Monetary Macroeconomics Lecture 2. Mark Hayes

Transcription

1 Diploma Macro Paper 2 Monetary Macroeconomics Lecture 2 Aggregate demand: Consumption and the Keynesian Cross Mark Hayes slide 1

2 Outline Introduction Map of the AD-AS model slide 2

3 Goods market KX and IS (Y, C, I) Money market (LM) (i, Y) Labour market (P, Y) AS IS-LM (i, Y, C, I) AD Foreign exchange market (NX, e) Phillips Curve (,u) AD-AS (i, P, Y, C, I) AD*-AS (i, P, e, Y, C, I, NX)

4 Short-run effects of an increase in demand In the short run when prices are sticky, P an increase in aggregate demand P SRAS AD 1 AD 2 causes output to rise. Y 1 Y 2 Y slide 4

5 Outline Introduction Map of the AD-AS model This lecture, we begin explaining the AD curve Step 1: Equilibrium with variable income and consumption - the Keynesian Cross Various Multipliers slide 5

6 The Circular Flow I slide 6

7 The Circular Flow II slide 7

8 Income in Classical model Profit and Rent Consumption Saving Investment Wages Consumption Consumption slide 8

9 First step to AD - the Keynesian Cross A simple closed economy model (NX exogenous) in which private consumption (C ) is the only element of demand which varies Notation: I = expected investment E = C + I + G = expected expenditure Y = real GDP = value of output slide 9

10 Elements of the Keynesian Cross Consumption function: Government consumption and tax: G G, T T for now, investment is exogenous: Expected expenditure: I I equilibrium condition: Value of output = expected expenditure slide 10

11 Plotting the equilibrium condition E expected expenditure E =Y 45º income, output, Y slide 11

12 Plotting planned expenditure E expected expenditure E =C +I +G income, output, Y slide 12

13 The equilibrium value of income E expected expenditure E =Y E =C +I +G 1 c 1 income, output, Y Equilibrium income slide 13

14 An increase in autonomous consumption E E =C +I +G 2 E =C +I +G 1 G E 1 = Y 1 Y E 2 = Y 2 Y slide 14

15 The spending multiplier Definition: the change in income resulting from a (small) change in autonomous expenditure such as G or I. (In the following slides MPC = c 1 ) slide 15

16 The multiplier as a partial derivative Y C I G Y C I G C G MPC Y G Collect terms with Y on the left side of the equals sign: (1 MPC) Y G equilibrium condition in changes because I exogenous because C = MPC Y Solve for Y : 1 Y G 1 MPC slide 16

17 The spending multiplier In this model, the spending multiplier equals If MPC = 0.8 Y G An increase in G causes income to increase 5 times as much! slide 17

18 Why the multiplier is greater than 1 An increase in G represents an equal increase in Y: Y = G. But Y C further Y further C further Y So the final impact on income is much bigger than the initial G. But not infinite, it converges. slide 18

19 Conventional explanation of convergence slide 19

20 The Phillips Machine, 1949 Invented by Bill Phillips at the LSE. A waterdriven analogue computer used to demonstrate Keynesian economics The flaw is that he used water, taking us back to a Classical corn model slide 20

21 The Phillips Machine, 1949 slide 21

22 The Phillips Machine, 1949 slide 22

23 The Phillips Machine, slide 23

24 An increase in taxes The tax increase reduces consumption, and therefore E: E E =C 1 +I +G E =C 2 +I +G C = MPC T E 2 = Y 2 Y E 1 = Y 1 Y slide 24

25 The tax multiplier Definition: the change in income resulting from a (small) change in T slide 25

26 The tax multiplier as a partial derivative Y C I G C equilibrium condition in changes I and G exogenous MPC Y T Solving for Y : (1 MPC) Y MPC T Final result: MPC Y T 1 MPC slide 26

27 The tax multiplier Y T MPC 1 MPC If MPC = 0.8, then the tax multiplier equals Y T slide 27

28 The tax multiplier is negative: A tax increase reduces C, which reduces income. is greater than one (in absolute value): A change in taxes has a multiplier effect on income. is smaller than the spending multiplier: Consumers save the fraction (1 MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G. slide 28

29 The balanced budget multiplier slide 29

30 slide 30 Y t T G G T Y t c Y ] ) 1[(1 G Y t G c Y c t Y ) ( ) 1 ( 1 1 G c tc tc c Y ) (1 ) 1 ( c c G Y BB By definition: Equilibrium Condition: The balanced budget multiplier

31 Summary Keynesian cross: equilibrium income determined with income and consumption variable Shows how the direction of causation between saving and investment is reversed from the Classical model The multiplier as comparative statics Spending, tax and balanced budget multipliers Comparing two equilibrium positions does not explain the dynamic process linking them slide 31

32 Next time Step 2 of building the AD curve Finding equilibrium when income, consumption and investment can all move the IS-LM model slide 32