Topic no. 11: Aggregate Demand and Aggregate Supply - Consumption and Investment Flashcards
Understand: - When is the economy at equilibrium - Components of Aggregate Demand - Multiplier effect - How output changes when AD changes - Determinants of consumption - Determinants of investment
How is equilibrium in the economy?
Microeconomics: Market equilibrium for a particular product is achieved when quantity demanded equals quantity supplied. D = S
Macroeconomics: Equilibrium is achieved when aggregate demand equals aggregate supply. AD = AS
Equilibrium (Ye) for AD = AS:
i) full employment output level; or
ii) below full employment; or
iii) above full employment
Full employment output level is where the natural rate of unemployment occurs. [Potential GDP]
What is an recessionary situation?
If economy is below full employment level, it’s called a recessionary situation.
AD must ↑ to reach desired full employment output level.
What is an inflationary situation?
If economy is above full employment, it’s called a inflationary situation, AD must ↓.
What are the components of Aggregate Demand?
AD = C + I + G + X-M
C: Consumer
I: Investment
G: Government
X-M: Exports - Imports
What is the income multiplier effect?
Informs of the number of times output changes whenever AD changes.
Formula: Multiplier = Change in output/Change in AD
Why is there a multiplier effect? An initial change in spending will cause further rounds of spending.
a) Keynesian economics assumes that people can only do two things with their income. [consumed/spent or saved]
(Y = C + S)
b) If there is any change in Y, there will be a portion of spend and a portion of save.
Marginal Propensity to Consume:
MPC = △c/△y
(Change in consumption/change in income)
(Get additional income)
Marginal Propensity to Save:
MPS = △s/△y
(Change in savings/change in income)
(Receive additional income)
c) income can only be spent or saved, so proportion must add up to 1:
MPC + MPS = 1
MPS = 1 - MPC
e.g. MPC = 0.75, MPS = 1 - 0.75 = 0.25
$1, spend 75% & save 25%
Multiplier formula = 1/MPS
How much will output change when AD changes?
Change in Y = (1/MPS) x Change in initial spending
△Y = (1/MPS) x △AD
**△AD can be a △C, a △I, △G or △(X-M)
What are the determinants of consumptions(C)?
a) Expectations
[Consumer expectations are optimistic or pessimistic views of the future which can change consumption spending in the present]
b) Wealth
[An increase/decrease in financial wealth(money, savings, accounts, stocks) leads to a rise/fall in consumption expenditures]
c) Interest rate
[More durable goods(cars, furniture and appliances) are purchased with borrowed funds. A lower rate of interest on loans encourages consumers to borrow more and consume more and a higher interest rate discourages borrowing, so they consume less]
What is investment?
Investment expenditures are expenditures by firms for new capital goods.
What are the determinants of investment?
a) Expectations
[Firms’ expectation concerning the economy can affect investment. If firms expect an expansion, likely to increase investment expenditures. (Rightward shift of AD) If firms expect a downturn, likely decrease investment expenditures. (Leftward shift of AD)
b) Technological Change
New technology to replace obsolete capital equipment → new technologies create investment spending → investment ↑
c) Interest Rate
Capital goods bought with borrowed money. An increase/decrease in interest rate leads to an increase/decrease in cost of borrowing. Firms therefore borrow lesser/more causing investment to fall/rise.
d) Government Policies
↑ in business taxes = ↓ profitability & investment
(Govt encourage investment by allowing a tax credit for new investment. Investments will ↑)
e) Depreciation
Wearing out of existing capital equipment. The larger the amount of capital equipment & the older the stock, the larger the amount of capital that wears out → more investment needed to replace worn-out capital.
