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Intermediate Macroeconomics: Lecture 1 – IS curve: Introduction:
- The macroeconomy is the product of millions of individual decisions o Households decide:
§ What to consume § How much to save § How much to work
o Firm decide § How much to produce § How many workers to hire § How much capital to employ
o Decisions are implemented in markets, where prices are set - Understanding individual decisions only partially explain macroeconomic phenomenon
o Output growth o Business cycle fluctuations o The price level and inflation o Trade
- We need to develop dedicated macroeconomic models Demand vs supply side macro:
- The evolution of GDP is considered as the sum of two components: o The long run trend o The short run fluctuations
- The evolution of GDP can be explained by: o Supply side factors: how much goods and services the economy is able to produce by
combining human capital, physical capital and technology o Demand side factors: the spending of individuals, firms, government and foreign
sector - According to the mainstream view in macro:
o The business cycle is determined by demand side factors o The trend is determined by supply side factors
- In the first part of the subject, we will look at the business cycle while the trend will be studied in the second part (growth model)
GDP: output and income:
- The focus is on GDP, unemployment and inflation - GDP is the amount of final goods and services produced within a country in a given period of
time - The selling of the goods and services generate income for all the subject involved in
production - As a consequence, we will use Y as the symbol for GDP to indicate both output and income
Demand-side macro: origins:
- Until the ‘30s the focus of economists was on the supply side - The great depression imposed a change of paradigm: low output relative to the recent past and
high unemployment o Output is not driven by economic potential o Input resources need not always be put to use (much less efficient use) o The economy may be subject to the “animal spirits” of public sentiment
- Keynes: role of effective demand - Keynesian model:
o Subsequently elaborated to formalise Keynes’ ideas o Demand-driven model of economic activity o It captures deviations from potential without really explaining the failures that
generate the deviations
A Simple Keynesian Model:
- Aggregate Demand (AD) is the sum of the four different sources of demand for economic output:
o C: Consumption from individuals o I: Investment from firms o G: Government expenditure o NX: Net exports (Exports minus imports)
- Formally: § AD= C + I + G + NX (1)
- The economy is in equilibrium when output Y equals demand § Y = AD (2)
- Deviations result in changes to inventory, referred to as unplanned inventory § UI = Y-AD (3)
A Simple Keynesian Model 1:
- Consumption is the sum of two components: o The amount that is spent on consumption goods independently from the level of
income of the population: Autonomous Consumption (C > 0) o The amount that depends on the level of income: c * YD where
§ c is the Marginal Propensity to Consumer (MPC): how much C increases for each dollar of additional income (with 0 < c< 1)
§ YD is the disposable income: government collects lump sum taxes (TA) and makes transfer payments (TR) such as unemployment benefits. Thus:
o YD = Y + TR – TA (4) • The Fraction of YD that is not consumed is saved. Savings S are
given by: o S = YD – C = sYD
§ S = 1-‐c marginal propensity to save • Therefore the equation for consumption is:
o C = C + cYD (5) A Simple Keynesian Model 2:
- In the simplest version I, G, NX are all autonomous (independent from income and exogenously set to a fixed value)
§ I = I(bar) (6) § G = G(bar) (7) § NX = NX(bar) (8)
- Consumer sentiment, in the form of optimism and pessimism, will move the economic equilibrium
o An optimistic consumer will save less and consumer a greater portion of their income
§ Optimism = Increase in C = AD shifts up = Increase in Y o A pessimistic consumer will save more (as precaution against future decline in
income) and consume less of their income § Pessimism = Decrease in C = AD shifts down = Decrease in Y § The “Paradox of Thrift”: Increase s = Decrease c (flatter AD) = decrease
in Y = Decrease in S o The impact is magnified through the multiplication process o The sentiment is self-‐fulfilling (a self fulfilling prophecy). Optimism is
substantiated by the resulting increase in output, pessimism substantiated by the resulting fall in output
o Other factors that influence spending; Wealth (as opposed to income) expectations about the future
- Investor sentiment, in the form of optimism and pessimism, will move the economic
equilibrium: o Optimistic (pessimistic) firms will increase (decrease) investment in capital:
o The impact is magnified through the multiplication process o As with consumers, investor sentiment is self-‐fulfilling
- Changes in Net Exports lead to changes in the equilibrium output
o Exports are driven by relative prices and foreign income
o The impact is magnified through the multiplication process
- Government Fiscal Policy, implemented through spending, can move aggregate output o An increase (decrease) in gov spending stimulates (dampens) aggregate
demand
o The impact is magnified through multiplication process
- Government Fiscal Policy, implemented through taxes, indirectly move aggregate output through consumer spending
o An increase (decrease) in gov spending stimulates (dampens) aggregate demand
o The impact is magnified through multiplication process
Keynesian Fiscal Policy:
- In this model, changing public sentiment is one of the main sources of economic fluctuations: there is a role for activist government fiscal policy to smooth the excesses brought about by public sentiment, to keep Y0 near Y*
o Stimulating the economy during periods of pessimism o Dampening the economy during periods of euphoria
- Budgetary implications of activist fiscal policy:
o During a recession, an activist policy would have government employ some combination of increasing G (or TR) and decreasing TA in order to stimulate the economy. The budget surplus is:
• BS = TA – TR – G o A balanced budget before the recession becomes a deficit as the government
stabilises output o The reverse is true during a boom with the government generating a surplus
from low G and high TA to dampen the economy § The Gov could set G and TA such that they are balanced on average over
the course of the business cycle § This would require spending restraint and higher taxes during a boom § The likely result is activist policy only during recessions
- The multiplier is smaller in the presence of an income tax – automatic stabilisation o Tax revenues are high when income is high while transfers (unemployment
benefits) are low, dampening output o Tax revenues are low when income is low while transfers are high, stimulating
output o Automatic stabilisation is undermined if the government pursues a balanced
budget policy
Duality:
- Goods market in equilibrium: Y = AD = C + I + G + NX - Rearranging and substituting for G from (11):
§ Y(1-‐t) – C + TR = I – BS + NX o From which:
§ S = I – BS + NX - Goods markets in equilibrium = savings/ investment market in equilibrium
Investment and interest rates:
- Investment can be considered as a function of the interest rate r: let us replace I = I(bar) with I = I(bar) – br, with b > 0
o This is roughly consistent with the more sophisticated investment decision to be developed later
o We can rewrite the aggregate demand equation as:
o Using (12) we can find the points for which AD = Y for any possible interest rate; o These points represent the IS curve o Note: here, investment depends on the real interest rate.
The IS curve:
- The IS curve o All (Y, r) combinations that represent equilibrium in the Goods market o Equilibrium in the Goods market means there is equilibrium in the market for
investment § From the duality between the two markets; I = S therefore the curve is
labelled the IS curve Movements along the curve:
- Movement from one equilibrium to another based on an unchanged relationship between r and Y
Shifts in the IS curve:
- The result of some event that changes the relationship between r and Y
- Move to a new equilibrium because the old equilibrium no longer exists
o E.g. an increase in consumer optimism shifts AD even though r remans the same
§ ^C = ^AD = ^Y (for same r)
o Other examples include ^G, ^NX, ^I (for reasons other than a change in r)
Mathematical representation: