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AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):

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Macroeconomics ECO 403
VU
LESSON 26
AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued...)
Context
·
Model of aggregate demand & aggregate supply
·
Long run
­  Prices flexible
­  Output determined by factors of production & technology
­  Unemployment equals its natural rate
·
Short run
­  Prices fixed
­  Output determined by aggregate demand
­  Unemployment is negatively related to output
·
Now, we develop the IS-LM model, the theory that yields the aggregate demand curve. We
focus on the short run and assume the price level is fixed.
The Keynesian Cross
·  A simple closed economy model in which income is determined by expenditure.
(due to J.M. Keynes)
·  Notation:
I = planned investment
E = C + I + G = planned expenditure
Y = real GDP = actual expenditure
·  Difference between actual & planned expenditure: unplanned inventory investment
Elements of the Keynesian Cross
C = C ( -T )
Y
Consumption function:
G = G , T =T
Govt policy variables:
For now, investment is exogenous:
I =I
Planned expenditure:
E = C ( -T ) + I + G
Y
Actual expenditure = Planned expenditure
Equilibrium condition:
Y = E
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Macroeconomics ECO 403
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Graphing planned expenditure
E
Planned
Expenditure
E =C +I +G
MPC
1
Income, output, Y
Graphing the equilibrium condition
E
E =Y
Planned
expenditure
45º
Income, output, Y
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Macroeconomics ECO 403
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The equilibrium value of income
E
E =Y
Planned
Expenditure
E =C +I +G
Income, output, Y
Equilibrium
income
An increase in government purchases
E
E =Y
E =C +I +G2
E =C +I +G1
ΔG
Y
ΔY
E1 = Y1
E2 = Y2
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Macroeconomics ECO 403
VU
At Y1, there is now an unplanned drop in inventory, so firms increase output, and income rises
toward a new equilibrium
Solving for ΔY
Y = C + I + G
Equilibrium condition
ΔY = ΔC + ΔI + ΔG
In changes form
ΔC
+ ΔG
Since I is exogenous
=
= MPC × ΔY + ΔG
Because ΔC = MPC ΔY
Collect terms with ΔY on the left side of the equals sign:
(1 - MPC) × ΔY = ΔG
⎛
⎞
1
Finally, solve for ΔY:
ΔY = ⎜
⎟ × ΔG
⎝ 1 - MPC ⎠
The government purchases multiplier
Example: MPC = 0.8
1
ΔY =
ΔG
1 - MPC
1
1
ΔG =
ΔG = 5 ΔG
=
1 - 0.8
0.2
The increase in G causes income to increase by 5 times as much!
Definition: the increase in income resulting from a Re.1 increase in G. In this model, the G
multiplier equals
ΔY
1
=
ΔG
1 - MPC
In the example with MPC = 0.8,
ΔY
1
=
ΔG
1 - MPC
Why the multiplier is greater than 1
·
ΔY = ΔG.
Initially, the increase in G causes an equal increase in Y:
·
⇒ ↑C
But ↑Y
⇒ Further ↑Y
⇒ Further ↑C
⇒ Further ↑Y
·
So the final impact on income is much bigger than the initial ΔG.
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Macroeconomics ECO 403
VU
An increase in taxes
E
E =Y
E =C1 +I +G
E =C2 +I +G
At Y1, there is now an
ΔC = -MPC ΔT
unplanned
inventory buildup...
Y
ΔY
E2 = Y2
E1 = Y1
Initially, the tax increase reduces consumption, and therefore E: so firms reduce output, and
income falls toward a new equilibrium
Solving for ΔY
ΔY = ΔC + ΔI + ΔG
Equilibrium condition in changes
I and G are exogenous
= ΔC
= MPC × (  ΔY - ΔT
)
(1 - MPC) × ΔY = - MPC × ΔT
Solving for ΔY:
⎛ - MPC ⎞
Final result:
ΔY = ⎜
⎟ × ΔT
⎝ 1 - MPC ⎠
The Tax Multiplier
Definition: the change in income resulting from a $1 increase in T:
ΔY
- MPC
=
ΔT
1 - MPC
If MPC = 0.8, then the tax multiplier equals
ΔY
- 0.8
- 0.8
=
=
= -4
ΔT
1 - 0.8
0.2
Properties of Tax Multiplier
1. Tax multiplier is negative: A tax hike reduces consumer spending, which reduces
income.
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Macroeconomics ECO 403
VU
2. Tax multiplier is greater than one (in absolute value): A change in taxes has a
multiplier effect on income.
3. Tax multiplier is smaller than the govt. spending multiplier: Consumers save the
fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller
than from an equal increase in G.
The IS curve
Definition: a graph of all combinations of r and Y that result in goods market equilibrium,
i.e. actual expenditure (output) = planned expenditure
The equation for the IS curve is:
Y = C ( - T ) + I (r ) + G
Y
Deriving the IS curve
E =Y
E
E =C +I (r2 )+G
E =C +I (r1 )+G
ΔI
Y
Y1
Y2
r
r1
r2
IS
Y1
Y2
Y
↓r
⇒ ↑I
⇒ ↑E
⇒ ↑Y
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Table of Contents:
  1. INTRODUCTION:COURSE DESCRIPTION, TEN PRINCIPLES OF ECONOMICS
  2. PRINCIPLE OF MACROECONOMICS:People Face Tradeoffs
  3. IMPORTANCE OF MACROECONOMICS:Interest rates and rental payments
  4. THE DATA OF MACROECONOMICS:Rules for computing GDP
  5. THE DATA OF MACROECONOMICS (Continued…):Components of Expenditures
  6. THE DATA OF MACROECONOMICS (Continued…):How to construct the CPI
  7. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES
  8. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  9. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  10. NATIONAL INCOME: WHERE IT COMES FROM AND WHERE IT GOES (Continued…)
  11. MONEY AND INFLATION:The Quantity Equation, Inflation and interest rates
  12. MONEY AND INFLATION (Continued…):Money demand and the nominal interest rate
  13. MONEY AND INFLATION (Continued…):Costs of expected inflation:
  14. MONEY AND INFLATION (Continued…):The Classical Dichotomy
  15. OPEN ECONOMY:Three experiments, The nominal exchange rate
  16. OPEN ECONOMY (Continued…):The Determinants of the Nominal Exchange Rate
  17. OPEN ECONOMY (Continued…):A first model of the natural rate
  18. ISSUES IN UNEMPLOYMENT:Public Policy and Job Search
  19. ECONOMIC GROWTH:THE SOLOW MODEL, Saving and investment
  20. ECONOMIC GROWTH (Continued…):The Steady State
  21. ECONOMIC GROWTH (Continued…):The Golden Rule Capital Stock
  22. ECONOMIC GROWTH (Continued…):The Golden Rule, Policies to promote growth
  23. ECONOMIC GROWTH (Continued…):Possible problems with industrial policy
  24. AGGREGATE DEMAND AND AGGREGATE SUPPLY:When prices are sticky
  25. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  26. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…):
  27. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  28. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  29. AGGREGATE DEMAND AND AGGREGATE SUPPLY (Continued…)
  30. AGGREGATE DEMAND IN THE OPEN ECONOMY:Lessons about fiscal policy
  31. AGGREGATE DEMAND IN THE OPEN ECONOMY(Continued…):Fixed exchange rates
  32. AGGREGATE DEMAND IN THE OPEN ECONOMY (Continued…):Why income might not rise
  33. AGGREGATE SUPPLY:The sticky-price model
  34. AGGREGATE SUPPLY (Continued…):Deriving the Phillips Curve from SRAS
  35. GOVERNMENT DEBT:Permanent Debt, Floating Debt, Unfunded Debts
  36. GOVERNMENT DEBT (Continued…):Starting with too little capital,
  37. CONSUMPTION:Secular Stagnation and Simon Kuznets
  38. CONSUMPTION (Continued…):Consumer Preferences, Constraints on Borrowings
  39. CONSUMPTION (Continued…):The Life-cycle Consumption Function
  40. INVESTMENT:The Rental Price of Capital, The Cost of Capital
  41. INVESTMENT (Continued…):The Determinants of Investment
  42. INVESTMENT (Continued…):Financing Constraints, Residential Investment
  43. INVESTMENT (Continued…):Inventories and the Real Interest Rate
  44. MONEY:Money Supply, Fractional Reserve Banking,
  45. MONEY (Continued…):Three Instruments of Money Supply, Money Demand