Transcript Aggregate Demand I

Aggregate Demand I
The Economy in the Short-run
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
1
Introduction
• Here, we continue our study of economic
fluctuations by looking more deeply at
aggregate demand
• In the long-run prices are flexible and
aggregate supply determines income
• In the short-run, prices are sticky, so
changes in aggregate demand influence
income
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
2
Introduction
• In 1936: John Maynard Keynes
revolutionised economics with his book:
The General Theory of Employment,
Interest and Money
• Keynes proposed that low aggregate
demand is responsible for the low income
and high unemployment that characterise
economic downturns
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
3
Introduction
• In previous chapter we derived the aggregate
demand curve very simply using the quantity
theory of money and we showed how monetary
policy shifts the AD curve
• This was an incomplete derivation of the AD
curve
• Here, we provide a complete derivation of the
AD curve and show that fiscal and monetary
policy will affect the AD curve
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
4
Introduction
• The model to explain the AD curve is the
IS-LM model
– It is an interpretation of Keynes’ theory
– IS: stands for investment and saving
• IS curve represents what’s going on in the market
for goods and services
– LM: stands for liquidity and money
• LM curve represents what’s going on in the money
market (demand and supply of money)
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
5
Introduction
• IS-LM Model:
– Model of aggregate demand
– It is based in the short-run, when prices are
sticky
– It shows what causes income to change and
therefore what causes the aggregate demand
curve to shift
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
6
Theory of Short-run Fluctuations
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
7
Summary
• What we will cover in this topic (over 2
chapters):
– Derive the IS curve using the Keynesian cross theory
– Derive the LM curve using the Liquidity Preference
theory
– Put the IS-LM curves together (which maps interest
rates and output)
– Study how fiscal policy shifts the IS curve and
monetary policy shifts the LM
– Use the IS-LM model to derive the aggregate demand
curve
– Use the IS-LM model to show how monetary and
policy , shift
demand curve
Source:fiscal
"Macroeconomics"
Mankiw,the
Fourthaggregate
Edition: Chapter 10,
8
Fifth Edition: Chapter 10
The Goods Market and the IS
Curve
• IS curve: plots the relationship between
the interest rate and the level of income
that arises in the market for goods and
services
• To develop the relationship, we use a
theory called: the Keynesian cross
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
9
The Goods Market and the IS
Curve
– Keynes proposed that in the short run,
economy’s income depended largely on the
desire to spend by households, firms and
the government.
– More people spend, more goods and
services firms can sell, more output will be
produced, more workers will be hired
– Problem during economic recessions:
inadequate spending
– The Keynesian Cross models this proposal
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
10
The Goods Market and the IS
Curve
• The Keynesian Cross:
– Distinction between actual and planned
expenditure
– Actual expenditure = amount households,
firms and the government spend on goods
and services
– Planned expenditure = amount households,
firms and the government would like to spend
on goods and services
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
11
The Goods Market and the IS
Curve
• Keynesian Cross:
– Why would actual and planned expenditure
be different?
– Answer: firms might engage in unplanned
inventory investment if sales do not meet
expectations. Firms sell less of the product
than expected, stock of inventories rises. And
if sales exceed expectations, stock of
inventories falls. These unplanned changes in
inventory are counted as investment spending
by firms
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
12
The Goods Market and IS Curve
• Keynesian cross:
– Determinants of planned expenditure
– Assume economy is closed (no exports or
imports)
– Planned expenditure (E) = sum of
consumption (C), planned investment (I), and
government purchases (G)
E=C+I+G
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
13
The Goods Market and IS Curve
• Keynesian cross:
E = C + I + G : Planned expenditure
– To this we add the consumption function:
C = C(Y-T)
– For now, assume planned investment is fixed
I =I
– Assume government purchases and taxes are fixed
by the government (fixed fiscal policy)
G=G
T=T
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
14
The Goods Market and IS Curve
• Keynesian cross:
E = C(Y-T) + I + G
– Planned expenditure is a function of income
– Graph of planned expenditure
– Upward sloping: higher income leads to
higher expenditure (because higher income
leads to higher consumption, which is part of
planned expenditure)
– Slope of the line is the marginal propensity to
consume
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
15
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
16
The Goods Market and the IS
Curve
• Keynesian Cross
– Planned expenditure: first piece of Keynesian
cross
– Next piece of Keynesian cross: assumption
that the economy is in equilibrium when actual
expenditure equals planned expenditure:
(when people’s plans have been realised,
there is no need to change)
– Recall: Y (GDP) = total income and total
output and total expenditure on goods and
services in economy
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
17
The Goods Market and the IS
Curve
• Keynesian Cross:
– Equilibrium condition:
Actual expenditure = Planned Expenditure
Y=E
– 45-degree line with Y on the horizontal axis
and E on the vertical axis: shows all the points
where the equilibrium condition holds
– Every point on the 45-degree: actual
expenditure equals planned expenditure
– Graph: the Keynesian Cross
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
18
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
19
The Goods Market and the IS
Curve
• Keynesian cross:
– Point A: Equilibrium of the economy, where
planned expenditure equals actual
expenditure (where the planned expenditure
function crosses the 45-degree line)
– How does the economy get to that
equilibrium?
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
20
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
21
The Goods Market and the IS
Curve
• Keynesian cross:
– Suppose GDP or output is at Y1 , then
planned expenditure E1 is less than
production Y1 :
– firms are selling less than they are producing
– Firms add the unsold goods to their stock of
inventories
– This induces firms to layoff workers and
reduce production
– So Y falls
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
22
The Goods Market and the IS
Curve
• Keynesian Cross:
– Suppose GDP or output is at Y2 , then
planned expenditure E2 is greater than
production Y2 :
– Firms are selling more than expected, so they
draw from inventories
– This induces firms to hire more workers and
increase production
– So Y increases
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
23
The Goods Market and the IS
Curve
• In Keynesian cross: given levels of
planned Investment I and fiscal policy, G
(government purchases) and T (taxes)
• Use this to show how income changes
when we change one of these exogenous
variables
• Government purchases: consider how
changes in government purchases affect
the economy
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
24
The Goods Market and the IS
Curve
• Keynesian Cross:
E = C(Y-T) + I + G
– Higher government purchases result in higher
planned expenditure
– If G changes by ΔG then the planned
expenditure function shifts upward (see graph
on next slide)
– Equilibrium in the economy moves from point
A to point B. Increase in G causes Y to
increase
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
25
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
26
The Goods Market and the IS
Curve
• Keynesian cross: (government-purchases
multiplier)
– The change in income is more than what the
change in government purchases was
– i.e. ∆Y is larger than ∆G
– Ratio ∆Y/ ∆G is called the governmentpurchases multiplier: it tells us how much
income rises in response to a €1 increase in
government purchases
– Keynesian cross: the government purchases
multiplier is larger than 1
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
27
The Goods Market and the IS
Curve
• Keynesian cross: (government-purchases
multiplier)
– Why does fiscal policy have a multiplier effect
on income?
– Answer relates to the consumption function:
C = C(Y – T)
– When government purchases increase, this
raises income, Y (Remember Y = E = C + I +
G). This increase in Y in turn increases
consumption, C.
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
28
The Goods Market and the IS
Curve
• Keynesian cross: (government-purchases
multiplier) (cont’d)
– The increase in consumption, in turn,
increases income again, which further
increases consumption and so on.
– How big is the multiplier?
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
29
The Goods Market and the IS
Curve
• Keynesian cross: (government-purchases
multiplier) (cont’d)
– Let’s trace through each step of the change in
income:
Initial change in G = ∆G, so Y (income) changes
by ∆G as well. This increase in income raises
consumption by MPC x ∆G, where MPC =
Marginal Propensity to Consume (as income
increases by €1 the MPC tells us how much
consumption will increase by)
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
30
The Goods Market and the IS
Curve
• Keynesian cross: (government-purchases
multiplier) (cont’d)
– Tracing through each step of the change in
income (cont’d):
The increase in consumption raises income
again, which raises consumption again and so
on.
– Using algebra, the government purchases
multiplier is:
∆Y/ ∆G = 1/(1- MPC)
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
31
The Goods Market and the IS
Curve
• Keynesian cross: (government-purchases
multiplier) (cont’d)
– Example: MPC = 0.6
∆Y/ ∆G = 1/(1- MPC)
= 1/(1 – 0.6)
= 2.5
This says that a €1 increase in government
purchases will lead to a €2.50 increase in
equilibrium income
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
32
The Goods Market and the IS
Curve
• Keynesian cross:
– What if taxes change?
E = C(Y – T) + I + G
– A decrease in taxes raises disposable income
(Y-T) and therefore increases consumption
– Therefore, planned expenditure function shifts
upward
– Economy moves from equilibrium A to
equilibrium B (See graph)
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
33
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
34
The Goods Market and the IS
Curve
• Keynesian Cross: (tax multiplier)
– Just as with an increase in government
purchases, a decrease in taxes has a
multiplied effect on income
– A decrease in taxes by ∆T increases
consumption by MPC x ∆T, which increases Y,
which increases consumption and so on.
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
35
The Goods Market and the IS
Curve
• Keynesian Cross: (tax multiplier)
– Using algebra the tax multiplier is
∆Y/ ∆T = - MPC/(1- MPC)
– Example: MPC = 0.6
∆Y/ ∆T = - 0.6/(1- 0.6) = -1.5
– This says that a €1 cut in taxes raises
equilibrium income by €1.50
Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10,
Fifth Edition: Chapter 10
36