National Income Determination III
Aggregate demand and Aggregate supply and the
equilibrium level of national income.
The multiplier and accelerator principles and changes
in national income.
Seminar exercise on national income determination.
1.- BUSINESS CYCLES, GDP FLUCTUATIONS, UNEMPLOYMENT AND INFLATION
IN THE U.S.A.
2.- The aggregate supply function
Aggregate Supply Function:
Whereas aggregate demand is the amount domestic and foreign residents
wish to spend on the national product of a country, aggregate supply
is the amount of national output domestic firms wish to produce.
An aggregate suppply function indicates how much national output firms
wish to produce in relation to the aggregate price level.
The aggregate demand and supply model is concerned with short-run
production decisions, i.e. decisions taken within a time span which
does not allow for changes in the capital stock or for technical
So we will be working with a short-run aggregate production function
in which the stock of capital and state of technology are constant.
The two kinds of factors of production which firms can vary in the
short run are the quantities of labour and raw materials they employ.
The aggregate supply function, then will take different shapes in
accordance with firm's costs.
The aggregate supply function can be horizontal, upward-sloping, or
vertical. Each will be related to costs behaviour:
HORIZONTAL: average and marginal costs are constant in the short
run as output is expanded, so long as firms are operating
with underutilized productive capacity. Because of this,
increased demand will not increase unit price.
UPWARD-SLOPING: Average and marginal costs rise in the short run as
output is increased. Demand-pull inflation will occur
here if demand increases because of increased income.
The short run rises in cost will occur because of
higher demand for labour will increase wages, or
higher demand for raw materials will have the same
VERTICAL: Firms are at full capacity: output cannot be expanded in
the short run and so average and marginal costs tend to
infinity once full capacity has been reached. The average
and marginal cost schedule is a vertical line at full
capacity output. Increased demand will push prices up but
output will not change.
We can still relate the shape of the aggregate supply function to the
shape of the aggregate cost function if firms are modelled as
oligopolists who set their prices as a mark-up average cost. Constant
unit costs will result in a horizontal aggregate supply schedule, while
rising marginal and average costs will probably give rise to an
upward-sloping aggregate supply function.
Having stablished the direct connection between the aggregate supply
function and the behaviour of average and marginal costs as output
varies in the short run, we need to consider the determinants of
short-run production costs. These determinants are of two kinds.
1.- The first is related to the nature of the physical aspects of the
production process as expressed in the production function. Of
prime concern here is how the marginal product of labour behaves as
output is increased in the short run. Is the marginal product
of labour constant as output expands, does it decline or does it
2.- The second determinant of the short-run average and marginal costs
of output is the money wage rate. How marginal and average costs
vary as output is expanded depends also on whether the money wage
rate stays constant or rises as more labour is employed. This in
turn depends on the shape of the aggregate supply of labour
If it is horizontal (i.e. perfectly elastic with respect to
the money wage rate) then firms can increase employment
(i.e. demand more labour) at an unchanged money wage rate.
If the supply of labour slopes upwards with respect to the
wage, then firms can only get more labour if they increase
the money wage rate.
If the average and marginal product of labour are constant and the
money wage rate remains unchanged as output expands, then the average
and marginal cost of output curve and the aggregate supply curve
will be horizontal.
If, as output expands, the money wage rate rises and/or the average
product of labour falls, then the short-run average cost and marginal
cost curves will be upward-sloping and so will be the aggregate supply
Aggregate supply and the labour market
In order to derive the aggregate supply function, therefore, we need
1 The nature of the short-run aggregate production function which
determines how the average and marginal product of labour behave
as output is expanded in the short run, when the capital stock and
the state of technology remain fixed.
2 The behaviour of the wage rate as output changes in the short run.
In order to analyse the determination of the wage rate we need to
consider the demand for and supply of labour.
Thus the aggregate supply function depends on the demand for and supply
of labour and on the short-run aggregate production function. So the
labour market is important in a macro model because from it is derived
the aggregate supply function.
AN OVERVIEW OF AGGREGATE DEMAND AND SUPPLY
Aggregate supply will depende upon the labour market
Aggregate demand will depende upon the interaction of the
goods market and the money market
AGGREGATE SUPPLY will depend upon:
demand for labour
supply of labour
short-run aggregate production function
profit-maximizing condition for firms which
is when real wage = marginal product of labour
AGGREGATE DEMAND will depend upon the interaction of the components
of the goods market:
expenditure = C + I + G + (X-H)
consumption (C) (national income, money balances
and rate of interest)
investment (I) (expectations, inflation,
rate of interest)
government spending (G) (political considerations)
exports (X) (exchange rate, costs of production)
imports (H) (national income, exchange rate)
and the components of the money market:
demand for money (national income,
rate of interest)
supply of money (credit, rate of interest,
equilibrium in the money market (when
demand for money equals money supply over
AGGREGATE DEMAND, NATIONAL INCOME AND EQUILIBRIUM CONDITION
When national income equals aggregate demand, there is equilibrium
in the economy. That is, planned expenditure by economic agents
(individuals, firms and government) is equal to national income.
If aggregate demand were less than than national income then firms
would be left with unsold goods on their hands and so would cut back
production. National income would be falling over time and so could
not be in equilibrium.
In the opposite situation of aggregate demand in excess of output, firms
would respond by increasing production provided that they had
underutilized productive capacity.
Excess aggregate demand at full employment would lead to rising prices.
In other words, if aggregate demand is larger than national
income (output), and there is spare capacity, the economy will tend
to grow, output, employment, import and prices will rise.
If aggregate demand is less than national income (output), then the
economy will tend to decrease, output, employment, imports and prices
For the authorities in charge of economic policies intervening with
efficiency to push output up via increasing aggregate demand, they
must know which will be the final effect of pumping one unit of money
in the economy. In order to do that, they must know what is the effect
of the propensity to save, the propensity to import and the level of
taxation in the final economic result of pumping one unit of currency
in the economy. That effect, in an arithmetic form, is known as the
Put simply, the multiplier is a measure of the 'knock-on' effect of a
change in autonomous demand, assuming that firms have the spare
capacity to supply the increased demand at constant average costs.
Suppose that the government increases its own spending by building
a new school. The income of the construction company that is awarded the
contract will go up. In turn it will employ extra people (or increase
overtime) and also by more bricks, cement, timber and other necessary
In other words, the company itself will generate another round of
increases in incomes for its employees and suppliers. The employees
and suppliers, too, will in time generate incomes for other groups in
the economy by buying goods and services from them; and the whole
process can be self-sustaining. The cumulative impact of the process
is given by the value of the multiplier.
The value of the multiplier, in turn, depends upon the size and number
of what are referred to as "leakages", which are the avenues of
withdrawal of spending power from the economy: taxes, savings and
Because we are dealing with calculations per unit of currency, we
talk of marginal propensity to save, marginal propensity to tax, and
marginal propensity to import.
The formula for calculating the value of the multiplier will be:
MPS + MPT + MPM
Of course, the value of the above fraction will be greater if MPS and/or
MPT and/or MPM decrease. Thus, unit of currency introduced in the
economy via more spending will have a larger 'knock on' effect than
Aggregate demand can increase without inflationary effects only up to
the point were full capacity/full employment is reached. If AD keeps
on increasing, then prices will shoot up, but output/employment will
If the government increases expenditure, aggregate demand will increase,
the problem here is knowing were to stop spending in order not to
reach the point of full capacity/full employment and trigger off
and inflationary process.
ABOUT THE SHAPES OF AGGREGATE DEMAND AND AGGREGATE SUPPLY SCHEDULES
A downward-sloping aggregate demand schedule will have a particular
position if held constant along a single AD schedule are:
1.- autonomous consumption *
2.- the marginal propensity to consume
3.- the tax rate
4.- autonomous investment
5.- government spending
7.- autonomous imports
8.- the marginal propensity to import
9.- the nominal stock of money
* autonomous consumption is the minimal consumption that would occur
irrespective of the level of national income.
An upward-sloping aggregate supply schedule is represented in one
shape if the variables held constant along a single AS schedule are:
1.- money wage rate
2.- stock of capital
3.- price of imported raw materials
4.- state of technology
5.- size of population of working age
6.- preference for leisure
7.- the replacement ratio *
* replacement ratio is given by the amount of income received when
Two schools of thought see the AD/AS model in different ways because
the see the shape of the AS schedule differently:
The Keynesian school see the supply curve first HORIZONTAL and then
VERTICAL (inverted L shape) when reaching full capacity/full
employment. Thus, for Keynesians, prices are not part of their
variables, because the economy will be working in the horizontal
section of AS.
Classical and neo-classical economists see an upward-sloping
aggregate supply curve, which means that rising prices with economic
growth will be an important concern for them.
Finally, let us comeback to the AD schedule:
--it shows the relationship between aggregate demand over a given
period and the price level.
--it encompasses the interlinkage between the goods market and the
money market and so shows the relationship between aggregate demand
and the price level when both markets are in equilibrium.
--its shape depends upon the influence of the price level on aggregate
demand. According to Keynes, the price level had no influence on
aggregate demand, or only a limited influence so long as the rate of
interest was above the floor level it woul reach in a depression.
Other economists have disagreed and argued that the real balance
effect has a greater influence than Keynes allowed for.
The nature and the extent of the influence of monetary variables,
such as the price level and the money supply, on aggregate demand
formed the chief focus of debate in macroeconomics in the 1950s and
1960s, which has been largely resolved by Keynesians accepting a
greater role for money and many monetarists acknowledging the influence
of fiscal policy on aggregate demand. The real crucial issue dividing
economists has been the way the supply side of the economy responds
to changes in aggregate demand, as we saw above.
1.- BUSINESS CYCLES, GDP FLUCTUATIONS, UNEMPLOYMENT AND INFLATION
IN THE U.S.A.
One reason we have been spending so much time on GDP = AD = C+G+I+X-M
is that movements in GDP are closely related to movements in other
important macroeconomic aggregates. For example, when GDP growth
accelerates, unemployment usually falls and inflation often increases.
Drawing from W. S. Brown, "Principles of Economics", West Publishing
Company, 1995, we have the following about the most important economy
in the world:
The overriding characteristic of the U.S. economy has been economic
growth. The average annual rate of growth since 1929 has been a little
over 3%, and real GDP is about three times the size it was in 1950...
...Economic growth has not been steady. Periods of rapid growth seem
inevitably to be followed by slower or declining GDP growth.
...The average rate of real economic growth since 1929 has been about
3.2 per cent. Most economists believe that long-term growth is brought
about by three main factors: more workers, a larger stock of capital
machines, and increasing labour productivity. (We will look at these
in some of the next lectures).
...A severe economic downturn occurred in the 1930s, a period known as
the Great Depression. The Great Depression is normally dated from the
stock market crash of October 1929, but few economists today believe
that the stock market crash was the only cause of the depression.
Most economists believe that poor bank lending practices, policy
mistakes, and a number of other factors were also important. Real GDP
plunged amost 30 percent between 1929 and 1933 and did not return to
its 1929 level until 1939.
...GDP fluctuations appear to have become less severe since the 1950s.
Economists are not certain why this occurred. Possibly, economic
policy has become more effective, or the economy may have undergone
structural changes that have made it more stable. Conversely, other
economists believe that the economy has not become appreciably more
stable since the 1950s.
Fluctutions in GDP growth are known as BUSINESS CYCLES...Historically,
fluctuations are far from regular -they can vary from 1 to 10 or 12
years in duration- but the history of capitalism has been marked by
general EXPANSIONS followed by general CONTRACTIONS in economic
It is useful to think of business cycles as having two phases,
EXPANSION and CONTRACTION, and two turning points, PEAK and TROUGH.
...the sequence is peak-contraction-trough-expansion-peak
...one special case of contraction is a RECESSION. It occurs when
GDP growth is negative during a relatively long period of time.
Of course, there is no a formal definition of recession because every
recession differs from the previous one. Generally speaking, a
recession exists when there is an overall downturn in many economic
indicators - GDP, employment, industrial production, and so on.
The following table presents data on the 12 business cycles that have
occurred since 1929:
TABLE 1. BUSINESS CYCLES IN THE UNITED STATES, 1929-1991
Percentage change in
Unemployment Unemployment Real GDP from Peak
Peak Trough at Peak at Trough to Trough
8/1929 3/1933 3.2% 24.9% -32.6%
5/1937 6/1938 11.0 20.0 -18.2
2/1945 10/1945 0.9 4.3 NA
11/1948 10/1949 3.8 7.9 -1.5
7/1953 5/1954 2.5 6.1 -3.2
8/1957 4/1958 3.7 7.5 -3.3
4/1960 2/1961 5.0 7.1 -1.2
12/1969 11/1970 3.4 6.1 -1.0
11/1973 3/1975 4.6 9.0 -4.9
1/1980 7/1980 5.7 7.8 -2.5
7/1981 12/1982 7.2 10.8 -2.6
7/1990 3/1991 5.5 6.8 -1.6
Post-World War II averages
Average recession : 11 months
Average expansion : 44 months
Average rise in unemployment in recession: 2.76 percentage points
Average decline in GDP in recession : 1.23%
Sources: G. H. Moore, "Business Cycles, Inflation, and Forecasting",
Cambridge, 1983, and Federal Reserve Bulletin, varios issues.
While it is apparent that each cycle differs from the previous cycle,
some broad generalizations are possible:
-the average recession has been just under a year in length, and the
typical expansion has lasted a little under four years.
-the longest recession occurred in 1981-1982 and lasted 17 months.
-the longest expansion occurred in the 1960s and lasted 106 months,
though the expansion of the 1980s was almost as long. The latter
has been labelled the "longest peacetime expansion" since World