Professor K.D. Hoover, Econ 210D Topic 6 Spring Econ 210D Intermediate Macroeconomics Spring 2015 Professor Kevin D. Hoover Topic 6 Aggregate Demand

Professor K.D. Hoover, Econ 210D Topic 6 Spring Aggregate Supply and Aggregate Demand Product-Expenditure Identity o AS = Y = C + I + G + NX = AD Initial Simplication o Closed Economy: NX = IM = EX =0 o Y = C + I + G

Professor K.D. Hoover, Econ 210D Topic 6 Spring Consumption Function - 1 John Maynard Keynes The General Theory of Employment, Interest, and Money (1936)

Professor K.D. Hoover, Econ 210D Topic 6 Spring Consumption Function - 2 A Linear Consumption Function: C = c 0 + cYD o marginal propensity to consume (mpc) = c o Keynes’s fundamental psychological law: 0 < c < 1 o average propensity to consume (apc) = C/YD Disposable-Income Identity: YD = Y + TR – T

Professor K.D. Hoover, Econ 210D Topic 6 Spring Savings Function Savings Function S = –c 0 + (1 – c ) YD o marginal propensity to save (mps) = (1 – c ) o mpc + mps = 1

Professor K.D. Hoover, Econ 210D Topic 6 Spring Tax Function A Linear Tax Function: T =  0 +  Y o  = marginal tax rate o A flat tax =  = constant o Reasonable simplification  0 = 0;  = 17% o T =  Y

Professor K.D. Hoover, Econ 210D Topic 6 Spring Simple Model of Aggregate Demand – 1 Inflow-Outflow Identity: I + G + EX = S + ( T – TR ) + IM Simplifications o No foreign sector: EX = IM = 0 o Transfers treated as negative taxes o Autonomous Expenditure ( A ) = I + G + EX Simplified Identity: A = S + T

Professor K.D. Hoover, Econ 210D Topic 6 Spring Simple Model of Aggregate Demand – 2 Example:  = 20%; c = 0.9

Professor K.D. Hoover, Econ 210D Topic 6 Spring Stimulus Economics His favorite part of economic analysis

Professor K.D. Hoover, Econ 210D Topic 6 Spring The Autonomous-Expenditure Multiplier The multiplier: o  > 1 o “spending begets spending”: the basis for stimulus economics o c     o     

Professor K.D. Hoover, Econ 210D Topic 6 Spring Fiscal Policy: Baseline Model -- Setup No EX, IM, TR: o I + G = S + T Behavior o Consumption function: C = 0.8( Y – T ) o therefore, S = (1 – 0.8)( Y – T ) o Tax function: T = (1/6) Y = Y o Initial Conditions: I = 500; G = 500

Professor K.D. Hoover, Econ 210D Topic 6 Spring Fiscal Policy: Baseline Model -- Solution Y = 500 Budget Deficit = G – T = 0

Professor K.D. Hoover, Econ 210D Topic 6 Spring Fiscal Policy: Experiment #1 Goal:  Y = 600 – i.e., Y = 3,600 How big a stimulus is needed?  G =  Y /3 = 600/3 = 200; G = 700 after stimulus Budget deficit: G – T = 700 – (1/6)3,600 = 100

Professor K.D. Hoover, Econ 210D Topic 6 Spring Fiscal Policy: Experiment #2 Goal:  Y = 600 – i.e., Y = 3,600 How big a tax cut is needed?  = 9.72% Budget deficit: G – T = 500 – × 3,600 = 150

Professor K.D. Hoover, Econ 210D Topic 6 Spring Fiscal Policy: Experiment #3 – 1 Goal: Target particular level of T not a particular rate of  Multiplier formulae: o Tax Multiplier o Autonomous expenditure multiplier

Professor K.D. Hoover, Econ 210D Topic 6 Spring Fiscal Policy: Experiment #3 – 2 Goal:  T = –100 Effect on Y ?  Y = – 4( – 100)= 400; Y = 3,400 after tax cut Tax rate:  = T/Y = 400/3,400 = 11.76% Budget Deficit: G – T = 500 – 400 = 100

Professor K.D. Hoover, Econ 210D Topic 6 Spring Fiscal Policy: Experiment #4 – 1 Goal: Raise G while keeping budget balanced – i.e., G = T at all times. Effect on Y ? Balanced-budget multiplier:

Professor K.D. Hoover, Econ 210D Topic 6 Spring Fiscal Policy: Experiment #4 – 2 Goal:  Y = 600; Y = 3,600 What  must be set?  G =  T =  Y = 600. Tax rate:  = T/Y = 1,100/3,600 = 30.56% Budget Deficit: G – T = 1,100 – × 3,600 = 0

Professor K.D. Hoover, Econ 210D Topic 6 Spring Opportunity Cost of Investment opportunity cost = rr -  As opportunity cost rises (  rr or  ), investment falls.

Professor K.D. Hoover, Econ 210D Topic 6 Spring

Professor K.D. Hoover, Econ 210D Topic 6 Spring The IS Curve  A  rightward shift   rightward shift    downward pivot

Professor K.D. Hoover, Econ 210D Topic 6 Spring The Limits to Aggregate Demand Where does stimulus pressure go at full employment, when real AD tries to be > real AS but must be real AD = real AS? o In short run, runs down inventories =  I = negative stimulus. o Leaks into imports and reductions of exports:  NX = negative stimulus. o Translates into inflation:  p   real AD for same level of nominal AD.

Professor K.D. Hoover, Econ 210D Topic 6 Spring END of Topic 6 Next Topic: 7. Macroeconomic Dynamics