Chapter 10 Aggregate Demand I

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1 Chapte 0 Aggegate Demand I CHATR 0 0 CHATR 0 Leaning Objectives Chapte 9 intoduced the model of aggegate demand and aggegate supply. Long un (Classical Theoy) pices flexible output detemined by factos of poduction & technology unemployment equals its natual ate Shot un (Keynes) pices fixed output detemined by aggegate demand unemployment is negatively elated to output CHATR 0 2 Leaning Objectives This chapte develops the -LM model (Hicks), the theoy that yields the aggegate demand cuve. We focus on the shot un and assume the pice level is fixed. CHATR 0 3 Keynesian Coss Theoy of Liquidity efeence The Big ictue cuve LM cuve -LM model Agg. demand cuve Agg. supply cuve Model of Agg. Demand and Agg. Supply xplanation of shot-un fluctuations CHATR 0 4. The Cuve. The Keynesian Coss A simple closed economy model in which income is detemined by expenditue. (due to Keynes) Notation: C + I + G planned expenditue eal GD actual expenditue Diffeence between actual & planned expenditue: unplanned inventoy investment CHATR 0 5

2 . The Keynesian Coss consumption function: govt policy vaiables: fo now, investment is exogenous: planned expenditue: quilibium condition: Actual expenditue C C ( T ) G G, T T I I C ( T ) + I + G lanned expenditue CHATR 0 6. The Keynesian Coss lanned xpenditue planned expenditue MC C +I +G income, output, CHATR 0 7. The Keynesian Coss quilibium Condition planned expenditue. The Keynesian Coss planned expenditue C +I +G 45º income, output, CHATR 0 8 quilibium income income, output, CHATR 0 9. The Keynesian Coss An incease in govenment puchases At, thee is now an unplanned dop in inventoy so fims incease output, and income ises towad a new equilibium G C +I +G 2 C +I +G 2 2. The Keynesian Coss An incease in govenment puchases C + I + G C + I + G C + G MC + G Collect tems with on the left side of the equals sign: ( MC) G equilibium condition in changes because I exogenous b.c. C MC ( - T) Finally, solve fo : G MC CHATR 0 0 CHATR 0 2

3 . The Keynesian Coss The govenment puchases multiplie Definition: the incease in income esulting fom a unit incease in G. In this model, the G multiplie equals G MC CHATR 0 2. The Keynesian Coss The govenment puchases multiplie xample: MC 0.8 G MC G G 5 G The incease in G causes income to incease by 5 times as much! G 0. 8 CHATR The Keynesian Coss The govenment puchases multiplie Why is the multiplie geate than? Initially, the incease in G causes an equal incease in : G. But C futhe futhe C futhe So the final impact on income is much bigge than the initial G. CHATR 0 4. The Keynesian Coss An incease in taxes Initially, the tax incease educes consumption, and theefoe : C MC T so fims educe output, and income falls towad a new equilibium 2 2 C +I +G C 2 +I +G At, thee is now an unplanned inventoy buildup CHATR 0 5. The Keynesian Coss An incease in taxes C + I + G C MC ( T ) Solving fo : Final esult: eq m condition in changes I and G exogenous ( MC) MC T MC T MC. The Keynesian Coss The tax multiplie Definition: the change in income esulting fom a unit incease in T : T MC MC If MC 0.8, then the tax multiplie equals T CHATR 0 6 CHATR 0 7 3

4 . The Keynesian Coss The tax multiplie is negative: An incease in taxes educes consume spending, which educes equilibium income. is geate than one (in absolute value): A change in taxes has a multiplie effect on income. is smalle than the govt spending multiplie: Consumes save the faction (-MC) of a tax cut, so the initial boost in spending fom a tax cut is smalle than fom an equal incease in G. CHATR Defining and Deiving the Cuve.2. Using Keynesian Coss and Investment Function Definition: a gaph of all combinations of and that esult in goods maket equilibium, i.e. actual expenditue (output) planned expenditue The equation fo the cuve is: C ( T ) + I ( ) + G CHATR Defining and Deiving the Cuve.2. Using Keynesian Coss and Investment Function C +I( 2 )+G I C +I( )+G I 2.2 Defining and Deiving the Cuve.2.2 Using Loanable Funds Appoach 2 (a) The L.F. model S 2 S 2 (b) The cuve 2 2 I( ) S, I 2 CHATR 0 20 CHATR Defining and Deiving the Cuve The cuve is negatively sloped. Intuition: A fall in the inteest ate motivates fims to incease investment spending, which dives up total planned spending ( ). To estoe equilibium in the goods maket, output (a.k.a. actual expenditue, ) must incease..3 Fiscal olicy and the Cuve We can use the -LM model to see how fiscal policy (G and T ) can affect aggegate demand and output. Let s stat by using the Keynesian Coss to see how fiscal policy shifts the cuve CHATR 0 22 CHATR

5 .3 Fiscal olicy and the Cuve At any value of, G so the cuve shifts to the ight. The hoizontal distance of the shift equals G MC C +I( )+G C +I( )+G CHATR The LM Cuve 2. The Theoy of Liquidity efeence A simple theoy in which the inteest ate is detemined by money supply and money demand. (due to Keynes again) CHATR The Theoy of Liquidity efeence 2. The Theoy of Liquidity efeence The supply of eal money is fixed: ( M ) s M inteest ate ( M ) s Demand fo eal money : d ( M ) L( ) inteest ate ( M ) s L() M eal money M eal money CHATR 0 26 CHATR The Theoy of Liquidity efeence The inteest ate adjusts to equate the supply and demand fo money: M L( ) inteest ate ( M ) s L() 2. The Theoy of Liquidity efeence A change in money supply To incease, Fed educes M inteest ate 2 L() M eal money M 2 M eal money CHATR 0 28 CHATR

6 2.2 Defining and Deiving the LM Cuve 2.2. Using Theoy of Liquidity efeence Now let s put back into the money demand function: L(, ) ( M ) d 2.2 Defining and Deiving the LM Cuve 2.2. Using Theoy of Liquidity efeence (a) The maket fo (b) The LM cuve eal money LM The LM cuve is a gaph of all combinations of and that equate the supply and demand fo eal money. The equation fo the LM cuve is: M L(, ) 2 M L(, 2 ) L(, ) 2 2 CHATR 0 30 CHATR Defining and Deiving the LM Cuve Using Quantity quation Quantity quation MV Quantity Theoy of money assumes constant velocity vetical LM cuve If we adjust it so that VV() then we get the upwad sloping LM cuve again. 2.2 Defining and Deiving the LM Cuve The LM cuve is positively sloped. Intuition: An incease in income aises money demand. Since the supply of eal is fixed, thee is now excess demand in the money maket at the initial inteest ate. The inteest ate must ise to estoe equilibium in the money maket. CHATR 0 32 CHATR Monetay olicy and the LM Cuve 2 (a) The maket fo eal money M 2 M L(, ) (b) The LM cuve 2 LM LM 2 CHATR The shot-un equilibium The shot-un equilibium is the combination of and that simultaneously satisfies the equilibium conditions in the goods & money makets: C ( T ) + I ( ) + G M L(, ) quilibium inteest ate LM quilibium level of income CHATR

7 Chapte summay. Keynesian Coss basic model of income detemination takes fiscal policy & investment as exogenous fiscal policy has a multiplied impact on income. 2. cuve comes fom Keynesian Coss when planned investment depends negatively on inteest ate shows all combinations of and that equate planned expenditue with actual expenditue on goods & sevices CHATR 0 36 Chapte summay 3. Theoy of Liquidity efeence basic model of inteest ate detemination takes money supply & pice level as exogenous an incease in the money supply lowes the inteest ate 4. LM cuve comes fom Liquidity efeence Theoy when money demand depends positively on income shows all combinations of and that equate demand fo eal money with supply CHATR 0 37 Chapte summay 5. -LM model Intesection of and LM cuves shows the unique point (, ) that satisfies equilibium in both the goods and money makets. eview of Chapte In Chapte, we will use the -LM model to analyze the impact of policies and shocks lean how the aggegate demand cuve comes fom -LM use the -LM and AD-AS models togethe to analyze the shot-un and longun effects of shocks lean about the Geat Depession using ou models CHATR 0 38 CHATR