.
Class exercise on AD/AS model
1. What are the components of Aggregate
demand? (1 m)
2. Explain how AD can be increased. (2m)
3. Explain how AD can be decreased (2m)
4. Explain using an AD/AS model the effects
of increase in government spending and
a fall in income tax.(12 marks)