Macroeconomic equilibrium in the short run Introduction The big - - PowerPoint PPT Presentation

Macroeconomic equilibrium in the short run

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

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

Fluctuations in real GDP growth (US)

Mankiw: Macroeconomics, Seventh Edition

Growth rates of real GDP, consumption, investment

• 30
• 20
• 10

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

Cyclical Fluctuations

 How can we explain these cyclical deviations?  Is it possible to reduce them?

Time Real GDP

Long-term growth trend Actual real GDP (-) cyclical deviation (+) cyclical deviation

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

How realistic are sticky prices?

Mankiw: Macroeconomics, Seventh Edition

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

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

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

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

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

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 (+)

Desired demand

Income (Y) Desired demand DD

varies Ceteris paribus (Exogenous variables)

(+) Demand

The higher my income, the higher my desired demand

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 demand

DD

 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

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

Desired demand

Income (Y) Desired demand DD

 

 

 

      

*

, , , , C T I i q G CA Y P Y DD Y

varies varies Ceteris paribus

(+) (-)

Question: Is the desired demand curve in the open economy flatter or steeper than in the closed economy?

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 Y P Y DD Y

Demand and supply

Income Desired demand DD Supply Demand Actual output Y = DD 45°

The equilibrium condition

 Equilibrium at the intersection of the two lines

Desired demand, actual output





equilibrium in the goods market i.e. =0 Y

DD Y   

excess supply

• f goods

DD Y

  0 Y

Income DD Y´ Y

Supply adjusts to demand

C D 45°

The 45° Diagram, a.k.a. “The Keynesian Cross”

 At A, actual output equals desired demand

Desired demand DD

Y Y

 

 

 

      

*

, , , , Y C Y T I i q G PCA Y Y

A Output, income

Point A: goods market equilibrium

45°

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 



       

The Keynesian demand multiplier

Desired demand Y DD 45° DD(Y) A Output

The Keynesian demand multiplier

Output Desired demand Y 45° DD´(Y) A DD1 DD(Y)

Government expenditures increase

Output

G

B DD2

 

  

  

* ´

´ , , , ,

G

DD C Y T I q r G G PCA Y Y 



       

B

The Keynesian demand multiplier

 Output increases to match increase in demand

Output Desired demand A Y Y 45° A´ DD(Y) DD´(Y) Output

G

The Keynesian demand multiplier

 BA´ increase in income means DD´ increases too

Output Desired demand A Y Y 45° B B´ DD(Y) DD´(Y) Output

G

A´

The Keynesian demand multiplier

 Output increases again to meet induced demand, A´B

Output Desired demand Y Y 45° B A´ B´ DD(Y) DD´(Y) A Output

G

A´´

The Keynesian demand multiplier

 The government spending multiplier

 Tells us how much income rises in response to a 1€ increase in G.

Output Desired demand A Y Y 45° B A´ E Y* Y B´ DD(Y) DD´(Y)

Y G   

Output

G

We talk about the multiplier because ΔY> ΔG:

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

• n 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 z c  

The Keynesian demand multiplier

Output Desired demand 45° DD1 Output DD2

 Slope of the DD schedule affects the demand multiplier:

Government spending multipliers

• ne

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

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

Deriving the IS curve

 Identifying an equilibrium combination of i and Y Desired demand Output Interest rate Output

DD i ( ) DD Y Y

Y=DD

i

A A

From DD to IS

 Decrease in i  Equilibrium output will change if the interest rate

changes

Desired demand Output Interest rate Output

 DD i ( ) DD i ( ) DD Y  DD

 Y Y  Y

Y=DD

 i

i

B A

 i i

A B

 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.

Desired demand Output Interest rate Output

 DD i ( ) DD i ( ) DD Y  DD  Y Y  Y A

IS Y=DD

i

B A  i i B

The IS curve

Desired demand Output Interest rate Output

 DD i ( ) DD i ( ) DD Y  DD  Y Y  Y A

IS Y=DD

 i

i

B A

Excess supply of goods

 DD i ( )

 i

B D C D C

Excess demand

• f goods

 Excess supply and excess demand

Shifting the IS-curve

• What shifts the IS curve?
• Everything that moves DD will also shift IS  except i!

Desired demand Output Interest rate Output

( ) DD G,i A DD

Y

Y=DD IS

Y

i

A

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       

Desired demand Output Interest rate Output

( ) DD G ,i  B A DD  Y

Y  Y

Y=DD

i

A

IS

B ( ) DD G,i DD

Y

Exogenous increase in aggregate demand

 For example: increase in G

Exogenous increase in aggregate demand

 Similar shift to that from A to B will occur for all other

values of the interest rate

Desired demand Output Interest rate Output

( ) DD G ,i  B A DD  Y

Y  Y

IS´ Y=DD

i

A

IS

B ( ) DD G,i DD

Y

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

Boom and bust in USA

90 100 110 120 130 140 150 1/95 1/97 1/99 1/01 1/03 1/05 1/07 100 200 300 400 500 600 700

Industrial production Housing prices Nasdaq Source: See text