MACROECONOMIC THEORY AND POLICY

201318010
li dongsheng

Chapter 3
Introduction to Income
Determination: The Multiplier
the basic GNP identity
C + I+ G +( X- M) = GNP = C+S+ T+ Rf
C = total value of consumption expenditure
I = total value of investment expenditure
G = government purchases of goods and services (X M) = net exports of goods and
services
S = gross private saving (business saving + personal saving + depreciation)
T = net tax revenues (tax revenue minus domestic transfer payments, net interest paid, and net
subsidies)
Rf = total private transfer payments to foreigners
eliminating the relatively minor foreign component from the

GNP identity

C + I+ G = Y = C+S+ T
THE SAVING-INVESTMENT BALANCE

Subtracting the real consumption component from each side of equation

y - c = i +g
y - c = s+ t
so I +g =s+ t ;
i = s+ (t- g);
i is total private investment (gross or net,depending on thedefinition of y),
s is total privatesaving,
(t - g) is the government surplus, which may be thought of asnet government saving
PLANNED AND REALIZED INVESTMENT

i=

i + inv ;

i is, investment that ispart of producers plans, andunintendedinvestment,

inv is unexpected changes in the level of consumption demand, or,in general, finalsales. Intended
investment i can, of course, include some planned amount of inventory accumulation
inv can be positive , negative , zero .

So theinvestment component in the saving-investment balance is

i + inv + g= s+t;
and adding real consumer expenditurec backinto
c +i + inv +g =y =c+ s+ t;
CONSUMPTION, AND SAVING FUNCTIONS

Tax revenue is a function of gross income y;

t = t(y); t ' >0
And consumer expenditure and saving are functions of disposable (after-tax) income
y -t(y),
c = c(y-t(y)); c ' >0
s= s(y-t(y)); s ' >0
s + t = s(y-t(y)) + t(y);
Then we can compute the expression for the change in (s + t)as y changes,
d(s + t) = s '( dyt ' dy ) + t ' dy
'
'
s ' = ( 1t ) dy+ t dy ;
d(s + t) / dy =

s '( 1t ' ) +t ' .

DETERMINATION OF EQUILIBRIUM INCOME

The saving-investment balance equation is

i + inv + g= y= s+ t;
If income is higher than that level which satisfies equation (s +t )
will exceed planned ( i + g), sales will be low, and inv will be
positive.
Conversely (s + t) < ( i +g), inv must be negative .
Cause inv=( s +t )( i+ g) ;
When inv=0 ;
i + inv= s(y-t(y)) + t(y);
The Stability of Equilibrium Income

s + t has a positive slope because of the assumption that both s

and t are increasing functions of y described in the previous section.
We have also assumed that /"and g are fixed independently of the
level of y, so that the 1 + g line is horizontal. The point at which s +
t = i + g, that is, where the two lines cross, determines the

equilibrium level of income Ye that satisfies equilibrium condition.

And we get
i + g+ inv= s(y-t(y)) + t(y);
where y < yEf the phase diagram shows dy/dt positive, so y is increasing. To the right of yE, dy/dt is
negative, so y is decreasing. Thus, any disturbance of y, moving it away from yEt will be followed by a
movement back toward yE through the inventory mechanism described above; yE is a stable
equilibrium.
Shifts in the Saving Function
1. people now save more than before. Shifts in saving behavior.
s + t < s1 + t;
i + + g is fixed exogenously, an exogenous increase in the desire to save leads to
an unchanged level of s +t but at a lower level of income.
2. the paradox of thrift
change the assumption that i and g are fixed independently of y,

+g is an increasing function of income

an increase in the desire to save can lead ultimately to a decrease in the realized level of 1, since the
drop in income reduces planned investment. This is the so-called paradox of thrift.
3. an increase in planned investment.
It is not the saving function that shifts autonomously but the level of planned investment.
Orders and production increase, bringing an increase in the level of income toward the new equilibrium
level y1.
4. Investment shifts and the s + t function
Function implying a large increase in saving plus tax revenue with a change in y, the
investment shift raises y only to y2. This relationship between the slope of the s + t
function and the size of the increase in equilibrium income following from a given
increase in exogenous investment demand o r government purchases takes us to
consideration of the multiplier.
Lump-Sum Taxes

The basic equilibrium condition. Is

c(y -t) +I +g = y = c(y - t) + s(y -t) + t

tax revenues are a fixed sum.

subtracting c from each of the three parts of this
expression
. i +g = y c(y-t)= s(y -t) + t

To find the change in equilibrium income following a change in planned investment in this case, we can

differentiate the left-hand equation in equilibrium condition

c ' dy + di=dydy ( 1c ' ) =di

dy/di = 1/1- c '
t he

Balanced-Budget Multiplier

the basic equilibrium condition : c(y -t) +i+g = y = c(y - t) + s(y -t) + t
y = c(y -t) +i+g;
dy= c '( dy dt )+ di+ dg
and dy(1- c ' ) = - c ' dt +di+dg
so that dy= (- c ' dt +di+dg /(1c' )
if we set di = 0;
dy= (- c ' d + dg /(1c ' ) = dg(1 - c ' )/(1 - c ' )
so dy/dg = (1 - c ' )/(1 - c ' ) = 1;
Taxes as a Function of Income

The basic equilibrium condition for income determination is

c(y t(y)) + I +g = y = c(y- t(y)) + s(y t(y)) + t(y)9 (19)
and subtracting c(y t(y)) from each part of equation (19) gives us the alternative form
i + g = y- c(y t(y)) = s(y t{y)) + t{y).
(20)
To obtain the general form of the multiplier with a given tax structure, we can
differentiate the left-hand equation in the equilibrium condition (19) to obtain
dy = c,*(dy t, dy) + dT + dg
and

dy = c'*(l t')dy + di+ dg, so that

the multiplier expression is given by
dy = (di+dg)/(1-

'

'

c (1t )

Introducing a tax function has reduced the multiplier. As tax revenue rises with income (with fixed tax
rates), the increase in disposable income that a person can either save or spend is smaller than the
increase in total income. A little is thus siphoned off of each round of expenditure by the existence of
the tax schedule, thereby reducing the size of the multiplier.

dy

c'*{1 - t f }dy = s'(l

t')dy + t, dy;

and 1 - c'*(1 - t') = s' * (1 - t') + t';

The Tax Rate Multiplier

we simplify the tax function by assuming that tax revenues are

proportional to income, so that t(y) = r*y, where r is a percentage tax
rate

we can wr ite the basic equation for equilibrium income as

y = c(y - ry) + I + g;
Since d(ry) is approximately equal tor dy + y dr, the differential of equilib-rium condition
(22) can be written as
dy = cr*(dy - r dy - y dr) + dr+ dg
and

dy = cr*(1 r )dy cydr + di+ dg

so that the multiplier expression with tax rates and g all changing is given by
dT+ dg-c'y dr

chapter 4
demand side equilibrium:
Income and the Interest Rate
LIBRIUM INCOME AND THE INTEREST RATE
IE PRODUCT MARKET

y=c(y-t(y)) + i + g,
where y is real GNP, c is real consumer expenditure as a function of real: disposable
income and s is real saving; t is real tax revenue as a function of real GNP, i is real
investment demand, and g is real government purchases, of goods and services.
Investment Demand and the interest Rate
The present discounted value(PDV)

R
R

PDV = -C +
+ )/(1+r) + (

R
)/ (1+r )2 + +(

R
/ (1+r )n

Derivation of the IS Curve (investment demand)

Dy = c*(dy tdy) + idr;
This equation does not represent a movement away from equilibrium, but

rather gives changes in y and r that can occur simultaneously and keep
the product market in equilibrium. Thus, it is also an equilibrium condition.
Isolating terms containing dy and dr gives us

Dy(1-c(1 t)) = Idr and dr/dy=(1 c(1 t))/ i;

Shifting the IS Curve
any initial level of r the g increase has increased equilibrium y, shifting the IS
curve to the right, any given r, implying again an unchanged i, the ratio of the
increase in y to the increase in g, dy/dg.
Demand for Money and Real Balances

Speculative demand = l(r);

Transactions demand = k(y) and k>0;

Both components of the demand for money, the
transactions demand and the speculative demand, should
be stated as demand for real money balance
M/P = m.
Summing the two components of the demand for money,
we have the demand function for real balances with l<o
and k>0;
M/P = l(r) + k(y);
In general, we should recognize that the speculative and transactions demands
cannot be separated. For example, as the interest rate on bonds rises we would expect
transactions balances to be reduced as people recognized the increasing opportunity
cost of holding idle cash balances and squeezed them down. Thus, the demand-formoney function, in general, might be written a
M/P = m(r,y);
Demand an supply in the money market:
This reduction in demand in the bond market drives bond price down and interest rates
up
The equilibrium condition in the money market

p = m(r,y) =/ l(r) + k(y).

M/P
Derivation of the LM Curve
The LM curve: equilibrium r and y in the money market
M/p = l(r) +k(y); 0 = ldr + kdy
Thus dr/dy = -k/l;

Chapter 5
An Introduction to Monetary and Fiscal policy
Changes in Government Spending ,g

the interest rate must rise from r0 following the g. With a

fixed level of real money balances (=M/P0)9 the increase in y
raises the demand for money, pulling interest rates up
along the LM curve. In the background, the g increase raises
the government deficit, increasing the amount of bonds the
government sells. To sell more bonds, that is, buy more
money to finance the g increase, the government must
raise the interest rate it pays. In general, the increase in
bond supply raises interest rates in the bond market, the
other side of the coin to the money market rise in r. The
increase in interest rates, along LM, reduces the level of
investment demand, tending to offset the increase in
government spending
Here we can summarize the results of the fiscal policy increase in g on the demand
side. With income increased and the tax rate unchanged, both

disposable income and consumer spending are higher. Government purchases have risen, and,
with an interest rate increase, the level of investment has fallen, partially offsetting the g increase.
We know the offset is only partial because for y to go up in the end, the i + g sum must have
risen. Thus, increasing g to raise equilibrium y shifts the mix of output away from investment
and toward g, and also raises consumer spending.
Change in the Tax Schedule, t ( y )

Much the same effects on the level of y and r [and thus i(r)] could be obtained by permanently
reducing tax rates or increasing transfer payments instead of raising government purchases. The
main difference between these two expansionary fiscal policy steps is in the resulting mix of
output: With an equal effect on y, r, and investment, a tax reduction favors consumer
expenditure, while a g increase obviously increases the government share of output.

to(y) = r 0 y

From the basic equilibrium condition

i(r) + g = y c(y-t(y)) = s(y-t(y))+t(y);
we can see that if i(r0) and g are unchanged, and the tax cut raises disposable income y
t(y)raising consumption, y must increase to maintain y - c equal to i(r) + g.

But the increase in income again creates excess demand in the

money market, raising r along LM. In the bond markets, the
increase in the deficit generated by the tax cut increases the
supply of bonds as the government increases borrowing. This
squeezes out borrowing for plant and equipment investment and
house building.
The main difference between the effects of a government
purchases in-crease and a tax cut that yield about the same final
level of y and r is in the composition of the final y. Since r rises
about the same in both cases, the final level of investment is the
same. But where in the case government purchases rose,
providing the initial fiscal policy stimulus, here g has remained the
same throughout. The stimulus here has come from the initial
increase in consumer spending following the tax cut, and this has
increased the consumers share of output.
Multiplier for g Changes

The IS curve represents the product- market equilibrium condition.

y = C(y- t(y)) + i(r) + g,

and the LM curve represents the money market equilibrium condition

M/P=l(r) + k(y).

The Multiplier for Tax Rate Changes

IS and LM equilibrium equations,

M/P = m(r,y) =/ l(r) + k(y).

And
y = c(y y ) + i(r) + g
so we get dy = c * (dy - )dy cydr + Idr;
dr= -(k/l) dy;
dy=(-cy)/(1-c(1- )+(ik/i));
when tax rates go up ,the policy-induced consumption change is
negative.
To get the effect of a g change ,dg,or a consumption change
induced
by
d
'
,c yd , onequilibrium demandsideincomeoutput , we multiply by
1/(1-c(1- )+(ik/l));
The Balanced-Budget Multiplier

By the introduction of money market effects. The IS and LM

equations,
Y = c(y - t) + i(r) +g;
M/P = l(r) + k(y);
Dy = c dy c dt + idr+ dg;
Dy = (dg cdt)/(1 c+(Ik/l));
Dy = (1 c)/(1-c+(ik/l));
The Multiplier for Changes in M
The product-market equation is
Y= c(y t(y)) + i(r) +g;
M/P = m = l(r) +k(y);
Dm/P = dm = ldr +k;dy;
Dr = dm/l k/l
Dy = c(1-t)dy+ Idr
Dr = c(1-t)dy+I/ldm Ik/ldy

Dy= (I/l)/(1-c(1-t)+(Ik/l)) * dm

The Effectiveness and Certainty of Monetary and Fiscal

Policy
interest rates very high, speculative balances will be squeezed to
a minimum with most of the real money supply already financing
transactions. An increase in demand by, say, an increase in g will
raise the interest rate enough that the initial g increase will be
nearly fully offset by a drop in investment demand.
Exogenous expenditure change
1/(1-c(1 t ) + (ik/l));
Money supply changes will be effective only if the change affects
the interest rate and credit conditions facing investors ,and if
these changes affect investment spending.
MULTIPLIERS AND THE AGGREGATE DEMAND CURVE

ere we will bring together the multipliers as demand shifts and the expression for the
slope of the aggregate-demand curve, solving for the total differential dy as g, M, or P changes.
We start from the product-market equation (3), reproduced here as

y = c(y - t(y)) + i ( r ) g .

(18)

Total differentiation, including movements in y, r, or dg, gives us the familiar IS differential

dy = cf(l t')dy + i, dr + dg.

Chapter 6
Daman and Supply in the Labor Market

IS: y = c( y t(y)) + i(r) + g ;

The money market equilibrium condition is LM= M/P = l(r) + k(y);
THE SIMIPLE DEPRESSION MODEL

The labor supply is more or less unlimited, so that a demand

increase can expand output y and employment N without raising
the price level. This essentially gives us as a supply curve a
horizontal line at Po in Figure 6-1with equilibrium output then at

y0. We can next introduce a short-run production function for real

output.

y
>0 ;
N
that in the short run the level of real output y depends on labor
input N only. All other factor inputs, included in k are fixed.
y=y(N;K);

Workers are interested in the purchasing power of their wageswhat they can buy with their income.
There is a close relationship between prices, wages, and the level
of employment, and that this relationship is more complicated
than the simple depression model outlined above;
y=c(y-t(y))+i(r)+g;
M/P=l(r)+k(y);
And introduced the production function
y=y(N;K);
the three equation s have four endogenous variables. y,r,P and N;

THE DEMAND FOR LABOR

One is average labor production ,y/N also known as the average
product of labor(APL).
Facing a given price level the revenue increase from employment
increase is
P y
R=
N
N
R= C
PP y
W=
N
or
W y
=
w=
;
p N
The Monopolistic Case

We can write the demand curve as

P =P(y(N;K)); p < 0;

With price as a declining function of quantity sold.

In this case total revenue is given by
R = y(N;K) * P(y(N;K));
So that the marginal revenue product of labor for a monopolist is .
dr
1 y
= p 1+
;
dn
e N
where e is the negative elasticity of demand along the demand
curve;
1 y
w=P 1+
;
e N

( )

( )

The Aggregate Demand for Labor

The aggregate demand for labor is given by

w
w= =f (n) ;
p
or w= pf ( n ) ;
There are two important things to notice about the aggregate labor- demand curve. First, its
negative slope is due to diminishing marginal productivity of labor as more labor is added to a fixed
capital stock. In a perfectly competitive economy with a fixed output mix, the demand curve f{N}
y
would be the aggregate MPL,
. Second, since profit-maximizing firms are interested in the

N
real wage they pay the price of the labor input relative to the price of outputthe price level
enters the money wage version of the demand function (10b) multiplicatively. We write W - P* f(N)9
rather than W = f(P N). This distinction will be important when we examine the effects of price
changes shifting the labor-demand and labor-supply curves.
The Supply Of Labor
1. How rapidly and completely do workers expectations of the future price level p e
adjust to changes in the actual price level
2. Is the nominal wage rate rigid or flexible over time?
(a) immediate and correct adjustment of Pe to changes in Pt and (b) no adjustment at all.
Assumption.
(b) results in the classical case in which the supply of labor depends only on the real
wage w
(c) which makes the labor supply a function of the money wage Wf may be a more
useful hypothesis for explaining actual short-run variations in employment. This is
the extreme Keynesian case.
The Individuals Work-Leisure Decision

a worker wants to achieve the mix of r

income and leisure that is anticipated to be most satisfactory to him or her. Assuming a
worker can allocate hours to work, thus earning expected real income ye, or to leisure S,
the limits or constraints on his or her ability to achieve maximum satisfaction, or, as we
will refer to it, utility U, are the number of hours in the day and the real wage rate. Thus,
the workers utility function is
U U
,
> 0;
U=U ( y e , S )
e
S

y
and is toWbe maximized subject to the constraint that

ye=

( T S )=we( T S ) ,

Equilibrium In The Labor Market

We have now derived equations for both the demand and

the supply of labor
Demand : w=f(N);
pe ( )
Supply: w= g N ;
p
Equating demand to supply gives the labor market equilibrium condition
e

p
g ( N ) ;
p
p * f(N) = pe * g(N);
labor demand and supply move together as the price level
changes, leaving employment and the real wage
unchanged.
f(N)=

In the zero-adjustment case (b), an extreme example of the

Keynesian model, as P rises from P0 there is no adjustment of Pe.
Therefore, in Figure

the demand for labor shifts up along an unchanged supply

curve, raising equilibrium employment and the nominal
wage.
the relation of expected price changes to movements in
the actual price level is crucial. At one extreme, i change in

the actual price level has no effect on equilibrium

employment; a the other extreme it does.

The

Supply of Workers and Hours

. The worker is maximizing the usual utility function of equation (11): U = U(ye,
*S), subject to the budget constraint ye = y + we(T S). T is total hours available, to be
divided between work n and leisure S. With the minimum n constraint, only points to
the left of the vertical S* line are permissible; the worker has to sacrifice at least S*
hours of leisure to get a job.
When the individual labor-supply curves of Figure 6-13 are aggregated over the
labor force, the slope of the resulting aggregate labor-supply curve, then, has the two
components pointed out at the beginning of this section: as w rises, first more workers
thresholds are passed, and E rises; and second, the number of hours worked by those
employed rises, raising n, average hours worked.
The shape of the aggregate worker-supply curve can be explained
as follows. As the wage rate rises from very low levels, increasing numbers
of workers become employed as their w* thresholds are passed, so that at
low wage levels, the curve is concave. But after most of the primary
workersworking heads of households and single malesare employed,
further w increases call forth diminishing increases in the supply of
workers, so that the curve turns convex and becomes nearly vertical at a
high wage level where virtually all potential workers are employed.