Chapter 3 (Macro I).ppt macroeconomics for 2 year students

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1. Aggregate Demand in The Closed Economy Chapter Three

2. Outline Foundations of Theory of Aggregate Demand The Goods Market and the IS curve The Money market and the LM curve The Short Run Equilibrium From the IS-LM to Aggregate demand Lecture ppt prepared by Abdela U. (Arsi University)

3. Aggregate Demand AD: Relationship between the quantity of output demanded and the aggregate price level. AD = C + I + G / Closed economy, NX = 0 / Lecture ppt prepared by Abdela U. (Arsi University)

4. AD… AD Why AD curve slopes downward? Lecture ppt prepared by Abdela U. (Arsi University) P Quantity of output

5. The Quantity theory of Money (QTM) A simple theory linking the inflation rate to the growth rate of money supply MV = PY M = Money supply V = velocity of money (how money times an average birr changes hands in a given time period P = Average price level = GDP-deflator Y = Quantity of output = RGDP Lecture ppt prepared by Abdela U. (Arsi University)

6. QTM… MV = PY Rearrange it = P = P = GDP deflator   Nominal GDP Lecture ppt prepared by Abdela U. (Arsi University)

7. Example: If in Ethiopia in year 2014, Nominal GDP = 500 billion birr Money supply = 100 billion birr V? Solution: V = = = 5 In year 2014, an average birr is used 5 times in transaction.   Lecture ppt prepared by Abdela U. (Arsi University)

8. QTM… V is constant RGDP = Y(L, K, A) Classical economists suggest that a money supply will cause only an equal increase in price level Lecture ppt prepared by Abdela U. (Arsi University)

9. QTM… Growth rates of M, V, P & Y? MV = PY, then: % △M + % △V = % △P + Y % △ Money Supply growth + 0 = Rate of inflation + 0 Lecture ppt prepared by Abdela U. (Arsi University)

10. Money demand & Quantity Equation Rearrange the quantity equation again: = is the real money balance (purchasing power of the money supply) If k = = inverse of velocity of money supply Demand for real money balance = d =   Lecture ppt prepared by Abdela U. (Arsi University)

11. Money demand…. d = Demand for real money balances is a function of RGDP or real income k is amount of money people wish to hold for each birr of income. for given M, k, there is a negative r/ship between P and Y . If P rises, each transaction requires more birr, so amount of transaction and output must fall   Lecture ppt prepared by Abdela U. (Arsi University)

12. Money demand…. If output is higher, people engage in more transactions and need higher real balances For a fixed money supply M, higher real balances imply a lower price level . If the price level is lower, real money balances are higher; the higher level of real balances allows a greater volume of transactions, which means a greater quantity of output is demanded.   Lecture ppt prepared by Abdela U. (Arsi University)

13. The Goods Market and The IS Curve IS curve : Plots the r/ship between r & Y that arises in the commodity market ( We will return to this concept later!!! ) Keynesian Cross : How income determined for given I, G, T Y = f( desired spending ) ……. in the short-run / Price is sticky!!!/ How do we model this? Lecture ppt prepared by Abdela U. (Arsi University)

14. Keynesian Cross Distinction b/n actual and planned expenditure Actual spending = RGDP = Y Planned spending = E = firms, HHs, & GG would like to spend on g/s E = C + I + G Why would E ever depart from Y? Unplanned inventory inv’t (i.e. Y > E) Sales fall down _ opposed to their plan Inventories pile up Forces firms to lay off workers & decrease prod’n Lecture ppt prepared by Abdela U. (Arsi University)

15. Keynesian Cross… E > Y, means Planned Spending > Actual spending Sales rises opposed to their plan Inventories rundown Induces firms to hire more workers & increase prod’n Lecture ppt prepared by Abdela U. (Arsi University)

16. Elements of the Keynesian Cross consumption function: for now, investment is exogenous: planned expenditure: E = C(Y –   Equilibrium condition: Y = E = C(Y – i.e. Planned expenditure = Actual expenditure   govt policy variables: Lecture ppt prepared by Abdela U. (Arsi University)

17. Planned Expenditure (E) E = C(Y – + + C = C o + MPC(Y – ) E = C o + MPC(Y – ) + + E = C o + + – MPC( ) + MPC(Y)   C o = Autonomous consumption MPC = Marginal propensity to consume 0 < MPC < 1 Slope of E is MPC Constant Lecture ppt prepared by Abdela U. (Arsi University)

18. Graphing the equilibrium condition income, output, Y E planned expenditure Y = E E 45 ° Y * E* Lecture ppt prepared by Abdela U. (Arsi University)

19. Graphing the equilibrium condition income, output, Y E planned expenditure Y = E E 45 ° Y 1 Y * A When Y > E, firms find their inventory pile up , then they will lay off workers & cut production . At point A = Unplanned inventory accumulation because Y > E, it causes Y to fall Y 1 E 1 E* Lecture ppt prepared by Abdela U. (Arsi University)

20. Graphing the equilibrium condition income, output, Y E planned expenditure Y = E E 45 ° Y 2 Y * When E > Y, firms find their inventory dropped, then they will employ more workers & increase production. At point B, Unplanned drop in inventory because Y < E, it causes Y to increase . Y 2 E 2 E* Lecture ppt prepared by Abdela U. (Arsi University) B

21. Equilibrium Y = E Y = C o + + – MPC( ) + MPC(Y) Solve for Y Y = [C o + + – MPC( )]   Lecture ppt prepared by Abdela U. (Arsi University)

22. Effect of Fiscal policy! Lecture ppt prepared by Abdela U. (Arsi University)

23. Effect of a change in G on Y = It is called gov’t purchases multiplier = > , …………… Because 0 < MPC < 1   Lecture ppt prepared by Abdela U. (Arsi University)

24. Effect of a change in T on Y = It is called Tax multiplier = Note that gov’t spending multiplier is greater than the tax multiplier   Lecture ppt prepared by Abdela U. (Arsi University)

25. Example: If MPC = 0.8, G-multiplier? T-multiplier ? Solution: G-multiplier = = = A one birr increase in gov’t spending leads to 5 times increase in total income. T-multiplier = = = A one birr tax cut leads to 4 times increase in total income .   Lecture ppt prepared by Abdela U. (Arsi University)

26. Effect of Increase in G on Y income, output, Y E planned expenditure E = Y E = C + I + G 2 45 ° Y * Y ** Y     When G increases, E shifts upward , b/c of the G-multiplier   E = C + I + G 1 Lecture ppt prepared by Abdela U. (Arsi University)

27. Effect of a decrease in T on Y income, output, Y E planned expenditure E = Y E = C 2 + I + G 45 ° Y * Y ** Y     When T decreases, C increases & causes E shift upward T , b/c of the T-multiplier   E = C 1 + I + G Lecture ppt prepared by Abdela U. (Arsi University)

28. Example: In the Keynesian Cross, assume that the consumption function is given by: C = 475 + 0.75(Y-T) Planned Investment, I = 150, G = 250, T = 100. Graph planned expenditure as a function of income What is the equilibrium level of income If government purchases increase by 125, what is the new equilibrium income ? Lecture ppt prepared by Abdela U. (Arsi University)

29. Solution income, output, Y E E = 800 + 0.75Y a ) E = C + I + G = 475 + 0.75(Y-100) + 150 + 250 E = 800 + 0.75Y 800 Lecture ppt prepared by Abdela U. (Arsi University)

30. Solution…. income, output, Y E E = 800 + 0.75Y b) At equilibrium E = Y Then, 800 + 0.75Y = Y Y = 3,200 800 3,200 3,200 E = Y Lecture ppt prepared by Abdela U. (Arsi University)

31. Solution…. income, output, Y E E 1 = 800 + 0.75Y c) first it needs to calculate the G-multiplier. = = 4 Then, Y = G)(4) Y = )(4 ) Y = 500   E = Y 800 E 2 = 925 + 0.75Y 925 3200 3700 Y = 500     Lecture ppt prepared by Abdela U. (Arsi University)

32. Effects of Interest rate changes on income: IS curve and Keynes’ Cross Until now, I = exogenously determined, Relax this assumption, and Inv’t is a function of real interest rate (r) Investment negatively related with the real interest rate When r drops, Inv’t rises & will cause Y to increase ( How? )   Lecture ppt prepared by Abdela U. (Arsi University)

33. Effect of Increase in Investment (I) on Y income, output, Y E planned expenditure E = Y E = C + I(r 2 ) + G 45 ° Y * Y ** Y     When r falls, Inv’t rises When I rises, E shifts upward   E = C + I(r 1 ) + G Lecture ppt prepared by Abdela U. (Arsi University)

34. Deriving IS curve using Keynesian Cross Y E = Y E = C + I(r 2 ) + G 45 ° Y 1 E = C + I(r 1 ) + G Y 2 E Y Y 1 Y 2 r 2 r 1   Y I 1 I 2 r 2 r 1 IS I (r) Lecture ppt prepared by Abdela U. (Arsi University)

35. IS curve? IS shows for any given interest rate, the level of income that brings the g/s market into equilibrium. Can we say also that IS shows for any given income, the level of r that brings the g/s market into equilibrium ? Lecture ppt prepared by Abdela U. (Arsi University)

36. Effects of Fiscal Policy on IS When G increases, Y rises for any given interest rate ; it means IS curve shifts to the right. Y E = Y E = C + I + G 2 45 ° Y 1 E = C + I + G 1 Y 2 E Y Y 1 Y 2 r 1   IS 2 IS 1 Y   Y   Lecture ppt prepared by Abdela U. (Arsi University)

37. Effects of Fiscal Policy on IS… When T decreases, Y rises for any given interest rate ; it means IS curve shifts to the right. Y E = Y E = G + I + C 2 45 ° Y 1 E = G + I + C 1 Y 2 E Y Y 1 Y 2 r 1   IS 2 IS 1 Y   Y   Lecture ppt prepared by Abdela U. (Arsi University)

38. A loanable-funds Interpretation of IS curve NIA – Identity: Y = C + I + G /Closed economy/ Y – C – G = I Y – T – C + T – G = I …… Add & subtract T Private Saving Public Saving National Saving Lecture ppt prepared by Abdela U. (Arsi University)

39. A loanable-funds Interpretation of IS curve National Saving = Investment S = I Supply for loanable funds = demand for loanable funds S = f(Y, G, T) I = f(r) Lecture ppt prepared by Abdela U. (Arsi University)

40. Market for Loanable-funds I(r) I = S S(Y) r * I, S r I is negative fun’n of r S does’t respond to △ r r equilibrates the supply and demand for loans Lecture ppt prepared by Abdela U. (Arsi University)

41. Deriving IS curve I(r) I 2 = S 2 I 3 = S 3 S(Y 1 ) S(Y 2 ) S(Y 3 ) I 1 = S 1 r 1 r 2 r 3 I, S r IS r Y r 1 r 2 r 3 Y 1 Y 2 Y 3 IS curve shows the r- that equilibrates the market for loanable funds for any given level of Y. Lecture ppt prepared by Abdela U. (Arsi University) Y S r & I

42. The Money Market and the LM Curve LM curve : Shows the r/ship between r and Y that arises in the market for money balances Lecture ppt prepared by Abdela U. (Arsi University)

43. The Theory of Liquidity Preference Terminology Liquidity of an Asset: shows the ease to change one asset into another asset. ( eg . Cash is the most liquid asset) Money : The stock of assets that can be readily used to make transaction. Lecture ppt prepared by Abdela U. (Arsi University)

44. The Theory of Liquidity Preference Function of money Medium of exchange (we use money to buy stuffs) Store of value (transfers purchasing power from the present to the future) Unit of account ( the common unit by which everyone measures prices and values) Lecture ppt prepared by Abdela U. (Arsi University)

45. The Theory of Liquidity Preference So, we hold money to buy g/s When we hold money, we give up an opportunity to earn interest If we deposit it in a bank, we earn interest income if we buy a bond/stock, we get interest/dividend But money is more liquid than bonds/stocks ( why? ) So, amount of money we hold positively related with income, but negatively related with interest rate. Lecture ppt prepared by Abdela U. (Arsi University)

46. The Money Market and the LM Curve How is the interest rate is determined in the short run? r adjusts to balance supply and demand for real money balance Supply for real money balance: s for given M & P Demand for real money balance: d = f(r, Y) for given Y   Lecture ppt prepared by Abdela U. (Arsi University)

47. The Money Market and the LM Curve     r *     r We hold money to pay our bills We hold money as a store of value The size of money we need related: Negatively with r Positively with Y Lecture ppt prepared by Abdela U. (Arsi University)

48. Effect of Change in Income in Money Market M d (Y 1 )     r LM r Y Y 1   r 3 r 2 r 1 M d (Y 2 ) M d (Y 3 ) r 3 r 2 r 1 Y 2 Y 3 When Y increases, M d shifts to the right, & r will rise Lecture ppt prepared by Abdela U. (Arsi University)

49. How Monetary Policy Shifts the LM Curve M d ,L (r)       r 1 r 2   r LM 1 r Y Y 1 r 1 r 2 LM 2   When M s increases, LM curve shifts to the right Lecture ppt prepared by Abdela U. (Arsi University)

50. The Short-run Equilibrium     r * Y     r r 1 r 2 a a 1 b 1 b : Y = C(Y – LM: = L(r, Y)   At r 1 to the right of IS (a) to the left of LM (a 1 ) S > I or Y > E > Leads to fall in r   Lecture ppt prepared by Abdela U. (Arsi University)

51. IS-LM as A theory of AD What happen to IS-LM model when P-changes? IS-LM explains the position and slope of AD curve To understand the determinants of AD, we use IS-LM Why AD downward slopping? What causes AD to shift? Lecture ppt prepared by Abdela U. (Arsi University)

52. What happen to IS-LM model when P-changes P 1 P 2 LM(P 1 ) r Y Y 1 r 2 r 1 Y 2 AD Y 1 Y 2 Y LM(P 2 ) IS P When P rises falls for given LM shifts upward r rises, Y falls   Lecture ppt prepared by Abdela U. (Arsi University)

53. AD Shifters: Increase in M   LM   r Y Y 1 r 1 r 2 Y 2 AD 1 Y 1 Y 2 Y LM   AD 2 IS P When M rises Y rises for given LM shifts downward (right) AD shifts upward   Lecture ppt prepared by Abdela U. (Arsi University)

54. AD Shifters: Increase G or Decrease T   LM   r Y Y 1 r 1 r 2 Y 2 AD 1 Y 1 Y 2 Y AD 2 IS 1 IS 2 P When G rises or T falls Y rises for given IS shifts Upward AD shifts upward   Lecture ppt prepared by Abdela U. (Arsi University)