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

Macroeconomic equilibrium in the short run

Introduction The big picture IS- TR Model TR curve IS-TR today and Monday AS-AD: lecture AS: Ch 12 notes (+ IS-TR with parts of capital flows: Ch 13) Wednesday

Outline Cyclical fluctuations 1. Short versus long run 2. Determinants of aggregate demand 3. The Keynesian Cross 4. Equilibrium of demand and supply 1. The Keynesian demand multiplier 2. The IS curve 5.

Fluctuations in real GDP growth (US) Mankiw: Macroeconomics, Seventh Edition

Growth rates of real GDP, consumption, investment Investment Percent 40 growth rate change from 4 quarters 30 earlier 20 Real GDP growth rate 10 0 Consumption growth rate -10 -20 -30 1970 1975 1980 1985 1990 1995 2000 2005 2010

Cyclical Fluctuations Long-term growth trend (+) cyclical deviation Actual real GDP Real GDP (-) cyclical deviation Time  How can we explain these cyclical deviations?  Is it possible to reduce them?

Short versus long run Flexible prices = Money neutrality Income influences demand for money Goods Money Market Market Interest rates affect aggregate demand Sticky prices ≠ Money neutrality  Classical dichotomy holds only when prices are flexible  Prices can be considered flexible in the long run, but are “sticky” in the short run

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 Aggregate supply Demand  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)

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 (+)

Ceteris paribus Desired demand (Exogenous variables) varies (+) Desired demand DD Demand The higher my income, the higher my desired demand Income (Y) 0

Slope of the desired demand function  Simple case: closed economy Desired demand DD = C + I + G DD Δ C  Slope of DD curve: Δ Y  Marginal propensity to consume (MPC)  Assumption: People consume 0 Income a fixed proportion c of income, MPC = c  When Y  : Consumption  , but less than Y  DD   Δ C=c Δ Y  Δ C < Δ Y  Example: c=0.6, Δ Y=10  Δ C=10*0.6=6

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 Ceteris paribus              * DD C , Y T I i q , G P CA Y , Y , varies varies (+) (-) Desired demand DD Question: Is the desired demand curve in the open economy flatter or steeper than in the closed economy? Income (Y) 0

Slope of the desired demand function        Open economy:        * DD C , Y T I i q , G P CA Y , Y , 1. When Y  : DD  by Δ C=c Δ Y (Example: c=0.6, Δ Y=10  Δ C=10*0.6=6) 2. When Y  : Consumption  and thus demand for imports   deterioriates PCA  DD  z% of every unit of C =imports (Z). Δ Z=z Δ C  Δ PCA = - Δ Z <0 ( Ex: z=0.4, Δ Z=0.4*6=2.4  Δ PCA=-2.4)  Total: When Y   DD increases by a lower proportion  that’s why the DD schedule is flatter than the 45° line Δ DD= Δ C – z Δ C =(1 – z)c Δ Y; 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

Demand and supply 45° Y = DD Supply Desired demand Actual output DD Demand Income 0

The equilibrium condition  Equilibrium at the intersection of the two lines 45°  DD Y Supply adjusts D to demand Desired demand, equilibrium in the goods market actual output  i.e. Y =0 C DD    DD Y excess supply of goods   0 Y Y Y´ 0 Income

The 45° Diagram, a.k.a. “ The Keynesian Cross ”  At A, actual output equals desired demand 45° Point A: goods market Desired demand equilibrium DD A     Y     Y C , Y T I i q ,      * G PCA Y Y , , Y 0 Output, income

The Keynesian demand multiplier  Consider the effects of an exogenous increase in public expenditure.                 PCA Y Y  * DD ´ C , Y T I q r , G G , ,  G ´  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: Δ Y > Δ G

The Keynesian demand multiplier 45° Desired demand DD ( Y ) DD A Y 0 Output

The Keynesian demand multiplier                 PCA Y Y  * DD ´ C , Y T I q r , G G , ,  G ´ 45° Government DD´ ( Y ) Desired demand expenditures increase B DD 2 DD ( Y )  G DD 1 A Y 0 Output Output

The Keynesian demand multiplier  Output increases to match increase in demand 45° DD´ ( Y ) Desired demand B DD ( Y ) A´  G Y A Y 0 Output Output

The Keynesian demand multiplier  BA´ increase in income means DD´ increases too 45° DD´ ( Y ) Desired demand B´ B DD ( Y ) A´  G Y A Y 0 Output Output

The Keynesian demand multiplier  Output increases again to meet induced demand, A´B 45° DD´ ( Y ) Desired demand B´ A´´ B DD ( Y ) A´  G Y A Y 0 Output Output

The Keynesian demand multiplier     The government spending multiplier Y G  Tells us how much income rises in response to a 1 € increase in G. 45° DD´ ( Y ) Desired demand E B´ B DD ( Y ) A´  G We talk about the Y A multiplier because Δ Y> Δ G:  Y Y Y* 0 Output Output

The Keynesian demand multiplier  Keynesian demand multiplier : 1   1 c ( 1 z )  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?)

The Keynesian demand multiplier  Slope of the DD schedule affects the demand multiplier: 45° Desired demand DD 2 DD 1 0 Output Output