Context. Context. Aggregate Demand I slide 2

Transcription

1 Context Chapter 9 introduced the model of aggregate demand and aggregate supply. Long run prices flexible output determined by factors of production & technology unemployment equals its natural rate Short run prices fixed output determined by aggregate demand unemployment is negatively related to output Aggregate Demand I slide 2 Context This chapter develops the IS-LM model, the theory that yields the aggregate demand curve. We focus on the short run and assume the price level is fixed. Aggregate Demand I slide 3

2 The Keynesian Cross A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) Notation: I planned investment C + I + G planned expenditure Y real GDP actual expenditure Difference between actual & planned expenditure: unplanned inventory investment Aggregate Demand I slide 4 lements of the Keynesian Cross consumption function: govt policy variables: for now, investment is exogenous: planned expenditure: C C( Y T ) G G, T T I I C( Y T ) + I + G quilibrium condition: Actual expenditure Y Planned expenditure Aggregate Demand I slide 5 2

3 Graphing planned expenditure planned expenditure C +I +G MPC income, output, Y Aggregate Demand I slide 6 Graphing the equilibrium condition planned expenditure Y 45º income, output, Y Aggregate Demand I slide 7 3

4 The equilibrium value of income planned expenditure Y C +I +G income, output, Y quilibrium income Aggregate Demand I slide 8 An increase in government purchases At Y, there is now an unplanned drop in inventory Y C +I +G 2 C +I +G ΔG so firms increase output, and income rises toward a new equilibrium Y 2 Y 2 Y Aggregate Demand I slide 9 4

5 Solving for Y C + I + G Δ Y Δ C + Δ I + ΔG Δ C + ΔG MPC Δ Y + ΔG Collect terms with on the left side of the equals sign: ( MPC) Δ Y ΔG equilibrium condition in changes because I exogenous because ΔC MPC Finally, solve for : Δ Y ΔG MPC Aggregate Demand I slide 0 The government purchases multiplier xample: MPC 0.8 Δ Y ΔG MPC Δ G Δ G ΔG The increase in G causes income to increase by 5 times as much! Aggregate Demand I slide 5

6 The government purchases multiplier Definition: the increase in income resulting from a $ increase in G. In this model, the G multiplier equals ΔG MPC In the example with MPC 0.8, ΔG Aggregate Demand I slide 2 Why the multiplier is greater than Initially, the increase in G causes an equal increase in Y: ΔG. But Y C further Y further C further Y So the final impact on income is much bigger than the initial ΔG. Aggregate Demand I slide 3 6

7 An increase in taxes Initially, the tax increase reduces consumption, and therefore : Y C +I +G C 2 +I +G ΔC MPC ΔT so firms reduce output, and income falls toward a new equilibrium 2 Y 2 At Y, there is now an unplanned inventory buildup Y Y Aggregate Demand I slide 4 Solving for Δ Y Δ C + Δ I + ΔG ΔC MPC ( ΔT ) eq m condition in changes I and G exogenous Solving for : ( MPC) Δ Y MPC ΔT Final result: MPC Δ Y ΔT MPC Aggregate Demand I slide 5 7

8 The Tax Multiplier def: the change in income resulting from a $ increase in T : MPC ΔT MPC If MPC 0.8, then the tax multiplier equals ΔT Aggregate Demand I slide 6 The Tax Multiplier is negative: An increase in taxes reduces consumer spending, which reduces equilibrium income. is greater than one (in absolute value): A change in taxes has a multiplier effect on income. is smaller than the govt spending multiplier: Consumers save the fraction (-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G. Aggregate Demand I slide 8 8

9 xercise: Use a graph of the Keynesian Cross to show the impact of an increase in investment on the equilibrium level of income/output. Aggregate Demand I slide 9 9