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IFT Notes for Level I CFA® Program

R14 Aggregate Output, Prices and Economic Growth

Part 3


 

3.  Aggregate Demand, Aggregate Supply, and Equilibrium

3.1. Aggregate Demand

Aggregate demand is the quantity of goods and services demanded by consumers (includes households, businesses, government, etc.) at any given price level. The aggregate demand curve (AD) represents the combinations of aggregate income and the price level at which the following two conditions must be satisfied:

  • Actual income must equal planned expenditure. This leads us to the IS curve.
  • There must be equilibrium in the money market. This leads us to the LM curve.

We will cover IS and LM curves later. The graph below shows an AD curve.

econ r16 3.1 1

Interpretation of the graph:

What the graph plots:

  • Price level on the y-axis.
  • Aggregate income and real output on the x-axis.

The demand curve in microeconomics and the AD curve here are both negatively sloped. But there are some major differences as listed below:

  • The demand curve in microeconomics maps the price of one good to the quantity demanded of that good. Ex: oranges. It is the demand curve for one market. Whereas, the AD curve in macroeconomics represents the average price level in an economy (of all the goods and services demanded) using an indicator such as GDP deflator.
  • In microeconomics, we also assume that all other variables such as income and the price of related goods remain constant; and that only the price and quantity demanded of the good change. Whereas in macroeconomics, as we move along the AD curve, income also changes along with the output.

Relationship between saving, investment, fiscal balance, and trade balance

The condition that is the basis for the IS curve is:

Aggregate Income = Aggregate Expenditure

Simply put, aggregate income is the sum of consumption, saving, and taxes. Think of it as how your income gets spent.

Aggregate Income = C + S + T

We saw in the previous section that aggregate expenditure = C + I + G + (X – M)

Equating the two, we get:

C + S + T = C + I + G + (X – M)

S + T = I + G + (X – M)

S = I + (G – T) + (X – M)

Recall that, G-T = fiscal deficit, if Government expenditure (G) > Taxes collected (T). X-M is the trade deficit.

So the above equation can also be rewritten as (G – T) = (S – I) – (X – M)

Or, (S – I) = (G – T) + (X – M)

Consumption spending

  • It is primarily disposable income which is GDP(Y) – business savings – taxes. So, it can be expressed as a function of disposable income.
  • Consumption spending = C(Y – SB ­– T).

Since SB is insignificant, consumption spending = C(Y – T)

  • Marginal propensity to consume (MPC): It is the portion of the additional unit of disposable income that an individual spends.
  • Marginal propensity to save (MPS): It is the portion of the disposable income that is saved.
  • MPS = 1 – MPC. If the marginal propensity to consume is 70% or 0.7, it means that for every $1 increase in disposable income, 70¢ is spent. MPS in this case is 30%.
  • Solved Example 5 in the curriculum shows us one possible consumption function C = 2000 + 0.7 (Y – T).

Consumption increases with an increase in real income, decrease in taxes, or increase in disposable income.

Example

Given that the aggregate expenditure must equal aggregate output, how can we express a government’s fiscal deficit in terms of private saving, investment, and net exports?

Solution:

(G – T) = (S – I) – (X – M)

Example

Because of a decline in housing costs, savings are up. Assume investment and the fiscal deficit are unchanged. What is the impact on net exports and capital outflows?

Solution:

S = I + (G – T) + (X – M)

It is given that I and (G-T) are unchanged. If savings are up, then net exports must also increase.

When net exports increase, then it also leads to the economy investing in foreign assets or lending money to foreigners. So, when savings go up, capital outflows also increase.

Balancing Aggregate Income and Expenditure: the IS Curve

The IS (Investment-Saving) curve gives us all possible combinations of real interest rates and income at which income and expenditure are equal. Equilibrium is at the point where income and expenditure are equal.

  • The IS curve gives us a negative relationship between real interest rates and income. It plots the real interest rate on the y-axis and real income on the x-axis.
  • The constraint to come up with the IS curve is aggregate income = aggregate expenditure.
  • The relationship we arrived at using the constraint above was S-I = (G-T) + (X-M).

Balancing Aggregate Income and Expenditure

The graph below shows an IS curve.

econ r16 3.1 2

Now, we will individually look at the relationship between each of these components and interest rates.

Relationship between investment spending and interest rates and aggregate income:

  • Investment decisions are based on two factors: the level of interest rates and aggregate output/income.
  • Investment and interest rates have a negative relationship. When interest rates are high, firms are less likely to invest as it is more expensive to borrow money. From a corporate finance perspective, you can also think of the interest rate as a hurdle rate. If the hurdle rate is low, then it will attract new investments.
  • If investment spending is up, then aggregate income is up.
  • Combining the two factors, investment I = I(r,Y)
  • where I = investment spending, r = the level of interest rates and Y= aggregate income.

Relationship between government spending/taxes and interest rates:

  • Government spending is an exogenous variable i.e. it is determined outside the model. Government spending is not affected by the level of interest rates, exchange rate, economic activity, etc.
  • Taxes may be considered an exogenous variable, too. But, the amount of net taxes collected depends on income.

Relationship between net exports and interest rates:

  • Net exports depend on income differential and price differential between the domestic economy and the rest of the world.
  • Increase in domestic income results in an increase in demand for imports. Net exports decline.
  • Increase in income in the rest of the world will increase demand for domestic products; net exports will increase.
  • Decrease in relative price of domestic goods will increase demand and increase net exports.

The graph below shows an IS curve.

econ r16 3.1 3

Interpretation of the graph:

  • The downward sloping curve represents the sum of government fiscal balance and trade balance at different levels of income. Income and (G – T) + (X – M) share a negative relationship.
  • As income increases, (G – T) decreases. Since: G is exogenous and T increases with income.
  • As income increases, (X – M) decreases. Since: imports (M) increases with income.
  • The upward sloping curve represents (S – I).
  • As income increases, savings goes up. Investment also goes up but the effect is not as large as that on saving. Overall, (S – I) goes up for a given interest rate, say 5%.
  • The intersection of the upward and downward sloping curves is the equilibrium point; it is the level of income at which income equals expenditure.

What happens when the interest rate decreases from 5% to, let us say, 4%?

  • The (S – I) curve will shift down because a lower interest rate attracts new investments. (I) increases and (S – I) decreases.
  • The new equilibrium point where the two curves intersect corresponds to a higher income level. Lower interest rate requires a higher income level to induce higher savings.
  • Income and interest rate have an inverse relationship.

The IS curve is called so because it is derived from investment and savings. Equilibrium points such as A and B corresponding to different interest rates (5% and 4%, respectively here) help us come up with the IS curve. The corresponding incomes are 100 and 110. Now that you have understood the individual relationships, you can see why the IS curve is downward sloping.

Summary: IS Curve

The key points related to the IS curve are summarized below:

  • Interest rate and investment spending are inversely related.
  • Interest rate and (S – I) are positively related.
  • Investment spending and income are positively related.
  • Net exports and income are inversely related.

Income and interest rate are inversely related.

The IS curve does not tell us the appropriate level of interest rate or the connection between output/income and price level. For this we need the LM curve.


Economics Aggregate Output, Prices, and Economic Growth Part 3