II. SHORT-RUN ANALYSIS. Chapters 3-5

Transcription

1 II. SHORT-RUN ANALYSIS Chapters 3-5

2 Analytical framework For now we will consider a closed economy (openness later) Analyze the Demand side and the Supply side Take into account the role of expectations for agents behavior (in the determination of consumption, investment, and saving) Distinguish between: The short-run: output is determined by aggregate demand The medium and long-run: output determined by supply side factors and institutional factors

3 Analytical framework (cont d) Examine equilibrium in three markets: Short-run equilibrium: The goods market The financial market Put it together within the ISLM model determine equilibrium interest rate and price level Note: up to here, it s still only the demand side Medium-term equilibrium: we add the labor market determine equilibrium employment and wage rate Put it all together in ISLM-FE model determine equilibrium output, interest rate, price level, C, I, G

4 II.a. The Goods Market 1. Composition of GDP (see Table 3.1) Highlights: Predominance of consumption as a share of GDP US net exports = relatively small reflection of the large domestic market (not of closed economy). Investment = small in level, but accounts for large share of GDP shortrun fluctuations. 2. Demand for goods: By households (Consumption, C), firms (investment, I), government (govt expenditure, G), and the rest of the world (Export Imports, X-IM) Aggregate demand for goods and services is represented by: Z = C + I + G + X II Note: for now we will leave out the rest of the world (X-IM)

5 2.a Consumption: we use a simple behavioral equation Consumption = determined by disposable income (aftertax income) C = C 0 + c 1 (Y T) The parameter c 1 is the marginal propensity to consume. 1-c1 = marginal propensity to save 2.b Investment: a simplified presentation assumed exogenous Note: later we will relax this assumption and consider Investment as a function of income and the interest rate.

6 2.c Government expenditure We will assume that G and T are exogenous; (G, T) describe fiscal policy. 2.d Equilibrium in the goods market: in a closed economy, the equilibrium condition is: output = aggregate demand Y = Z Y = C + I + G Y=C 0 + c 1 Y T + I + G Y = 1 1 c 1 C 0 + I+G c 1 T 1 is the demand multiplier 1 c 1

7 2.e. Alternative representation of the equilibrium: Saving = Investment Use a simple definition of Saving as after-tax income that is not consumed Private saving: S p = Y T C Public/govt saving: S g = T G In equilibrium, income = aggregate demand: Y = C + I + G Subtracting T from each side and rearranging yields: I = Y T C + T G = S p + S g I = S: Investment = Saving

8 2.f) Impact of T on C and S C = C 0 + c 1 Y T ; so an increase in T decreases C S = Y T C; so an increase in T decreases S 2.g) Impact of G and T on equilibrium Y In equilibrium: Y = 1 C 0 + I+G c 1 T Y = 1 of 1 c 1 Y = 1 1 cc cc 1 cc 1 c 1 G An increase in G yields an increase in Y by a factor T: An increase in T causes a decrease in Y by a factor of c 1 1 c 1 Note that the increase in Y caused by an increase in G is larger than the absolute decline in Y caused by an increase in T The balanced budget multiplier: If G and T increase by the same amount, then Y increases by a factor of 1: Y increases by the same amount as the increase in G. The total impact is: Y = 1 cc G + T 1 cc 1 cc If G = T then Y = G

9 Example of multiplier effect: A) Suppose govt increases expenditure by $15bn, with no increase in taxes; suppose MPC=0.75 Effect on income is: Y = $15bb = $60bb B) Suppose now govt is constrained to a balanced budget rule. So it increases expenditures by $15bn and simultaneously increases taxes by $15bn. MPC=0.75 Effect on income is: Y = = $15bb + $15bb = $60bb $45bb = $15bb

10 Summing up The government can stimulate economic activity by manipulating G and T. But, there are limits: Concerns about the impact on the deficit and government debt; Concerns about the impact on inflation (depends on relative effects on demand vs. supply) Also, the effect depends on whether the changes in G and T are perceived by private agents as permanent or temporary: agents take into account government actions in their decisions in consumption, investment, and employment. The effect is larger if the changes in G and T are perceived as permanent.

11 Role of demand stimulus in recovery from a crisis Economic/financial crisis Consumption declines Investment declines Crisis creates pent-up demand Govt implements policy stimulus Increased production and increased hiring Household incomes rise Business profits rise Demand/Spending rise Virtuous circle: rising incomes, improved credit conditions, recovery

12 Suggested practice exercises Blinder (5 th edition) Chapter 3, problems 2-5