1. Macroeconomics I
Lecture 3

2. Output and aggregate demand

3. Equilibrium model of J. M. Keynes (1936)
Simple model ( no government, the closed economy):
AD = C + I
Sticky wages and prices of goods
factors of production not fully employed
Short run approach: output depends on demand only

4. Demand for consumption goods
Determined by the personal disposal income Yd
Consumption function: C= MPC . Yd + Ca (KSK=MPC)

5. M. Friedman and F. Modigliani consumption function
Permanent income hypothesis of M. Friedman: consumption determined not by current income but by long term income expectations. Short term change in income have little effects on consumer spending behavior
Life cycle hypothesis of F. Modigliani: close to PIH, consumers make consumption plans for the whole life. They dissave early and late in the life and save during their peak earnings years – consumption smoothening. It explains why students live at much better level than their incomes suggest.

6. Saving function
S= MPS x Yd – Ca, KSO= MPS

7. Marginal propensity to consume: fraction of a dollar by which consumption increases when income rises by a dollar
MPC = 0.75 means that 75 cents of every extra dollar in income is consumed
The rest, remaining 25 cents is saved
MPS (marginal propensity to save) = 0.25
MPS + MPC = 1

8. Investment demand
investment plans do not depend on the level of income (autonomous character of I )

9. Goods market equilibrium
AD aggregate demand:
Amount of planned spending
On domestic goods and
Services at each level of
income
AD = C + I
at point E
aggregate demand is equal to
the level of supplied output

10. adjustment to equilibrium
Y, output I C=
8+0.7Y
AD=
C+I
Y-AD
Inventories are
output 30 22 29 51
-21 ↓ ↑ 80 64 86 -6
100 78
No inventories (E)
constant
120 92
114 +6

11. Equilibrium outpt and full employment
AD = Y (output) does not guarantee output at full employment level. At Ye unemployment is possible, distance Yb- Ye = output gap, Yb = full employment output

12. Y=I/1-MPC = I/MPS or if MPC=c, MPS=s
Income determination
C = MPC x Y,
Y = C+I=MPC x Y + I
Y(1-MPC)=I
Y=I/1-MPC
MPC + MPS =1
Y=I/1-MPC = I/MPS or if MPC=c, MPS=s
Y=I/1-c=I/s

13. What is the equilibrium level of output?
C = Y
I = 13
C + I = Y
Y = Y
21 = Y (1-0.7)
Y = 21 : 0.3
Y = 70

14. The multiplier (M)
M = ratio of the change in equilibrium output to the change in autonomous investment
M > 1, because any given change in investment demand sets off further changes in consumption demand
We should expect that that M related to the MPC
M= 1/1- MPC
M=1/MPS
If MPC=0.7, M=1/1-0.7 or
M=1/0.3 = 3.33
The source of multiplier: Increase of the consumption that takes place when autonomous investment goes up

15. adjustment to a shift in investment demand
steps Y I
C= 8+0.7Y
Ad=
C+I
Y-AD
inventories
output
step 1
100 22 78
constant
Constant
step 2 13 91 9 ↑ ↓
step 3
71.7
84.7
6.3
step 4
67.3
80.3
4.4
New equilibrium 70 57
Change in investment
= 9
Change in
= 30
Multiplier = equals
30/9

16. Saving equals investment
I = Y – C
S = Y – C
I = S
In the economy firms are investing and households do the saving
Planned I=planned S only at the equilibrium level of output (unplanned inventory changes = 0)
Out of the equilibrium level of output: actual saving = actual investment (change in inventories counts as investment)
Actual means: planned + unplanned

17. The paradox of thrift Virtues of saving and spending:
1) the increase in the consumption is good for a society, spending provides jobs
2) saving is a good thing, it enables to provide more consumption in the future
Paradox of thrift (Keynesian model):
If AD = Y, but there is no full employment level, the private virtue of saving is not a public virtue (the collective thrift may be bad for the economy)
If AD = Y, but the economy operates at a full employment, the desire to save will increase actual saving and encourage investment, so AD and Y need not decline
What is true of the parts must not be true of the whole

18. The government and aggregate demand 1
The government’s spending and tax decisions constitute fiscal policy
A budget – a description of the spending and financing plans of an individual, business or government
Budget deficit – excess of government expenditure over its receipts
Deficit paid by borrowing from the public through selling bonds
The national debt – amount of government debt in the hands of the public

19. The government and aggregate demand 2
Government’s spending financed by: indirect taxes minus transfers payed to business, direct taxes minus transfers payed to households (NT), income from state property D
Government purchases G - a part of the demand for goods and services
AD=C+I+G
If we assume that net indirect taxes = 0 and D = 0, the budget income equals net income from direct taxes NT = t x Y, Yd=Y-NT, Yd=Y-tY, Yd=Y(1-t)
C =MPC x Yd, C=MPC x Y(1-t)
MPC’ = MPC(1-t),
Multiplier = 1/ 1-MPC’ = 1/1-MPC(1-t)
Taxes drive a gap between GNP and personal disposable income

20. The impact of changes in G and NT
Change in G (NT=0) changes the equilibrium output level. The increase of G – the same effect as an increase in investment demand ( the role of multiplier)
The aggregate demand curve shifts upward by the amount=G
The change of NT – change of C because of the change in MPC’
The slope of C curve is changing
The increase in G and decrease in NT – the increase of the equilibrium output level.

21. The budget deficit
The government budget describes: a) what goods and services the government will buy, b) what transfers it will make and c) how it will finance its spending with tax revenues
D=0, indirect taxes =0, so net direct taxes NT taken into consideration only
S+NT= leakages from circular flow: net taxes and saving – incomes not spent on consumption
I+G=injections: income of firms and government not financed by huseholds
Budget deficit = G - NT
S+NT =G+I, it means that S ≠ I if there is budget deficit or surplus
S-I=G-NT,
If G > NT (budget deficit) , some saving used to finance the deficit (S>I)
2 cases:
1) The increase in G. It makes the budget deficit higher: the equilibrium output level goes up, personal disposable income goes up, that increases saving and S-I, because I does not depend on income. At the same time tax revenues go up because income is going up. But tax revenue do not increase by so much as to end up reducing the deficit. The increased G is only partially, not fully self-financing
2a) G constant, tax rate increases, a direct increase in tax revenue, but also a decline of tax collection because income falls. Direct effect always dominates: higher taxes improve the budget situation, the deficit is going down.
2b) G constant. A tax cut, a direct decrease in tax revenue, but also an increase in tax collection because income goes up. Direct effect dominates – a reduction of budget deficit not possible

22. G=250, MPC=0.75, t=0.2, M=2.5=1/1-0.75(1-0.2)
(1)
Change in G
MPC
(2)
Tax rate
(3)
Multiplier
(4)=(3)x(1)
Change in Y
(5)=(2)x(4)
Change in taxes
(6)=(1)-(5)
Change in deficit
100
0.75
0.2
2.5
250 50
0.9
3.57
357
71.4
28.6
0.7
0.4
1.72
172
68.8
31.2

23. Fiscal policy
Changes in budget revenues and expenditure change aggregate demand level. Increase in G and decrease in NT may stimulate growth of AD
Active use of fiscal policy can get the economy close to its potential level,
Tools of fiscal policy: a) public investment, b)programs supporting employment (subsidies to firms creating new jobs, c)increase in social transfers, tax cut
Limited effects because of: recognition lag, legislation lag (gridlock), implementation lag.
Automatic stabilizers: mechanism that reduces the response of GNP to shifts in aggregate demand caused by oil shock for example or the war
Main automatic stabilizers: unemployment benefits, the income tax

24. the multiplier with proportional taxes
MPC t
MPC’=
MPC(1-t)
multiplier
1/1-MPC’
0.9 O
0.90
10.00
0.2
0.72
3.57
0.7
0.70
3.33
0.56
2.27
0.4
0.42
1.72

25. Foreign trade and income determination
Y=C+I+G+Ex-Im
The marginal propensity to import: the increase in imports per 1$ increase in national income
Multiplier in the open economy 1/1-(MPC’-MPI) = 1/1-MPC’+MPI
Does imports steal jobs at home? Yes but it is dangerous view. It can lead to world wide restriction of trade.
Recession – a need for world-wide expansionary policies not for policies in which each country attempts to steal employment from abroad