Aggregate Demand I

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Source: "Macroeconomics" , Mankiw, Fourth Edition: Chapter 10, Fifth Edition: Chapter 10

Aggregate Demand I

The Economy in the Short-run

Introduction

• Here, we continue our study of economic fluctuations by looking more deeply at aggregate demand

• In the long-run prices are flexible and aggregate supply determines income

• In the short-run, prices are sticky, so changes in aggregate demand influence income

Introduction

• In 1936: John Maynard Keynes revolutionised economics with his book: The General Theory of Employment, Interest and Money

• Keynes proposed that low aggregate demand is responsible for the low income and high unemployment that characterise economic downturns

Introduction

• In previous chapter we derived the aggregate demand curve very simply using the quantity theory of money and we showed how monetary policy shifts the AD curve

• This was an incomplete derivation of the AD curve

• Here, we provide a complete derivation of the AD curve and show that fiscal and monetary policy will affect the AD curve

Introduction

• The model to explain the AD curve is the IS-LM model – It is an interpretation of Keynes’ theory– IS: stands for investment and saving

• IS curve represents what’s going on in the market for goods and services

– LM: stands for liquidity and money• LM curve represents what’s going on in the money

market (demand and supply of money)

Introduction

• IS-LM Model:– Model of aggregate demand– It is based in the short-run, when prices are

sticky– It shows what causes income to change and

therefore what causes the aggregate demand curve to shift

Theory of Short-run Fluctuations

Summary

• What we will cover in this topic (over 2 chapters):– Derive the IS curve using the Keynesian cross theory– Derive the LM curve using the Liquidity Preference

theory– Put the IS-LM curves together (which maps interest

rates and output)– Study how fiscal policy shifts the IS curve and

monetary policy shifts the LM – Use the IS-LM model to derive the aggregate demand

curve– Use the IS-LM model to show how monetary and

fiscal policy shift the aggregate demand curve

The Goods Market and the IS Curve

• IS curve: plots the relationship between the interest rate and the level of income that arises in the market for goods and services

• To develop the relationship, we use a theory called: the Keynesian cross

– Keynes proposed that in the short run, economy’s income depended largely on the desire to spend by households, firms and the government.

– More people spend, more goods and services firms can sell, more output will be produced, more workers will be hired

– Problem during economic recessions: inadequate spending

– The Keynesian Cross models this proposal

• The Keynesian Cross:– Distinction between actual and planned

expenditure– Actual expenditure = amount households,

firms and the government spend on goods and services

– Planned expenditure = amount households, firms and the government would like to spend on goods and services

• Keynesian Cross:– Why would actual and planned expenditure

be different?– Answer: firms might engage in unplanned

inventory investment if sales do not meet expectations. Firms sell less of the product than expected, stock of inventories rises. And if sales exceed expectations, stock of inventories falls. These unplanned changes in inventory are counted as investment spending by firms

The Goods Market and IS Curve

• Keynesian cross:– Determinants of planned expenditure– Assume economy is closed (no exports or

imports)– Planned expenditure (E) = sum of

consumption (C), planned investment (I), and government purchases (G)

E = C + I + G

• Keynesian cross:E = C + I + G : Planned expenditure– To this we add the consumption function:

C = C(Y-T)– For now, assume planned investment is fixed

I = I – Assume government purchases and taxes are fixed

by the government (fixed fiscal policy)

• Keynesian cross:E = C(Y-T) + I + G– Planned expenditure is a function of income– Graph of planned expenditure– Upward sloping: higher income leads to

higher expenditure (because higher income leads to higher consumption, which is part of planned expenditure)

– Slope of the line is the marginal propensity to consume

• Keynesian Cross– Planned expenditure: first piece of Keynesian

cross– Next piece of Keynesian cross: assumption

that the economy is in equilibrium when actual expenditure equals planned expenditure: (when people’s plans have been realised, there is no need to change)

– Recall: Y (GDP) = total income and total output and total expenditure on goods and services in economy

• Keynesian Cross:– Equilibrium condition:Actual expenditure = Planned Expenditure

Y = E– 45-degree line with Y on the horizontal axis

and E on the vertical axis: shows all the points where the equilibrium condition holds

– Every point on the 45-degree: actual expenditure equals planned expenditure

– Graph: the Keynesian Cross

• Keynesian cross:– Point A: Equilibrium of the economy, where

planned expenditure equals actual expenditure (where the planned expenditure function crosses the 45-degree line)

– How does the economy get to that equilibrium?

• Keynesian cross:– Suppose GDP or output is at Y1 , then planned

expenditure E1 is less than production Y1 :– firms are selling less than they are producing– Firms add the unsold goods to their stock of

inventories – This induces firms to layoff workers and

reduce production – So Y falls

• Keynesian Cross:– Suppose GDP or output is at Y2 , then planned

expenditure E2 is greater than production Y2 :

– Firms are selling more than expected, so they draw from inventories

– This induces firms to hire more workers and increase production

– So Y increases

• In Keynesian cross: given levels of planned Investment I and fiscal policy, G (government purchases) and T (taxes)

• Use this to show how income changes when we change one of these exogenous variables

• Government purchases: consider how changes in government purchases affect the economy

• Keynesian Cross:E = C(Y-T) + I + G– Higher government purchases result in higher

planned expenditure – If G changes by ΔG then the planned

expenditure function shifts upward (see graph on next slide)

– Equilibrium in the economy moves from point A to point B. Increase in G causes Y to increase

• Keynesian cross: (government-purchases multiplier)– The change in income is more than what the

change in government purchases was– i.e. ∆Y is larger than ∆G– Ratio ∆Y/ ∆G is called the government-

purchases multiplier: it tells us how much income rises in response to a €1 increase in government purchases

– Keynesian cross: the government purchases multiplier is larger than 1

• Keynesian cross: (government-purchases multiplier)– Why does fiscal policy have a multiplier effect

on income?– Answer relates to the consumption function: C = C(Y – T)– When government purchases increase, this

raises income, Y (Remember Y = E = C + I + G). This increase in Y in turn increases consumption, C.

• Keynesian cross: (government-purchases multiplier) (cont’d)– The increase in consumption, in turn,

increases income again, which further increases consumption and so on.

– How big is the multiplier?

• Keynesian cross: (government-purchases multiplier) (cont’d)– Let’s trace through each step of the change in

income:Initial change in G = ∆G, so Y (income) changes

by ∆G as well. This increase in income raises consumption by MPC x ∆G, where MPC = Marginal Propensity to Consume (as income increases by €1 the MPC tells us how much consumption will increase by)

• Keynesian cross: (government-purchases multiplier) (cont’d)– Tracing through each step of the change in

income (cont’d):The increase in consumption raises income

again, which raises consumption again and so on.

– Using algebra, the government purchases multiplier is:

∆Y/ ∆G = 1/(1- MPC)

• Keynesian cross: (government-purchases multiplier) (cont’d)– Example: MPC = 0.6

∆Y/ ∆G = 1/(1- MPC)

= 1/(1 – 0.6)

This says that a €1 increase in government purchases will lead to a €2.50 increase in equilibrium income

• Keynesian cross:– What if taxes change?

E = C(Y – T) + I + G– A decrease in taxes raises disposable income

(Y-T) and therefore increases consumption– Therefore, planned expenditure function shifts

upward– Economy moves from equilibrium A to

equilibrium B (See graph)

• Keynesian Cross: (tax multiplier)– Just as with an increase in government

purchases, a decrease in taxes has a multiplied effect on income

– A decrease in taxes by ∆T increases consumption by MPC x ∆T, which increases Y, which increases consumption and so on.

• Keynesian Cross: (tax multiplier)– Using algebra the tax multiplier is

∆Y/ ∆T = - MPC/(1- MPC)– Example: MPC = 0.6

∆Y/ ∆T = - 0.6/(1- 0.6) = -1.5– This says that a €1 cut in taxes raises

equilibrium income by €1.50

Aggregate Demand I

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