1. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. Chapter 3 Income and Interest Rates: The Keynesian Cross Model and the IS Curve

2. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-2 Theory of Business Cycles: Outline Ch 3: Spending, Income and Interest Rates –Use the Keynesian Cross Model to derive the IS curve Ch 4: Monetary and Fiscal Policy in the IS/LM Model –Use equilibrium in the money market to derive the LM curve –Combine the IS and LM curves to determine Y and i Ch 5: Financial Markets, Financial Regulation and Economic Instability Ch 6: The Government Budget, Government Debt and the Limitations of Fiscal Policy Ch 7: International Trade, Exchange Rates and Macroeconomic Policy

3. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-3 The Volatile Business Cycle The goal of monetary and fiscal policy is to dampen business cycle fluctuations and to promote steady economic growth. The “Great Moderation” refers to the 1986-2007 period where business cycle fluctuations noticeably diminished. The Global Economic Crisis or “Great Recession” followed the “Great Moderation.” –Casts doubt on belief of the improved effectiveness of monetary and fiscal policy in the 1986-2007 period –Alternate explanation: Shocks were moderate 1986-2007

4. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-4 Figure 3-1 Real GDP Growth in the United States, 1950–2010

5. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-5 Aggregate Demand and Supply Aggregate Demand (AD) is the total amount of desired spending expressed in current (or nominal) dollars. –A demand shock is a significant change in desired spending by consumers, business firms, the government or foreigners. Algebraically, any change in C, I, G or NX Aggregate Supply (AS) is the amount that firms are will to produce at any given price level. –A supply shock is a significant change in costs of production for business firms, including wages and the prices of raw materials, like oil. AS and supply shocks will be considered in Chapters 8 and 9.

6. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-6 Modeling Preliminaries Simplifying assumption: –The price level (P) is fixed in the short run. Implication: All changes in AD automatically cause changes in real GDP by the same amount and in the same direction. The variables that an economic theory tries to explain are called endogenous variables. –Examples: Output and interest rates Exogenous variable are those that are relevant but whose behavior the theory does not attempt to explain; their values are taken as given. –Examples: Money supply, government spending, tax rates

7. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-7 Consumption and Savings The consumption function is any relationship that describes the determinants of consumption spending. General linear form: C = C α + c(Y – T) where… C α = Autonomous consumption c = marginal propensity to consume c(Y – T) = induced consumption Savings (S) = Y – T – C Substituting in C from above yields: S = Y – T – [C α + c(Y – T)]  S =– C α + (1 – c)(Y – T)] where… (1 – c) = marginal propensity to save (s)

8. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-8 Figure 3-2 A Simple Hypothesis Regarding Consumption Behavior

9. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-9 Factors Affecting C α Interest Rates (r): When r ↓  borrowing is cheaper for consumers  C α ↑ –Example: Low interest rates in 2001-04 stimulated consumption of automobiles and other consumer products. Household Wealth (W) is the total net value of all household assets (minus any debt), including the market value of homes, possessions such as automobiles, and financial assets such as stocks, bonds and bank accounts. –If W ↑  HH spending can ↑ even if income is fixed  C α ↑ –Example: The 1990’s stock market boom raised consumption. The set of Financial Market Institutions determines the ease with which households can borrow to buy “big-ticket” items. –Example: From 2001-06, loans were easily obtained, which helped fuel the housing bubble.

10. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-10 Planned vs. Unplanned Expenditure Recall the National Income Accounting Identity: Y = C + I + G + NX GDP or Output = Unplanned Expenditure –Unplanned Expenditure always equals GDP because the equation is an identity. Planned Expenditure (E P ) = C + I P + G + NX –Only Investment has an unplanned spending component Goods that are produced, but not sold are counted as unplanned inventories. –E P = GDP only at equilibrium (when unplanned spending = 0) Algebraically, E P = A P + c(Y – T) where… –A P = Autonomous Spending = C α – cT α + I P + G + NX

11. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-11 The Equilibrium of the Economy At equilibrium, Y = E P Y = A P + cY (assuming T = 0) To find equilibrium Y, solve the above equation for Y:  (1 – c)Y = A P  sY = A p  Y = (1/s) A P If the level of A P changes over time by ∆A P, then the change in output, ∆Y, is given by: ∆Y = (1/s) ∆A P 1/s is called the multiplier because it shows how each additional dollar of autonomous spending results in a greater than $1 increase in equilibrium output.

12. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-12 Figure 3-3 How Equilibrium Income Is Determined

13. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-13 Table 3-1 Comparison of the Economy’s “Always True” and Equilibrium Situations

14. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-14 Figure 3-4 The Change in Equilibrium Income Caused by a $500 Billion Increase in Autonomous Planned Spending

15. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-15 Shifts in Planned Spending Recall: E P = C + I P + G + NX = A P + cY where A P = C α – cT α + I P + G + NX Any increase in A P will shift up E P on the Keynesian Cross Diagram. –Effect on Y: ∆Y = (1/s) ∆A P where If c changes, the E P line will rotate If the effect on Y is negative, fiscal policy can be used to offset the effect.

16. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-16 Government Budget Deficit and its Financing Suppose an increase in G is financed by issuing bonds –C α, T α, I P and NX are unchanged  ∆Y = (1/s) ∆G –What happens to the “Magic Equation” ? Recall: (T – G) = (S – I ) + NX In “∆” form: (∆T – ∆G ) = (∆S – ∆I) + NX Since T, I and NX are constant  ∆G = ∆S Using ∆Y = (1/s) ∆G  ∆G = s∆Y… but s∆Y = ∆S !!! –Result: The higher level of government purchases leads to an increase in income, which yields the higher level of savings needed for households to purchase the bonds to pay for the increase in G!

17. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-17 The Balanced Budget Multiplier Suppose an increase in G is paid for by raising taxes (i.e. the government is running a balanced budget) –∆G = ∆T α (while I P and NX are unchanged) –∆Y = (1/s) ∆A P = (1/s)(∆G – c∆T α ) = (1/s)(∆G – c ∆G) –Recall: s = (1-c) –Then: –Result: The balanced budget multiplier is 1!

18. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-18 Figure 3-5 Relation of the Various Components of Autonomous Planned Spending to the Interest Rate

19. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-19 Investment Volatility and Business Cycles Investment Falls Relative to GDP in Every Recession

20. Copyright © 2012 Pearson Addison-Wesley. All rights reserved. 3-20 Figure 3-6 Relation of the IS Curve to the Demand for Autonomous Spending