Economics I Aggregate Expenditure and Product. Macroeconomic Equilibrium (4h)

The aim of the first lecture lies in the analysis and understanding of aggregate demand and aggregate supply, in the understanding of the AS/AD model – a model of macroeconomic equilibrium. The emphasis will be laid on division of the short and long term and the related definition of the short-term and long-term aggregate supply. Two basic controversial concept of macroeconomic balance will be determined, the Classical and the Keynesian. On the basis of different assumptions there will be described different interpretations of macroeconomic problems and, consequently, there will be pointed out different recommendations for the performing the state macroeconomic policy and impacts of these measures taken by the Government affecting macroeconomic development in the national economy. In the second lecture, the students get acquainted with the circumstances that affect the development of the product on its macro-economic equilibrium level, and the circumstances that lead to change to a new equilibrium, thus leading to variations in the actual product. The main cause of here will be changes in the expenditure on the purchase of the total production (the AD-side). The next point is the interpretation of Neo-Keynesian multiplier model, which will be explained first in terms of the 2-sectorial economy, and then in the conditions of 3-sectorial (closed) and 4-sectoral (real) economy.

Content introduction – defining the goals AS – aggregate supply; short-run aggregate supply (SRAS) and the long-term aggregate supply (LRAS) AD – aggregate demand macroeconomic equilibrium – the AS/AD model classical and Keynesian macroeconomic equilibrium concept multiplier model simple model of 2-sectoral economy and the multiplier model, macroeconomic equilibrium in a model of 45° the multiplier effect in the model of 45° and a simple presentation of the investment multiplier the multiplier effect in a closed (3-sectoral) economy the multiplier effect in an open (4-sectoral) economy conclusion – summary, homework

AS – aggregate supply; the short-run aggregate supply (SRAS) and the long-term aggregate supply (LRAS) AS = Aggregate Supply, aggregate (total) supply of goods and services in the economy short run and long run aggregate supply (SRAS and LRAS) - the factor of time has an impact on the resolution of short-term and long-term aggregate supply shifts in SRAS curve (nominal and real supply shocks) and shifts in LRAS (real supply shocks) shifts in SRAS – are known as positive or negative nominal supply shocks (according to the direction of motion): – they are associated with a change in the total cost of companies (firms) – main factors: change of nominal wage rates, rates of social and health insurance, expectations of future developments, expectations of changes in the price level, the change in the prices of raw materials and energy, and the appreciation of the currency, the sum-of-change the amount of the import duties, a change in tax rates. Real supply shocks: positive or negative (according to the direction of motion): – they are associated with changing the production function

AD – Aggregate demand AD = Aggregate Demand, aggregate (total) demand for goods and services planned expenditures of all economic operators: AD = C + I + G + NX we distinguish the movement along the AD curve (change in price level) and shift the AD curve (demand shocks) the effect of wealth (the Pigou effect) the Keynes effect the main variables that affect the level of AD: the planned consumer expenditures (C) and the planned investment (I) shocks in demand: positive and negative (according to the direction of motion), induced by changing the components of the AD, AD = C + I + G + NX, or induced by the other variables (factors), which in turn affect the AD: e. g. change in interest rates, household wealth, expectations of changes in price levels, expectations of future developments

Macroeconomic Equilibrium – the AS/AD model the term „equilibrium“, point „E“ the balance of the amount demanded and supplied, the total produced and demanded production (in macroeconomics). short run macroeconomic equilibrium: SRAS = AD long run macroeconomic equilibrium: LRAS = AD equilibrium in AS/AD model classical and Keynesian macroeconomic equilibrium concept, the main two assumptions are based on : – different price elasticity (including the prices of inputs) – the mechanism of the equilibrium formation at capital market, where the mechanism of the conversion of savings into investment plays a role (S → I)

Classical and Keynesian macroeconomic equilibrium approach Classical approach of macroeconomic equilibrium: – historically older (conservative stream, neo-classical tradition, liberal economics) – economy is an inherently stable system – flexible prices at production markets and inputs markets – interest rates clean capital market, savings are transformed into investment – economy operates at the level of potential output, which is its center of gravity Keynesian approach of macroeconomic equilibrium: – historically younger concept – economy is an inherently unstable system – limited flexibility in market prices at production and inputs markets (wage rigidity, the existence of imperfect competition, the state-regulated prices) – at capital market disorders are manifested in the mechanism of conversion of savings into investments – economy is operating below the potential output, capital market imbalance is transmitted through the „investment multiplier“ on other markets

Neokeynesian compromise in present economic literature the elastic shape of SRAS as a rising curve is accepted and after its crossing the level of potential output (Y*) it becomes inelastic we distinguish Keynesian field (left from the potential output – there is low elasticity of SRAS) and classical field (right from the potential product – there is high elasticity of SRAS) we use the model of AS/AD with the assumption that economic performance can temporarily exceed the level of potential output

9 AS/AD model – Neokeynesian compromise P Y (GDP) LRAS Y*Y* SRAS AD E PEPE Classical field Keynesian field

Model of multiplier a basic tool of Neokeynesianism (in the US, 50s and 60s in the 20th century, STOP & GO policy) model of multiplier = 45 ° Keynesianism = Keynesian Cross model is based on the concept of Keynesian macroeconomic equilibrium, all assumptions in this model are important, and in graphic presentation the Keynesian spending and savings functions are a prerequisite for understanding the model of multiplier

Simple model of a 2-sectoral economy and the multiplier effect players: firms and households aggregate planned expenditures: AD = C + I Y = YD (DI), it is valid only for 2-sectoral economy macroeconomic equilibrium: Y (AS) = AD model is based on the Keynesian consumption and savings function (C and S) the conversion of savings into investments at the capital market is assumed

12 Keynesian spending a savings function YD = C, S = 0 YD Disposable Income C, S 45° C = Ca + mpc.YD S = - Ca + mps.YD - Ca (negative autonomous spending) YD 3 0 Ca C = YD S = 0 YD 2 YD 1 If C > YD, households create negative savings. If C < YD, households create positive savings.

Simple investment multiplier Kahn-Keynesian multiplier, multiplier in 2-sectoral (simple) economy (α): α = = mpc = marginal propensity to consume mps = marginal propensity to save mpc + mps = 1 (apc + aps = 1; average propensity to consume; to save) - multiplier "α" indicates how many times the product is changed, if autonomous spending (I or Ca) is changed by one unit: ΔY = α. Δ I = Δ I – mpc 1 mps 1 1 – mpc

14 Determination of macroeconomic equilibrium using the model of multiplier (top graph) and determination of macroeconomic equilibrium through savings and investments (bottom graph) AS(Y) = AD Y = YD AD I,S AD = C + I E 45° C = Ca + mpc.YD S = - Ca + mps.YD - Ca I E Y0Y0 Y0Y0 Y*Y* Y 0 = AD AD = C + I Y 0 = YD = C + S YD – C = AD – C S = I 0

15 AS(Y) = AD Y = YD Y AD P AD´ = C + I + ΔI E 45° AD = C + I Y1Y1 Y1Y1 Y*Y* Multiplier effect of investment expenditure in a 2-sectoral (simple) economy Ca + I ΔIΔI LRAS Y*Y* SRAS extreme cause Y2Y2 Y2Y2 AD AD´ E´ ΔYΔY mpc α = Δ Y = α. Δ I Δ Y = mpc. Δ Y + Δ I Increasing Y comprises ΔI and induced consumption mpc.Y. EE´ P stable

16 AS(Y) = AD Y Y AD P AD´ = C + I + G + ΔG E 45° AD = C + I + G Y1Y1 Y1Y1 Y*Y* A ΔGΔG LRAS Y*Y* SRAS extreme cause Y2Y2 Y2Y2 AD AD´ E´ ΔYΔY 1 1 – mpc (1 – t) α G = ΔY = α G. ΔG Increasing Y comprises ΔI and induced consumption mpc.Y. EE´ P stable Multiplier effen in a 3-sectoral (closed) economy

AS(Y) = AD Y Y AD P AD´ = C + I + G + NX + ΔI E 45° AD = C + I + G + NX Y1Y1 Y1Y1 Y*Y* A ΔIΔI LRAS Y*Y* SRAS extreme cause Y2Y2 Y2Y2 AD AD´ E´ ΔYΔY 1 1 – mpc (1 – t) + mpm α I = Δ Y = α I. Δ I Increasing Y comprises ΔI and induced consumption mpc.Y. EE´ P stable Multiplier effect in a 4-sectoral (open) economy

Literature FRANK, R. H., BERNANKE, B. S. Principles of Macroeconomics. 3rd Edition. McGraw- Hill/Irwin: NY, ISBN p. MANKIW, G. N. Principles of Macroeconomics. 4 th ed. USA: Thomson South- Western, p. ISBN McCONNELL, C. R., BRUE, S. L. Economics: Principles, Problems, and Policies. 17th ed. NY: McGraw/Irwin. 716 p. ISBN SAMUELSON, P. A., NORDHAUS, W. D. Economics. 15th ed. McGraw-Hill, 1995.

Homework Exercise “Macroeconomic Equilibrium“ Assume the economy at the level of potential output. Explain what happens to the real GDP and the price level in the economy in the short and long run, and use the AS/AD model for graphic processing, if: a)foreign demand for production of domestic economy increases b)fuel price rises c)labor productivity rises permanently d)personal income and corporate taxes increase e)VAT rate drops f)number of population and labor force drop.

Homework Exercise “Aggregate Expenditure and Product“ Calculate GDP in the 2-sectoral economy, if you know the consumption function C = ,8Y; size autonomous consumption of 100 billion and investment spending I = 30 billion. How will the size of GDP change, if investment spending increases at a) 35; b) 40; c) 65 billion? Calculate the first 5 rounds of multiplication in the 2-sectoral economy, if you know that the increase autonomous spending (i.e. investment spending or autonomous consumption) is 500 monetary units and the marginal propensity to save mps = 0.2. Consider 3-sectoral model of the economy. This economy shows the following statistics: Ca = 100 billion, mpc = 0.8, I = 60 billion, G = 85 billion, TA = 15 billion, TR = 35 billion, t = 25 %. Calculate the size of the equilibrium production. Suppose further increase in investment spending by 20 billion, and calculate how this change will affect the product. Consider the 4-sectoral model of the economy. The economy shows the following statistics: mps = 0.2, t = 25 % mpm = 0.1. Calculate how the change in autonomous spending (e. g. investment spending) will affect the output when increases by 25 billion.