Chapter 4 - Potential GDP.pdf

MGT 4073/CFB 1133 MACROECONOMICS  CHAPTER 4: Potential GDP  CHAPTER 4: Potential GDP At the end of this chapter, you should be able to: Interpret the meaning of aggregate demand and aggregate supply. Identify the component of aggregate demand and aggregate supply. ...

MGT 4073/CFB 1133 MACROECONOMICS  CHAPTER 4: Potential GDP  CHAPTER 4: Potential GDP At the end of this chapter, you should be able to: Interpret the meaning of aggregate demand and aggregate supply. Identify the component of aggregate demand and aggregate supply.  AGGREGATE DEMAND  Aggregate Demand = Consumption of goods and services + Investment ( Demand for capital goods)  Investment Acquiring or buying physical or financial assets for the purpose of making profit. In Macroeconomics, investment is the sum of spending made by business firm per unit of time (one year) to build stock of Capital. Capital is stock of productive assets : machinery and equipments Residential land and building Inventories  Investment (cont.) Investment is flow concept: It is measured per unit of time, generally one year. Investment refers to addition to the physical stock of capital, Capital = K Investment = K  Investment (cont.) Type of Investment : Induced Investment - It is caused by the increase in income and decrease in interest rate. I = f (Y, i) Y is assumed to remain constant I = f (i)  Investment (cont.) Autonomous Investment: it is caused by the Exogenous factors than income and interest rate. As: Innovation in production technique Invention of new business process Expansion plans of business firm Discovery of new market  Investment (cont.) Autonomous investment largely made by government. In the following area : Physical Infrastructure - Transport, Power and communication network Human Infrastructure – Health & Education Public Goods- Defence  Investment (cont.) Investment Demand based on : 1. Rate of interest ( does not change in short run) 2. Marginal efficiency of capital: Replacement cost of the capital goods. Profit expectations of entrepreneurs.  Investment (cont.)  Hence, Investment demand is remain constant in short run. _ Therefore : AD = C + I (CONSTANT INVESTMENT)  Consumption : Based on various factors:  Income , wealth, interest rate, expected future income , consumer credit, age and sex.  Income is primary determinant of consumption and saving.  Consumption Function  C = f (Y) (Consumption is positive function of income)  Consumption increases with increases in income.  As per Keynes, relationship between income and consumption is based on:  “ Psychological Law” (with increase of income consumption does not increase in same proportion of increment of income.)  Consumption Function (cont.)  But, increase in what proportion?  > Proportionately  < Proportionately  = Proportionately  Increase can be explained by Marginal Propensity to Consume (MPC)  MPC = Relationship between Marginal income and Marginal Consumption  Consumption Function (cont.)  MPC = C/ Y  MPC increased at decreasing proportion with the increase in marginal income because people like to save also income (non-linear consumption function applies to individual house holds)  Linear Consumption Function Applicable to economy as a whole or at aggregate level C = a+b Y Y = Total disposable income a = Intercept is positive constant. (denotes the level of consumption at ZERO level of income on the basis of past saving, called “AUTONOMOUS CONSUMPTION” ) b = is positive constant (mathematically represents slope of linear consumption function.  Linear Consumption Function (cont.)  Average Propensity to Consume (APC): APC is the ratio of the amount of the Consumption to total income. APC = C/Y  C = a+bY  APC = a+bY  Y  If Consumption function assumed to be form of C = bY  APC = bY = b  Y APC= MPC  Saving Function (cont.)  It is counter Part of the consumption function. AS:  Y =C+S  Therefore: S = f (Y)  Saving rises at increasing rate at upward movement of the national income  If consumption function is given as : C = a+b Y  Saving function can be derived as :  Y = C+S  S = Y-C or  S= Y – (a+bY)  = -a+(1-b)Y  1-b gives MPS where b = MPC  Saving Function (cont.) If consumption function is C = a+ b Y, C = 200+0.75 Saving function as: S =Y- (200+0.75Y) =Y – 200 - 0.75Y = -200+(1-0.75)Y = -200+0.25Y(saving function)  Aggregate Supply Aggregate supply (National Product) based on : 1. Supply of final goods and services in a year 2. Output of capital goods. Aggregate supply or money value of national product of goods and services is distributed among the various factors of production. Therefore it is National income also.  Formal Model of Income Determination AD = AS C+I = C+S C+I = C+S I=S There can be two approaches to determine National Income: 1. AD-AS Approach 2. S-I Approach AD-AS Approach C+I = C+S  Y = C+I  C= a+bY, I is constant  Y= a+a Y+I  Y-b Y = a+I  Y(1-b) = a+I  Y = _a+I_ 1- b Y = __1_ (a+ I) 1- b  Saving –Investment Approach C +I = C+S C +I = C+S I=S Investment is remain constant S= f(Y) S= Y-C C=a+b Y S =Y –(a+b Y) END OF CHAPTER 4 THANK YOU