In Chapter 5 and at the beginning of this chapter, we used an Aggregate Demand and Aggregate Supply model to explain business cycle fluctuations in real GDP and employment. In this chapter we have developed a basic explanation for the shifts in AD that cause changes in real output. In the short run:
- wages, prices, money supply, interest rates and exchange rates are assumed to be constant;
- distinction between autonomous and induced expenditures is important; and
- equilibrium real GDP requires output equal to planned aggregate expenditure.
In this model, investment and exports are the main sources of fluctuations in autonomous expenditures. The marginal propensities to consume and import describe the changes in aggregate expenditure caused by changes in income. These induced expenditures are the source of the multiplier. When business changes its investment plans in response to predictions and expectations about future markets and profits, or exports change in response to international trade conditions, the multiplier translates these changes autonomous expenditure into shifts in the AD curve. Shifts in the AD curve cause changes in equilibrium output and employment.
Figure 6.12 shows how this works. Equilibrium real GDP in the upper panel determines the position of the AD curve in the lower panel.
Figure 6.12: Equilibrium GDP and Aggregate Demand
Equilibrium in a) determined the position of the AD curve in b). A change
in autonomous expenditure in a) changes equilibrium Y and shifts AD by
the change in autonomous expenditure times the multiplier.
Initially, equilibrium real GDP at the price level P0 is determined by the equilibrium condition Y0 = A0 + (c − m)Y in the upper panel and by the equilibrium condition AD0 = AS0 in the lower panel.
Changes in autonomous expenditure shift the AD curve. If autonomous expenditure increased from A0 to A1 as shown in Panel a), equilibrium output would increase from Y0 to Y′e. The change in equilibrium output would be (∆A×multiplier). The AD curve would shift to the right to AD1 as a result of the increase in autonomous expenditure. The size of the horizontal shift would be (∆A×multiplier).
This model provides an important first insight into the sources of business cycles in the economy. However, it is a pure private household/private business sector economy. Autonomous consumption, investment, exports and imports, and the multiplier drive real GDP and income and fluctuations in those measures of economic activity. There is no government, and thus no way for government policy to affect real output and employment. There is no financial sector to explain the interest rates and foreign exchange rates that affect expenditure decisions, and thus no monetary policy. In the next few chapters we extend our discussion of aggregate expenditure and aggregate demand to include the government sector and financial sectors, as well as fiscal and monetary policy. The framework becomes a bit more complicated and realistic, but the basic mechanics are still those we have developed in this chapter.