AD and The Multiplier

Dr. Mrutyunjay Dash

Aggregate Demand

The aggregate demand implies effective demand which equals

actual expenditure. The aggregate effective demand means the
aggregate expenditure made by the society per unit time,
usually, one year.
It has two components:

I) aggregate demand for consumer goods

II) aggregate demand for capital goods
Thus AD=C+I
 Consumption Expenditure
• Exogenous factors affecting consumption:
– Tax rates
– Incomes – short term and expected income over lifetime
– Wage increases
– Credit
– Interest rates
– Wealth
• Property
• Shares
• Savings
• Bonds
 The Wealth Effect
•Wealth effect – Financial and Physical
Assets
Arise in stock market value prompts people reorient
their consumption spending.
Increased consumption
Less saving
More financial assets.
 The International Effect
• International effect – as the price level
falls net exports will rise.
 Investment Expenditure
• Spending on:
– Machinery
– Equipment
– Buildings
– Infrastructure
• Influenced by:
– Expected rates of return
– Interest rates
– Expectations of future sales
– Expectations of future inflation rates
 The Interest Rate Effect
• The interest rate effect works as follows:

a decrease in the price level ⇒

increase of real cash ⇒
banks have more money to lend ⇒
interest rates fall ⇒
investment expenditures increase
 The International Effect
• The international effect works as follows:

a decrease in the price level in the U.S.⇒

the fall in price of U.S. goods relative to
foreign goods ⇒
U.S. goods become more competitive
internationally ⇒
U.S. exports rise and U.S. imports fall
Aggregate Demand Schedule:
AD=C+I and C=a+bY where a is a
constant showing C when Y =0 and b
is the proportion of income
consumed, i.e., b=∆C/ ∆Y.
AD=C+I=a+bY+I
DERIVATION OF AD FUNCTION:
C=a+bY
Where a is a constant implying C when y=0 and b
is the proportion of income consumed.
b= ∆C/∆Y
AD function:
C+I=a+bY+I
The C+I schedule can be constructed on the basis
of the following assumptions:
C=50+0.5Y
I=Rs 50 Billion
AD function would be C+I=50+0.5Y+50
 AD Schedule

Income (Y) C=50+0.5Y I C+I Schedule

0 50 ` 50 100
50 75 50 125
100 100 50 150
150 125 50 175
200 150 50 200
250 175 50 225
 The AD Curve

Price
Price
level
level
P0 Wealth, interest rate, and
international effects
Multiplier effect
P1 Aggregate
demand

Y 0 Y1 Ye Real output
Real output
 The Multiplier Effect
• Initial changes in expenditures set in motion a
process in the economy that amplifies the
initial effects.
• Multiplier effect – the amplification of initial
changes in expenditures.
 The Multiplier Effect
• The multiplier effect works as follows:

An increase in the price level in the U.S.⇒

U.S. exports fall and U.S. imports rise ⇒
U.S. firms lose sales and cut output ⇒
U.S. incomes fall ⇒
U.S. households buy less ⇒
U.S. firms cut back again ⇒ and so on
 The Multiplier Effect
• The multiplier effect amplifies the initial
wealth, interest rate, and international
effects, making the AD curve flatter than it
would have been.
 Aggregate Supply
• AS: AS refers to the total value of goods and services
produced and supplied in an economy per unit of
time. AS includes both consumer goods and producer
goods.
In the Keynesian theory of income determination
aggregate income equals consumption and savings.
Thus AS=C+S
Eqilibrium National Income: Rs 200 billion
If C+S[AS]>C+I[AD], then
Firms produce goods and services worth more than
required demand.
Over stock – reduction in production- cut in expenses on
inputs
If C+S<C+I, Then
AD>AS
Expansion of pdn. Activities-generation of more income
in the economy.
 The AD Curve and the AE Curve

Desired Expenditure
AE = Y AE0
E0
AE1

E1 AE2

E2

[i]. Aggregate expenditure

45o
0 Y2 Y1 Y0 Real National Income [GDP]
Price Level

E2
P2
E1 [ii]. Aggregate Demand
P1 E0

P0
AD

0 Y0 Real National Income (GDP)

Y2 Y1 Y0
 The relationship between AE and AD curves

At each price level

consistency between
A. Desired Spending,
Total output and
Level of income at
that output.
 Consumption Function

As income increases consumption increases but

not proportionately
C=f(Y)
APC [Average Propensity to consume]
It is the fraction of total income spent on
consumption.
If C=100+0.75Y
APC=C/Y
MPC [Marginal Propensity to Consume]

Symbolically expressed as MPC (b)= ∆C/ ∆Y.

The range 0<b<1
b is always greater than 0 but less than 1.
Multiplier
• The theory of multiplier states that an original new
investment will raise national income by more than
the original investment.
• It is defined as the ratio of the change in income to
the change in investment.
• Then K= ∆Y/ ∆I. As Y=C+I then ∆Y= ∆C+∆I.
• Dividing both sides by ∆Y we get 1= ∆C/∆Y+ ∆I/∆Y.
• ∆I/∆Y=1- ∆C/∆Y Or I/ ∆I/∆Y=1/I-MPC
• K=1/1-b
1. The mpc through remains constant
2. The government activity concerning
taxation is absent
3. There is autonomous investment in the
economy.
4. There is no time lag.
Greater the saving co-efficient, greater is the leakage and
smaller will be the magnitude of K, since K=1/mps and vice
versa.

Leakages:
•Debt cancellation
•Idle deposits-Adv. Inv. Climate/restrictive credit policy
•Liquidity preference
•Financial investments :Sellers of shares may not spend the
proceeds.
•Net Imports
Inflation: Investment after excess capicity
b is always greater than 0 but less than 1.
If b=0, then K=1
Income will increase only by an amount equivalent to an increase in
investment
If b=1, then K=∞
A small increment in investment will lead to an infinite increase in income.
Higher is the mpc greater will be the magnitude of K.
Higher is the mps lower will be the magnitude of K.
Comparative Static Multiplier:
In a comparative static system, given the mpc and single
dosage of investment ,the national income will be found
to grow exponentially and the growth of income will
follow a geometrical progression.
If b= ∆C/∆Y Then investment increases by an
amount equal to ∆I, the increments in income
will follow the folloeing pattern.
Y1= ∆I
Y2= ∆I +b∆I
=(1+b) ∆I
Y3= ∆I +b∆I+ b2∆I=(1+b+b2) ∆I
If b = 0.5 and ∆I=100
Here(1+b+b2+………….. +bn-1 forms a geometrical progression. The
sum of all the terms upto infinity can be determined through the
expression S=a/1-r where S is the sum of all items of a G.P.
upto infinity, a=initial term and r= common ratio.
S=1/1-b
∆Y=1/1-b. ∆I
National Income Determination

AS=C+S

E C+I
Expenditure[Rs billion]
50 200

200 Income [Rs billion]

 Y=C+S
CONSUMPTION AND INVESTMENT

C+I+ ∆I

C+I

Y1 Y2
Income
Remarks of Higgins:
The analysis of the Multiplier Theory conferred a new importance and
new respectability on public investment policy; it was elevated from
the rank of the last line of defence to major offensive strategy.
 An increment in investment will generate an income several times
more than the investment.
 Digging of holes and filling them up.
Relevance of Investment Multiplier in UDCs:
The magnitude of investment multiplier varies directly with the
magnitude of the marginal propensity to consume.
Dr.V.K.R.V. Rao Report
The existence of involuntary unemployment
Disguised Unemployment- Requirement of huge investment to relocate/no
consideration of unemployment by the mass. Disguised unemployment: More
labour force
Limitation : Fuller utilisation of gigantic labour force requires huge
investment.
Increase in investment leads to inflation.

Inelastic supply curve of output.

[Agricultural Pdts(Inelastic). (Increased Inv.-increased demand-increased
Price
Fear of over production and decline in prices.[lack of administered price]
Absence of Excess capacity
If idle capital equipment is available in ample measure a
small injection of investment will set these idle
machines into motion and lead to more output, income.
UDCs: Excess capacity in terms of capital is negligible.
[over utilisation]
The expansion of output and employment in such a
situation requires huge investment rather than a small
injection of new investment.
Supporters of Keynes: Utilisation of Surplus workforce/
Huge Investment.
Inelastic supply of working capital
Lack of banking and institutional finance.
Critics: Strict Standards
Price
level
 The Simple Multiplier and Shifts in the AD Curve
AE = Y

Desired Expenditure
E1 AE1

AE0

E0

∆ A

[i]. Aggregate Expenditure 45o

0 Y0 Y1 Real GDP
Price Level

E0 E1

P0

∆ Y AD1
[i]. Aggregate Demand AD0

0 Y0 Y1 Real GDP
 The simple multiplier and shifts in the AD curve

• A change in autonomous expenditure changes

equilibrium GDP for any given price level, and the
simple multiplier measures the resulting horizontal
shift in the aggregate demand curve.
• The original AE curve is at AE0 with equilibrium at E0,
GDP=Y0 and Price level=P0; the yield point E0 on AD0.
• AE0 shifts to AE1 because of an autonomous expenditure
increase ∆ A, and GDP increases to Y1.
• With given price level P0, the AD curve shifts rightward
to E1.
A Short-run Aggregate Supply Curve
SRAS

Y
Real GDP
 A Short-run Aggregate Supply Curve
SRAS

P0

Y0
Real GDP
 A Short-run Aggregate Supply Curve
SRAS

P1

P0

Y0 Y1
Real GDP
 The short-run aggregate supply curve

• The SRAS curve is positively sloped.

• The positive slope shows that with prices of labour and
other inputs given, total desired output and the price
level will be positively associated.
• A rise in the price level from P0 to P1 will be associated
with a rise in output supplied from Y0 to Y1.
• The slope of the SRAS curve is fairly flat at low levels of
output and very steep at higher levels.
 Macroeconomic Equilibrium

AD
SRAS
Price Level

E0
P0

0 Y0
Real GDP
 Macroeconomic Equilibrium

AD
SRAS
Price Level

E0
P0

P1

0 Y1 Y0 Y2
Real GDP
 Macroeconomic Equilibrium

• Macroeconomic equilibrium occurs at the intersection

of the AD and SRAS curves and determines the
equilibrium values for GDP and the price level.
• Equilibrium occurs at E0 with GDP equal to Y0 and the
price level P0.
• If the price level were P1, below P0, the desired output
of firms would be Y1 but desired demand would be Y2,
so desired spending would exceed desired production.
• Only at E0 are desired plans of producers and
consumers consistent.
 The AE Curve and the Multiplier When the Price Level Varies
AE = Y

Desired Expenditure
AE0

E0

[i]. Aggregate expenditure

45o
0 Y0
Real GDP

SARS
Price Level

P1 E0
P0
[i]. Aggregate demand
AD0

Y0 Real GDP
 The AE Curve and the Multiplier When the Price Level Varies
AE = Y
E’1 AE’1

Desired Expenditure
AE0

∆ A
E0
1

[i]. Aggregate expenditure

45o
0 Y0 Y’1
Real GDP

SARS
Price Level

P1 E0
E’1
P0
1
[i]. Aggregate demand
AD0
Y0 Y1 Y’1 Real GDP
 The AE Curve and the Multiplier When the Price Level Varies
AE = Y
E’1 AE’1

Desired Expenditure
AE1

2 E1 AE0

∆ A
E0
1
[i]. Aggregate expenditure ∆ Y
45
o

0 Y0 Y1 Y’1
Real GDP

SARS
Price Level

E1
P1 E0
2
E’1
P0 AD1
1
[i]. Aggregate demand
AD0
Y0 Y1 Y’1 Real GDP