Ch 3: Aggregate Demand and Aggregate Supply Analysis PDF

Ch 3: Aggregate Demand and Aggregate Supply Analysis in a Closed Economy In this chapter, we will learn:  The Keynesian Cross;  Fiscal Policy Multipliers;  The IS curve, and its relation to the Keynesian cross;  The loanable funds model ,  The LM curve, and its relation to the theory of liquidity preference ;  How the IS-LM model determines income and the interest rate in the short run when P is ﬁxed. Addis Ababa University School of Commerce 1 Ch. 3.1 Introduction  What explains a large and sudden economic downturn? And, how can policy intervention correct this?  This part of macro theory is often called the Keynesian model. Keynes proposed that, low Aggregate Demand (AD) is responsible, for the low income and high unemployment that characterize economic downturns. Addis Ababa University School of Commerce 2 Basic Assumption of the Model  Prices are exogenous or constant.  Output is demand-determined.  It is a short-term analysis.  It is a static model.  It is assumed a closed economy. Addis Ababa University School of Commerce 3 The Keynesian Cross  Isa simple closed economy model in which income is determined by expenditure. (Due to J.M. Keynes).  Notation: Y = real GDP = actual expenditure E = C + I + G = planned expenditure I = planned investment, C = Consumption, G = Government spending, T = Tax  Difference between actual and planned expenditure is = unplanned inventory investment Addis Ababa University School of Commerce 4 Elements of the Keynesian Cross Consumption function: C C (Y T ) Govt policy variables: G G , T T , I  I Planned Expenditure: E C (Y T ) I G Equilibrium condition: Actual expenditure = Planned Expenditure Y  E Addis Ababa University School of Commerce 5 Graphing Planned Expenditure E planned expenditure E =C +I +G Y , income, output, Addis Ababa University School of Commerce 6 Graphing the Equilibrium Condition E E =Y planned expenditure 45º Y , income, output Addis Ababa University School of Commerce 7 THE EQUILIBRIUM VALUE OF INCOME E E =Y planned expenditure E =C +I +G Y, income, output Equilibrium income Addis Ababa University School of Commerce 8 AN INCREASE IN GOVERNMENT PURCHASES ( G) E Y = If G increases E E =C +I +G2 at E1 = Y1, there is an E =C +I +G1 unplanned drop in inventory… …so ﬁrms increase output, and income rises G toward a new equilibrium, E2 = Y2. Y Y E1 = Y1 E2 = Y2 Addis Ababa University School of Commerce 9 FISCAL POLICY AND THE MULTIPLIER Equilibrium condition Y  C  I  G in changes Y  C  I  G  C  G (Assume I is exogenous, and ∆I = 0) (C = MPC Y ) Y  M P C  Y  G Collect terms with Y on the left side of the equal’s sign: Solve for Y :  1  Y    G 1  MPC  (1  M P C )  Y  G Addis Ababa University School of Commerce 10 The Government Purchases Multiplier Deﬁnition: It is the increase in income resulting from a 1 birr increase in G. In this model, the government purchases multiplier equals Y 1  G 1  MPC Example: If MPC = 0.8, then An increase in G causes Y 1   5 income to increase 5 G 1  0.8 times as much! Addis Ababa University School of Commerce 11  Initially, the increase in G causes an equal increase in Y: Y = G.  But Y  C, C = f(Y) C  further Y, Y = C + I + G Y  further C C  further Y  So, the ﬁnal impact on income is much bigger than the initial G. Addis Ababa University School of Commerce 12 TAXES MULTIPLIER Initially, the tax increase reduces E Y consumption, C, = E E =C1 +I +G and therefore reduces E: E =C2 +I +G At E1 =Y1, there is now an C = MPC(Y – T) unplanned inventory buildup… C = MPC(Y - T) …so ﬁrms reduce output, and income, Y falls toward a new E2 = Y2 Y Y equilibrium E1 = Y1 Addis Ababa University School of Commerce 13 Addis Ababa University School of Commerce 14 Addis Ababa University School of Commerce 15 The Tax multiplier …is negative: A tax increase reduces C, which reduces income. …is greater than one (in absolute value): A change in taxes has a multiplier effect on income. …is smaller than the government 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. Addis Ababa University School of Commerce 16  Addis Ababa University School of Commerce 17  Intuition: Why is the balanced budget multiplier less than the multiplier without balancing the budget? Answer: In the balanced budget case, the government has to raise T by 1br when it raises G by 1br. Raising T will lower output, but by less than the G raising output. The net result is a higher level of output, but less than if the government did not have to simultaneously raise taxes. Exercise: Use a graph of the Keynesian cross to show the effects of an increase in planned investment on the equilibrium level of income/output. Addis Ababa University School of Commerce 18 Calculating Equilibrium Income Disposable Income, Yd, is the net income, Yd = Y + TR – TA C=͞ C + c(Yd ) , c = MPC =͞C + c (Y + TR – TA) We assume that G=͞ G constant government purchases TR = T͞R constant transfer TA = tY government collects propor tional income tax collecting a fraction t of income Y in the form of taxes. Substituting, C=͞ C + c(Y + T͞ C + cY + cT͞ R – tY) = ͞ R – ctY C=͞ C + cT͞R + cY – ctY = ͞C + cT͞ R + c (1 – t)Y Addis Ababa University School of Commerce 19 Combining for E, planned expenditure (i.e. AD) E = AD = C + I + G, where, I = ͞ I,G=͞ G C + c (T͞ =͞ R) + c (1 – t)Y + ͞ I+͞ G C + cT͞ AD = ( ͞ R+͞ I+͞ G) + c (1 – t)Y E = AD = ͞ A + c (1 – t)Y, where, C + cT͞ A=(͞ ͞ R+͞ I+͞ G) is autonomous spending Addis Ababa University School of Commerce 20 Addis Ababa University School of Commerce 21 Interest Rate and Investment We specify an investment spending function of the form I = I– br , b > 0 …..eqn. 1 where, r is the rate of interest, b is coefﬁcient that measures the responsiveness of investment spending (I ) to the interest rate (r ). I͞now denotes autonomous investment spending, that is investment independent of both income and interest rate. Addis Ababa University School of Commerce 22 The Investment curve is negatively sloped, reﬂecting the assumption that a decline in r increases the proﬁtability of additions to the capital stock, and, therefore, leads to a larger rate of planned investment spending. Graph 1. Changes in autonomous spending, ͞ I shifts the investment schedule curve. i.e., if ͞ I increases, ﬁrms plan to invest more at each level of the interest rate; and the investment curve shifts outward. Addis Ababa University School of Commerce 23 Interest Rate and AD: The IS – Curve Planned spending, E (AD) still consists of C + I + G Investment spending, is now not only ͞ I, depends on the interest rate, too, I = f(r ). Then with the investment function, I = ͞ I – br, included the planned spending E = AD = C + I + G will be: C + cT͞ AD = [ ͞ R + c (1 – t)Y] + ( ͞ I – br ) + ͞ G =[͞C + cT͞R+͞ I+͞ G] + c (1 – t)Y – br = A + c (1 – t) Y – br Addis Ababa University School of Commerce 24 AD = ͞ A + c (1 – t) Y – br …. eqn. 2. where, C + cT͞ A = [͞ ͞ R+͞ I+͞ G], is autonomous spending. From eqn. 2, we see that an increase in r reduces AD for a given level of income, because a higher r reduces investment spending. Note that ͞ A, which is the part of AD unaffected by either the level of income (Y) or the interest rate (r ), includes part of investment spending, ͞ I. Addis Ababa University School of Commerce 25 At any given r we can determine the equilibrium level of income, output (Yo). As the interest rate ( r ) changes, however, the equilibrium level of income (Yo) changes. Addis Ababa University School of Commerce 26 ***The IS curve Deﬁnition: It is a graph of all combinations of r and Y that result in goods market equilibrium, Y=E (actual expenditure = planned expenditure, AD) The equation for the IS curve is: Y  C (Y  T )  I ( r ) G  The IS curve shows a set of combinations of interest rate (r) and income levels (Y) for which, the commodity market is in equilibrium. I Addis Ababa University School of Commerce 27 DERIVING THE IS CURVE E =Y E =C +I (r2 )+G E r  I E =C +I (r1 )+G  E I  Y Y1 Y2 r Y r1 r2 IS Y1 Y2 Y Addis Ababa University School of Commerce 28 Graph 2 also shows how the IS curve is derived. For a given level of the interest rate, say r1, the last term of eqn.2. is a constant (br1 ), and we can draw the AD function in Graph 2, with an intercept (͞ A ͞ – br1) this time. The equilibrium level of income obtained is Y1 at point E1. Since that level of equilibrium income is derived for a given level of the interest rate r1, (r1 , Y1) is plotted as point E1 at the bottom part of Graph 2. Addis Ababa University School of Commerce 29 This gives us one point, E1, on the IS curve, that is, one combination of the interest rate and income (r1, Y1) which clears the goods market. Consider next a lower interest rate, r2. Investment spending, I, is higher when the interest rate falls. In terms of Graph 2, that implies an upward shift of the AD Curve. The curve shifts upward because the intercept, ( ͞ A – br) increased. Addis Ababa University School of Commerce 30 Given the increase in AD, the equilibrium shifts to point E2, with an associated income level Y2. At point E2, interest rate r2 implies the equilibrium level of Y2 in the goods market. Thus point E2 is another point on the IS – curve. By applying the same procedure to all conceivable levels of the r, we generate all the points that make up the IS– curve. Addis Ababa University School of Commerce 31 These points have the common property that, they represent combinations of r and Y at which the good’s market clears. So, the curve is called the goods market equilibrium curve. Addis Ababa University School of Commerce 32 ***Why the IS curve is negatively sloped  A fall in the interest rate (r ) motivates ﬁrms to increase investment spending ( I ), which drives up total planned spending (E ).  To restore equilibrium in the goods market, output i.e., actual expenditure (Y ) must increase. Graph 2 shows that the IS –curve is negatively- sloped, reﬂecting the increase in AD associated with a decrease in r. Addis Ababa University School of Commerce 33 Addis Ababa University School of Commerce 34 THE IS CURVE AND THE LOANABLE FUNDS MODEL  (a) The L.F. model (b) The IS curve As r increases, I r S2 S1 r decreases, AD decreases. So, Y should r2 decrease. r2 r1 r1 I (r ) IS S, I Y Y2 Y1 Addis Ababa University School of Commerce 35 FISCAL POLICY AND THE IS CURVE  We can use the IS – LM model to see how ﬁscal policy (change in G and T ) affects aggregate demand and output.  Let’s start by using the Keynesian cross to see how ﬁscal policy shifts the IS curve… Addis Ababa University School of Commerce 36 SHIFTING THE IS CURVE: G E E =Y At a given r, An G  E  Y E =C +I (r1 )+G1 …so the IS curve shifts to the right. r Y1 Y2 Y The horizontal distance of the r1 IS shift equals 1 Y  G Y 1 M P C IS2 YIS1 Y1 Y2 Addis Ababa University School of Commerce 37 Exercise: Shifting the IS-Curve, T  Use the diagram of the Keynesian cross to show how an increase in taxes shifts the IS curve. Addis Ababa University School of Commerce 38 The Quantity Theory of Money  is a simple theory linking the inﬂation rate to the growth rate of the money supply. The theory begins with a concept called “velocity”…  Money is the stock of assets that can be readily used to make transactions.  Money has three purposes (functions): store of value - transfers purchasing power from the present to future. unit of account – serves as the common unit by which everyone measures prices and values. medium of exchange - used to buy goods and services. People hold money to buy goods and services. Addis Ababa University School of Commerce 39  The link between transaction and money is expressed in quantity equation. MV = PY where, M = Money(Nominal) , V = Velocity, P = Price, Y = Total output Velocity measures the rate at which money circulates in the economy. Real money balance is M/P Addis Ababa University School of Commerce 40  Addis Ababa University School of Commerce 41 How can the Central Bank control money supply? Three Instruments:  Open Market Operations (through selling and buying of bonds and securities).  Reserve requirements ratio  Discount Rate Addis Ababa University School of Commerce 42 The Theory of Liquidity Preference Due to John Maynard Keynes, a simple theory in which, the interest rate is determined by money supply and money demand Money Supply The nominal quantity of money, M is controlled by the central bank ; it is taken as given at the level ͞ M. The ‘price level’ is assumed constant at the level ͞ P. So, the real money supply is at the level ͞ M/ ͞ P. Addis Ababa University School of Commerce 43 s The supply of r M P  real money inte balances rest is ﬁxed: rate s M P  M P M P M/P real money balances Addis Ababa University School of Commerce 44 MONEY DEMAND r Demand for intere real money st rate balances: d M P   L (r ) L (r ) M/P real money balances Addis Ababa University School of Commerce 45 Addis Ababa University School of Commerce 46 Addis Ababa University School of Commerce 47 The demand for real balances, which we denoted by L, is thus expressed as L = kY – hr , k, h > 0 The parameters k and h reﬂect the sensitivity of the demand for real balances L, to, the level of income, Y and the interest rate, r, respectively. Addis Ababa University School of Commerce 48 Equilibrium r The interest rate, r , s inter M P  adjusts to equate est the supply and rate demand for money: r1 M P  L (r ) L (r ) M P M/P real money balances Addis Ababa University School of Commerce 49 How the Central Bank Changes the Interest Rate r inter To increase r, est Central bank rate reduces M; r2 r1 L (r ) M/P M 2 M 1 real money P P balances Addis Ababa University School of Commerce 50 The LM curve Placing Y into the money demand function: d M P   L ( r ,Y ) The LM curve is a graph of all combinations of r and Y that equate the supply and demand for real money balances. The equation for the LM curve is: M P  L ( r ,Y ) Addis Ababa University School of Commerce 51 Deriving the LM Curve An increase in r reduces the demand for real balances; and to maintain equilibrium (L = the ﬁxed real balance, M/P), the level of income Y must increase (so that the demand for real balances rises). Accordingly, the money market equilibrium implies that an increase in r is accompanied by an increase in Y. The LM – curve is positively sloped. Addis Ababa University School of Commerce 52 (a) The market for (b) The LM curve real money balances r r LM r2 r2 r1 L (r , Y2 ) r1 L (r , Y1 ) M M/P Y1 Y2 Y 1 P Addis Ababa University School of Commerce 53 Why the LM curve is upward sloping  An increase in income (Y) raises money demand. There is now excess demand in the money market at the initial interest rate, since the supply of real balances is ﬁxed  The interest rate (r) must rise to reduce money demand and restore equilibrium in the money market.  The LM – curve, or money market equilibrium curve, therefore, shows all combinations of r and Y such that, the demand for real balances is equal to the supply. Along the LM – curve the money market is in equilibrium. Addis Ababa University School of Commerce 54 The LM – Equation The equation for the LM – curve can be obtained directly by combining the equations of : the demand curve for real balances, L = kY – hr , and the ﬁxed supply of real balances, (͞ m/͞ p). For the money market to be at equilibrium, demand must equal supply, kY – hr = ͞m/͞ p Solving for the interest rate, we get, r = 1/h(kY – ͞m/ ͞ p ), the equation of the LM – curve. Addis Ababa University School of Commerce 55 How M shifts the LM curve The real money supply ( ͞ p ) is held constant along the LM m/͞ curve. So a change in ( ͞ p ) will shift the LM – curve. m/͞ In the graph below, with the initial real money supply, ͞ m2/ ͞ p, the equilibrium is with interest rate r1. If the money supply decreases to ( ͞ m1/ ͞ p ), the vertical money supply curve shifts leftward. To restore money market equilibrium, at the income level Y1, the interest rate, r must increase to r2. The increase in r implies that the LM – curve shifts to the left, to LM2. Addis Ababa University School of Commerce 56 (a) The market for (b) The LM curve real money balances r r LM2 LM1 r2 r2 r1 r1 L (r , Y1 ) M/P Y M 2 M of Commerce Y1 Addis Ababa University School 1 57 P Thus, with decrease in M, at each level of income, the equilibrium r has to be higher for people to hold less real quantity of money. -Or, alternatively, at each level of the interest rate the level of income Y has to be lower to reduce the transactions demand for money, and thereby hold less real money supply. Similarly, increases in the supply of real money balances shift the LM – curve to the right. Addis Ababa University School of Commerce 58 The Short-run equilibrium The short-run equilibrium is the combination of r and Y that satisﬁes the simultaneous equilibrium conditions in the goods & money markets: r LM M P  L ( r ,Y ) Equilibrium interest Y C (Y T ) I (r ) G rate IS Y Equilibrium level of income Addis Ababa University School of Commerce 59 SUMMARY Keynesian  IS Cross curve IS-LM model Explanation of Theory of LM short-run Liquidity curve ﬂuctuations Preference Agg. demand Model of curve Agg. Demand Agg. and Agg. supply Supply curve Addis Ababa University School of Commerce 60

Ch 3: Aggregate Demand and Aggregate Supply Analysis PDF

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