Derivation of Aggregate Demand

8/10/2019 Derivation of Aggregate Demand

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Derivation of Aggregate Demand;

Interrelations between product, Moneyand Labor Market

Qazi Subhan


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Summary

From product market, IS Curve is derived and from

money market LM Curve is derived

With the intersection of IS and LM, Aggregate Demand

would be determined

From Labor Market, we can derive Aggregate Supplywith the help of production function.

At That point where Aggregate Demand and Aggregate

Supply are making intersection, that is the point of

determination for GENERAL EQUILIBRIUM for theeconomy which shows the relationship between General

Price Level and GNP or National Income


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Introduction to Aggregate Demand To capture the concept of Aggregate

demand, following markets should bediscussed

Product Market

Money Market

Labor Market


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Product Market

Product market is concerned with the supplyand demand of consumer goods.

But in Macro economics, National Income

identity equation; Y=C+I+G+(X-M) isdepicting the goods market for the whole

economy.

All the elements of the equation are

concerned with the transaction of tangible

goods.


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Technically

Y = C + I + G +X-M is considered as goodsMarket because in it, all the components of

aggregate expenditure, goods are involved. So any

change in mentioned components would cause a

change in Aggregate Demand. From Product Market, we can derive IS

(Investment Saving) Curve for the derivation of

Aggregate Demand.


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Derivation of IS Curve from product

market

IS (Investment Saving) curve shows negative

relation between rate of interest and national

income.

According to this approach, as rate of interestincreases, Investment would come down. With

decrease in Investment, total national income

would come down due to decrease in economicactivities.


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Shifting factors of IS Curve

Consumption

Government Expenditure

Exports

Imports

Taxes


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Money Market

Money market consists of two market forces

which are involved for the determination of rateof interest and quantity of money. Market forcesare as follows:

Money Demand

Money supply

Money Demand

The people are demanding money for three

purposes; Money Demand for daily Transactions

Money Demand for Precaution

Money Demand for Speculation


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Money Supply Money supply is defined as M1, M2 and M3

M1= Currency + Demand Deposits

M2=M1+Money market mutual funds +Time Deposits + Postal Deposits

M3= M2-Postal deposits

Normally, Money Supply is in the hand of centralbank so it is generally kept fixed in the analysis.


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Derivation of LM Curve from Money

Market

Liquidity of Money (LM) curve can be derived

from money market.

As national income increases, the people aredemanding more money for speculation and

ultimately the rate of interest will increase.

LM curve shows positive relation between

rate of interest and national income


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Shifting Factors of LM Curve

There are two shifting factors of LM Curve

Money Supply

As Money Supply increases, LM Curve Shift to

rightward

Inflation

With an increase in inflation, real money balance

(M/P) would decrease which will cause to shift theLM Curve to left ward.


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Derivation of Aggregate Demand from Product

and Money Market

With the intersection of product and money

market or (with IS and LM), Aggregate

Demand would be determined.

Aggregate demand shows negative relation

between price and national income.


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The downward-sloping ADcurve

An increase in theprice level causes

a fall in real money

balances (M/P),

causing adecrease in the

demand for goods

& services.Y

P

AD


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Shifting Factors of Aggregate Demand

Consumption


Exports

Imports

Taxes

Money Supply


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Shifting the ADcurve

An increase in

the money

supply shifts the

ADcurve to the

right.

Y

P

AD1

AD2


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Derivation of Aggregate Supply

Labor Market

For derivation of Aggregate Supply, we require twothings; Labor Market and Production Function.

In labor market, wages and employment level has beendetermined with the help of two market forces

Labor Demand

Labor Supply

Labor Demand

Labor demand has negative relation with wage

because as wage increases, cost of production wouldincrease. As cost of production increases, it implies thatthe firm would reduce the demand for labor. Briefly,there is reciprocal relationship between wage and labordemand


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Labor Supply

With intersection of labor demand and labor

supply, wage and employment level has beendetermined

Labor supply has positive relation with wage.

As wage increases, the incentives for thelabor would increase and more people are

willing to offer their services at high wage rate

to any organization.


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Derivation of Aggregate supply from Labor

Market

Aggregate Supply can be derived from labormarket and production function.

As employment increases, output will amplify.

An increase in output will cause to increase inGNP because GNP is the value of totalproduct which has been produced by onenation in a specified time period.

The labor market is related to aggregatesupply through production function.


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Interrelations between Labor Market and

Production Function

Aggregate supply is determined with the helpof labor market and production function

Q = f (K, L)

In the labor market, two variables have been

determined; wage, employment level

They are linked with production functionthrough labor.

As employment increases, labor supplywould increase which increases output. Withan increase in output, overall national incomewould increase as can be seen in the nextslide.


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To understand this, lets look at the sources of economic growthwhere

does production come from?

LKAFY ,,

LKAY %%%%

Real GDP

is a function of

Productivity CapitalEmployment

Real GDP

Growth

Capital

Growth

Productivity

Growth

Employment

Growth

Therefore, we should be able to break down economic growth into its individual

components


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Shift in Aggregate Supply

Labor Supply

Labor Demand

Production Techniques

Labor Intensive technology

Capital Intensive Technology Neutral Technology


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Demand Management Policies

Fiscal Policy

Monetary Policy

Exchange Rate Policy


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Fiscal Policy

Definition

Objectives of Fiscal policy

Tools of Fiscal Policy

Kinds of Fiscal Policy

Application of tools of fiscal policy to

Economic situation.


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Definition

Fiscal Policy means that policy which is

formulated by the government to achieve itsobjectives with the help of its tools.

Objectives

Economic Growth

Price stability

Employment Opportunities


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Tools Of Fiscal Policy


Taxes

Direct Tax Indirect Tax

i d f Fi l P li


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Kinds of Fiscal Policy

Contractionary Fiscal Policy (Tax and G )

Expansionary Fiscal Policy (G and Tax )


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Application of Fiscal Policy to the

Economy

Business Cycles

To Product Market

To Money Market

To Labor Market


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Monetary Policy

Definition

Objectives of Monetary policy

Tools of Monetary Policy

Kinds of Monetary Policy

Application of tools of Monetary policy to

Economic situation.


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Definition

Monetary Policy is designed by State Bank to

stabilize the economy with the monetary toolsObjectives

To improve the economic growth

To stabilize the prices To increase employment opportunities


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Tools of Monetary Policy

Bank Rate

Required Reserve Ratio (RRR)

Open Market Operation (OMO)


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Types of Monetary Policy

There are two types

Expansionary Monetary Policy

Bank Rate decrease

RRR decrease

Purchase of Public shares

Contractionary Monetary Policy

Bank Rate Increase

RRR Increase Sale of Public shares


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Application of Monetary Policy

Money Market

Product Market

Labor Market

Business Cycle

Derivation of Aggregate Demand

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