CHAPTER TEN Aggregate Demand I

Transcription

1 CHAPTER TEN Aggegate Demand I 1 The Geat Depession ( ) caused many economists to question the validity of classical economic theoy 1936: John Maynad Keynes wote The Geneal Theoy of Employment, Inteest and Money. A new way to analyze the economy, an altenative to the classical theoy. Keynes poposed that low aggegate demand is esponsible fo the low income and high unemployment Keynesian means diffeent things..., The Keynesian model can be thought of as an elaboation and extension of the classical theoy. Its vaiable velocity of money and sticky sticky pices eflects Keynes belief that the Classical model s shotcomings aose fom its ovely-stict assumptions of constant velocity and highly flexible wages and pices. The Keynesian Model: The model of aggegate demand (AD) can be split into two pats: IS model of the goods maket and the LM model of the money maket. 2 1

2 The Keynesian model: shows what causes the aggegate demand cuve to shift. Consequence: In the shot un, when the pice level is fixed, shifts in the aggegate demand cuve lead to changes in national income, Y. The model of aggegate demand: IS-LM is the leading intepetation of Keynes wok. The IS-LM model takes the pice level as given and shows what causes income to change. It shows what causes AD to shift. Pice Level, P Y* Y*' Y*'' SRAS AD'' AD' AD 3 The IS cuve (investment saving) plots the elationship between the inteest ate and the level of income that aises in the maket fo goods and sevices. The LM cuve (liquidity and money) plots the elationship between the inteest ate and the level of income that aises in the money maket. The inteest ate influences both investment and money demand, it is the vaiable that links the two pats of the IS-LM model. The model shows how inteactions between these makets detemine the position and slope of the aggegate demand cuve, and theefoe, the level of national income in the shot un. 4 2

3 Geneal Theoy of Money, Inteest and Employment (1936): Keynes poposed that an economy s total income was, in the shot un, detemined lagely by the desie to spend by households, fims and the govenment. The moe people want to spend, the moe goods and sevices fims can sell. The moe fims can sell, the moe output they will choose to poduce and the moe wokes they will choose to hie. Thus, the poblem duing ecessions and depessions, accoding to Keynes, was inadequate spending. The Keynesian coss is an attempt to model this insight. 5 How is income Y detemined fo given levels of planned investment I and fiscal policy G and T? (exogenous vaiables) Actual expenditue is the amount households, fims and the govenment spend on goods and sevices (GDP). Planned expenditue is the amount households, fims and the govenment would like to spend on goods and sevices. The economy is in equilibium when: Actual Expenditue = Planned Expenditue o Y=E Expenditue, E How does the economy get to this equilibium? Inventoies! Wheneve the economy is not in equilibium, fims expeience unplanned changes in inventoies, and this induces them to change poduction levels. Changes in poduction influence total income and expenditue, moving the economy towad equilibium. Actual Expenditue, Y=E Planned Expenditue, E = C + I + G Y 2 Y* Y 1 6 3

4 The ole of Govenment Puchases (G) Highe govenment puchases esult in highe planned expenditue, fo any given level of income. Expenditue, E Actual Expenditue, Y=E G A B Planned Expenditue, E = C + I + G Y* Y 1 An incease of G in G aises planned expenditue by that amount fo any given level of income. The equilibium moves fom A to B and income ises. Note that the incease in income Y is highe than G. Thus, fiscal policy has a multiplied effect on income. 7 If govenment spending wee to incease by $1, then you might expect equilibium output (Y) to also ise by $1. But it doesn t! The multiplie shows that the change in demand fo output (Y) will be lage than the initial change in spending. Why? When thee is an incease in govenment spending ( G), income ises by G as well. The incease in income will aise consumption by MPC G, whee MPC is the maginal popensity to consume. The incease in consumption aises expenditue and income again. The second incease in income of MPC G again aises consumption, this time by MPC (MPC G), which again aises income and so on. Similaly, if something in the economy deceases investment spending, then people whose incomes have deceased will spend less, theeby diving equilibium demand down even futhe. The govenment-puchases multiplie is: Y/ G = 1 + MPC + MPC 2 + MPC 3 + = 1 / (1 MPC) The tax multiplie is: Y/ T = - MPC / (1 - MPC) 8 4

5 Let s now add the elationship between the inteest ate and investment to ou model, witing the level of planned investment as: I = I (). The investment function is downwad-sloping showing the invese elationship between investment and the inteest ate. To detemine how income changes when the inteest ate changes, we combine the investment function with the Keynesian-coss diagam. An incease in the inteest ate lowes planned investment I() Investment, I 9 An incease in the inteest ate (gaph a), lowes planned investment, which shifts planned expenditue downwad (gaph b) and lowes income (gaph c). (a) I() (b) E Investment, I (c) Y=E Planned Expenditue, E = C + I + G the IS cuve shows the combinations of the inteest ate and the level of income that ae consistent with the maket equilibium. IS 10 5

6 Begin with the supply of eal money balances (); both of these vaiables ae taken to be exogenously given. This yields a vetical supply cuve. Now, the demand fo eal money balances is L. The theoy of liquidity pefeence suggests that a highe inteest ate lowes the quantity of eal balances demanded, because is the oppotunity Supply cost of holding money. The supply and demand fo eal money balances detemine the inteest ate. At the equilibium inteest ate, the quantity of money balances demanded equals the quantity supplied. Demand, L () 11 L() = Money Demand equals Real Money Balances () d = L (,Y) The quantity of eal money balances demanded is negatively elated to the inteest ate (because is the oppotunity cost of holding money) and positively elated to income (because of tansactions demand). 12 6

7 A Reduction in the Money Supply: M/p Supply' Supply Since the pice level is fixed, a eduction in the money supply educes the supply of eal balances. The equilibium inteest ate ises. Demand, L (,Y) 13 Supply LM 2 1 Y Y Y An incease in income aises money demand, which inceases the inteest ate; this is called an incease in tansactions demand fo money. The LM cuve: the money maket equilibium. L(,Y ) L(,Y) 14 7

8 Supply' Supply LM' LM M /P L (,Y) A contaction in the money supply aises the inteest ate that equilibates the money maket. Why? Because a highe inteest ate is needed to convince people to hold a smalle quantity of eal balances. Result: the LM shifts upwad. Y 15 IS LM(P 0 ) 0 IS cuve/equation: Y= C (Y-T) + I() + G LM cuve/equation: = L(, Y) Y 0 Y IS x LM detemines the level of aggegate demand. This epesents simultaneous equilibium in the maket fo goods and sevices and in the maket fo eal money balances fo given values of govenment spending, taxes, the money supply, Chapte and Ten the pice level. 16 8

9 IS-LM Model IS Cuve LM Cuve Keynesian coss Govenment-puchases multiplie Tax multiplie Theoy of liquidity pefeence 17 9