Topic 4

Business Cycles and Aggregate

Demand
 Questions
What causes aggregate income to rise? To fall?
Why is GDP what it is at any time, rather than
something larger or smaller?
What causes too little spending: recession and
depression?
What causes too much spending: demand pull
inflation?

2
 Our objective
First ANALYSIS:
What are factors on which aggregate demand
depends?
How aggregate demand determines the aggregate
output level
Recession/depression (and inflation) are often caused
by changes in aggregate demand
Then POLICY:
How can these factors be influenced for a better
outcome more growth, less inflation?

3
 GDP = Y = C + I + G + Ex - M
Govt exp on
goods & services Government

Taxes

Consumer Households
spending

Market for goods Factor Financial

markets markets
& services
Wages etc
GDP

I spending Firms
Exports
Rest of
World
Imports 4
 Initial assumption

Closed economy
No government
Two sectors:
Households
Firms
Hence two types of aggregate demand:
Consumption and
Investment
5
 Two approaches
Aggregate Demand- Supply Framework
Keynesian Multiplier Model
A special case of AD-AS framework when
aggregate price level and wages are held constant
 In Keynesian Approach

How aggregate demand determines GDP

 Recall: Consumption Function
(Link between C and DI)

C
C

0 DI
8
 Now Consumption Function
(Link between C and GDP assuming no taxes)

C
C

0 GDP = Y = DI
9
 Recall: Investment Demand Function
Rate of interest (%)

30%

25%

20%

15%

10%

5%

Investment spending
 Aggregate Demand Curve
(=Total Expenditure Curve)
TE (=C+I)
TE=
AD
C

I is constant by assumption:
For given rate of interest, future expectations etc
0 GDP
11
 Will the economy actually produce
the potential output?
TE
TE

QP: Potential output

0
GDP = Y12
 Basic assumptions
Demand constrained economy: it is operating
at less than QP (potential output)
Firms produce more (subject to capacity
constraints) if market demand is greater than their
current production
Firms produce less if market demand is less than
their current production
Prices are not changed till full capacity
(potential output) is reached
Not unrealistic
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 How Aggregate Demand determines Y
TE 02
TE
E* E2
E1

01

Potential
output
45
0 Y1 Y* Y2
At Y1, Total demand (=E1Y1) Total production (=0Y1=01Y1) more production
At Y2, Total demand (=E2Y2) Total production (=0Y2=02Y2) less production

At Y*, Total demand = Total production

Y* is the equilibrium Y 14
Note: In a closed economy

Production = Output = Supply = Income

 Use of 450 line
02
TE
E1 E*
E2

01

Potential
output
45
0 Y1 Y* Y2
Note: 01 and 02 are in the 450 line
Thus 0Y1 = 01Y1 and 0Y2 = 02Y2. The 45 line basically helps to compare demand (measured
in y-axis) and production (measured in x-axis)

At Y1, E1Y1 > 0Y1 and at Y2, E2Y2 < 0Y2 16

 Equilibrium Income level

Is the level where the system tends to stay

It is not necessarily the optimal level
In the previous example, the equilibrium point
Y* is sub-optimal - it is less than the potential
output

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 Recessions/Expansions
45-degree line
Upward shift sin
TE demand

TE

Downward shift in
demand

Potential output

Y1 Y* Y2 Y 18
 Recessions/Expansions

Examples of crises
New economy bubble in late 1990s
Housing bubble in late 2000
Crash in real estate:
Investment in housing falls
As business climate worsens, firms reduce I
People affected reduce C

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 Question
Which is more volatile?
Investment expenditure or
Consumption expenditure
 Deflationary gap
Deflationary gap
TE

TE

Potential
output

45

Y* Y 21
Impact of Increase of
Spending on Income:

Multiplier Analysis

22
 Multiplier
A Change in any exogenous variable, e.g., in
investment spending arising from say a change
in future expectations starts a chain reaction
in which the initial change in aggregate
production leads to changes in consumer
spending leading to further changes in
production levels.
Thus production ultimately increases more
than the initial increase in investment
spending

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 Multiplier
A Change in investment spending (or any
other changes in exogenous variables) arising
from say a change in future expectations
starts a chain reaction in which the initial
change in aggregate production leads to
changes in consumer spending leading to
further changes in production levels.
Thus production ultimately increases more
than the initial increase in investment
spending

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 How multiplier works
Expenditure = I + b I + b2 I +..
(= Demand)
Production (= Y ) = I + b I + b2 I +..
= I (1+ b + b2 +.)
= I 1
1-b
where b : marginal propensity to consume
0<b<1

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 How multiplier works
I = Rs 10
Expenditure = 10 + b10 + b2 10 +..
(= Demand)
Production (= Y ) = 10 + b10 + b2 10 +..
= 10 (1+ b + b2 +.)
= 10 1
1-b
where b : marginal propensity to consume
0<b<1
If b= , then, ultimately, Y = Rs 10(4) = Rs 40

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 Multiplier Impact: Some examples
War
Olympics/World Cup football
Compare
World Cup Football in Russia, 2018
World Cup Football in Qatar, 2022
Compare:
Irrigation project in a depressed area
Software Park in Bangalore
 Multiplier
45-degree line
TE2
TE
TE1

Potential output

Y* Y2 Y 28
 Deriving Savings Function
Y = C(Y) + S(Y)
Hence Y C(Y) = S(Y)
 At equilibrium

Production = demand, i.e., Y= C(Y) + I

Hence Y C(Y) = I, or
S(Y) = I

30
 How S and I determine Y
S,I S(Y)

0 Y1 Y* Y2 Potential
Y
output

At Y1, I > S => Demand > Supply => production

At Y2, S > I => Supply > Demand => production

Equilibrium at Y*, Demand = Supply

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If Ex ante S = Ex ante I, Demand = Supply
C S

I
If S are always equal to I, then the economy
will not face a demand problem
But except accidentally S is not equal to I
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Govt exp on Government borrowing
goods & services Government
Transfers
Taxes
Household savings

Consumer Households
spending
Wages etc

Market for goods Factor Financial

& services markets markets
Wages etc
GDP

I spending Firms
Barrowing & stocks issued
Exports
Rest of Foreign borrowing etc
World
Imports Foreign lending etc 33
 If Ex ante S > Ex ante I, Demand < Supply
C S

Amount not demanded

I
Then the amount which the households do not demand
is more than the amount which firms demand and
hence aggregate demand is less than aggregate supply

But Ex post S = Ex post I always

34
 If Ex ante I > Ex ante S, Demand > Supply
C S
Excess demand

I
Then the amount which the households do not demand
is less than the amount which firms demand and
hence aggregate demand is greater than aggregate supply

But Ex post S = Ex post I always

35
 Planned I not necessarily = Planned S

Saving and investment activities are generally done

by different people and for different reasons (note:
exceptions)
Investment is primarily undertaken by the Business
sector and is influenced by future profit expectations
Household sectors motivation to save (to provide for
old age, for future expenditure, childrens education
etc) has little to do with investment opportunities of
business

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 Planned I not necessarily = Planned S

Funds resulting from household savings are routed to

the firms for investment through the financial system
When S , funds available for I . I actually
when the firms take these funds for I
Just because the household sector has decided to
save more, the firms do not decide to I more, even if
the rate of interest falls
Similarly planned I can be > planned S, financed
through excess liquidity in the financial system,
money creation etc

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Recession/Expansion
Recession:

When planned I < planned S

Expansion:

When planned I > planned S

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 Impact of I on Y
S, I
S(Y)

I + I

Y* Y*1 Y

39
 Impact of S on Y
(I remaining the same)
S,I

S(Y)
S(Y)

0
Potential
Y*1 Y* output
Y

40
 Paradox of thrift
Attempts by individuals to increase savings
may not lead to higher actual savings
It may lead to lower level of output with no
additional savings
Hence private prudence may be social folly
 In fact
If Investment depends on current output level
(the Accelerator Principle)
Attempts by individuals to save more may
result in less actual aggregate savings
 Higher S(Y) leading to less actual S

S,I

S(Y) S(Y)
I (Y)

0
Y*1 Y* Y

43
 Thus
If I goes up, then not only Y goes up, but also S
But if S increases, then I necessarily does not
go up:
If I remains the same, then Y goes down:
undesirable outcome
What should be the Policy Emphasis?

(Here we are assuming a demand constrained economy)

44
 But in a supply constrained
When aggregate demand is greater than
potential output, an increase in I leads to
inflation
Higher savings propensities by reducing
consumption demand help to ensure higher
investment without generating inflationary
pressures
 Supply constrained economy
C1 + I + I

AE
C1 + I

Inflationary gap

Potential output

Y
Y* 46
 Supply constrained economy
C1 + I + I

AE
C2 + I + I

Inflationary gap:
Can be avoided despite
Higher I, if S increase
And C decrease (C2)

Potential output

Y
Y* 47
 A Clarification on two approaches
Aggregate Demand- Supply Framework
Keynesian Multiplier Model
A special case of AD-AS framework when
aggregate price level and wages are held constant
 Recall: Aggregate Supply
Price level AS; link between aggregate price
level and AS other factors
remaining the same
More production and supply if
profit per unit is more
As P changes, AS can change due
to several reasons including:
When some costs in money terms,
for example wages do not change
with the price level

Real Supply
49
 AS now graphically

Aggregate Supply
(AS) Curve
Price level

Potential
output

GDP 50
 Recall: Aggregate Demand
Price level
AD = Consumption (C) +
Private investment (I) +
Government Expenditure
(G) + Net exports (X)
AD: Link between AD and
aggregate price level other
factors remaining the
same
As P changes, AD can
changes due to several
reasons including:

Real Demand
51
Movement along the Consumption function =
Shift of the AD curve
 Keynesian Demand framework

How Demand changes due to

AD Changes in other factors
With the price level remaining the
same, for example
Price level

C rises due to a rise in Disposable

income or
I falls due to a rise in the rate of
interest

(C + I + G + X)
GDP