ECA 112 THE NATIONAL

ECONOMY
Lecture V
Aggregate Demand

HISTORICAL BACKGROUND

Up to this point, we have investigated

Consumer and Business Demand only.

Since our objective is to understand the

National Economy we need to evaluate the
complete demand for goods and services.

We can do this by including the other sectors of

the economy, namely Government and Net
Exports.

MARSHALL S VIEW

Chronologically, the first attempt to do this

(from a utilitarian perspective) was Alfred
Marshall in his book Principles of Economics
[1890].
It should also be noted that it was Marshall who

developed Partial Equilibrium Analysis.

Which produces the standard graph of Supply, Demand
and Equilibrium

This technique evaluates changes in Price and

Quantity only with all other factors remaining

constant.

For Marshall, the national economy is

really nothing more than a very large
market. Consequently, total demand
for goods and services for the whole
economy can be analyzed in the same
manner that the total demand for any
specific good can be analyzed.

The same as with Euclid, namely that the whole is

equal to the sum of its parts

This is accomplished by graphically

adding all of the components (C; I; GE;
E-M) horizontally

This standard Demand Curve is sloped downward to show the Law

of Demand [Higher Price=Lower Quantity Demanded] because of
three (3) Effects:
Real Balances Effect

As inflation s Purchasing Power s in effect the price is higher

Quantity Demanded
Not really true because inflation doesnt increase prices , rather it
decreases affordability. In other words related to income not prices.
Foreign Trade Effect
The quantity demanded of U. S. products increases as the value of
the $ decreases. The reverse is also true, at least in theory.
This assumes that price is the only determinant of demand, which is
no really true.
French demand for American products has been decreasing,
regardless of the exchange rate
Interest Rate Effect
As Price interest rate (because the amount of money
demanded (in the form of loans) Quantity demand (output)
increases
This assumes that borrowing is a function of price and that the
interest rate is the price of money[which also assumes that money is
a commodity]. Both are incorrect.

The standard Supply Curve is upward-sloping to the right to show the

Law of Supply [Higher Price=Larger Quantity Supplied] because of:
Profit Effect
As Price Profit Output
As Price Profit Output
[According to some, we currently have deflation which should
mean that profits decrease. THEY HAVE, IN FACT, BEEN RISING. ]
[In addition, we have the realization that this assumes perfect
competition,
throughout the economy, which is not the case.]

Cost Effect
Since some production costs are variable, as Producers increase
output costs increase. The greater the increase in output the
greater the increase in costs.
This is true , but there is more to it than that. The extreme right
portion of the standard Aggregate Supply curve actually
represents limited physical capacity. But this is correct only in
the very Short-term. If the profit effect is correct, then Producers
should have known [and planned for] the expansion of output
with greater physical capacity

CLASSICAL AGGREGATE
EQUILIBRIUM

Combine the Aggregate Demand and Supply Curves

on the same co-ordinate system in order to show
how the Price Level and Real Output are related.

This can be thought of as the Marshallian Cross

The intersection represents the only Price and

Output combination at which the Aggregate
Quantity Demanded is equal to the Aggregate
Quantity Supplied

If price were at P1 there would be a surplus. In

order to get rid of the excess inventory producers
would reduce the price , eventually landing at P e.
The reverse would happen if the price was below P e.

MACROECONOMIC FAILURE

The problem is that Macroeconomic Equilibrium

if it does occur, may not occur at either Full
Employment or Stable Prices. Further if it does
occur under those conditions, it may not last.
The Classical School recognizes that the Real
World is different than a theoretical construct.
This leads to three alternative possibilities all
shown on the next slide:
Aggregate Equilibrium (a)
Insufficient Demand (Recession) (b)
Excess Demand (Inflation) (c)

Aggregate Equilibrium
Alternatives

Macro Success (a)

This graph represents Macroeconomic

equilibrium.

It also demonstrates full employment

(Qf)

It also represents price stability (P*)

Recessionary GDP Gap

In this instance, Aggregate Demand is insufficient

to reach full employment.
This leads to an unexpected accumulation of
inventories which results in a
Decrease in production which, in turn, leads to an
increase in unemployment. Consider the
following example:
Stable prices (P*) at Aggregate Supply= $10T
Stable prices (P*) at Aggregate Demand= $8T
This imbalance results in a Price which causes
equilibrium to be re-established at Qe [which is still less
than full employment, and prices are still unstable]

Inflationary GDP Gap

In this case, the total of all participants

spending is greater than available output
[Aggregate Demand > Aggregate Supply]
In order to meet this excess demand,
workers and wages increase which
further pushes up prices
The original inflationary gap is reduced,
but

It still remains and the economy is operating

at > full employment

The easiest way to see how this interpretation works is through the
following adjusted Circular Flow Diagram

According to Classical theory

if Injections = Leakages then
the system does have Full
Employment Equilibrium at
Stable prices.
The only condition is that
market interest rates need to
be flexible
The question now is, are they?

What is the interest rate?

According to the Classical School, the interest rate is the price of money.

Since the price for ANY Good is determined by the Supply of and
Demand for it, changes in those conditions change the price for
that Good.

The interest rate is no different

The interest rate is flexible by default.

At this point it will probably help to know that during the time that
the Classical School is writing most of the world was on some
form of Gold Standard.

so it is not really a stretch to think of money as a commodity

KEYNES VIEW

Many
economists maintain that Keynes purpose in The

General Theory of Employment, Interest and Money

[1936], was to understand the causes and cures of the
Great Depression. THIS IS SIMPLY NOT THE CASE.

Keynes wanted to explain:

- The inherent and potentially catastrophic instability of
the
market mechanism.
He never claimed that the market was unstable, only the
mechanism
- That Consumption was determined more by Income
than by Prices
One needs to have an income before lower prices
can make
a product more affordable
- The need to include the financial sector in any analysis
of the National Economy

Keynesian Cross
A.

B.

C.

This is compared to the Marshallian Cross

[Demand & Supply Graphs on slide 12]
The Keynesian Cross is a theoretical construct
based on an extension of the ideas presented
in our discussion of the Consumption Function
It assumes:
1- Closed Economy
2- A Known (and constant) MPC
3- No Municipal Government
4- The Federal Budget is Balanced

Y=AE
AE=C+I+GE+[EM]
AGGREGATE
EXPENDITURE

EXPENDITURES
(AGGREGATE)

E1

*45represents
production =
consumption
Slope is positive, but <
1 (MPC<1)

Y3

Y2
Y1
Income
[Output]
(AGGREGATE)

1- Equilibrium occurs at Y1
2- At Y2: Production > Expenditures [Recessionary
Gap]
Sometimes referred to as a Deflationary Gap. To
resolve this problem, the Aggregate Expenditure curve
must be shifted upward to the 45 line.
3- At Y3 Production< Expenditures [Inflationary Gap]
4- As changes occur in C; I; (E-M), Aggregate
Expenditures shift up (or down) resulting in a new
equilibrium
5- More importantly equilibrium (Y1) does not
necessary produce full employment

IMPLICATIONS FOR POLICY

If Aggregate Demand <
Aggregate Supply
Recessionary Gap = $ 10,000,000
in order to eliminate this Gap GE
by = $1,000,000
GE must by $ 1,000,000 to get to
equilibrium as well as accommodating the
investment multiplier (Ki).