1. slide 1 Diploma Macro Paper 2 Monetary Macroeconomics Lecture 2 Aggregate demand: Consumption and the Keynesian Cross Mark Hayes

2. slide 2 Outline Introduction Map of the AD-AS model

3. Goods market KX and IS (Y, C, I) Money market (LM) (i, Y) IS-LM (i, Y, C, I) AD Labour market (P, Y) AS AD-AS (i, P, Y, C, I) Foreign exchange market (NX, e) AD*-AS (i, P, e, Y, C, I, NX) Phillips Curve (,u)

4. slide 4 Short-run effects of an increase in demand Y P AD 1 In the short run when prices are sticky,… …causes output to rise. SRAS Y2Y2 Y1Y1 AD 2 …an increase in aggregate demand…

5. slide 5 Outline Introduction Map of the AD-AS model This lecture, we begin explaining the AD curve Step 1: Equilibrium with variable income and consumption - the Keynesian Cross Various Multipliers

6. slide 6 The Circular Flow I

7. slide 7 The Circular Flow II

8. slide 8 Income in Classical model Profit and Rent Wages Consumption Saving Investment Consumption

9. slide 9 First step to AD - the Keynesian Cross A simple closed economy model (NX exogenous) in which private consumption (C ) is the only element of demand which varies Notation: I = expected investment E = C + I + G = expected expenditure Y = real GDP = value of output

10. slide 10 Elements of the Keynesian Cross Consumption function: for now, investment is exogenous: Expected expenditure: equilibrium condition: Government consumption and tax: Value of output = expected expenditure

11. slide 11 Plotting the equilibrium condition income, output, Y E expected expenditure E =Y 45 º

12. slide 12 Plotting planned expenditure income, output, Y E expected expenditure E =C +I +G

13. slide 13 The equilibrium value of income income, output, Y E expected expenditure E =Y E =C +I +G Equilibrium income c1c1 1

14. slide 14 An increase in autonomous consumption Y E E =Y E =C +I +G 1 E 1 = Y 1 E =C +I +G 2 E 2 = Y 2 Y G

15. slide 15 The spending multiplier Definition: the change in income resulting from a (small) change in autonomous expenditure such as G or I. (In the following slides MPC = c 1 )

16. slide 16 The multiplier as a partial derivative equilibrium condition in changes because I exogenous because C = MPC Y Collect terms with Y on the left side of the equals sign: Solve for Y :

17. slide 17 The spending multiplier In this model, the spending multiplier equals If MPC = 0.8 An increase in G causes income to increase 5 times as much!

18. slide 18 Why the multiplier is greater than 1 An increase in G represents an equal increase in Y: Y = G. But Y C further Y further C further Y So the final impact on income is much bigger than the initial G. But not infinite, it converges.

19. slide 19 Conventional explanation of convergence

20. slide 20 The Phillips Machine, 1949 Invented by Bill Phillips at the LSE. A water- driven analogue computer used to demonstrate Keynesian economics The flaw is that he used water, taking us back to a Classical corn model

21. slide 21 The Phillips Machine, 1949

22. slide 22 The Phillips Machine, 1949

23. slide 23 The Phillips Machine, 1949 www.sms.cam.ac.uk/media/1094078

24. slide 24 An increase in taxes Y E E =C 2 +I +G E 2 = Y 2 E =C 1 +I +G E 1 = Y 1 Y C = MPC T The tax increase reduces consumption, and therefore E:

25. slide 25 The tax multiplier Definition: the change in income resulting from a (small) change in T

26. slide 26 The tax multiplier as a partial derivative equilibrium condition in changes I and G exogenous Solving for Y : Final result:

27. slide 27 The tax multiplier If MPC = 0.8, then the tax multiplier equals

28. slide 28 The tax multiplier …is negative: A tax increase reduces C, which reduces income. …is greater than one (in absolute value): A change in taxes has a multiplier effect on income. …is smaller than the spending multiplier: Consumers save the fraction (1 – MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.

29. slide 29 The balanced budget multiplier

30. slide 30 By definition: Equilibrium Condition: The balanced budget multiplier

31. slide 31 Summary Keynesian cross: equilibrium income determined with income and consumption variable Shows how the direction of causation between saving and investment is reversed from the Classical model The multiplier as comparative statics – Spending, tax and balanced budget multipliers – Comparing two equilibrium positions does not explain the dynamic process linking them

32. slide 32 Next time Step 2 of building the AD curve Finding equilibrium when income, consumption and investment can all move the IS-LM model