Chapter 3

BASIC AGGREGATE DEMAND MODEL

Goal: Determine the equilibrium output

Understand year on year movements in economic activity by focusing on the interactions between production, income, demand

THE COMPOSITION OF GDP

- Consumption (C) refers to the goods and services purchased by consumers.- Investment (I) sometimes called fixed investment is the purchase of capital goods. It

is the sum of non-residential investment and residential investment - Government spending (G) refers to the purchases of goods and services by the

federal state and local governments. It does not include government transfers, nor interest payments on the government debt.

- Imports (IM) are the purchases of foreign goods and services by consumers, business firms and the US government

- Exports (X) are the purchases of US goods and services by foreigners

Net exports (X - IM) is the difference between exports and imports, also called the trade balance

- Exports > imports = trade surplus - Export < imports = trade deficit

Note that sales ≠production

Inventory investment is the difference between production and sales.

Production

Income

Demand

THE DEMAND FOR GOODS

- The total demand for goods is written as Z ≡ C + I + G + X – IM

≡ means that this equation is an identity or a definition.

Assume for the moment that economy is closed (no relation with the outside world) X = IM = ) then:

Z ≡ C + I + G

COMPONENTS OF AGGREGATE DEMAND

Consumption (C)

- Disposable Income (Yd) is the income that remains once consumers have paid taxes and received transfers from the government.

C = C(Yd)- The function C(Yd) is called the consumption function. It is a behavioural equation,

that is, it captures the behaviour of consumers - A more specific form of the consumption function is this linear relation:

C = C0 + C1Yd

This function has two parameters C0 and C1:

- C1 is called the marginal propensity to consume, or the effect of an additional dollar of disposable income on consumption.

- C0 is the intercept of the consumption function (what people would consume if their income were equal to zero)

- Disposable income is given by Y0 = Y-T

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Investment(I)

- Variables that depend on other variables within the model are called endogenous- Variables that are not explained within the model are called exogenous. Investment

here is taken as given or treated as an exogenous variable: - I = I

Government Spending (G)

- G together with taxes T describes fiscal policy – the choice of taxes and spending by the government

- We shall assume that G and T are also exogenous for two reasons:o Governments do not behave with the same regularity as consumers or firmso Macroeconomists must think about the implications of alternative spending

and tax decisions of the government

THE DETERMINATION OF EQUILIBRIUM OUTPUT

- An increase in demand leads to an increase in production and a corresponding increase in income

- The end result is an increase in output that is larger than the initial shift in demand, by a factor equal to the multiplier

- Assuming that exports and imports are both zero, the demand for goods is the sum of consumption investment and government spending:

Z ≡C + I + GThen: Z= c 0 + c 1 (Y – T) +I + GEquilibrium in the goods market requires that production, Y, be equal to the demand for goods Z: Y = Z So :

Y = C0+C1(Y-T)+I + G can also be expressed as:

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Multiplier autonomous spending

Summary:

- An increase in demand leads to an increase in production and a corresponding increase in income.

- The end result is an increase in output that is larger than the initial shift in demand, by a factor equal to the multiplier

- To estimate the val- ue of the multiplier, and more generally to estimate behavioural equations and their

parameters, economists use econometrics – a set of statistical methods used in economics.

INVESTMENT EQUALS SAVING: AN ALTERNATIVE WAY OF THINKING ABOUT GOODS-MARKET EQULIBRIUM

Saving is the sum of private + public saving.

Private saving (S) is saving by consumers:

S ≡ Yd – C S ≡ Y-T-C

- Public saving = taxes – government spending - If T>G the government is running a budget surplus public saving is positive - If T<G the government is running a budget deficit public saving is negative - Y=C+I+G

I= S+(T-G)

The equation states that equilibrium in the goods market requires that investment equals saving – the sum of private + public saving.

This equilibrium condition for the goods market is called the IS RELATION.

What firms want to invest must be = to what people and the government want to save.

IS THE GOVERNMENT OMNIPOTENT? A WARNING

- Changing government spending or taxes is not always safe- The responses of consumption, investment, imports etc. are hard to assess with

much certainty - Anticipations are likely to matter- Achieving a given level of output can come with unpleasant side effects - Budget deficits and public debt may have adverse implications in the long run.

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LECTURE 2

THE DEMAND FOR MONEY

- Goal: to determine the equilibrium interest rates - Money, which you can use for transactions pays no interest. There are 2 types of

money: currency, coins and bills, and checkable deposits, the bank deposits on which you can write checks.

- Bonds pay a positive interest rate, i, but cannot be used for transactions

Deriving the demand for money

Md = $Y L(i)

The demand for money, Md is equal to nominal income $Y times a function of the interest rate i, denoted by L(i).

The demand for money:

o Increases in proportion to nominal income ($Y) o Depends negatively on the interest rate L(i)

For a given level of nominal income, a lower interest rate increases the demand for money. At a given interest rate, an increase in nominal income shifts the demand for money to the right (on graph).

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EQUILIBRIUM INTEREST RATE

Money demand, money supply and the equilibrium interest rate

Equilibrium in financial markets requires that money supply to be equal to money demand or that Ms = Md

Money supply (fixed):

Ms = M

Money supply = Money demand

M=$YL(i)

- This equilibrium relation is called the LM RELATION.

- The interest rate must be such that the supply of money (which is independent of the interest rate) is = to the demand for money (which DOES depend on the interest rate).

An increase in nominal income leads to an increase in the interest rate

An increase in the supply of money leads to a decrease in the interest rate

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MONETARY POLICY AND OPEN MARKET OPERATIONS

Open market operations

- Open market operations which take place in the “open market” for bonds are the standard method central banks use to change the money stock in modern economies.

- If the central bank buys bonds expansionary open market operation because the central bank increases (expands) the supply of money

- If the central bank sells bonds contractionary open market operation because the central bank decreases (contracts) the supply of money

The balance sheet of the central bank and the effects of an expansionary open market operation

- The assets of the central bank are the bonds it holds. - The liabilities are the stock of money in the economy- An open market operation in which the central bank buys bonds and issues money

increases both assets and liabilities by the same amount

THE DETERMINATION OF THE INTEREST RATE, I

Bond prices and bond yields

Relation between the interest rate and bond prices

o Treasury bills or T-Bills are issued by the U.S government promising payment in a year or less. If you buy the bond today and hold it for a year, the rate of return (or interest) on holding a $100 bond for a year is ($100-$Pb)/$Pb

o If we are given the interest rate, we can figure out the price of the bond using the same formula.

i = $100−$ Pb$ Pb =

$1001+i

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Choosing money or choosing the interest rate

A decision by the central bank to lower the interest rate from i to i’ is equivalent to increasing the money supply.

MONEY BONDS AND OTHER ASSETS

Financial intermediaries are institutions that receive funds from people and firms and use these funds to buy bonds or stocks, or to make loans to other people and firms.

o Liabilities of banks = checkable deposits o Banks keep as reserves some of the funds they receive:

Some depositors withdraw cash from their accounts Banks are subject to reserve requirements (at the CB)

o Assets of banks = loans + bonds Loans represent roughly 70% of banks’ non-reserve assets. Bonds count for the rest, 30%.

SUPPLY AND DEMAND FOR CENTRAL BANK MONEY

Demand for money

- Involves 2 decisions:1. Decide how much money to hold 2. Decide how much of this money to hold in currency and how much in deposits

Overall money demand: Md = $Y L(i)

Demands for currency: CUd = cMd

Demands for deposits: Dd = (1 – c ) Md

Demand for reserves

- The larger the amount of deposits, the larger the reserves banks must hold: Rd= θ(1 – c)Md

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Demand for central bank money

- Equals to the sum of the demand for currency and the demand for reserves. Hd=CUd+Rd

Hd=cMd +θ (1 – C) Md

= [c+θ (1 – c ) ]$YL(i)

Supply of central bank money

- Denote by H the supply of CB money equlibrium interest rate is given by

H=¿

DETERMINATION OF THE EQUILIBRIUM INTEREST RATE

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