Macroeconomics & Business Environment

MBA Sem II
 2020

Aggregate Demand and Aggregate Supply

2
 2020

After attending this session, you will learn:

Key Concepts
• The nature of aggregate demand and aggregate • Aggregate Demand and Aggregate
supply. Supply,
• Why the short-run AS curve slopes upward? • Factors determining aggregate demand
and supply
• Why AD slopes downward?
• Determination of price level through
• How aggregate demand and aggregate supply affect aggregate demand and supply,
the economy? • Aggregate supply curve in Classical
• Use the AD-AS model to explain the equilibrium view.
levels of real GDP and price level • Aggregate supply curve in the
• Examine factors that shift aggregate supply and Keynesian view.
aggregate demand • Says Law of Market.

• Illustrate economic growth, unemployment, and

inflation using the AS/AD model

3

Fluctuations in business activities !
Economic activity fluctuates from year to year. In most
years, the production of goods and services rises. In
some years, however, the economy contracts. Firms find
themselves unable to sell all the goods and services they
have to offer, so they reduce production. Workers are
laid off, unemployment becomes widespread, and
factories are left idle. With the economy producing fewer
goods and services, real GDP and other measures of
income decline.
Basic concepts of ECONOMICS
2020
An example:
From the fourth quarter of 2007 to
the second quarter of 2009, real
GDP for the U.S. economy fell by
4.0 percent. The unemployment
rate rose from 4.4 percent in May
2007 to 10.0 percent in October
2009—the highest level in more
than a quarter century.
4
 2020

Fluctuations in business activities !

What causes short-run fluctuations in economic activity?

Economists use the model of aggregate

demand (AD) and aggregate supply (AS) to
explain short run fluctuations.

Basic concepts of ECONOMICS 5

The model of Aggregate Demand and
2020

Aggregate Supply

The model of short-run economic fluctuations focuses on the

behavior of two variables:-
1. the economy’s output of goods and services, as measured by
real GDP.
2. the average level of prices, as measured by the CPI or the GDP
deflator.
 The model of Aggregate Demand and
Aggregate Supply 2020

The aggregate-
supply curve
shows the quantity
of goods and
The aggregate- services that firms
demand curve produce and sell at
shows the quantity each price
of goods and level.
services that
households, firms,
the government, According to this
and customers model, the price level
abroad want to buy and the quantity of
at each price level. output adjust to
bring aggregate
demand and
aggregate supply into
balance.
Aggregate Demand Curve
The aggregate-demand curve tells us the quantity of all goods and
services demanded in the economy at any given price level.
Aggregate Demand Curve

Why the Aggregate-Demand Curve Slopes

Downward?
We know that,
• an economy’s GDP (Y) is the sum of its consumption (C), investment (I),
government purchases (G), and net exports (NX):
Y=C+I+G+NX
• Each of these components contributes to the AD for goods and services. For now, we
assume that government spending is fixed by policy. The other three components
depend on economic conditions and, in particular, on the price level.
• Therefore, to understand the downward slope of the aggregate-demand curve, we
must examine how the price level affects the quantity of goods and services
demanded for consumption, investment, and net exports.
Note: We assume that the aggregate-demand curve is drawn holding “other things
equal.” That is, how a change in the price level affects the demand for goods and
services, holding the amount of money in the economy constant.
Aggregate Demand Curve
Why the Aggregate-Demand Curve Slopes Downward?
1. The Price Level and Consumption (The Wealth Effect)
• A decrease in the price level raises the real value of money and makes consumers wealthier, thereby
encouraging them to spend more. The increase in consumer spending means a larger quantity of goods
and services demanded.
2. The Price Level and Investment ( The Interest-Rate Effect)
• When the price level is lower, households do not need to hold as much money to buy the goods and
services they want. They hold less and lend or deposit/invest their excess money in interest-bearing
savings account/assets. These drive down interest rates. This encourages greater spending on
investment goods. Households also spend more on durables due to low interest rate.
3. The Price Level and Net Exports ( The Exchange-Rate Effect)
• A lower price level lowers the domestic interest rate. Some investors will seek higher returns by
investing abroad. This will increase the supply of money (domestic currency) in the foreign-currency
exchange market. The increased supply causes the domestic currency to depreciate relative to the
foreign currency. As a result , domestic goods now become cheaper, and therefore foreigners buy
more. So the domestic exports increase.
Aggregate Demand Curve
Why the Aggregate-Demand Curve shifts?
1. Shifts Arising from Changes in Consumption
• Any event that changes how much people want to consume at a given price level shifts the aggregate-
demand curve. For example, if people are more concerned about saving for retirement, then it will reduce
their current consumption and hence demand for goods and services at any price level. Therefore, the
aggregate-demand curve shifts to the left. Similarly , stock market boom makes people wealthier, and
therefore they spend more now, shifting the AD curve to the right.
2. Shifts Arising from Changes in Investment
• Any event that changes how much firms want to invest at a given price level also shifts the aggregate-
demand curve. For instance, if the computer industry introduces a faster line of computers and many firms
decide to invest in new computer systems; the quantity of goods and services demanded at any price level
will be now higher, which shifts the aggregate-demand curve shifts to the right. Conversely, if firms
become pessimistic about future business conditions, they may cut back on investment spending, shifting
the aggregate-demand curve to the left. Other factors may be tax policy, increase in the money supply.
3. Shifts Arising from Changes in Government Purchases
• If the government start building more highways, the result is a greater quantity of goods and services
demanded at any price level, so the aggregate-demand curve shifts to the right.
Aggregate Demand Curve
Why the Aggregate-Demand Curve shifts?
4. Shifts Arising from Changes in Net Exports
• Any event that changes net exports for a given price level also shifts aggregate demand. For instance,
when India experiences a recession, it buys fewer goods from the rest of the world. India’s net exports
decline at every price level, shifting the aggregate-demand curve for the Indian economy to the left. When
it recovers from its recession, it buys more and the aggregate-demand curve shifts to the right. Changes in
the currency value also changes the net exports and shifts the AD curve.
Aggregate Supply Curve
• The aggregate-supply curve tells us
the total quantity of goods and
services that firms produce and sell
any given price level.
• The aggregate-supply curve shows a
relationship that depends crucially
on the time horizon.
• In the long run, the aggregate-supply
curve is vertical, whereas in the
short run, the aggregate-supply
curve slopes upward.
• To understand short-run economic
fluctuations, we need to examine
both the long-run aggregate-supply
curve and the short-run aggregate
supply curve.
Aggregate Supply Curve
Why the Aggregate-Supply Curve is vertical in the long run?
• In the long run, an economy’s production of goods and services (its real GDP) depends on its supplies of
labor, capital, and natural resources and on the available technology used to turn these factors of
production into goods and services.
• The vertical long-run aggregate-supply curve is a graphical representation of the classical dichotomy
and monetary neutrality. The Classical macroeconomic theory is based on the assumption that real
variables do not depend on nominal variables.
• The long-run aggregate-supply curve is consistent with this idea because it implies that the quantity of
output (a real variable) does not depend on the level of prices (a nominal variable).

The classical dichotomy is the separation of variables into real variables (those that measure quantities)
and nominal variables (those measured in terms of money). According to classical macroeconomic theory,
changes in the money supply affect nominal variables but not real variables. And therefore monetary
neutrality, which means nominal variables (the money supply and the price level) does not affect real
variables (real GDP, the real interest rate, and unemployment).
Aggregate Supply Curve

Why the Long-run Aggregate-Supply Curve might shift?

• The long-run level of production is sometimes called potential output or full-employment output. It is
also called as the natural level of output because it shows what the economy produces when
unemployment is at its natural, or normal, rate.

• Any change in the economy that changes the natural level of output shifts the long-run aggregate-
supply curve. Because output in the classical model depends on labor, capital, natural resources, and
technological knowledge, so shifts in the long-run aggregate-supply curve arises from these four
sources.
Aggregate Supply Curve
Why the Long-run Aggregate-Supply Curve might shift?
1. Shifts Arising from Changes in labour
• In case of immigration of labour, LRAS curve would shift to the right. Similarly, if government enacts a
successful job training program for unemployed workers, the natural rate of unemployment would fall and
the long-run aggregate-supply curve would shift to the right.
2. Shifts Arising from Changes in capital
• An increase in the economy’s capital stock increases productivity and thereby increases the quantity of
goods and services supplied. As a result, the long-run aggregate-supply curve shifts to the right.
3. Shifts Arising from Changes in natural resources
• The discovery of a new mineral deposit, for example shifts the long-run aggregate-supply curve to the
right. A change in weather patterns that makes farming more difficult shifts the long-run aggregate-supply
curve to the left.
4. Shifts Arising from Changes in technological knowledge
• The invention of the computer, for instance, has allowed us to produce more goods and services from any
given amounts of labor, capital, and natural resources.
Aggregate Supply Curve
Why the Aggregate-Supply Curve slopes upward in the short-run?
• In the short run, the price level affects the economy’s output. Why?
• Macroeconomists have proposed three theories for the upward slope of the short-run aggregate supply
curve.

1. The Sticky-Wage Theory: According to this theory, the SRAS curve slopes upward because nominal wages
are slow to adjust to changing economic conditions in the short run. The slow adjustment of nominal wages
is attributable to long-term contracts between workers and firms that fix nominal wages. This stickiness of
wages gives firms an incentive to produce less output when the price level turns out lower than expected
and to produce more when the price level turns out higher than expected.
2. The Sticky-Price Theory: The sticky-price theory emphasizes that the prices of some goods and services also
adjust sluggishly in response to changing economic conditions. This slow adjustment of prices occurs in part
because there are costs to adjusting prices, called menu costs. These menu costs include the cost of printing
and distributing catalogs and the time required to change price tags. As a result of these costs, prices may be
sticky in the short run. Not all prices adjust immediately to changing conditions, an unexpected fall in the
price level leaves some firms with higher-than-desired prices, and these higher-than-desired prices depress
sales and induce firms to reduce the quantity of goods and services they produce.
Aggregate Supply Curve

Why the Aggregate-Supply Curve slopes upward in the short-run?

3. The Misperceptions Theory: According to this theory, changes in the overall price level can temporarily
mislead suppliers about what is happening in the individual markets in which they sell their output. As a result
of these short-run misperceptions, suppliers respond to changes in the level of prices, and this response leads to
an upward-sloping aggregate-supply curve.

For example, wheat farmers may notice a fall in the price of wheat before they notice a fall in the prices of the
many items they buy as consumers. They may infer from this observation that the reward for producing wheat is
temporarily low, and they may respond by reducing the quantity of wheat they supply.
Aggregate Supply Curve
Why the Short-run Aggregate-Supply Curve might shift?
• the short-run aggregate-supply curve also depends on all those variables that shift the long-run
aggregate-supply curve. In addition, we have to consider a new variable—the expected price level.
• For example, when an increase in the economy’s capital stock increases productivity, the economy is
able to produce more output, both in the short run and long run.
• Shifts Arising from Changes in the Expected Price Level: The important new variable that affects the
position of the short-run aggregate supply curve is the price level that people expected to prevail. We
know that, the quantity of goods and services supplied depends, in the short run, on sticky wages,
sticky prices, and misperceptions. And the wages, prices, and perceptions are set based on the
expected price level. So when people change their expectations of the price level, the short-run
aggregate-supply curve shifts.
• when the expected price level rises, wages are higher, costs increase, and firms produce a smaller
quantity of goods and services at any given actual price level. Thus, the short-run aggregate-supply
curve shifts to the left. Conversely, when the expected price level falls, wages are lower, costs decline,
firms increase output at any given price level, and the short-run aggregate-supply curve shifts to the
right.
So, what are the two basic causes of economic
fluctuations?
 (1). Shifts in aggregate demand and (2). shifts in aggregate supply
The Effects of a shift in aggregate demand
Let us take an example to understand how shift in AD impacts
an economy:
Suppose that a wave of pessimism suddenly overtakes the
economy due to the current pandemic. This creates a trouble
for the government; a crash in the stock market, and so on.
Because of the situation, people may lose confidence in the
future and alter their plans. Households cut back on their
spending and delay major purchases, and firms put off buying
new equipment.
What is the macroeconomic impact of
such a wave of pessimism?
In answering this type of question, follow
the following steps:
1. determine whether the event affects
aggregate demand or aggregate supply.
2. determine the direction that the curve
shifts.
3. use the diagram of AD and AS to
compare the initial and new equilibria.
4. Use the diagram of AD and AS to
analyze how the economy moves from
its new short-run equilibrium to its new
long-run equilibrium.
The Effects of a shift in aggregate demand
• A fall in aggregate demand is
represented by a leftward shift in
the AD curve from AD1 to AD2 . In
the short run, the economy moves
from point A to point B. Output
falls from Y1 to Y2 , and the price
level falls from P1 to P2 .
• Over time, as the expected price
level adjusts, the short-run AS
curve shifts to the right from AS1
to AS2 , and the economy reaches
point C, where the new AD curve
crosses the long-run AS curve.
• In the long run, the price level falls
to P3 , and output returns to its
natural level, Y1 .
The Effects of a shift in aggregate demand
To sum up:

• In the short run, shifts in AD

cause fluctuations in the
economy’s output of goods and
services.
• In the long run, shifts in AD affect
the overall price level but do not
affect output.
• If policymakers influence AD, they
can potentially mitigate the
severity of economic fluctuations.
The Effects of a shift in aggregate supply

Let us take an example to understand how shift in AS impacts What is the macroeconomic impact of rise
an economy: in the cost of production?

1. An economy is in its long-run equilibrium. Now suppose that

suddenly some firms experience an increase in their costs of
production due to the bad weather, which destroyed some crops,
driving up the cost of producing food products.

2. A war in the Middle East might interrupt the shipping of

crude oil, driving up the cost of producing oil products.
The Effects of a shift in aggregate supply
When some event increases firms’
costs, the short-run aggregate supply
curve shifts to the left from AS 1 to
AS 2 . The economy moves from
point A to point B. The result is
stagflation: Output falls from Y 1 to
Y2 , and the price level rises from P
1 to P 2.
The Effects of a shift in aggregate supply
Transition from the short-run
equilibrium to the long-run
equilibrium. Firms and workers may
at first respond to the higher level of
prices by raising their expectations of
the price level and setting higher
nominal wages. In this case, firms’
costs will rise yet again, and the
short-run aggregate-supply curve will
shift farther to the left, making the
problem of stagflation even worse.
This phenomenon of higher prices
leading to higher wages, in turn
leading to even higher prices, is
sometimes called a wage-price
spiral.
The Effects of a shift in aggregate supply

Policymake Faced with an adverse

rs might shift in aggregate supply
attempt to from AS1 to AS2 ,
offset some policymakers who can
of the influence AD might try
effects of to shift AD curve to the
the shift in right from AD1 to AD2 .
the short- The economy would
run move from point A to
aggregate- point C. This policy
supply would prevent the
curve by supply shift from
shifting the reducing output in the
aggregate- short run, but the price
demand level would permanently
curve. rise from P1 to P3 .
The Effects of a shift in aggregate supply

To sum up:

• Shifts in aggregate supply can

cause stagflation—a
combination of recession
(falling output) and inflation
(rising prices).
• Policymakers who can
influence aggregate demand
can mitigate the adverse impact
on output but only at the cost of
exacerbating the problem of
inflation.
 2020

Consumption and Investment function

29
 2020

After attending this session, you will learn:

• What is consumption?
• What is saving?
• The meaning of consumption function
• The meaning of saving function
• Determinants of the Consumption function.
• What is investment?
• What is investment function?
• Determinants of the Investment
Key Concepts
• Consumption function
• Keynes Psychological Law of
Consumption
• Marginal Propensity to Consume
• Marginal Propensity to Save
• Average Propensity to Consume
• Average Propensity to Save
• Determinants of Consumption
• Investment function
• Investment demand curve
• Determinants of Investment
• Induced Vs. Autonomous
• Gross vs. Net investment

30
 2020

Consumption and saving

Consumption or desired consumption is expenditures by
households on final goods and services, given income and
other factors that determine households’ economic
opportunities.

Three main categories of consumption are: durable

goods, nondurable goods, and services.

• Consumption spending by households is by far the largest

component of the demand for goods and services.

• Saving is that part of personal disposable income

that is not consumed. It is Income minus
consumption
Basic concepts of ECONOMICS 31
 2020

Income , consumption and saving

• Income, consumption, and To understand the way consumption affects national
saving are all closely linked. output, we need to introduce some new tools. We need
• income is the primary to understand how each dollar of additional income is
determinant of consumption
divided between additional saving and additional
and saving.
• Consumption and saving rise
consumption.
with disposable income. This relationship is shown by:
• The consumption function, relating consumption and
income. And
• The saving function, relating saving and income

Basic concepts of ECONOMICS 32

The consumption function 2020

The consumption function shows

the relationship between the level
of consumption expenditures and
the level of disposable personal
income. This concept, introduced
by Keynes, is based on the
hypothesis that there is a stable
empirical relationship between
consumption and income.
C= a + b(Y)
Where, a is the autonomous
consumption and b is the
slope(MPC)

• Autonomous consumption is
not influenced by income
• Induced consumption changes
with income
The consumption function 2020

The 45° line tells us whether

consumption spending is
equal to, greater than, or less
than the level of disposable
income. The point where the
consumption schedule
intersects the 45° line is the
break-even point—it is the
level of disposable income at
which households just break
even.
• At B-E point,
Consumption = DI

How much is the saving at an

income of $28,000?
The Saving Function
The saving function shows the relationship
between the level of saving and income.
How do you obtain saving function graphically
from the consumption function?
• Graphically, the saving function is obtained
by subtracting vertically the consumption
function from the 45° line
• At point A in the 2nd Figure , we see that the
household’s saving is negative because the
consumption function lies above the 45°
line. Similarly, positive saving occurs to the
right of point B.

How much is the saving at point B and why?

 Response of consumption/saving to changes in
income.
Response of consumption to
changes in Income is nothing but
Marginal Propensity to consume

The MPC is the extra amount that

people consume when they
receive an extra rupee of
disposable income.

The marginal propensity to save is

the fraction of an extra rupee of
disposable income that goes to
extra saving.

MPC is the slope of the

consumption function and MPS is
the slope of saving function. Calculate MPC and MPS
Response of consumption/saving to changes in
income.
Average propensity to consume and average We know,
propensity to save Disposable income= C +S

APC is the ratio of consumption expenditure to • This implies that each extra
disposable income. rupee of disposable income
APC= C/Y must be divided between
extra consumption and extra
APS is the ratio of saving to disposable income. saving.
APC= S/Y Therefore,
MPS + MPC = 1
Problems on MPC ,MPS, APC and APS
Calculate Income Consump Saving APC APS
APC and (Y) tion (C) (S)
APS 100 80 20 0.80 0.20
200 120 80 0.60 0.40
300 180 120 0.60 0.40

Calculate Income Consump MPC MPS

MPC and (Y) tion (C)
MPS 400 240 - -
500 320 0.80 0.20
600 395 0.75 0.25

700 465 0.70 0.30

Problems on MPC ,MPS, APC and APS
Using the consumption function equation, calculate- Given below is the consumption function of an
Consumption expenditure at Y= 500 crores, if economy:
autonomous consumption is 40 crores and 40% of C = 100 + 0.5Y
additional income is saved. With the help of a numerical example, show that in
this economy, as income increases, APC will decrease.
Solution: Consider the hypothetical income schedule as 100,
MPS= 0.4 200, 300, 400 and 500
Therefore, MPC = 0.6
C= a+bY
C= 40+0.6(500)
Income (Y) Consumption C =(100 APC
C= 340 crores
+0.5Y) =C/Y
100 150[=100+0.5(100] 1.50
200 200 1
300 250 0.83
400 300 0.75
500 350 0.70
 Determinants of consumption
Consumption behavior is crucial for
understanding both short-term
business cycles and long-term
economic growth.
• In the short run, consumption is a
major component of aggregate
spending.
• When consumption changes sharply,
the change is likely to affect output
and employment through its impact
on AD.
• consumption behaviour is crucial
because what is not consumed—
that is, what is saved—is available
for investment in new capital goods,
and capital serves as a driving force
behind long-term economic growth.
Any factor that increases the desired consumption of individual
households will increase Cd, and any factor that decreases the
desired consumption of individual households will decrease Cd.
Current Disposable Income When DI declines in recessions,
consumption usually follows the decline. Increases in DI, say,
following tax cuts, stimulate consumption growth.
Expected Future Income Today’s consumption decisions may
depend not only on current income, but also on the income that
one expects to earn in the future. For example, an individual who is
currently not employed but who has a contract to begin a high-
paying job in three months will probably consume more today than
a similar individual who is currently not employed, but has no
prospects for a job in the near future.
 Determinants of consumption
Permanent Income Permanent income is the trend
level of income— that is, income after removing
temporary or transient influences due to windfall
gains or losses. This approach implies that
consumers do not respond equally to all income
shocks. If a change in income appears permanent
(such as being promoted to a secure and high-
paying job), people are likely to consume a large
fraction of the increase in income.

The life-cycle hypothesis assumes that people save

in order to smooth their consumption over their
lifetime. People tend to save while working so as to
save for retirement. Social security impacts saving
significantly.
Wealth and Other Influences. A further important
determinant of the amount of consumption is
wealth.
 Investment function
The second major component after consumption, is investment.
Investment plays two roles in macroeconomics.
1. As it is a large and volatile component of spending,
investment often leads to changes in aggregate demand and
affects the business cycle.
2. Investment leads to capital accumulation. Adding to the
stock of buildings and equipment increases the nation’s
potential output and promotes economic growth in the long
run.
Investment refers to the purchase or construction of capital
goods, including buildings, equipment, software, and
intellectual property products used in production, and additions
to inventory stocks.

Presentation Title 42
Desired capital stock
• To understand what determines the amount of investment,
we must consider how firms decide how much capital they
want.
• A firm’s desired capital stock is the amount of capital that
allows the firm to earn the largest expected profit.
Managers can determine the profit maximizing level of the
capital stock by comparing the costs and benefits of using
additional capital—a new machine, for example. If the benefits
outweigh the costs, expanding the capital stock will raise
profits.
Benefit = marginal product of capital, MPKf.
MPKf is the increase in output that a firm can obtain by
adding a unit of capital, holding constant the firm’s work force
and other factors of production.
This expected future benefit must be compared
to the expected cost of using that extra unit of
capital, or the user cost of capital.
The user cost of capital is the expected real cost
of using a unit of capital for a specified period
of time.
UC = Depreciation cost + Interest cost
Example: Mr X, the bakery’s owner-manager, is
considering investing in a new solar-powered
oven.
pK = 100/- per cubic foot)
d = 10% per year
r = 8% per year
uc = (0.08 per year x 100/- per cubic foot)
+ (0.10 per year x 100/- per cubic foot)
= 18/- per cubic foot per year.
 Determining the Desired capital stock
A firm’s desired capital stock is
the capital stock at which the
expected future marginal product
of capital equals the user cost of
capital.

The MPKf curve slopes downward

because the marginal product of
capital falls as the capital stock is
increased.

When the capital stock is 5000

cubic feet, the expected future
marginal product of capital,
MPKf, is equal to the user cost of
capital, uc.
Changes in the Desired capital stock
Any factor that shifts the MPKf curve or
changes the user cost of capital changes the
firm’s desired capital stock.

1. If there is a decline in the interest rate

from 8% to 6% in the above example,
calculate the user cost, and draw a diagram
to show the effect on desired capital stock.

2. If there is a technological advancement,

show with the help of diagram the effect on
desired capital stock.
 Changes in the Desired capital stock
Therefore,
1. A decline in the real interest rate raises the desired capital
stock.
2. An increase in the expected future mpK raises the desired
capital stock
Now let’s look at the link between a firm’s desired capital stock
and the amount it invests. In general, the capital stock (of a firm
or of a country) changes over time through two opposing
channels.
1. the purchase or construction of new capital goods increases
the capital stock. This is “investment,” or more precisely
gross investment.
2. the capital stock depreciates or wears out, which reduces the
capital stock. The difference between gross investment and
depreciation—is net investment.
Induced and autonomous investment
• Induced investment depends on the profit
expectations and is directly related to the
income level. The curve slopes upward.
• Autonomous investment is not affected by
changes in the level of income. For example,
government expenditures on infrastructure .
The curve is parallel to x-axis.
Ex-ante and ex-post investment
• Ex-ante investment is a planned investment,
mainly determined by rate of interest.
• Ex-post investment is the realised or actual
investment.
 Determinants of investment

1. Revenues
An investment will bring the firm additional revenue if it helps the firm
sell more product. This suggests that the overall level of output (or GDP)
will be an important determinant of investment. Most studies find that
investment is very sensitive to the business cycle.
2. Costs
A second important determinant of the level of investment is the costs
of investing. The cost of capital includes not only the price of the capital
good but also the interest rate that borrowers pay to finance the capital
as well as the taxes that firms pay on their incomes.
3. Expectations
profit expectations and business confidence are central to investment
decisions. Business investments require a weighing of certain present
costs with uncertain future profits. If businesses believe that Internet
commerce is the key to riches, they will invest heavily in that sector.
Summary
• Because saving equals income minus consumption, a
household’s decisions about how much to consume
and how much to save are really the same decision.
• for the same amount of income, an increase in current
saving reduces current consumption but increases the
amount that the individual or household will be able
to consume in the future.
• At any point on the 45° line, consumption exactly
equals income and the household has zero saving.
• When the consumption function lies above the 45°
line, the household is dissaving. When the
consumption function lies below the 45° line, the
household has positive saving.
• The consumption function relates the level of
consumption to the level of disposable income.
• The saving function relates saving to disposable
income.
2020
• The marginal propensity to consume (MPC) is the
amount of extra consumption generated by an extra
dollar of disposable income. Graphically, it is given
by the slope of the consumption function.
• The marginal propensity to save (MPS) is the extra
saving generated by an extra dollar of disposable
income. Graphically, this is the slope of the saving
schedule.
• Because the part of each rupee of disposable income
that is not consumed is necessarily saved, MPS= 1 -
MPC .
• The economic reason for diminishing marginal
productivity of capital is as follows: When the capital
stock is low, there are many workers for each
machine, and the benefits of increasing capital
further are great; but when the capital stock is high,
workers already have plenty of capital to work with,
and little benefit is to be gained from expanding48
capital further.
Summary
2020

• The second major component of spending is gross

private domestic investment in housing, plant,
software, and equipment. Firms invest to earn
profits.
• The major economic forces that determine
investment are -the revenues produced by
investment (primarily influenced by the state of the
business cycle), the cost of investment (determined
by interest rates and tax policy), and the state of
expectations about the future.
• Because it depends on highly unpredictable future
events, investment is the most volatile component
of aggregate spending.

49
 2020

Multiplier
50
After attending this session, you will learn: 2020

• Meaning of multiplier Key Concepts

• Assumptions of Multiplier
• Types of the multiplier
• implications of multiplier on economy
• Multiplier
• investment multiplier
• balanced budget multiplier
• foreign trade multiplier
• Balanced Budget multiplier
• Tax multiplier

51
Multiplier 2020

• The basic macroeconomic theory of business According to Keynes, an initial increment in

cycles holds that shifts in aggregate demand
produce the frequent and unpredictable
fluctuations in output, prices, and employment
known as business cycles.
• Economists try to understand the mechanism
by which changes in spending get translated
into changes in output and employment.
• The simplest approach to understanding
business cycles is known as the Keynesian
multiplier model.
investment increases the final income many times.
This is known as Multiplier (k). It is the ratio of
change in income due to change in investment.
k = change in Y/change in I
Suppose an additional investment of 4000crores in an
economy generates an additional income of 16000
crores. Here, the value of multiplier is 4.

The multiplier model shows that an increase in investment will

increase GDP by an amplified or multiplied amount—by an
amount greater than itself.
52
Multiplier 2020

• Multiplier is directly related to MPC. Higher the

MPC, more will be the value of k and vice versa.
• K is the reciprocal of MPS or,

K = 1/MPS Or k = 1/1-MPC

If MPC is 1, K will be infinity. And if MPC is zero, k will

be 1.

53
Working of Multiplier 2020

Assumptions To understand multiplier model, we start with

• wages and prices are fixed and that there are Keynesian cross, which shows the total
unemployed resources in the economy. expenditure-output relationship.
• the role of monetary policy is assumed to be
constant
• financial markets do not react to changes in the
economy.
• there is no international trade and finance.
• there is no any time-lag between the increase in
investment and the resultant increment in income

The total expenditure curve ( TE ) shows the level of

expenditure desired or planned by consumers and
businesses corresponding to each level of output. The
economy is in equilibrium at the point where the TE =
C+ I curve crosses the 45° line—at point E in Figure.
54
Working of Multiplier 2020
Working of Multiplier-an example 2020

When the government buys Rs. 100 crores of goods from Boeing, that
purchase has repercussions on economy.

• The immediate impact is rise in employment and profits at Boeing.

• Then, as the workers see higher earnings and the firm’s owners see
higher profits, they respond to this increase in income by raising their
own spending on consumer goods.
• As a result, the demand for the products of many other firms in the
economy also rise.

Because each rupee spent by the government can raise the aggregate
demand for goods and services by more than a rupee, government
purchases are said to have a multiplier effect on aggregate demand.

• This multiplier effect continues even after this first round. Once all these
effects are added together, the total impact on the quantity of goods and
services demanded can be much larger than the initial boost from higher
government spending.
Working of Multiplier-an example 2020

By • Additional investment Rs. 100 crores • What is the additional

Govt.
income generated
between 4th round and
1st round
increase in
• Rs. 100 crores the final round?
income • What is the value of
multiplier here?
• Rs. 90 crores with MPC = 0.9
2nd round • How did you calculate?

3rd round
• Rs. 81 crores with MPC = 0.9

4th round
• Rs. 72.9 crores with MPC = 0.9

Total
increase in
• Rs. 1000 crores (=100+90+81+72.9+……….)
income
Working of
Multiplier
the multiplier model explains how AD
is affected by consumption and
investment spending under certain
assumptions.
 Working of
Multiplier-an 2020

example

Suppose that the government raises

defense purchases by $100 billion.
This changes the expenditure line by
$100 billion. If MPC is 2/3, show the
multiplier effect with the help of a
diagram. Also show the effect on AD.

Because the MPC is 2/3, the new

level of output is $300 billion higher.

To sum up:
Government purchases of goods and services (G ) are an important force in determining output and
employment. In the multiplier model, if G increases, output will rise by the increase in G times the
expenditure multiplier. Government purchases therefore have the potential to increase or decrease
output over the business cycle.
Types of Multiplier 2020

Tax Multiplier Tax Multiplier = -MPC/1-MPC

• Changes in Taxes have impact on Aggregate = -MPC/MPS
Demand.
• However, the tax multiplier is smaller than the the tax multiplier is always negative. This is
because there is an inverse relationship
spending multiplier. between taxes and aggregate demand. When
• This is because when the government spends taxes decrease, aggregate demand increases.
money, it directly impacts AD.
• When the government cuts taxes instead, there is The multiplier effect of a tax cut can be affected
an increase in disposable income, a part of the by the size of the tax cut, the marginal propensity
which may be spent, and other may be saved. to consume, as well as the crowding out effect.
• The money that is saved does not contribute to the
multiplier effect.
• The change in aggregate demand caused by a change in
taxation levels, is the Tax multiplier.
Types of Multiplier 2020

Foreign trade Multiplier or export multiplier Foreign trade Multiplier

• It is the amount by which the national income of a
country rises by a unit increase in domestic = 1/MPS+MPM
investment on exports.
• As exports increase, there is an increase in the
income, which creates demand for goods and
services.
• Export multiplier depends on marginal propensity to
save (MPS) and the marginal propensity to import
(MPM).
• The smaller these two marginal propensities are, the
larger will be the value of the multiplier, and vice
versa.
Types of Multiplier 2020

Balanced Budget Multiplier Balanced Budget Multiplier

• balanced-budget multiplier analyzes what happens when
there is an equality between changes in government = 1/MPS+(-)MPC/MPS
purchases and taxes, that is, actions that keep the budget
"balanced.“
=1-MPC/MPS
• balanced-budget multiplier indicates the overall impact on =MPS/MPS
aggregate production of a change in government =1
purchases that is matched by an equivalent change in
taxes.
• This is the combination of the expenditures multiplier and
the tax multiplier.
• The balanced-budget multiplier is equal to one.
• The "positive" impact on aggregate output caused by a
change in government purchases is largely, but not
completely, offset by the "negative" impact of the change
in taxes.
Problems on Multiplier 2020

1. Calculate multiplier if MPS is 0.4 1. 2.5

2. Calculate multiplier if MPC is 0.75 2. 4
3. In an economy, income generated is four times the increase in 3. 0.25, 0.75
investment expenditure. Calculate the values of MPS and MPC. 4. 5000 crores
4. In an economy, MPC is 0.8. If investment increases by Rs. 1000 crores, 5. 10 cr, 4 cr
calculate the total increase in income. 6. Infinity
5. In an economy, 60% of increased income is spent on consumption. If 7. 0.75, 250, 750,
Rs. 4 crores are invested in a project, find out the increase in income 4
and saving. 8. 3
6. In an economy, the entire increase in income is spent on consumption.
What will be the value of multiplier?
7. An increase of Rs 250 cr is invested in a nan economy resulted in total
increase in income of Rs 1000 crores. Calculate (a) MPC, (b) change in
saving, (c) change in consumption expenditure, (d) value of multiplier.
8. The ratio of mpc to mps is 2:1 . Find the value of multiplier.
Summary
2020

64
 References 2020

1. Macroeconomics by Andrew B. Abel, Ben Bernanke, and Dean Croushore

2. Macroeconomics by Samuelson

Presentation Title 65