PAPER No. 2: MANAGERIAL ECONOMICS MODULE No.29 : AGGREGATE DEMAND FUNCTION

Transcription

1 Subject Paper No and Title Module No and Title Module Tag 2. MANAGERIAL ECONOMICS 29. AGGREGATE DEMAND FUNCTION COM_P2_M29

2 TABLE OF CONTENTS 1. Learning Outcomes 2. Aggregate Demand 3. Policy Implication 4. Derivation of Ad function 5. Algebraic Derivation of Aggregate Demand Function 6. Properties of Aggregate Demand Function 7. Demand Management. 8. Implications of Fiscal Policy 9. Implications, of Monetary Policy 10. Summary

3 1. Learning Outcomes After studying this module, you would be able to Know about the Modern Aggregate Demand. Derive the Aggregate demand function Understand the shape and slope of the Aggregate demand function Examine policy implication of demand management

4 2. Aggregate Demand Function An ordinary market. Situation has a supply function& a demand function. This is known as the price-cross because it determines the price & quantity simultaneously. On the Y axis, we have price & on the x-axis, we have quantity. However it is important to note 3 differences between Price cross & macro AD function On the y axis, if we consider the modern Ad function we would measure general price level. On the x-axis, it would not measure qty. demanded, but we measure real NY or Output. Thirdly the AD & AS functions are not a simple addition of the individual functions. On the other hand, they are derived from IS-LM functions.

5 3. Policy Implication Under the Keynesian assumptions the policy framework was simpler. Either money supply has to be increased or Govt. Expenditure had to be increased. The purpose was to remove unemployment. In the classical system, neither FP nor MP are in any way useful for affecting the real output. We now have to consider an AD function which is sensitive to the general price level & therefore our task is to derive a modern macro Ad & As function which are based on the IS-LM framework & are price sensitive so that changes in M s & govt. expenditure will bring about changes not only in real output but also in the price level. 4. Derivation of Ad function Graphical method A modern AD function depicts the combinations of price level & real dd or output at which both the goods market & the asset market are simultaneously in the equilibrium. M remains constant & for the given price level, there is a given level of LM function.

6 Since M is constant & the price level has gone down to P1. With a given nominal M s & Po as the price level, there is one equilibrium level of income is Yo.

7 Similarly when the price level goes down to P1, nominal money supply remains constant. The real money SS expands from M upto M. At you, P O P 1 M1(yo) is constant but the money SS has increased. Therefore M2 has to increase proportionately. This can happen only if the ROI falls & it should fall to such an extent that the new general equilibrium is established. The new Lm function has to intersect the IS function in such a manner that the increase inm s is exactly compensated by the increase in M2. & this is possible only at r1. However r1 corresponds to a new LM function LM (P1) under equilibrium the level of income cannot remain the same. This shows that the Ad or real output is sensitive to changes in price level. 5. Algebraic Derivation of Aggregate Demand Function When the price level falls with a given nominal M s, the SS of real cash balances increase the ROI falls; when the ROI falls, then investment spending increases. When investment spending increases, aggregate expenditure increases and AD increases. Hence it can be seen that price level falls Ad increases &each point on the AD function represents general equilibrium. Algebraic method:- AD = C + I (1) now C = C + cy (2) & I = I (2a) From (1), (2) & (2a) Ad = C + cy + I (3) In Suppose that the equilibrium takes place at Yo. At empirical terms, c = MPC has been found to be equal to APC. Under equilibrium in the product market. AS = AD (4) Y = (C + I ) + cy Y = A + cy 4 (4a) (4b)

8 Yo. Y0 = A + cy0 (5) Yo = A 1 c (6) In the asset market, M s is given & the price level is also given. M s = M P (7a) M d = ky hi (8) M s = M d (7b) M s = M d (8) M P = ky hi (9) i= 1 h M (ky ) (10) P If we consider disposable income then small c becomes C, we have an investment equation as I = I bi (10a) where b is the interest sensitivity of investment demand. now, Y = (C + I ) + C Y bi (11) Y = AD = A + CY bi (12) So, at Yo; - Yo =A + C Y0 bi (12a) Yo = A bi (i c) (13) is equation:- Yo = αg (A bi) (14) [ αg = 1 1 c ] From (10) we have LM equation:- i = 1 M [ky - h P ] (15) From (14) & (15) We have Y = αg[a b M (ky )] (16) h P

9 Y + ( bαgk )Y = h αg [A ] + b (M ) h P (16a) Y [ 1+ ( bαgk )] = h αg [A ] + b (M ) h P Y = α G [A 1+kα b G( h ) (16b) + b (M )] (17) h P Let, γ = Y = γa + γ b h Let β = γ b h α G 1+kα G( b h ) (17a) M P (18) (18a) Y = γa +β M P (19) AD function :- P = β [ M y γa ] (20) Where, γ = fiscal policy multiplier β = monetary policy multiplier 6. Properties of Aggregate Demand Function Given an exogenous spending of A &exogenous nominal M s of M. The following conclusions arise (a) P is inversely related to Y (b) General equilibrium is obtained at each point of AD. (c) Ad function is non linear (d) Price level change is proportional to the changes in M s. (e) The AD function is flatter. - The smaller the interest responsiveness of the demand for money, h

10 - The larger the interest responsiveness of the investment demand, b - the larger the multiplier, αg - The smaller the income responsiveness of the demand for money, k. 7. Demand Management. In the classical case, money dd is totally irresponsible to rate of interest according to the quantity theory of money, the equilibrium in the Money market will take place when ss of real cash balances is equal to the demand for real cash balances. It is known that ss of real cash balances is M/P. Fischer s Equation :- MV = PT Where, M = stock of money V = velocity of circulation P = Price level T= volume of transactions. There are two types of velocity of circulation - transactionary velocity of circulation - income velocity of circulation - Cambridge equation allowed that people could hold money & it is related to the level of money ss in the economy. - The Cambridge equation is given as M = k Py where k = 1 & is the proportion of income held v y = real O/P M/P = M P = 1 v y The LM function in the case of classical economics is vertical because there is only one equilibrium level of income at which full employment takes

11 place & this LM function represents the relationship between income & interest rate. As the ss of real cash balances increase in M1 must be extremely large the responsiveness of income & spending is very large for a small increases in the real cash balances. In the Keynesian case, the liquidity trap leads to a situation in which all the investors are prepared to hold any increase in the real money supply because they are not interested in holding bonds. As a result there is no change under such conditions, the AD function will be vertical because there is no change in the level of output, neither is there any change in ROI. 8. Implications of Fiscal Policy:- The initial LM & IS schedules correspond to a given nominal quantity of money & the price level P. equilibrium is obtained at point E & there is a corresponding point on the Ad function. Now, the govt. increases its spending, say on infrastructure. As a consequence, the IS schedule shifts outwards & to the right. At the initial price level there is a new equilibrium at point E with higher interest rates & a higher level of income & spending. Thus at the initial level of prices, Po, equilibrium income & spending are now higher. The new equilibrium E is at the new AD curve Ad reflecting the effect of higher govt. Spending. The AD function shifts to the right by an amount indicated by the fiscal policy multiplier which is r which appears in the denominator of equation (20). but with the between price & level of output. However because the relationship is proportional, the shift in Ad would not be exactly parallel

12 While the level of output has increased from you to y1 in comparison to old Ad function, the same level of output Y o is now associated with a higher price level P 1. This shows that unlike Keynesian theory, expansion of income does not take place at the same price level. [If the price level were to remain same, then the output would have been Y2. There is excess demand. In the economy the adjustment takes place in the product market such that the price level rises as large as the excess dd exists. The final price level is established at P1.]

13 9. Implications, of Monetary Policy:- An increase in the nominal money stock implies a higher real money stock at each level of prices in the assets markets interest rates decline to induce the public to hold higher real balances. The decline in interest rates, in turn, stimulates aggregate demand & thus raises the equilibrium level of income & spending. The increase in nominal money ss is matched an equiproportionateincrease in prices. M is unchanged, & hence interest rates, P AD & equilibrium income & spending will remain unchanged. This gives us the clue to the vertical shift of the AD schedule.

14 The implications for Ad is that the price level changes in proportion to the increase in nominal Ms. In equation (20), price level is related to nominal M s through B. β therefore the relationship is direct when all other things (y, r & A) are constant. This results in a proportional change which is depicted in diag. As a result everything else remains constant& there is a vertical shift in the AD function such that only price level increases. The effect of MP is to shift the AD function in such a manner that for the same level of output Yo, the prevailing price level is P1. If the price level, were to remain at Po, then there would be excess dd. Therefore the price level is pushed up to the extent that excess old gets eliminated & the final price is settled at P1, therefore MP has to pay the cost of inflation. 10. Summary We have derived aggregate demand function which is price sensitive We have examined the properties of aggregate demand function We have studied demand management under classical conditions We have studied the impact of fiscal and monetary policy on aggregate demand function