Short-Run Macro Economic Equilibrium

Short-run MacroeconomicShort-run MacroeconomicEquilibriumEquilibrium

Short-run Macroeconomic EquilibriumShort-run Macroeconomic Equilibrium

Background to the Theory

Background to the Theory

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

Cd


CdIncomes


Cd

W = S + T + M

Incomes


Cd

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




O

Cd, W, J

Y

Cd + W (=Y)

£100bn

£100bn

The 45 line





• Consumption




• Consumption





• Consumption

– the consumption function

– the mpc




• Consumption


– the mpc

0

20

40

60

80

100

120

0 20 40 60 80 100 120 140

Con

sum

ptio

n (£

bn)

Y

C

Y (£bn)

50

50

C = 8

Y = 10

mpc = C / Y = 8/10 = 0.8

The consumption functionThe consumption function

0

20

40

60

80

100

120

0 20 40 60 80 100 120 140

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

onsu

mpt

ion

(£bn

)

Y

C1

Y (£bn)

0

20

40

60

80

100

120

0 20 40 60 80 100 120 140

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

onsu

mpt

ion

(£bn

)

Y

C2

Y (£bn)

0

20

40

60

80

100

120

0 20 40 60 80 100 120 140

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

onsu

mpt

ion

(£bn

)

Y

C3

Y (£bn)

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

onsu

mpt

ion

(£bn

)

Y

C4

Y (£bn)

0

20

40

60

80

100

120

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

0 20 40 60 80 100 120 140

Con

sum

ptio

n (£

bn)

Y

Y (£bn)

Cnow

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

0 20 40 60 80 100 120 140

Con

sum

ptio

n (£

bn)

Y

Clong run

Y (£bn)

Cnow

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

0 20 40 60 80 100 120 140

The consumption of domestic productThe consumption of domestic productC

onsu

mpt

ion

(£bn

)

Y

C

Y (£bn)

Cd

• Withdrawals– net saving: the saving function

• the mps• determinants of saving




40

50

60

70

80

90

100

110

120

130

140

150

160

170

180

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

40

50

60

70

80

90

100

110

120

130

140

150

160

170

180

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


Disposable income

40

50

60

70

80

90

100

110

120

130

140

150

160

170

180

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




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



– 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





– imports: import functions• the mpm




– imports: import functions• the mpm





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










– the withdrawals function





– the withdrawals function






– the withdrawals function• the mpw





– the withdrawals function• the mpw


OY

Cd + W (=Y)

W

Cd, W

Cd

100

100

70

30

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

OY

W

Cd, W, J

J


Determination of National IncomeDetermination of National Income

DETERMINATION OF NATIONAL INCOMEDETERMINATION OF NATIONAL INCOME

• Equilibrium national income

– withdrawals equal injections



OY

W

Cd, W, JDeriving equilibrium national incomeDeriving equilibrium national income

OY

W

Cd, W, J

J

Y1

b

a

Deriving equilibrium national incomeDeriving equilibrium national income

OY

W

Cd, W, J

J

Y2

c

d


OY

W

Cd, W, J

J

Ye

x





– income equals expenditure




OY

Y = Cd + W

W

Cd, W, J

J


OY

W

Cd, W, J

J

Cd

Y = Cd + WE = Cd + J

J


OY

W

Cd, W, J

J

Cd


Y1

f

e


OY

W

Cd, W, J

J

Cd


Y2

h

g


OY

W

Cd, W, J

J

Cd


Ye

x

z






• The multiplier: introduction










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






Cd

W = S + T + M

J = I + G + X

Incomes








– definition of the multiplier: Y/J






– definition of the multiplier: Y/J


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


OY

W

W, J

J1

Ye1

a

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

OY

W

J1

J2

Ye1

a

Ye2

b

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



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



OY

W

J1

J2

Ye1

a

Ye2

b

Y

c

WJJ1

J2

Multiplier = Y / J

= Y / W= ca / bc


OY

W

J1

J2

Ye1

a

Ye2

b

Y

c

WJJ1

J2

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

= 1/mpw





– numerical illustration








– the withdrawals multiplier





OY

W1

J

Ye1

a

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

OY

W1

J

Ye1

a

W, J

W2

Ye2

c

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

OY

W1

J

Ye1

a

W, J

W2

Ye2

c

Y

W b

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






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






OY

E, W, J

Y

E1

Ye1

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

OY

Y

E1

Ye1

E2

Ye2

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

OY

Y

E1

Ye1

E2

Ye2

Multiplier = Y / J= ca / ba

a

c

Y

J

E, W, J

b

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

Y

Cd, W, JY

E1

Ye1

O

AS

AD1


P

Y

Y

Cd, W, JY

Ye1

O

O

E1


P

Y

Y

Cd, W, JY

Ye1

O

O

AD1

E1

E2

Ye2

AS

AD2


P

Y

Y

Cd, W, J

AS

Y

Ye1

O

O

AD1

E1

E2

Ye2


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



OY

W

W, J

J

Ye

The deflationary gapThe deflationary gap

OY

W

W, J

J

YeYF

Deflationary gap

c

d





– income and expenditure approach




OY

W, J, E

YeYF

Y

E


OYYe

YF

Y

Ea

b

Deflationary gap

W, J, EThe deflationary gapThe deflationary gap

OY

W

J

YeYF

c

d

Y

Ea

b

Deflationary gap

W, J, EThe deflationary gapThe deflationary gap





• The inflationary gap
















OY

W

W, J

Ye

J

The inflationary gapThe inflationary gap

OY

W

W, J

YeYF

J


OY

W

W, J

YeYF

Inflationary gap

Jg

h















OY

YE

W, J, E

Ye


OY

YE

W, J, E

Ye


OYYF

YE

Inflationary gap

W, J, E

e

f

Ye


OYYe

YF

YE

Inflationary gap

e

f

W

Jg

h

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

OY

Pri

ce le

vel

YF

AS1

OY

AS1

Pri

ce le

vel

YF

AS2

Unemployment and inflationUnemployment and inflation




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




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


P

Cd, W, J, E

Y

Y

AS

P1

Y1

AD1

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

Y1

E1

P

Cd, W, J, E

Y

Y

AS

P1

Y

AD1


Y2

P

Cd, W, J, E

Y

Y

AS

AD1

Y1

Y

E1

AD2

E2

P1

P2


P

Cd, W, J, E

Y

Y

AS

AD1

P1

Y1

Y

E1

AD2

E2

Y2

E3

Y3

P2



Keynesian Analysis of the Business Cycle

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 accelerator



– the instability of investment

• The accelerator




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

alan

ces

(%)

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

02

%

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


• The accelerator




• The multiplier / accelerator interaction

• The accelerator





-14

-12

-10

-8

-6-4

-2

0

2

4

6

8

1012

14

16

18

20

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

GD

P, I

nves

tmen

t (%

ann

ual c

hang

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

-14

-12

-10

-8

-6-4

-2

0

2

4

6

8

1012

14

16

18

20

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

GD

P, I

nves

tmen

t (%

ann

ual c

hang


GDP

-14

-12

-10

-8

-6-4

-2

0

2

4

6

8

1012

14

16

18

20

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

GD

P, I

nves

tmen

t (%

ann

ual c

hang


GDP

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?


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Short-Run Macro Economic Equilibrium

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