Unit 4

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Unit 4: Short Run Economic Fluctuations

★ Aggregate Demand
★ Spending Multiplier
★ Aggregate Supply
★ Aggregate Expenditure

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There is positive and stable
relationship between consumption
and income, both for the
household and for the economy
as a whole

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 Look at Consumption and Income

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Disposable income, is the income actually
available for consumption and saving.

There is a clear and

direct relationship between
consumption and disposable
income.
Consumption is the dependent
variable and disposable income, the
independent variable.
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 consumption is a function of income.

Marginal Propensities to Consume

and to Save
The marginal propensity to consume, or MPC,
equals the change in consumption divided by
the change in income.

The marginal propensity to consume, or MPC,

equals the change in consumption divided by
the change in income.
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For example,

if India's income from ₹14.0 trillion to ₹14.5 trillion,

consumption by ₹0.4 trillion and saving by ₹0.1 trillion.

The marginal propensity to consume equals the change in

consumption divided by the change in income.
MPC is 0.4/0.5, or 4/5.

Saving by ₹0.1 trillion

MPS is 0.1/0.5, or 1/5.

Because disposable income is either spent or saved.

4/5 + 1/5 = 1.

MPC + MPS = 1.

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The slope of any straight line is
constant everywhere along the
line, the MPC for any linear, or
straight-line, consumption function
is constant at all incomes.

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 Non income Determinants of Consumption

consumer spending depends on

disposable income in the economy, other
things constant.

What factors are held constant and

how changes in them could shift the
entire consumption function up or down.

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 ➢ Net Wealth and Consumption
➢ The Price level
➢ The interest Rate
➢ Expectations
The distinction between a movement along a
given consumption function, which results
from a change in income,

and a

shift of the consumption function, which

results from a change in one of the
factors assumed to remain constant along the
consumption function. 12
 The Life-Cycle Hypothesis
According to the life-cycle model of
consumption and saving –
● young people tend to borrow to
finance education and home
purchases.
● In middle age, people pay off debts
and save more.
● In old age, they draw down their
savings, or dissave.
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The life-cycle hypothesis suggests that
the saving rate for an economy as a
whole depends on, among other things,
the relative number of savers and
dissavers in the population.

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Investment

Second component of aggregate

expenditure is investment, or, more
precisely, gross private domestic
investment.

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Firms buy new capital goods only
if they expect this investment to
yield a higher return than other
possible uses of their funds

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The expected rate of
return of each cart
equals the expected
annual earnings
divided by the cart’s
purchase price.

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 The market
interest rate is
the opportunity
cost of investing
in capital.

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From Micro to Macro

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Investment depends more on interest
rates and on business expectations
than on the prevailing income level.

And investment, once in place, is

expected to last for years,
sometimes decades.

The investment decision is thus said

to be forward looking, based more on
expected profit than on current
income.
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 Investment is
assumed to be
autonomous
with respect to
disposable
income.

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 Non Income
Determinants of
Investment
● Market interest Rate

● Business Expectations

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● Market interest Rate

A drop in the rate of interest from

8 percent to 6 percent, other things
remaining constant, reduces the
cost of borrowing and increases
investment from $1.0 trillion to
$1.1 trillion, as reflected by the
upward shift of the investment
function from I to I0.

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● Business Expectations

Investment
depends primarily
on business
expectations, or on
what Keynes
called the “animal
spirits” of
business.

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 Examples of factors
that could affect
business expectations,
and thus investment
plans, include wars,
technological change,
tax changes, and
destabilizing events
such as terrorist
attacks or the
meltdown of financial
institutions.
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Changes in
business
expectations
would shift
the
investment
demand
curve

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 Government Purchase Function

The government purchase function

relates government purchases to
income in the economy, other
things constant.

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Government purchases represent only
one of the two components of
government outlays; the other is
transfer payments, such as for Social
Security, welfare benefits, and
unemployment insurance.

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Net taxes equal taxes minus transfers.
Because taxes tend to increase
with income but transfers tend to
decrease with income, for simplicity, let’s
assume that net taxes do not vary with
income.

Thus, we assume for now that net taxes

are autonomous, or independent of
income.

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 exportsNet
The rest of the world
affects aggregate
expenditure through
imports and exports and
has a growing influence
on the economy

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 The aggregate
expenditure line shows
how much households,
firms, governments, and
the rest of the world
plan to spend on
output at each level of
real GDP, or real
income.
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 How much
aggregate
output would
be demanded
at a given price
level?

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Real GDP, can be viewed in two ways—

as the value of aggregate output and as the

aggregate income generated by that output.

The 45-degree line identifies all points

where spending equals real GDP.

Aggregate output demanded at a given

price level occurs where aggregate
expenditure, [measured along the vertical
axis,] = real GDP, [measured along the
horizontal axis]
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 What If
Spending
Exceeds Real
GDP?

What If Real
GDP
Exceeds
Spending? 36
Spending
Multiplier

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 A stone thrown into a still pond

The effect of any change in spending

ripples through the economy,
generating changes in aggregate
output that exceed the initial change
in spending. 38
consider the effect of an increase
in one of the components of
spending.

Suppose that firms become more

optimistic about profit prospects and
decide to increase their investment
from $1.0 trillion to $1.1 trillion per
year at each level of real GDP

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What happens to real GDP demanded?
An instinctive response is to say that
real GDP demanded increases by $0.1
trillion

The new spending line intersects the

45-degree line at point e’, where real GDP
demanded is $14.5 trillion.

How can a $0.1 trillion increase in

spending increase real GDP demanded
by $0.5 trillion?

What’s going on?

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An upward shift of the aggregate expenditure
line means that, at the initial real GDP of $14.0
trillion, spending now exceeds output by $0.1
trillion, or $100 billion.

The distance between point e and point f.

Initially, firms match this increased investment
spending by an unplanned reduction in inventories.

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John Deere, for example, satisfies the
increased demand for tractors by
drawing down tractor inventories. But
reduced inventories prompt firms to
expand production by $100 billion.

As shown by
[the movement from point f to point g].

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This generates $100 billion more
income. The movement from e to
g shows the first round in the
multiplier process.
The income-generating process
does not stop there, however,
because those who earn this
additional income spend some of it
and save the rest, leading to round
two of spending and income.

Given a marginal propensity to

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consume of 0.8
 As long as
spending exceeds
output, production
increases, thereby
creating more
income, which
generates still
more spending.

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 The simple spending multiplier is
the factor by which real GDP
demanded changes for a given
initial change in spending.

Simple spending multiplier 1 /1 — MPC

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The simple spending
multiplier provides a
shortcut to the total change
in real GDP demanded.

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 This multiplier
depends on the
MPC.

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The larger the MPC, the
larger the simple spending
multiplier , “simple” because only
consumption varies with income

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The Aggregate
Demand Curve

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The aggregate expenditure line is
to find real GDP demanded for a
given price level.

But what happens to spending

plans if the price level changes?

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 A Higher Price Level

A higher price level decreases the

real value of these money holdings.
This cuts consumer wealth,
making people less willing to spend
at each income level.

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 For reasons that will be
explained in a later chapter, a
higher price level also tends
to increase the market
interest rate, and a higher
interest rate reduces
investment.

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Finally, a higher U.S. price level,
other things constant, means that
foreign goods become cheaper for
U.S. consumers, and U.S. goods
become more expensive abroad. So
imports rise and exports fall,
decreasing net exports.

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Therefore, a higher price level
reduces consumption, investment,
and net exports, which all reduce
aggregate spending.

This decrease in spending

reduces real GDP demanded.

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 A Lower price LEVEL

The opposite occurs if the price

level falls. At a lower price level,
the value of bank accounts,
currency, and other money
holdings increases.

Consumers on average are

wealthier and thus spend more at
each real GDP.
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A lower price level also tends to
decrease the market interest rate,
which increases investment.

Finally, a lower U.S. price level,

other things constant, makes U.S.
products cheaper abroad and
foreign products more expensive
here, so exports increase and
imports decrease.

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Because of a decline in
the price level,
consumption, investment,
and net exports increase at
each real GDP.

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The aggregate expenditure line and the aggregate
demand curve present real output from different
perspectives.

The aggregate expenditure line shows, for a given

price level, how spending relates to income, or
the amount produced in the economy.

Real GDP demanded is found where spending

equals income, or the amount produced.

The aggregate demand curve shows, for various

price levels, the quantities of real GDP demanded.
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A shift of the aggregate
expenditure line relates to
a shift of the aggregate
demand curve, given a
constant price level

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 Real GDP
demanded is
found where
the amount
people plan to
spend equals
the amount
produced.

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 Le
t’s
Re
vis
e
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STUDY
WELL

Dr. Jyotsna Haran

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Aggregate Supply in the Short Run

Aggregate supply is the

relationship between the
economy’s price level and
the amount of output firms
are willing and able to
supply, with other things
constant.

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 The aggregate supply
curve slopes upward in
the short run and is
vertical at the
economy’s potential
output in the long run.

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Assumed constant along a given
aggregate supply curve are

● resource prices,
● state of technology, and
● the set of formal and informal
institutions that structure production
incentives,
● such as the system of patent laws,
tax systems, respect for the laws,
and the customs and conventions of
the marketplace.
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The Short-Run Aggregate Supply Curve

The relationship between

the actual price level and
real GDP supplied

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https://youtu.be/45ru0F_kN48?si=2I9aXR48w1xeYX
uQ

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Given this short-run aggregate supply curve,
the equilibrium price level and real GDP
depend on the aggregate demand curve.

The actual price level would equal the

expected price level only if the aggregate
demand curve intersects the aggregate
supply curve at point ‘a’
where the short-run quantity equals
potential output.

‘a’ reflects potential output of $14.0

trillion and a price level of 130, which is
the expected price level.
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 if aggregate demand turns out to be
greater than expected, such as AD,
which intersects the short-run aggregate
supply curve SRAS 130 at point b.

Point b is the short-run equilibrium,

reflecting a price level of 135 and a
real GDP of $14.2 trillion.

The actual price level in the short run is

higher than expected, and output
exceeds the economy’s potential of
$14.0 trillion

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The amount by which short-run output exceeds the
economy’s potential is called an expansionary gap.

The more that short-run output

exceeds the economy’s
potential, the larger the
expansionary gap and the
greater the upward pressure on
the price level.

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The expansionary gap is closed by
long-run market forces that shift the
short-run aggregate supply curve from
SRAS 130 left to SRAS 140.

Whereas SRAS 130 was based on

resource contracts reflecting an
expected price level of 130, SRAS
140 is based on resource contracts
reflecting an expected price level of 140.

At point c the expected price level and

the actual price level are identical,

so the economy is not only in short-run

equilibrium but also is in long-run
equilibrium 77
 The aggregate demand curve intersects the
short-run aggregate supply curve to the left of
potential output, yielding a price level below
that expected.

The intersection of the aggregate demand curve,

‘AD’, with SRAS 130 yields the short-run
equilibrium at point d, where the price level is
below expectations and production is less than
the economy's potential.

The amount by which actual output falls short

of potential GDP is called a contractionary gap.

In this case, the contractionary gap is $0.2

trillion, and unemployment exceeds its natural
rate.
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 Closing an
expansionary gap
involves inflation
and closing a
contractionary gap
involves deflation.

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 Le
t’s
Re
vis
e
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