Aggregate Expenditure and Equilibrium Output. The Core of Macroeconomic Theory.
Macroeconomic equilibrium in the short run
Transcript of Macroeconomic equilibrium in the short run
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Macroeconomic equilibrium
in the short run
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The big picture
Introduction
IS-TR today and Monday
IS-TR with capital flows: Wednesday
AS-AD: lecture notes (+ parts of Ch 13)
AS: Ch 12
TR curve
IS- TR
Model
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Outline
1. Cyclical fluctuations
2. Short versus long run
3. Determinants of aggregate demand
4. The Keynesian Cross
1. Equilibrium of demand and supply
2. The Keynesian demand multiplier
5. The IS curve
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Fluctuations in real GDP growth (US)
Mankiw: Macroeconomics, Seventh Edition
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Growth rates of real GDP, consumption, investment
-30
-20
-10
0
10
20
30
40
1970 1975 1980 1985 1990 1995 2000 2005 2010
Percent
change
from 4
quarters
earlier
Investment growth rate
Real GDP growth rate
Consumption growth rate
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Cyclical Fluctuations
How can we explain these cyclical deviations?
Is it possible to reduce them?
Time
Rea
l G
DP
Long-term growth trend
Actual real GDP
(-) cyclical deviation
(+) cyclical deviation
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Short versus long run
Classical dichotomy holds only when prices are flexible
Prices can be considered flexible in the long run, but are “sticky” in the short run
Goods
Market
Money
Market
Interest rates affect
aggregate demand
Income influences
demand for money
Flexible prices =
Money neutrality
Sticky prices ≠
Money neutrality
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How realistic are sticky prices?
Mankiw: Macroeconomics, Seventh Edition
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Aggregate demand and aggregate supply
Classics long run
Prices are flexible
Aggregate supply (K, L, A) determines income Prices adjust aggregate demand = aggregate supply
Keynes short run
Assumption of sticky prices
Aggregate demand determines output of firms
Prices cannot adjust aggregate demand can differ from supply supply adjusts to demand
Who is right? Both! AD-AS Model accommodates the two different views in one
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Aggregate demand
Today
We start to develop the IS-TR model, the basis of the aggregate demand curve
AD curve: Relation between quantity of output demanded and the aggregate price level (Chapter 13)
We focus on the short run and assume the price level is fixed
Outline
1) What is the aggregate demand?
2) Show how we find the equilibrium between aggregate demand and supply of goods
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Aggregate demand and the goods market
What is aggregate demand?
Y = C + I + G + X - Z
Aggregate supply
Total volume of goods and services brought to the market by producers at a given price level
Aggregate demand
Sum of planned consumption, investment, government purchases of goods and services plus net exports of goods and services PCA: primary current account=net exports of goods and services (X-Z)
Aggregate
supply
Aggregate
Demand
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Actual versus desired expenditure
Y = actual income (or actual output, expenditure)
Production, supply of goods
DD= desired or planned expenditure (C+G+I+PCA)
What amount the economic agents would like to spend given their income Y (level of GDP ) and given that the price level is fixed
Equilibrium
Actual expenditure = desired expenditure
Y = DD
When firms have sold all their output and people were able to buy everything they planned
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Actual versus desired expenditure Why can Y (supply/income) and DD (demand) differ?
Y >DD: Firms did not sell us much as they expected at the given price level.
At the end of the year, they have to buy the rest of their products unplanned increase of investment in inventory
Actual I > planned I (actual expenditure > planned expenditure)
Y <DD: Firms sold more then they had planned because of an unexpected high
demand from the households unplanned decrease of investment in inventory
Actual I< planned I
Study graphically the link between income (Y) and DD 1. Components of the aggregate demand (DD)
2. Keynesian Cross
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The components of aggregate demand
Closed economy: link between DD and Y?
Aggregate demand (DD) = C + G + I
G: public expenditure (assumed exogenous)
I=I(i, q) Chapter 8
i : (real) interest rate (-)
q:Tobin’s q, (measure of entrepreneur’s expectations about the future) (+)
C=C(Ω, Y-T) Chapter 8
Ω: wealth, assumed exogenous (+)
Y-T: disposable income. T=exogenous (+)
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Desired demand
Income (Y)
Desired d
em
and
DD
0
varies
Ceteris paribus
(Exogenous variables)
(+)
Demand
The higher my income,
the higher my desired
demand
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Slope of the desired demand function
Simple case: closed economy
DD = C + I + G
Slope of DD curve:
Marginal propensity to consume (MPC)
Assumption: People consume a fixed proportion c of income, MPC = c
Income
Desired d
em
and
DD
0
When Y : Consumption , but less than Y DD
ΔC=cΔY ΔC < ΔY
Example: c=0.6, ΔY=10 ΔC=10*0.6=6
ΔY
ΔC
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The components of aggregate demand Open economy:
Adding imports and exports (primary current account).
What is aggregate demand for domestic goods and
services?
Aggregate demand (DD) = C + G + I + PCA
PCA =X – Z = Net exports = PCA (Y, Y*, σ)
σ: real exchange rate (-) impacts on our
competitiveness (σ↑ X↓) (exogenous)
Y*: foreign GDP (+) increases our exports (exogenous)
Y: (-) increases our imports
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Desired demand
Income (Y)
Desired d
em
and
DD
0
*, , , ,C T I i q G CA YP YDD Y
varies varies
Ceteris paribus
(+) (-)
Question: Is the
desired demand curve
in the open economy
flatter or steeper than
in the closed
economy?
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Slope of the desired demand function Open economy:
1. When Y : DD by ΔC=c ΔY (Example: c=0.6, ΔY=10 ΔC=10*0.6=6)
2. When Y : Consumption and thus demand for imports deterioriates PCA DD
z% of every unit of C =imports (Z). ΔZ=zΔC ΔPCA = -ΔZ <0
(Ex: z=0.4, ΔZ=0.4*6=2.4 ΔPCA=-2.4)
Total: When Y DD increases by a lower proportion that’s why the DD schedule is flatter than the 45° line
ΔDD=ΔC–zΔC =(1–z)cΔY; slope is given by MPC = (1 – z)c
(Ex: 6 –2.4= (1- 0.4)0.6*10=3.6), MPC = (1-0.4)*0.6= 0.36
*, , , ,C T I i q G CA YP YDD Y
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Demand and supply
Income
De
sire
d d
em
an
d
DD
0
Supply
Demand
Actu
al outp
ut
Y = DD 45°
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The equilibrium condition
Equilibrium at the intersection of the two lines
Desired d
em
and,
actu
al outp
ut
0
equilibrium inthe goods market i.e. =0 Y
DD Y
excess supply of goods
DD Y
0Y
Income
DD
Y ́Y
Supply adjusts
to demand
C
D
45°
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The 45° Diagram, a.k.a. “The Keynesian Cross”
At A, actual output equals desired demand D
esired
dem
and
0
DD
Y
Y
*
, ,
, ,
Y C Y T I i q
G PCA Y Y
A
Output, income
Point A:
goods market
equilibrium
45°
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The Keynesian demand multiplier
Consider the effects of an exogenous increase in public expenditure.
What will be its effect on aggregate income?
1. Increase in desired demand (planned expenditures)
2. Output (and income) will follow and raise also
Effect on actual output is going to be bigger than just the direct effect on demand brought about by the
increase in public expenditure: ΔY > ΔG
*
´
´ , , , ,
G
DD C Y T I q r G G PCA Y Y
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The Keynesian demand multiplier
D
esired d
em
and
Y
DD
45°
DD(Y)
A
Output 0
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The Keynesian demand multiplier
Output
Desired d
em
and
Y
45°
DD (́Y)
A DD1
DD(Y)
Government
expenditures
increase
Output 0
G
B DD2
*
´
´ , , , ,
G
DD C Y T I q r G G PCA Y Y
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B
The Keynesian demand multiplier
Output increases to match increase in demand
Output
Desired d
em
and
A
Y
Y
45°
A ́ DD(Y)
DD (́Y)
Output 0
G
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The Keynesian demand multiplier
BA ́increase in income means DD ́increases too
Output
Desired d
em
and
A
Y
Y
45°
B B ́
DD(Y)
DD (́Y)
Output 0
G
A ́
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The Keynesian demand multiplier
Output increases again to meet induced demand, A B́
Output
Desired d
em
and
Y
Y
45°
B A ́
B ́
DD(Y)
DD (́Y)
A
Output 0
G
A´́
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The Keynesian demand multiplier The government spending multiplier
Tells us how much income rises in response to a 1€ increase in G.
Output
Desired d
em
and
A
Y
Y
45°
B A ́
E
Y*
Y
B ́
DD(Y)
DD (́Y)
Y G
Output 0
G We talk about the
multiplier because
ΔY> ΔG:
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The Keynesian demand multiplier
Keynesian demand multiplier :
The multiplier is bigger…
…the bigger c, the share of my income that I consume
…the lower z, the share of my consumption that I spend on imports Our example: 1/(1-0.6(1-0.4)) = 1.56
This leads to a steeper DD schedule and thus to a higher multiplier
(Why does the multiplier process stop?)
)1(1
1
zc
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The Keynesian demand multiplier
Output
Desired d
em
and
45°
DD1
Output 0
DD2
Slope of the DD schedule affects the demand multiplier:
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Government spending multipliers
one two
Euro area 1.1 1.6
UK 0.8 0.5
USA 1.9 2.2
Belgium 0.9 0.5
Germany 1.2 1.1
Italy 1.0 1.4
Portugal 1.2 1.5
Spain 1.2 1.5
Years after change
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IS curve
IS-curve
graphs all combinations of i and Y that result in goods market equilibrium actual output = planned expenditure (desired demand)
downward sloping
So far: we have kept i, and thus planned investment, fixed
Now let’s see what happens to the DD schedule when i varies
Keep in mind: prices are fixed so: i = r !
Key equation: I = I(i)
lower i higher I higher Y
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Deriving the IS curve
Identifying an equilibrium combination of i and Y
De
sir
ed
de
ma
nd
Output
Inte
rest ra
te
Output
DD i( )
DD
Y Y
Y=DD
i
A
A
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From DD to IS Decrease in i
Equilibrium output will change if the interest rate changes
De
sir
ed
de
ma
nd
Output
Inte
rest ra
te
Output
DD i( )
DD i( )
DD
Y
DD
Y Y Y
Y=DD
i
iB
A
i i
A
B
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i
From DD to IS IS curve derived by finding Y’s for all i’s
The lower i the higher the equilibrium output negative slope
Each point on the IS curve represents equilibrium in the goods market.
De
sir
ed
de
ma
nd
Output
Inte
rest ra
te
Output
DD i( )
DD i( )
DD
Y
DD
Y Y Y
A
IS Y=DD
iB
A
i i B
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The IS curve D
esir
ed
de
ma
nd
Output
Inte
rest ra
te
Output
DD i( )
DD i( )
DD
Y
DD
Y Y Y
A
IS Y=DD
i
iB
A
Excess
supply of
goods
DD i( )
i
B
D
C
D
C
Excess
demand
of goods
Excess supply and excess demand
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Shifting the IS-curve
What shifts the IS curve?
Everything that moves DD will also shift IS except i!
De
sir
ed
de
ma
nd
Output
Inte
rest ra
te
Output
( )DD G,i
A DD
Y
Y=DD
IS
Y
iA
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Exogenous and endogenous variables
Exogenous variables Model Endogenous variables
Example IS curve:
ENDOGENOUS variables: those determined by the model.
hint: those on the axes of the graph move on the curve Example IS curve: Y and i
EXOGENOUS variables: all predetermined variables that affect the endogenous variables
hint: NOT on the axes of the graph but in the equation that determines the curve shift the curve Example IS curve: Ω, T, q, G, Y* (overbar variables)
*, , , ,Y C Y T I q i G PCA Y Y
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De
sir
ed
de
ma
nd
Output
Inte
rest ra
te
Output
( )DD G ,iB
A
DD
Y Y Y
Y=DD
iA
IS
B ( )DD G,i
DD
Y
Exogenous increase in aggregate demand
For example: increase in G
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Exogenous increase in aggregate demand
Similar shift to that from A to B will occur for all other values of the interest rate
De
sir
ed
de
ma
nd
Output
Inte
rest ra
te
Output
( )DD G ,iB
A
DD
Y Y Y
IS ́
Y=DD
iA
IS
B ( )DD G,i
DD
Y
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Shifting the IS curve
Any exogenous change in demand leads to a shift of the IS. Various possible sources:
Exogenous change in G
Exogenous changes in expectations on the economy (through Tobin’s q)
Exogenous change in household wealth
Foreign disturbances (Y* and real exchange rate changes)
“More” outward shift, “Less” inward shift
Real exchange rate depreciation outward sift
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Boom and bust in USA
90
100
110
120
130
140
150
1/95 1/97 1/99 1/01 1/03 1/05 1/07 0
100
200
300
400
500
600
700
Industrial production Housing prices Nasdaq
Source: See text