Introduction to Economics MACROECONOMICS Chapter 2 Aggregate Demand and Aggregate Supply
contents 2.1 2.2 2.3 2.4 2.5 2.6 Equilibrium of a National Economy Aggregate Demand and Consumption Expenditure Investment Expenditure Government Expenditure and Net Export Derivation of Aggregate Demand Curve Derivation of Aggregate Supply Curve
2.1 Equilibrium of a National Economy in the market of a certain commodity, an equilibrium is reached at the intersection of demand and supply curves how about the case of an equilibrium of a national economy? an equilibrium is reached at the intersection of aggregate demand(ad) and aggregate supply(as) curves aggregate demand curve : how much commodities are demanded for each price level for the economy as a whole aggregate supply curve : how much commodities are supplied at each price level for the economy as a whole
2.1 Equilibrium of a National Economy Aggregate Demand and Aggregate Supply Curves since there are many different kinds of commodities, it is difficult to measure total demand or supply of the economy as a whole to solve this problem, we assume a (hypothetical) representative commodity when we derive aggregate demand and aggregate supply curves horizontal axis : quantity of the representative commodity vertical axis : price of the representative commodity But in effect, horizontal axis : national income(gdp) vertical axis : price level
2.1 Equilibrium of a National Economy Equilibrium of the Market an equilibrium is reached at the intersection of two curves
2.1 Equilibrium of a National Economy Shift of Aggregate Demand and Aggregate Supply Curves an increase in aggregate demand a decrease in aggregate supply ex) an increase in the demand for our products in foreign markets - a rightward shift of aggregate demand curve - GDP increases and price level rises ex) a sudden rise in crude oil price - a leftward shift of aggregate supply curve - GDP decreases and price level rises stagflation
2.1 Equilibrium of a National Economy Shift of Aggregate Demand and Aggregate Supply Curves
2.2 Aggregate Demand and Consumption Expenditure aggregate demand - sum of the expenditures of households, firms, government and foreign sector - components of aggregate demand consumption expenditure of households(c ) investment expenditure of firms(i ) government expenditure(g ) net export(x n ) - component which is the largest in size is C (consumption expenditure)
2.2 Aggregate Demand and Consumption Expenditure Consumption Expenditure consumption and consumption expenditure could be different due to the existence of durable consumer goods, but we use them interchangeably consumption expenditure in general, consumption expenditure by households constitutes more than 50% of aggregate demand the most important determinant of consumption expenditure is the size of income (more income more consumption) disposable income and consumption expenditure - strictly speaking, consumption expenditure is determined by the size of disposable income
2.2 Aggregate Demand and Consumption Expenditure Disposable Income and Consumption Expenditure data: The Bank of Korea (2014), Economics Statistics System
2.2 Aggregate Demand and Consumption Expenditure Consumption Function the relationship between disposable income(y d ) and consumption expenditure(c ) can be expressed by the following consumption function C = a + by d (a > 0, 0 < b < 1 ) marginal propensity to consume (MPC ) - if disposable income increases by 1 dollar and consumption expenditure increases by b dollar, we say MPC is b MPC = C Y d = b
2.2 Aggregate Demand and Consumption Expenditure Consumption Curve and MPC consumption curve shows the relationship between disposable income and consumption marginal propensity to consume has a constant value(b )
2.2 Aggregate Demand and Consumption Expenditure Other Factors Affecting Consumption Expenditure (1) wealth - wealth effect : a rise in prices of stocks and houses an increase in wealth an increase in consumption expenditure (2) price level - real balance effect : a change in price level causes a change in real value of assets whose nominal value is fixed ex) a rise in price level a decrease in the real value of assets whose nominal value is fixed a decrease in consumption expenditure
2.2 Aggregate Demand and Consumption Expenditure Other Factors Affecting Consumption Expenditure (3) interest rate - a rise in interest rate people may reduce consumption expenditure and increase saving - but many empirical studies figure out that the impact of interest rate on consumption and saving is not that strong (4) future income - someone who expects an increase in future income can increase current consumption expenditure even though there is no increase in current income
2.3 Investment Expenditure the proportion of investment expenditure in aggregate demand is not so large as consumption expenditure but it is quite variable depending on economic conditions main cause of business cycles we should know exactly what investment means - in macroeconomics, investment means firms expenditure on capital goods which are newly produced domestically - total stock of capital increases by the amount of investment
2.3 Investment Expenditure Various Types of Investment fixed investment - purchase of production facilities such as machines, equipment, vehicles and construction of factories, bridges and roads inventory investment - an increase in the stock of inventory is considered an inventory investment
2.3 Investment Expenditure Criterion of Investment a firm decides to make an investment if expected return from it is greater than its cost returns form an investment project materialize as the stream of future incomes therefore we should calculate the present value of future income and compare it with cost through the process of discounting, we can calculate the present value of future income discount rate strictly speaking, discount rate and interest rate are different from each other but interest rate is used as discount rate in many cases
2.3 Investment Expenditure Criterion of Investment suppose discount rate is r and expected returns from a certain investment project for next three years are R 1, R 2, R 3 we can calculate the present value of the stream of future incomes like this; PV R = R 1 1+r + R 2 (1+r )² if it costs C to carry out the investment project and PV R > C holds, it is worthwhile to carry out the investment project determinants of investment (1) interest rate : negative( ) relation (2) expected return (3) easiness of mobilizing investment funds + R 3 (1+r )³
2.4 Government Expenditure and Net Export government expenditure total value of government purchase of goods and services in a year limited to the purchase of final goods and services produced in that year should be distinguished from fiscal expenditure which means the total expenditure of government including transfer payments government expenditure is considered a kind of policy variables
2.4 Government Expenditure and Net Export Net Export net export = export import - aggregate demand includes only the expenditure on domestically produced commodity (expenditure on imports excluded) - therefore net export could become a component of aggregate demand in most countries, the proportion of net export in aggregate demand is relatively small
2.4 Government Expenditure and Net Export Changes in Export, Import and Net Export (as % of GDP)
2.4 Government Expenditure and Net Export (1) size of national income Determinants of Net Export positive(+) relation between own national income and import - an increase in (own) national income increases in consumption and investment increases in importation of consumption goods and investment goods the size of export is affected by the level of foreign national income an increase in own national income a decrease in net export an increase in foreign national income an increase in net export
2.4 Government Expenditure and Net Export Determinants of Net Export (2) relative level of domestic prices and foreign prices if domestic inflation rate is higher than foreign inflation rate, net export will decrease changes in exchange rate also affect net export conclusion : determinants of net export are (1) domestic and foreign national income (2) domestic and foreign price level (3) exchange rate
2.5 Derivation of Aggregate Demand Curve aggregate demand is composed of consumption expenditure, investment expenditure, government expenditure and net export what happens to these components of aggregate demand if price level rises? (1) consumption expenditure decreases due to real balance effect (2) a rise in domestic price level a decrease in export and an increase in import net export decreases a rise in price level a decrease in aggregate demand downward sloping aggregate demand curve
2.5 Derivation of Aggregate Demand Curve Aggregate Demand Curve
2.5 Derivation of Aggregate Demand Curve Shift of Aggregate Demand Curve when we draw aggregate demand curve, we assume that there is no change in variables other than price level aggregate demand curve shifts if there is a change in any of such variables ex) an increase in export at price level of P 0, aggregate demand increases from Y 0 to Y 1 aggregate demand curve shifts rightward from AD 0 to AD 1 if there is a decrease in any component of aggregate demand, aggregate demand curve will shift to the left
2.5 Derivation of Aggregate Demand Curve Shift of Aggregate Demand Curve
2.5 Derivation of Aggregate Demand Curve Shift of Aggregate Demand Curve an increase in either consumption expenditure, investment expenditure or government expenditure independently of price level change rightward shift of aggregate demand curve when the economy is in a recession, we can revitalize it by expanding aggregate demand expansionary policies are meant to shift aggregate demand to the right (1) fiscal policy : changes in government expenditure or tax revenue (2) monetary policy : changes in money supply or interest rate
2.6 Derivation of Aggregate Supply Curve profit from producing one more unit of a commodity = price of the product additional cost of production when we derive aggregate supply curve, we assume that all variables other than price level remain unchanged a rise in price level a rise in the price of the commodity, but no change in additional cost an increase in profit such an increase in profit will result in an increase in production upward sloping aggregate supply curve
2.6 Derivation of Aggregate Supply Curve Aggregate Supply Curve
2.6 Derivation of Aggregate Supply Curve Shift of Aggregate Supply Curve if there is a change in variables other than price level, aggregate supply curve will shift ex) a rise in wage an increase in production cost a decrease in profit production will decrease a decrease in aggregate supply at the price level of P 0, aggregate supply will decrease from Y 0 to Y 1 leftward shift of aggregate supply curve
2.6 Derivation of Aggregate Supply Curve Shift of Aggregate Supply Curve
2.6 Derivation of Aggregate Supply Curve Shift of Aggregate Supply Curve if there is an increase in the availability of labor or capital, aggregate supply curve will shift to the right even though there is no increase in the availability of labor or capital, aggregate supply curve will shift to the right if productivity improves due to innovation or other reasons but these kinds of rightward shifts take a lot of time usually in contrast, a leftward shift of the curve caused by a rise in wage or the prices of raw materials does not take that much time
2.6 Derivation of Aggregate Supply Curve Equilibrium of a National Economy
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