Since whatever is not consumed must be saved, as soon as we specify a

consumption function we have necessarily specified a savings function

we assume that some part of each extra dollar earned is saved. That gets us to the next
point, We know from our savings identity that in all circumstances

once we know our consumption function, we can always derive the relationship between Y
and S. We can also easily figure out the Marginal Propensity to Save. Since every extra
dollar earned is either saved or consumed

E.g. if my MPC is .75, I spend seventy-five cents of each extra dollar earned on goods
and services, so I must be saving the remaining quarter. Hence my MPS is .25

Notice the fiscal deficit, and the fact that government has to borrow from the flow of
savings, via the financial sector. There is no reason here to seek a balanced budget in
which G = T
How does the economy move from a situation of disequilibrium toward its equilibrium?

When income falls, what happens to C? Does it stay as high? No.

When income falls, consumers find that they have less income and so they spend less.

If firms cut output too much, then we have a situation in which Y < C + Ip.
In this case inventories will fall, not rise, so that inventory change will be negative and I
will fall short of Ip. Firms, seeing this, will expand output and hence Y will rise. And so on.

what happens to equilibrium income when one of the exogenous factors in expenditures
change? In particular, what happens if we change government purchases or taxes?
if one of the exogenous components (like Ip) increases, this will increase total
expenditures by that amount
Next, firms will recognize the additional demand for goods and raise output to meet that
extra demand. As a result, Y will rise.
The fact that Y begins rising means that incomes are going up. As Y rises, C must rise too.
Each extra dollar of Y raises C by that dollar times the MPC
Government Purchases are all the direct expenditures on final goods and services by the
Government
Government Purchases are all the direct expenditures on final goods and services
by the Government
Transfer payments are all the transfers of income like social security, unemployment
compensation, and so on that the government gives to households
Net Taxes is the net amount of taxes less transfer payments that the government
takes out of the circular flow

By changing G or net taxes T the government can change equilibrium income (Y). This is
called fiscal policy
equilibrium Y rises or falls by the amount of the change in G times the multiplier
taxes and transfers do not affect expenditures directly. They affect expenditures by
affecting the amount of disposable income, and so they work their effects through C

So the difference between raising taxes $100 million and lowering government purchases $
100 million is that the first impact on aggregate demand is different. Changing G means
directly changing part of AD, while a change in T has to work through the MPC before it has
its first direct effect on AD
When the economy is in a recession, the government can increase G and/or decrease T to
increase demand and income.
When the economy is booming and inflationary pressures start to grow in the economy, the
Government can decrease G and increase T.
If the budget is normally more or less in balance, then this means that the government runs
deficits in recessions, and surpluses in booms.
—-> This should stabilize the level of aggregate expenditure and income in an economy.
When the government does this, it is called counter-cyclical policy. Essentially the
government is trying to damp down swings in Y
If firms' intended investment (Ip) falls, that's a component of AD and Y will tend to fall. In that
case, in theory, G can be increased to make up for the fall in Ip
In that case, in theory, G can be increased to make up for the fall in Ip.
In real life, this is hard because it may take a while to actually figure out that Ip is
dropping, and the political process of approving changes in G or T may drag on for long
enough that by the time fiscal policy is actually changed, Ip has risen again.
-—-> In this case your intended counter-cyclical policy might actually end up being a
pro-cyclical policy, amplifying rather than damping the changes in Ip.

Counter-cyclical policy would also lower G when Ip rises, to reduce booms

that a boom sets up conditions for a painful crash by encouraging overinvestment
(too much Ip, so that it collapses once firms realize they have bought too many
machines.
that overly-rapid growth provokes rapid inflation

we have assumed that G and T are fixed, and don't depend on income Y. But in a more
sophisticated model, transfer payments and taxes in particular will change as Y changes
If tax revenues are a percentage of income, then as Y rises taxes will rise by themselves
If transfers like unemployment compensation rise when people lose their jobs and fall
when employment rises, then when Y rises transfers fall, and when Y falls transfers rise

since net taxes (T) represent total taxes minus transfer payments, it follows that T will rise
when Y rises and fall when Y falls
this amounts to a counter-cyclical policy but that it's automatic - it requires no extra
decision by government to do this. This kind of countercyclical policy is also pretty rapid
What happens when the government runs a deficit - that is when G>T? It borrows money
Another way is that it sells securities (IOUs).
If G>T, the size of the difference (G-T) - which is how much has to be borrowed - is called
the deficit.
suppose the government already owes money from previous deficits.
Then this year's deficit adds to the total debt of the government.
So the federal debt is the total amount owed by the federal government, while the
deficit is the amount this debt rises in a single year.
—-> In other words the debt is the cumulative total of all past deficits.
So while recent deficits have been around $200 billion, the total federal debt is
approaching $5 trillion

1. Countercyclical policy raising G or lowering T help reduce the severity of a recession

there is less lost output during recessions - when output drops
that means that workers and machines that could be making stuff
are idle

2. Capital expenditures
Businesses borrow all the time to buy capital equipment.
Suppose government wants to build a highway system if the
highway system will raise future incomes and hence tax
revenues over the future, it makes sense to borrow the money to
build the highways, and then tax incomes to repay the borrowing.
Of course, this means increasing taxes after the highway system
is built, and people won't like that
1. The budgetary burden of higher interest payments
As the total debt rises, the annual interest payments go up too
If those payments rise faster than taxes then interest payments make up a large part of
federal outlays every year. The result of this is that taxpayers pay interest to people who
hold the government's debt .
the effect is a wash: some people have less income from taxes, others have more
from interest payments
But if government debt is held mainly by rich people, while the tax burden is more
evenly distributed, then having a large debt may tend to transfer command over
resources from poorer people to wealthier ones - a real effect

2. Crowding out
If G>T, government borrows. In order to attract savings, government may have to bid
against businesses that are trying to borrow money for capital investment projects
When government bids against capitalists for savings, it may have to offer a higher
interest rate, and at the higher interest rate capitalists may then borrow less and
undertake less Ip
if G rises without a rise in T, then government "crowds out" private sector
borrowing, and goods/services that would have gone to private firms now flow
to government - a real effect
The IS-LM model makes both Y and r endogenous. The key advantage of this is that we
can have r determine Ip
So what determines r?
We regard r as the outcome of the interaction between money demand and money supply.
This is why IS-LM is essentially two models stuck together: a model of the goods market,
and a model of the money market

both r and Y can change

If Ip rises, equilibrium Y rises, right? This was because a higher level of demand for capital
goods caused more to be made, more workers got hired, they bought more stuff, and so on
If Ip rises when r falls -- the cheaper it gets to borrow money, the more new capital
investment projects firms undertake.

The different values of r, and the resultant equilibrium values of Y, give us a set of Y, r points
that represent "goods market" equilibrium -- a situation in which AD=AS
So we start moving, spiralling gently counterclockwise toward the new equilibrium point.
In equilibrium, production, Y (the left side of the equation), is equal to demand (the right
side). Demand in turn depends on income, Y, which is itself equal to production
Note that we are using the same symbol Y for production and income
you will want to have enough money on hand to avoid having to sell bonds too often

The higher the interest rate, the more you will be willing to deal with the hassle and the
costs associated with buying and selling bonds
: an increase in the interest rate decreases the demand for money, as people put
more of their wealth into bonds
The equilibrium condition is that the supply of central bank money be equal to the demand
for central bank money:

as long as people hold some deposit

accounts (so that c < 1), the term in
square brackets is less than 1.

the demand for central bank money is

less than the overall demand for
money

due to the fact that the demand for reserves by banks is only a fraction of the
demand for deposit accounts
In particular, an increase in the
supply of central bank money leads
to a shift in the vertical supply line
to the right
This leads to a lower interest rate
In other words, an increase of a euro of high-powered money leads to an increase of 1/θ
euros in the money supply
The total effect of a change in the interest rate on production depends, therefore, on the
sensitivity of investment to the interest rate and on the demand multiplier
Notice that the lower the sensitivity of money demand to income – f1 is small – the larger
must be the change in income for any given change in M. The reason is simple. If f1 is small,
the response of money demand to a change in income is low. Then income must grow
enough to increase the demand for money and balance the money market
Therefore the total effect of a change in the interest rate on output depends on the
ratio f2 /f1. If this ratio is high, the curve will flatten
Buying or selling foreign assets implies buying or selling foreign currency – sometimes
called foreign exchange – the volume of transactions in foreign exchange markets gives
us a sense of the importance of international financial transaction.

The transactions above the line record payments to and from the rest of the world. They
are called current account transactions
The sum of net payments to and from the rest of the world is called the current
account balance.
If net payments from the rest of the world are positive, the country is running a
current account surplus;
if they are negative, the country is running a current account deficit.
Transactions below the line are called capital account transactions
A country that runs a current account deficit must finance it through positive net capital
flows. Equivalently, it must run a capital account surplus
An increase in domestic income, Y, leads to an increase in imports
An increase in the real exchange rate, ε, leads to an increase in imports, IM
(As ε goes up, note that IM goes up, but 1/ε goes down, so what happens to IM/ε, the
value of imports in terms of domestic goods, is ambiguous.)
this assumption implies that the following arbitrage relation – the interest parity condition
– must hold
If inflation turns out to be higher than expected, real wages may plunge, and workers will
suffer a large cut in their living standard.
If inflation turns out to be lower than expected, real wages may go up sharply. Firms may
not be able to pay their workers. Some may go bankrupt.
A line on a chart indicating the series of interest rates at which a
country's balance of payments (that is, the amount of money entering
a country less the money leaving it) is at equilibrium. It generally
trends upward. It affects the exchange rates of currencies.