Aggregate Demand Model and the Multiplier

  • Aggregate Demand Model

    • Y-axis: Aggregate Demand

    • X-axis: Output (Q) or Income (Y)

    • AD=C<em>0+C</em>1Y+I0AD = C<em>0 + C</em>1Y + I_0 (Consumption function plus initial investment)

    • Equilibrium: where AD curve intersects the 45-degree line.

  • The Multiplier Process: Occurs due to disturbances like changes in investment, government expenditure, or net exports.

    • Increase in Investment: Shifts the AD curve upwards (e.g., from I<em>0I<em>0 to I</em>1I</em>1).

    • New Equilibrium: Achieved at the intersection of the new AD curve and the 45-degree line.

    • Process: Firms respond to excess demand by increasing output, leading to a new equilibrium.

    • The multiplier effect guarantees convergence to a new equilibrium.

  • Measuring the Multiplier

    • The distance between the old and new equilibrium on the Y-axis represents the change in output or aggregate demand.

    • The multiplier makes the initial change (e.g., in investment) bigger. For example, a 100millionchangeininvestmentleadstoagreaterthan100 million change in investment leads to a greater than100 million change in output.

  • Types of Multipliers

    • Government Expenditure Multiplier (KG)

    • Aggregate Investment Multiplier (KI)

    • Savings, represented by S, can reduce the multiplier's size, and is counterintuitively a real problem in the aggregate economy because they reduce the size of the multiplier.

  • Paradox of Thrift: Savings are leakages that can reduce the multiplier's size.

    • During COVID, reduced consumption/increased saving lowered the multiplier, impacting government spending effectiveness.

  • Automatic Stabilizers

    • Definition: Changes in government expenditure through taxes or government investment that happen automatically.

    • Goal: To reduce the amplitude of the business cycle.

      • During a boom, stabilize by seeking reduce aggregate demand.

      • During a trough/a slump, seek a recovery of the economy by increasing aggregate demand.

    • Examples:

    • Taxes: Progressive tax system reduces inflationary pressures during economic expansion.

    • Benefits (e.g., unemployment): Increase aggregate demand during economic downturns.

    • Advantage: Automatic, doesn't require government intervention.

    • Disadvantage: May be insufficient during extreme events like COVID, requiring additional discretionary measures.

  • Business Cycle Diagram

    • X-axis: Time

    • Automatic stabilizers aim to lower peaks (through taxes) and raise troughs (through benefits) in the cycle.

    • The ideal calibration prevents excessive drag or pull.