Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 1

Econ 210D Intermediate Macroeconomics

Spring 2015Professor Kevin D. Hoover

Topic 6Aggregate Demand

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 2

Aggregate Supply and Aggregate Demand Product-Expenditure Identity

o AS = Y = C + I + G + NX = AD

Initial Simplicationo Closed Economy: NX = IM = EX =0o Y = C + I + G

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 3

Consumption Function - 1

John Maynard Keynes

The General Theory of Employment, Interest, and Money (1936)

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 4

Consumption Function - 2 A Linear Consumption Function:

C = c0 + cYD

o marginal propensity to consume (mpc) = c o Keynes’s fundamental psychological law: 0 < c < 1o average propensity to consume (apc) = C/YD

Disposable-Income Identity:

YD = Y + TR – T

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 5

Savings Function

Savings Function

S = – c0 + (1 – c)YD

o marginal propensity to save (mps) = (1 – c)o mpc + mps = 1

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 6

Tax Function

A Linear Tax Function:

T = 0 + Y = marginal tax rateo A flat tax = = constanto Reasonable simplification 0 = 0; = 17%o T = Y

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 7

Simple Model of Aggregate Demand – 1 Inflow-Outflow Identity:

I + G + EX = S + (T – TR) + IM

Simplificationso No foreign sector: EX = IM = 0o Transfers treated as negative taxeso Autonomous Expenditure (A) = I + G + EX

Simplified Identity: A = S + T

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 8

Simple Model of Aggregate Demand – 2

Example: = 20%; c = 0.9

Ac

Y)1(1

1

AAAY 57.328.01

)2.01(9.011

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 9

Stimulus Economics

His favorite part of economic analysis

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 10

The Autonomous-Expenditure Multiplier The multiplier:

o > 1o “spending begets spending”: the basis for

stimulus economicso c

)1(11

cA

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 11

Fiscal Policy: Baseline Model -- Setup No EX, IM, TR:

o I + G = S + T

Behavioro Consumption function: C = 0.8(Y – T)o therefore, S = (1 – 0.8)(Y – T)o Tax function: T = (1/6)Y = 0.1667Yo Initial Conditions: I = 500; G = 500

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 12

Fiscal Policy: Baseline Model -- Solution Y = 500

Budget Deficit = G – T = 0

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 13

Fiscal Policy: Experiment #1

Goal: Y = 600 – i.e., Y = 3,600 How big a stimulus is needed?

G = Y/3 = 600/3 = 200; G = 700 after stimulus

Budget deficit: G – T = 700 – (1/6)3,600 = 100

3))6/1(1(8.01

1)1(1

1

tc

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 14

Fiscal Policy: Experiment #2

Goal: Y = 600 – i.e., Y = 3,600 How big a tax cut is needed?

= 9.72%

Budget deficit: G – T = 500 – 0.0972 × 3,600 =

150

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 15

Fiscal Policy: Experiment #3 – 1 Goal: Target particular level of T not a

particular rate of Multiplier formulae:

o Tax Multiplier

o Autonomous expenditure multiplier

cc

TY

T

1

cAY

A

1

1

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 16

Fiscal Policy: Experiment #3 – 2 Goal: T = –100 Effect on Y?

Y = –4(–100)= 400; Y = 3,400 after tax cut

Tax rate: = T/Y = 400/3,400 = 11.76% Budget Deficit: G – T = 500 – 400 = 100

48.018.0

TY

T

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 17

Fiscal Policy: Experiment #4 – 1 Goal: Raise G while keeping budget

balanced – i.e., G = T at all times. Effect on Y?

Balanced-budget multiplier:

1

TG

BB GY

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 18

Fiscal Policy: Experiment #4 – 2 Goal: Y = 600; Y = 3,600 What must be set?

G = T = Y = 600. Tax rate: = T/Y = 1,100/3,600 =

30.56% Budget Deficit:

G – T = 1,100 – 0.3056 × 3,600 = 0

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 19

Opportunity Cost of Investment opportunity cost = rr -

As opportunity cost rises (rr or ), investment falls.

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 20

Figure 12.11 U.S. Real Investment and Real Interest Rates

-200.00

0.00

200.00

400.00

600.00

800.00

1000.00

1200.00

1400.00

1600.00

1800.00

1953 1958 1963 1968 1973 1978 1983 1988 1993 1998

1996

con

stan

t dolla

rs (b

illions

)

-5.0

5.0

15.0

25.0

35.0

45.0

perc

ent

Real Investment(left -hand scale)

Real Interest Rates(right -hand scale)

Real interest rates are 10-year Treasury-bond rates less annual inflation based on the GDP im plicit price deflator.

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 21

The IS Curve

A rightward shift

rightward shift

downward pivot

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 22

The Limits to Aggregate Demand Where does stimulus pressure go at full

employment, when real AD tries to be > real AS but must be real AD = real AS?o In short run, runs down inventories = I =

negative stimulus.o Leaks into imports and reductions of

exports: NX = negative stimulus.o Translates into inflation: p real AD for

same level of nominal AD.

Professor K.D. Hoover, Econ 210D Topic 6 Spring 2015 23

END of Topic 6

Next Topic: 7. Macroeconomic Dynamics