Short-Run Macro Economic Equilibrium

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Short-run MacroeconomicShort-run MacroeconomicEquilibriumEquilibrium

Short-run Macroeconomic EquilibriumShort-run Macroeconomic Equilibrium

Background to the Theory

A simplified circular flow of income modelA simplified circular flow of income model

CdIncomes

W = S + T + M

Incomes

W = S + T + M

J = I + G + X

Incomes

BACKGROUND TO THE THEORYBACKGROUND TO THE THEORY

• Defining aggregate demand and national income

• The 45° line diagram

– the significance of the 45° line

Cd, W, J

Cd + W (=Y)

£100bn

The 45 line

• Consumption

– the consumption function

– the mpc

• Consumption

– the mpc

0 20 40 60 80 100 120 140

Y (£bn)

Y = 10

mpc = C / Y = 8/10 = 0.8

The consumption functionThe consumption function

0 20 40 60 80 100 120 140

Different consumption functions (a)Different consumption functions (a)C

Y (£bn)

0 20 40 60 80 100 120 140

Different consumption functions (b)Different consumption functions (b)C

Y (£bn)

0 20 40 60 80 100 120 140

Different consumption functions (c)Different consumption functions (c)C

Y (£bn)

Different consumption functions (d)Different consumption functions (d)C

Y (£bn)

0 20 40 60 80 100 120 140

• Consumption

– the mpc

– other determinants of consumption

• Consumption

– the mpc

• Consumption

– the mpc

– short-run and long-run consumption functions

• Consumption

– the mpc

0 20 40 60 80 100 120 140

Y (£bn)

C5 years’ time

C10 years’ time

Long-run and short-run consumption functionsLong-run and short-run consumption functions

0 20 40 60 80 100 120 140

Clong run

Y (£bn)

C5 years’ time

C10 years’ time

Long-run and short-run consumption functionsLong-run and short-run consumption functions

• Consumption

– the mpc

– the consumption of domestically produced goods

• Consumption

– the mpc

– the consumption of domestically produced goods

0 20 40 60 80 100 120 140

The consumption of domestic productThe consumption of domestic productC

Y (£bn)

• Withdrawals– net saving: the saving function

• the mps• determinants of saving

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

UK consumption and savingUK consumption and saving£m

Disposable income

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Disposable income

1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Disposable income

Consumer expenditure

Saving

Household saving as % of personal disposable incomeHousehold saving as % of personal disposable income

Source: Datastream

– net taxes: tax functions

– net taxes: tax functions• the tax rate and the mpt

– net taxes: tax functions• the tax rate and the mpt• expenditure taxes and Cd

– imports: import functions

– imports: import functions• the mpm

– imports: import functions• the mpm• effect of imports on Cd

– the withdrawals function

– the withdrawals function• the mpw

Cd + W (=Y)

The W and Cd functionsThe W and Cd functions

• Injections

– investment

• increased consumer demand

• expectations

• cost and efficiency of capital

• rate of interest

– government expenditure

– exports

– the injections function

• Injections

– investment

• increased consumer demand

• expectations

• cost and efficiency of capital

• rate of interest

– government expenditure

– exports

– the injections function

The injections and withdrawals functionsThe injections and withdrawals functions

Cd, W, J

Determination of National IncomeDetermination of National Income

DETERMINATION OF NATIONAL INCOMEDETERMINATION OF NATIONAL INCOME

• Equilibrium national income

– withdrawals equal injections

Cd, W, JDeriving equilibrium national incomeDeriving equilibrium national income

Cd, W, J

Deriving equilibrium national incomeDeriving equilibrium national income

Cd, W, J

– income equals expenditure

Y = Cd + W

Cd, W, J

Y = Cd + WE = Cd + J

Cd, W, J

• The multiplier: introduction

– the circular flow of income and effects of changes in injections

W = S + T + M

J = I + G + X

Incomes

– definition of the multiplier: Y/J

• The multiplier: the withdrawals and injections approach– graphical analysis: shift in the J line

The multiplier: (a) a shift in injectionsThe multiplier: (a) a shift in injections

W, JThe multiplier: (a) a shift in injectionsThe multiplier: (a) a shift in injections

– the formula: 1 / mpw or: 1 / (1 – mpcd )

Multiplier = Y / J

= Y / W= ca / bc

Multiplier = Y / J= Y / W= ca / bc

= 1/mpw

– numerical illustration

– the withdrawals multiplier

W, JThe multiplier: (b) a shift in withdrawalsThe multiplier: (b) a shift in withdrawals

The multiplier: (b) a shift in withdrawalsThe multiplier: (b) a shift in withdrawals

Multiplier = Y / W= ca / ab

The multiplier: (b) a shift in withdrawalsThe multiplier: (b) a shift in withdrawals

• The multiplier: the income and expenditure approach

• The multiplier: the income and expenditure approach– graphical analysis

E, W, J

The multiplier: (c) a shift in the expenditure curveThe multiplier: (c) a shift in the expenditure curve

E, W, JThe multiplier: (c) a shift in the expenditure curveThe multiplier: (c) a shift in the expenditure curve

Multiplier = Y / J= ca / ba

E, W, J

The multiplier: (c) a shift in the expenditure curveThe multiplier: (c) a shift in the expenditure curve

• The multiplier: some qualifications

– deriving the mpcd from the mpc

– effects of changes in one injection or withdrawal on other ones

• Relationship between the 45° line diagram and the AD and AS diagram

• The multiplier: some qualifications

– deriving the mpcd from the mpc

– effects of changes in one injection or withdrawal on other ones

• Relationship between the 45° line diagram and the AD and AS diagram

Showing the multiplier effect on the 45o line and AD/AS diagramsShowing the multiplier effect on the 45o line and AD/AS diagrams

Cd, W, JY

Cd, W, J

Simple Keynesian Analysis of Unemployment and

Inflation

Simple Keynesian Analysis of Unemployment and

Inflation

UNEMPLOYMENT AND INFLATIONUNEMPLOYMENT AND INFLATION

• The deflationary gap

– withdrawals and injections approach

The deflationary gapThe deflationary gap

Deflationary gap

– income and expenditure approach

W, J, E

Deflationary gap

W, J, EThe deflationary gapThe deflationary gap

Deflationary gap

W, J, EThe deflationary gapThe deflationary gap

• The inflationary gap

The inflationary gapThe inflationary gap

Inflationary gap

W, J, E

Inflationary gap

W, J, E

Inflationary gap

W, J, EThe inflationary gapThe inflationary gap

• Inflation and unemployment at the same time

– inflationary pressures before the full-employment level of income

– implications for shape of AS curve

Unemployment and inflationUnemployment and inflation

– relationship between 45° line diagram and the AD & AS diagram

Cd, W, J, E

Allowing for inflation in the 45° line and AD / AS diagramsAllowing for inflation in the 45° line and AD / AS diagrams

Cd, W, J, E

Keynesian Analysis of the Business Cycle

KEYNESIAN ANALYSIS OF THE BUSINESS CYCLEKEYNESIAN ANALYSIS OF THE BUSINESS CYCLE

• The accelerator

– changes in national income and induced investment

• The accelerator

The accelerator effectThe accelerator effect

• The accelerator

– the accelerator coefficient

• The accelerator

– the instability of investment

• The accelerator

Indicator of industrial confidence in the EUIndicator of industrial confidence in the EUB

Source: European Economy Business and Consumer Surveys (Commission of the European Communities)

EU Euro area

Indicator of level of capacity utilisation (%) in the EUIndicator of level of capacity utilisation (%) in the EU

Source: European Economy Business and Consumer Surveys (Commission of the European Communities)

• The accelerator

• The multiplier / accelerator interaction

• The accelerator

1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

e)Fluctuations in UK real GDP and investment: 1978-2002Fluctuations in UK real GDP and investment: 1978-2002

1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

Investment

• The accelerator

• Fluctuations in stocks

• The accelerator

• Fluctuations in stocks

• Analysing the phases of the business cycle– causes of the upturn

– causes of the expansion

– causes of the peaking out

– causes of the recession

• Conclusions– why do booms and recessions persist?

– why do booms and recessions come to an end?

• Analysing the phases of the business cycle– causes of the upturn

– causes of the expansion

– causes of the peaking out

– causes of the recession

• Conclusions– why do booms and recessions persist?

– why do booms and recessions come to an end?

Short-Run Macro Economic Equilibrium

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