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UOL Summer Camp 2017 - Macro

Aggregate Demand

Models
UOL Summer Camp 2017 - Macro

[Models 1]
 Before we continue, we should mention that our objective
is to build a model for the macroeconomy
 Models built to explain macroeconomic phenomena
 The important phenomena are
 Long-run growth (supply side economics, last topic of the
summer camp)
 Business cycles (main focus for the summer camp and the
questions on past exams)
 A macroeconomic model captures the essential features of
the world needed to analyze a particular macroeconomic
problem
 Macroeconomic models should be simple, but they need
not be realistic
UOL Summer Camp 2017 - Macro

[Models 2]
 In the following sections (Aggregate demand, Money and
banking, Monetary and fiscal policy, Aggregate demand and
aggregate supply), we are going to develop the IS-LM and
aggregate demand & supply models
 The IS-LM model present two markets that interact
- Money: Provide an equilibrium for the quantity of money and the interest
rate. This equilibrium is affect by output or income (goods market)

Goods market Market for money

- Goods: In this market the production of goods is determined. Output is


affected by interest rates, which are determined in the money market
 The IS-LM model will be extended to consider the
possibility of having an open economy (i.e. an economy that
makes transactions with the rest of the world). The model
develop will be the IS-LM-BP
UOL Summer Camp 2017 - Macro

Aggregate Demand

The Goods Market


UOL Summer Camp 2017 - Macro

The Goods Market


 A simple closed-economy model in which income is
determined by expenditure (due to J. M. Keynes)
 Depending on the textbook, aggregate demand is
sometimes called planned expenditure. Begg et. al (2014)
used aggregate demand, we are going to use planned
expenditure
 Notation:
 I = planned investment
 PE = C + I + G = planned expenditure
 Y = real GDP = actual expenditure
 Difference between actual & planned expenditure =
unplanned inventory investment (i.e. sales do not meet
their expectations, then inventories accumulate)
UOL Summer Camp 2017 - Macro

The Goods Market

(1) Consumption function: C  C (Y - T )


Remember, this is a function. It says that total consumption depends on (Y-T), which is
disposable income. An example of this function: C = a + b(Y-T), where b>0 and b=Marginal
Propensity to Consume (MPC). Mathematically, MPC  C Y  b

(2) Gov. policy variables: G  G , T T

(3) Investment: I  I (r )

(1-3) Planned expenditure: PE  C (Y - T ) + I (r ) + G


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

Equilibrium condition: actual expenditure = planned expenditure


Y  PE
UOL Summer Camp 2017 - Macro

The Consumption Function


C  C (Y - T )
UOL Summer Camp 2017 - Macro

The Investment Function


I  I (r )
 There are different interest rates. Interest rates can differ according to
their maturity, or according to their risk characteristics
 Typically, the government affect the shortest and most secure interest
rate in the economy. When this rate is increased, all the other rates
also go up (the opposite is also true)
 The IS-LM world assumes one real interest rate
Nominal Interest Rates of US Government Bonds with Nominal Long Term Bond Yields,
different maturities 1919–2011
UOL Summer Camp 2017 - Macro

The Investment Function


I  I (r )

US - Investment and The Interest Rate Spread

Spread: the difference between BAA and AAA corporate bonds. Note that the data shows the % deviation
with respect to each trend
UOL Summer Camp 2017 - Macro

The Goods Market: Equilibrium


Planned expenditure depends
positively on income (slope is “b”
in the example of the previous
slide)
In equilibrium, planned
expenditure is equal to
expenditure and is equal to
PE income
planned Y
expenditure (1) What happens if Y>PE? (to
C +I + G
the right of the equilibrium
Actual point) Inventories are
production
accumulated (sales were below
Planned sales expectations). This induce firms
(or demand)
Y to lay off workers and reduce
Equilibrium
production. Until when? Until
output Y=PE
UOL Summer Camp 2017 - Macro

The Goods Market: Equilibrium


PE
planned Y
(2) What happens if Y<PE? (to
expenditure the left of the equilibrium point)
C +I + G Inventories are reduced. This
induce firms to hire more
workers and increase
production. Until when? Until
Y=PE
Y
Equilibrium
output

The intersection of the two curves represent the equilibrium. This


equilibrium for production does not indicate that the economy is
producing at the level of potential output (the economy could be
produce more or less than the potential output). The way to
interpret the model is that this is a model for the short run, where
output is determine by aggregate demand (or PE)
UOL Summer Camp 2017 - Macro

Fiscal Policy & The Goods Market

PE FISCAL POLICY

PE =C +I +G2 If we increase
government
PE =C +I +G1
expenditures we can
increase PE and
output
ΔG
The key question is:
How big is the
change in Y for a $1
Y increase in G?
PE1 = Y1 ΔY PE2 = Y2
UOL Summer Camp 2017 - Macro

Impact of Government Expenditures: Multiplier

Y  C + I + G equilibrium condition

DY  DC + DI + DG in changes

 DC + DG because I exogenous

 MPC �DY + DG because ΔC = MPC ΔY

Collect terms with ΔY Solve for ΔY :


on the left side of the
equals sign: � 1 �
DY  � ��DG
(1 - MPC) �DY  DG 1 - MPC �

UOL Summer Camp 2017 - Macro

The Multiplier
Definition: the spending multiplier is the increase in
income resulting from a $1 increase in G, I or C autonomus
Example: If MPC = 0.8, then
DY 1 DY 1
   5
DG 1 - MPC DG 1 - 0.8

Initially, the increase in G causes an equal increase in Y


But #Y g #C
g further #Y
g further #C
g further #Y
UOL Summer Camp 2017 - Macro

Aggregate Demand

Government
UOL Summer Camp 2017 - Macro

Government
 Resources: Taxation
 Lump-sum tax: It is a tax that does not depend in any way on the actions
of the economic agent who is being taxed
 Sales tax or Value Added Tax (VAT): taxation over consumption
 Income tax (proportional tax): taxation over income
 Typical consumption function (without taxes): C  c0 + c1Y
 Sales tax:  1 - tVAT  C   1 - tVAT   c0 + c1Y 
 Income tax: C  c0 + c1  1 - tIT  Y
 Other sources of income for the government: debt and
printing money. The IS-LM model is a static model, then
debt cannot be modeled (it would require more than
one period). Typically in the IS-LM model printing
money is not part of government resources, and its
effects are confined to the money market
UOL Summer Camp 2017 - Macro

Government
 Expenditures: in the IS-LM world, expenditures typically
are assumed exogenous. In other words, there is no
theory of why governments spend the level G
 An exception is the case of a balance budget. If the
budget is balanced, then income = expenditures, or the
government is not saving, nor borrowing
 Then, if there is a proportional tax, or an income tax:
C  c0 + c1  1 - t IT  Y
G  t IT Y
UOL Summer Camp 2017 - Macro

Government
 The multiplier for the case of an income tax, a balanced
budget, and a closed economy is
Y  C + I + G   c0 + c1  1 - t IT  Y  + I +  t IT Y 
Y  1 - c1  1 - t IT  - t IT    c0 + I 
1 1
Y  0 
c + I   c0 + I 
1 - c1  1 - t IT  - t IT 1- M

 What are the effects of an increase in the tax rate?


M
 -c1 + 1  0
t IT

 The multiplier: 1
1- M 
UOL Summer Camp 2017 - Macro

Money and Banking

Back to the IS-LM model: the


Money Market
UOL Summer Camp 2017 - Macro

The Money Market


 Due to John Maynard Keynes
 A simple theory in which the interest rate is determined
by money supply and money demand
 Caveat: we discuss about interest rates in the context of
an static model (1 period)
 Simplification: assume
that the Fed controls
the money supply
(there is no MB, M1,
M2, etc; but recall
M=mMB)
 Prices are fixed (we
are in the short-run)
UOL Summer Camp 2017 - Macro

The Money Market

How to interpret the


shape of the money
demand? Think about a
portfolio choice problem.
You can invest in money
and bonds (or deposits).
Only bonds pay “r”.
In this case, the interest rate is the “opportunity cost of holding money”
UOL Summer Camp 2017 - Macro

The Money Market: Equilibrium


UOL Summer Camp 2017 - Macro

Monetary Policy & Money Market

Note: the demand


for money not
only depends on
the interest rate, it
can also depend
on income, hence
L(r,Y)
UOL Summer Camp 2017 - Macro

The Money Market


 Following Begg et. al (2014), the money market
equations are given by
Interest rate that could be earned by
LS investing wealth elsewhere

LD   +  Y -   r - rd    0,   0,   0
Interest rate on deposits

LS  LD   +  Y -   r - rd 

Equilibrium: for given levels of LS, Y and rd, there is only one level of
r that ensures the equilibrium in the money market
UOL Summer Camp 2017 - Macro

Index
 Introduction to macroeconomics
 Aggregate demand
 Money and banking
 Monetary and fiscal policy
 Aggregate demand and aggregate supply
 Inflation
 Unemployment
 Exchange rates and the balance of payments
 Open economy macroeconomics
 Business cycles
 Supply-side economics and economic growth
UOL Summer Camp 2017 - Macro

The IS-LM Model


 In the previous sections (Aggregate demand, Money and
banking, Monetary and fiscal policy, Aggregate demand and
aggregate supply) we developed the foundations for the IS-
LM model
 Recall that the IS-LM model present two markets that
interact

- Money: Provide an equilibrium for the quantity of money and the interest
rate. This equilibrium is affect by output or income (goods market)

Goods market Market for money

- Goods: In this market the production of goods is determined. Output is


affected by interest rates, which are determined in the money market
UOL Summer Camp 2017 - Macro

Derivation of the IS curve: The Goods Market


Def. IS curve: a graph of all combinations of r and Y that result in goods market eq.
The equation for the IS curve is Y  C (Y - T ) + I (r ) + G

Derivation of the IS curve:


UOL Summer Camp 2017 - Macro

Derivation of the IS curve: The Goods Market


Def. IS curve: a graph of all combinations of r and Y that result in goods market eq.
The equation for the IS curve is Y  C (Y - T ) + I (r ) + G

Derivation of the IS curve:


UOL Summer Camp 2017 - Macro

The Goods Market: The IS Curve & Fiscal Policy


UOL Summer Camp 2017 - Macro

Derivation of the LM Curve: The Money Market


Def. LM curve: a graph of all combinations of r and Y that result in money market eq.
The equation for the LM curve is
Derivation of the LM curve:
UOL Summer Camp 2017 - Macro

Derivation of the LM Curve: The Money Market


Def. LM curve: a graph of all combinations of r and Y that result in money market eq.
The equation for the LM curve is
Derivation of the LM curve:

If Y increases:
Demand for
money is
higher, L shifts
to the right.
The
equilibrium L (r , Y2 )
interest rate
increases

Note: in the derivation of the IS “r” was exogenous (fixed or given), and in order to derive the IS we move
“r”. In the derivation of the LM “y” is exogenous, and we move this variable
UOL Summer Camp 2017 - Macro

The Money Market: The LM Curve & Monetary Policy


 Same exercise: FED raise “r” (contractionary MP). In
order to raise “r”, the FED contracts the money supply

For the same level of output


UOL Summer Camp 2017 - Macro

The IS-LM Model: Equilibrium

We can use the IS-LM model to analyze the effects of fiscal policy
(G and/or T) and monetary policy ( M)
UOL Summer Camp 2017 - Macro

The IS-LM Model: Equilibrium

Goods market Market for money

“Y” is determined, is endogenous “r” is determined, is endogenous


From the point of view of the From the point of view of the
goods market (partial money market (partial
equilibrium), “r” is fixed or equilibrium), “Y” is fixed or
exogenous exogenous
Changes in “G” will change “Y” Changes in “MS” will change “r”
UOL Summer Camp 2017 - Macro

The IS-LM Model: Equilibrium

Goods market Market for money

“Y” is determined, is endogenous “r” is determined, is endogenous


From the point of view of the From the point of view of the
goods market (partial money market (partial
equilibrium), “r” is fixed or equilibrium), “Y” is fixed or
exogenous exogenous
Changes in “G” will change “Y” Changes in “MS” will change “r”

If there are changes in the goods market, “Y” will


change. Changes in “Y” will affect the market for
money, because money demand depends on “Y”
UOL Summer Camp 2017 - Macro

The IS-LM Model: Equilibrium


If there are changes in the market for money, “r”
will change. Changes in “r” will affect the goods
market, because investment depends on “r”

Goods market Market for money

“Y” is determined, is endogenous “r” is determined, is endogenous


From the point of view of the From the point of view of the
goods market (partial money market (partial
equilibrium), “r” is fixed or equilibrium), “Y” is fixed or
exogenous exogenous
Changes in “G” will change “Y” Changes in “MS” will change “r”

If there are changes in the goods market, “Y” will


change. Changes in “Y” will affect the market for
money, because money demand depends on “Y”
UOL Summer Camp 2017 - Macro

The IS-LM Model


 Following Begg et. al (2014), a simplified version of the
IS-LM model (a more complete version is on the
University of London’s study guide) is given by
Y  A - br IS _ schedule A, b  0
Y  D + er LM _ schedule e  0, 0  D  A

IS  LM : A - br  D + er
r   A - D  b + e Y   Ae + bD   b + e 
UOL Summer Camp 2017 - Macro

The IS-LM Model

Changes in Fiscal Policy &


Monetary Policy
UOL Summer Camp 2017 - Macro

The IS-LM Model: Fiscal Policy, an Increase in G

Key point: there is an interaction between the two markets. The reduction
in private investment related to an expansionary fiscal policy is called
“CROWDING OUT” effect
UOL Summer Camp 2017 - Macro

IS-LM & Aggregate Demand

IS-LM & Aggregate Demand


UOL Summer Camp 2017 - Macro

Aggregate Demand
 The IS-LM model is a model for the short-run. It assumes
that prices are fixed in the short run
 Now, the question is what is the relation between the
model and aggregate demand?
 Aggregate demand is a negative relation that indicates
that the higher the level of prices, the lower the quantity of
goods demanded in the economy
 Fortunately, the IS-LM model considers these two
variables: prices and output

IS : Y  C  Y  + I  r  + G
LM : M P  L  r , Y 
UOL Summer Camp 2017 - Macro

Derivation of Aggregate Demand

r LM(P2)
Intuition for slope LM(P1)
r2
of AD curve:
r1
hP g i(M/P )
IS
g LM shifts left Y2 Y1 Y
P
g hr
P2
g iI
P1
g iY
AD
Y2 Y1 Y
UOL Summer Camp 2017 - Macro

Aggregate Demand: Expansionary Fiscal Policy

r LM
Expansionary fiscal policy
(hG and/or iT ) increases r2
agg. demand: r1 IS2
iT g hC IS1
Y1 Y2 Y
g IS shifts right P

g hY at each
P1
value of P
AD2
AD1
Y1 Y2 Y
UOL Summer Camp 2017 - Macro

Aggregate Demand: Expansionary Monetary Policy

r LM(M1/P1)
The Fed can increase
r1 LM(M2/P1)
aggregate demand:
r2
hM g LM shifts right
IS
g ir Y1 Y2 Y
P
g hI
g hY at each P1
value of P AD2
AD1
Y1 Y2 Y
UOL Summer Camp 2017 - Macro

IS-LM, Aggregate Demand & Aggregate Supply

IS-LM, Aggregate Demand &


Aggregate Supply
UOL Summer Camp 2017 - Macro

Business Cycle Measurement: GDP and Unemploym.


Recession Recession

Output
Potential
Output output
(GDP)

Time

Unemployment

Natural rate of
unemployment
Actual unemployment
Time

Note: recession in the graph is defined as: output below potential


NBER recession: period of falling output
UOL Summer Camp 2017 - Macro

US data: GDP/potential vs Unemployment-Natural U

Note: GDP and


potential is in
billions of 2009
dollars
UOL Summer Camp 2017 - Macro

Aggregate Supply
 Aggregate supply represents the production side of the
economy
 Aggregate supply describes the relation between output,
that firms are willing to produce, and prices
 We will not provide a formal model to derive the
aggregate supply curve
 In the short run, we can argue that the supply curve
(SRAS) is upward sloping (firms are willing to produce more
if prices are higher), while in the long run the aggregate
supply is vertical (production is determined by supply side
factors like technology or productivity and there is no
relation between production and prices)
UOL Summer Camp 2017 - Macro

Aggregate Supply & Demand


 Equilibrium in the short run
UOL Summer Camp 2017 - Macro

Aggregate Supply & Demand


 Equilibrium in the long run
 We have a self-correcting mechanism:
 If Y  Y,nno pressures on the labor market (output
is equal to its potential, which is consistent with the
natural rate of unemployment or NAIRU - no
accelerating inflation rate of unemployment)
 If Y  Y n , production is above its potential. Firms
will want to hire more workers. Labor markets are
tight, wages increase, production costs increase, the
SRAS shifts to the left
 If Y  Y n, the opposite
 Note that we require flexibility in the labor market, or
that wages are flexible
UOL Summer Camp 2017 - Macro

Aggregate Supply & Demand


 Adjustment to long run equilibrium: from 1 to 3
UOL Summer Camp 2017 - Macro

Shocks & Aggregate Supply & Demand


 Changes in equilibrium caused by AD shock

 Short run: from 1 to 1’ / Long run: from 1’ to 2


 An AD shock can be a change in autonomous
investment or consumption. The same movements can
be generated using an expansionary government policy
 Government policies affect output in the short-run
UOL Summer Camp 2017 - Macro

Shocks & Aggregate Supply & Demand


 Changes in equilibrium caused by AS shock
 Short run: from
1 to 2
 Long run: from
2 to 1

 An AS shock can be a weather shock, or new temporary


government’s regulations that affect firms performance
 Adjustment requires a reduction in prices, as in the
figure. Keynesians argue that the adjustment process is
very slow (wages are sticky), and the government can
intervene (fiscal/monetary) to stabilize the economy
UOL Summer Camp 2017 - Macro

Productivity Shocks
 We mentioned that the supply side is linked to the
production side of the economy, in particular, to firms
 Firms are typically modeled in the following way
  AF  K , L  - wL - rK
 The firms’ profits () are the difference between (1)
income or production (which is a combination of
productivity A, capital K and labor L) and (2) production
costs (the wage cost, which is the product of wages w
and labor, and the cost of capital, which is the product of
the cost per unit of capital r and capital)
 A positive productivity shock can be interpreted as an
increase in potential output, or an increase in the LRAS