advanced macroeconomics (806) (1)

8/2/2019 Advanced Macroeconomics (806) (1)

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Advanced Macroeconomics (805) Roll# AI-54458

Advanced Macroeconomics (806)

Assignment # 1

Name: Komal Almas

Roll# AI-544589

Q1: (a) Show that a given change in money stock has a larger effect on output

the less interest sensitive the demand for money?

The demand for money is the desired holding of financial assets in the form of money:

that is, cash or bank deposits. It can refer to the demand for money narrowly defined

as M1 (non-interest-bearing holdings), or for money in the broader sense of M2 or M3.

Money in the sense of M1 is dominated as a store of value by interest-bearing assets.

However, money is necessary to carry out transactions; in other words, it provides

liquidity. This creates a trade-off between the liquidity advantage of holding money and

the interest advantage of holding other assets. The demand for money is a result of

this trade-off regarding the form in which a person's wealth should be held. In

macroeconomics motivations for holding one's wealth in the form of money can roughlybe divided into the transaction motive and the asset motive. These can be further

subdivided into more micro economically founded motivations for holding money.

Generally, the nominal demand for money increases with the level of nominal output

(price level times real output) and decreases with the nominal interest rate. The real

demand for money is defined as the nominal amount of money demanded divided by

the price level. For a given money supply the locus of income-interest rate pairs at

which money demand equals money supply is known as the LM curve.The magnitude of the volatility of money demand has crucial implications for the

optimal way in which a central bank should carry out monetary policy and its choice of

a nominal anchor.

Conditions under which the LM curve is flat, so that increases in the money

supply have no stimulatory effect (a liquidity trap), play an important role in Keynesian

theory. This situation occurs when the demand for money is infinitely elastic with

respect to the interest rate.A typical money-demand function may be written as

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An increase in the economy's potential to produce output is captured by an outward

shift in the long-run aggregate supply function. A tax policy that:

a) Increases the return or profitability from supplying inputs and stimulates a

greater use of inputs (at each aggregate price level) or

b) Increases the productivity of inputs will lead to an outward shift in the

aggregate supply curve.

Examples of such tax policies are investment tax credits, reduced corporate profits

taxes, and educational tax credits. For each tax policy, a specific linkage to economic

growth must be developed. For instance, an investment tax credit will lead to increased

net investment and an increase in the capital stock; with more capital the aggregatesupply function shifts outward. Economic growth leads to an outward shift in the

economy's production possibilities frontier or boundary.

Relationship between the quantity of a commodity that producers have available for

sale and the quantity that consumers are willing and able to buy. Demand depends on

the price of the commodity, the prices of related commodities, and consumers' incomes

and tastes. Supply depends not only on the price obtainable for the commodity but alsoon the prices of similar products, the techniques of production, and the availability and

costs of inputs. The function of the market is to equalize demand and supply through

the price mechanism. If buyers want to purchase more of a commodity than is

available on the market, they will tend to bid the price up. If more of a commodity is

available than buyers care to purchase, suppliers will bid prices down. Thus, there is a

tendency toward an equilibrium price at which the quantity demanded equals the

quantity supplied. The measure of the responsiveness of supply and demand to

changes in price is their elasticity.

A fundamental economic concept, which holds that the price is set at an amount where

the quantity supplied and quantity, demanded clear the market. From that intersection,

higher prices will increase supply, reduce demand, or both. Lower quantities demanded

will reduce prices.

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Example: The prices of rents and real estate products are set in the market by supply

and demand. However, the amount of real estate adjusts slowly to market forces

because of the long planning and development period and the lengthy physical life of

improvements.

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Q2: Derive from standard Keynesian model the fiscal (government

expenditures) and money multiplies and discuss the circumstances in

which these multipliers are respectively equal to zero. Explain n words

why this can happen and how likely you think this is.

Money multiplier:

In monetary macroeconomics and banking, themoney multipliermeasures how much

themoney supply increases in response to a change in themonetary base.

The multiplier may vary across countries, and will also vary depending on what

measures of money are considered. For example, considerM2as a measure of the U.S.

money supply, andM0as a measure of the U.S. monetary base. If a $1 increase in M0

by theFederal Reservecauses M2 to increase by $10, then the money multiplier is 10.

Fiscal multipliers:

Multipliers can be calculated to analyze the effects offiscal policy, or other exogenous

changes in spending, onaggregate output.

For example, if an increase in German government spending by 100, with no

change in taxes, causes GermanGDPto increase by 150, then thespending

multiplieris 1.5. Other types offiscal multiplierscan also be calculated, like multipliersthat describe the effects of changing taxes (such aslump-sum taxesorproportional

taxes).

Keynesian multiplier:

Keynesianeconomists often calculate multipliers that measure the effect onaggregate

demandonly. (To be precise, the usualKeynesian multiplierformulas measure how

much theIS curveshifts left or right in response to an exogenous change in spending.)Opponents of Keynesianism have sometimes argued that Keynesian multiplier

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calculations are misleading; for example, according to the theory ofRicardian

equivalence, it is impossible to calculate the effect of deficit-financed government

spending on demand without specifying how people expect the deficit to be paid off in

the future.

American EconomistPaul SamuelsoncreditsAlvin Hansenfor the inspiration behind hisseminal 1939 contribution. The original Samuelson multiplier-accelerator model (or, as

he belatedly baptised it, the "Hansen-Samuelson" model) relies on a multiplier

mechanism which is based on a simple Keynesian consumption function with a

Robertsonian lag:

Ct= c0 + cYt 1

So present consumption is a function of past income (with c as the marginal propensity

to consume)Investment, in turn, is assumed to be composed of three parts:

It= I0 + I(r) + b (Ct Ct 1)

The first part is autonomous investment, the second is investment induced by interest

rates and the final part is investment induced by changes in consumption demand (the

"acceleration" principle). It is assumed that 0 < b. As we are concentrating on the

income-expenditure side, let us assume I(r) = 0 (or alternatively, constant interest), so

that:

It= I0 + b(CtCt 1)

Now, assuming away government and foreign sector, aggregate demand at time t is:

Ytd= Ct+ It= c0 + I0 + cYt 1 + b(CtCt 1)

Assuming goods market equilibrium (soYt = Ytd), then in equilibrium:

Yt = c0 + I0 + cYt 1 + b(CtCt 1)

But we know the values ofCtandCt 1are merelyCt= c0 + cYt 1andCt

1 = c0 + cYt 2respectively,

Then substituting these in,

Yt = c0 + I0 + cYt 1 + b(c0 + cYt 1 c0 cYt 2)

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Or, rearranging and rewriting as a second order linear difference equation:

Yt (1 + b)cYt 1 + bcYt 2 = (c0 + I0)

The solution to this system then becomes elementary. The equilibrium level of Y (call

itYp, the particular solution) is easily solved by lettingYt = Yt 1 = Yt 2 = Yp,

Or:

(1 cbc+ bc)Yp = (c0 + I0)

Yp = (c0 + I0) / (1 c)

The complementary function,Ycis also easy to determine. Namely, we know that it willhave the formYc=A1r1t+A2r2twhereA1andA2are arbitrary constants to be defined

and wherer1andr2are the twoeigenvalues(characteristic roots) of the following

characteristic equation:

r2 (1 + b)cr+ bc= 0

Thus, the entire solution is written asY= Yc+ Yp

In economics, the fiscal multiplier is the ratio of a change in national income to the

change in government spending that causes it. More generally, the exogenous

spending multiplier is the ratio of a change in national income to any autonomous

change in spending (private investment spending, consumer spending, government

spending, or spending by foreigners on the country's exports) that causes it. When this

multiplier exceeds one, the enhanced effect on national income is called the multiplier

effect. The mechanism that can give rise to a multiplier effect is that an initial

incremental amount of spending can lead to increased consumption spending,

increasing income further and hence further increasing consumption, etc., resulting in

an overall increase in national income greater than the initial incremental amount of

spending. In other words, an initial change in aggregate demand may cause a change

in aggregate output (and hence the aggregate income that it generates) that is a

multiple of the initial change.

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However, multiplier values less than one have been empirically measured, suggesting

that certain types of government spending crowd out private investment or consumer

spending that would have otherwise taken place. This crowding out can occur because

the initial increase in spending may cause an increase in interest rates or in the price

level.The existence of a multiplier effect was initially proposed by Richard Kahn in 1930 and

published in 1931. It is particularly associated with Keynesian economics. Some other

schools of economic thought reject or downplay the importance of multiplier effects,

particularly in terms of the long run. The multiplier effect has been used as an

argument for the efficacy of government spending or taxation relief to stimulate

aggregate demand.

Various types of fiscal multipliers:

The following values are theoretical values based on simplified models, and the

empirical values corresponding to the reality have been found to be lower (see below).

Note: In the following examples the multiplier is the right-hand-side equation without

the first component.

y is original output (GDP)

bC is marginal propensity of consumption (MPC)

bT is original income tax rate

bM is marginal propensity to import

yis change in income (equivalent to GDP)

aT is change in lump-sum tax rate

bT is change in income tax rate

G is change in government spending

Tis change in aggregate taxes

Iis change in investment

Xis change in exports

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Q3: Considering the model, draw the short run aggregate supply curve under

these cases:

Aggregate supply

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Aggregate Supply (AS) measures the volume of goods and services produced within the

economy at a given overall price level. There is a positive relationship between AS and

the general price level. Rising prices are a signal for businesses to expand production

to meet a higher level of AD. An increase in demand should lead to an expansion of

aggregate supply in the economy.

Short-run aggregate supply curve

Aggregate supply is determined by the supply side performance of the economy.

It reflects the productive capacity of the economy and the costs of production in

each sector.

Shifts in the AS curve can be caused by the following factors:

changes in size & quality of the labour force available for production

changes in size & quality ofcapital stock through investment technological progress and the impact ofinnovation

changes in factor productivity of both labour and capital

changes in unit wage costs (wage costs per unit of output)

changes in producer taxes and subsidies

changes in inflation expectations - a rise in inflation expectations is likely to

boost wage levels and cause AS to shift inwards

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In the diagram above - the shift from AS1 to AS2 shows an increase in aggregatesupply at each price level might have been caused by improvements in technology and

productivity or the effects of an increase in the active labour force.

An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price level. This

might have been caused by higher unit wage costs, a fall in capital investment

spending (capital scrapping) or a decline in the labour force.

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Q4: In the Keynesian model, how will an increased desire by the public to hold

money balances affect prices, income, and employment? How your answers

would differ in classical model?

KEYNESIAN MODEL:

A macroeconomic model based on the principles of Keynesian economics that is used to

identify the equilibrium level of, and analyze disruptions to, aggregate production and

income. This model identifies equilibrium aggregate production and income as the

intersection of the aggregate expenditures line and the 45-degree line. The Keynesian

model comes in three basic variations designated by the number of macroeconomic

sectors included--two-sector, three-sector, and four sector. The Keynesian model is

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also commonly presented in the form of injections and leakages in addition to the

standard aggregate expenditures format. This model is used to analyze several

important topics and issues, including multipliers, business cycles, fiscal policy, and

monetary policy.

The Keynesian model, commonly presented as the Keynesian cross-intersection

between the aggregate expenditures line and the 45-degree line, was the standard

macroeconomic analysis throughout the mid-1900s, from the Great Depression to the

early 1980s. While it was largely replaced by aggregate market analysis (or AS-AD

analysis) in the 1980s, it continues to provide important insight into the workings of

the macro economy.

A Keynesian Overview

Keynesian economics is a theory of macroeconomics developed by John Maynard

Keynes based on the proposition that aggregate demand is the primary source of

business-cycle instability and the most important cause of recessions. Keynesian

economics points to discretionary government policies, especially fiscal policy, as the

primary means of stabilizing business cycles and tends to be favored by those on the

liberal end of the political spectrum. The basic principles of Keynesian economics were

developed by Keynes in his book, The

General Theory of Employment, Interest and Money, published in 1936. This work

launched the modern study of macroeconomics and served as a guide for both

macroeconomic theory and macroeconomic policies for four decades.

The three key assumptions of Keynesian economics are:

Rigid Prices: Keynesian economics presumes that prices are inflexible or rigid,

especially in the downward direction. This can prevent markets from

achieving equilibrium.

Effective Demand: Keynesian economics is also based on the notion of effective

demand, the principle that consumption expenditures are based on the

disposable income actually available to the household sector rather than incomethat would be available at full employment.

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Saving and Investment Determinants: Keynesian economics also presumes

that factors in addition to the interest rate influence on saving and investment,

household saving is based on household income and business investment is

based on the expected profitability of production.

A few highlights of Keynesian economics include:

One, the macro economy is a distinct entity operating by its own set of principles

and that standard microeconomic market principles do not necessarily apply.

Two, the primary source of business-cycle instability is changes in aggregate

demand (or aggregate expenditures) especially investment expenditures.

Three, markets, especially resource markets, do not automatically achieve

equilibrium, meaning full employment is not guaranteed.

Four, persistent unemployment problems, especially those occurring during the

Great Depression, result due to the lack of aggregate demand.

Five, the recommended way to maintain full employment is through government

intervention, especially fiscal policy changes in government purchases.

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Q5: Suppose that real money supply increases in the economy due to decrease

in the price level. Show the effect of their change on the position of LM and AD

curves.

The AD-AS or Aggregate Demand-Aggregate Supply model is a macroeconomic model

that explains price level and output through the relationship of aggregate demand and

aggregate supply. It is based on the theory of John Maynard Keynes presented in his

work The General Theory of Employment, Interest, and Money. One of the primary

simplified representations in the modern field of macroeconomics, and is used by a

broad array of economists, from libertarian, Monetarist supporters of laissez-faire, such

as Milton Friedman to Post-Keynesian supporters of economic interventionism, such as

Joan Robinson.

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Modeling

The AD/AS model is used to illustrate the Keynesian model of the business cycle.Movements of the two curves can be used to predict the effects that various exogenous

events will have on two variables: real GDP and the price level. Furthermore, the model

can be incorporated as a component in any of a variety of dynamic models (models of

how variables like the price level and others evolve over time). The AD-AS model can

be related to the Phillips curve model of wage or price inflation and unemployment.

Aggregate demand curve

Aggregate Demand

The AD curve is defined by the IS-LM equilibrium income at different potential price

levels. The equation for the AD curve in general terms is:

where Y is real GDP, M is the nominal money supply, G is real government spending, T

is an exogenous component of real taxes levied, P is the price level, and Z1 is a vector

of other exogenous variables that affect the location of the IS curve (exogenous

influences on any component of spending) or the LM curve (exogenous influences on

money demand). The real money supply has a positive effect on aggregate demand, as

does real government spending (meaning that when the independent variable changes

in one direction, aggregate demand changes in the same direction); the exogenous

component of taxes has a negative effect on it.

Aggregate supply curve

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Aggregate Supply

The aggregate supply curve may reflect either labor market disequilibrium or labor

market equilibrium. In either case, it shows how much output is supplied by firms at

various potential price levels.

The equation for the aggregate supply curve in general terms for the case of excesssupply in the labor market, called the short-run aggregate supply curve, is

Where W is the nominal wage rate (exogenous due to stickiness in the short

run), Pe is the anticipated (expected) price level, and Z2 is a vector of exogenous

variables that can affect the position of the labor demand curve (the capital stock or

the current state of technological knowledge). The real wage has a negative effect on

firms' employment of labor and hence on aggregate supply. The price level relative to

its expected level has a positive effect on aggregate supply because of firms' mistakesin production plans due to mis-predictions of prices.

The long-run aggregate supply curve refers not to a time frame in which the

capital stock is free to be set optimally (as would be the terminology in the micro-

economic theory of the firm), but rather to a time frame in which wages are free to

adjust in order to equilibrate the labor market and in which price anticipations are

accurate. In this case the nominal wage rate is endogenous and so does not appear as

an independent variable in the aggregate supply equation.

The long-run aggregate supply equation is simply Y = Ys(Z2) and is vertical at

the full-employment level of output. In this long-run case, Z2 also includes factors

affecting the position of the labor supply curve (such as population), since in labor

market equilibrium the location of labor supply affects the labor market outcome.

Shifts of aggregate demand and aggregate supply

The following summarizes the exogenous events that could shift the aggregate supply

or aggregate demand curve to the right. Of course, exogenous events happening in the

opposite direction would shift the relevant curve in the opposite direction.

Shifts of aggregate demand

The following exogenous events would shift the aggregate demand curve to the right.

As a result, the price level would go up. In addition if the time frame of analysis is the

short run, so the aggregate supply curve is upward sloping rather than vertical, real

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output would go up; but in the long run with aggregate supply vertical at full

employment, real output would remain unchanged.

Aggregate demand shifts emanating from the IS curve:

An exogenous increase in consumer spending

An exogenous increase in investment spending on physical capital An exogenous increase in intended inventory investment

An exogenous increase in government spending on goods and services.

An exogenous increase in transfer payments from the government to the people

An exogenous decrease in taxes levied

An exogenous increase in purchases of the country's exports by people in other

countries

An exogenous decrease in imports from other countries

Aggregate demand shifts emanating from the LM curve:

An exogenous increase in the nominal money supply

An exogenous decrease in the demand for money (in liquidity preference)

Shifts of aggregate supply

The following exogenous events would shift the short-run aggregate supply curve to

the right. As a result, the price level would drop and real GDP would increase.

An exogenous decrease in the wage rate

An increase in the physical capital stock

Technological progress improvements in our knowledge of how to transform

capital and labor into output

The following events would shift the long-run aggregate supply curve to the right:

An increase in population

An increase in the physical capital stock Technological progress

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