Chapter 1

The demand side captures the spending decisions of:

- Households: Domestic C and Foreign X-M (open economy)
- Firms: I
- Government: G

Aggregate demand: Yd = C + I + G + (X-M)

Consumption is higher portion of GDP.

Investment more volatility because it can be postponed in recession and depends on
expected future profits.

IS curve
Investment-Savings curve = combination of the real interest rate r and output Y under goods
market equilibrium.

(Goods market equilibrium Yd = Y 45o line)

(Or aggregate demand = output or income)

Closed economy AD: Yd = C + I + G

- Consumptions demand, C = expenditure by individuals on goods and services, on
durables and non-durables
- Investment demand, I = Firm expenditure on capital goods, Household expenditure
on new houses, Government expenditure on infrastructure
- Government purchases, G = Government expenditure on salaries, goods and services.

Downward sloping because of the negative relationship between interest rate and output.
Low interest rate makes borrowing cheaper, investment increases  increases output.
Keynesian consumption function
C = Co + c1 (1-t) Y

- Co: autonomous consumption, not affected by income

- T: tax rate
- Y: income
- (1-t) Y: disposable income
- C1: marginal propensity to consume

Marginal propensity to consume: how spending changes as result in changes in disposable

income. Between 0 and 1.

Aggregate demand is then given by:

Yd = Co + c1 (1-t) Y + I + G

Multiplier effect

Eg, government expenditure increases  lower inventory  increase

production/investment  increase output  increase wages/income  increase
consumption

Aggregate demand rises further, until we reach equilibrium at new AD curve. Increase in AD
is larger than increase in government expenditures

Multiplier: change in output due to a change in autonomous demand.

The slope of the IS curve:

- Changes with multiplier and hence c1 (MPC) and t (tax)
- Changes with a1 (interest sensitivity of investment

Shifts the IS curve:

- When autonomous consumption co, autonomous investment ao, or government
spending G change
- When the multiplier changes

Future
IS curve is static: single point in time. But, spending decisions today are influenced by
expectations of the future.

Consumption smoothing

Households adjust current spending based on expected future income. Diminishing marginal
utility of consumptions. Requires to take into account the future and the ability to save and
borrow.

Permanent income hypothesis (PIH)

Individuals optimally choose consumption by allocating resources (assets & PV of future

income) across their lifetimes.

Consumption is forward looking as opposed to the Keneysian consumption function:

depends on R, Ao, expected future income and taxes.

PIH predicts that optimal C is smoother than income: consumer save when earning income
and draw on savings when retired.

Predictions of PIH:
- Anticipated changes (change is known) in income should have no effect on
consumption when they occur. Changes already incorporated when the news arrived.
If you know income is increasing at the end of the year, your consumption will
increase immediately
- Unanticipated changes (change is unkown) should affect consumption as permanent
income needs to be recalculated.

Why PIH might fail:

- Credit constraints: inability to smooth consumption by borrowing. Prefer to smooth
consumptions but prevented because they are not able to borrow. Banks not always
willing to lend
- Impatience: reluctance/prevention to save for consumption smoothing
 - Uncertain about future income: leads to precautionary savings above the level
predicted by the PIH

Excess sensitivity: consumption overresponse to anticipated changes in temporary income.

PIH households borrow at the moment they get the news of increase of future income.
Increase consumption as soon as they get the news.

Credit-constrained households have to wait until their income actually increases. So still see
a change in consumption when the actual income rises, even if the change is anticipated.

Excess smoothness: consumption does not change fully with the changes in permanent
income.

Fail to save.

PIH households save immediately when the news arrives that income will fall. Smooth
consumption.
Impatient households fail to reduce current consumption when the news arrives.
Consumption falls when income decreases.

Multiplier PIH
- Permanent income shocks: effect larger than 1. MPC = 1. Households increase
consumption permanently to higher income. Increase in output higher than increase
in government spending
 - Temporary income shocks: multiplier close to 1. MPC = r / 1+r: close to zero. Output
will increase by the same amount as the government spending.
- Credit constraint & impatience: Multiplier larger than 1.

Other factors: expected changes in lifetime wealth. Shifts the IS curve.

Tobin’s q: Theory of investment

Firm’s decision of investment. Depends on future investment after tax profits.

Marginal benefit/marginal cost.
Optimal is Mb = Mc.

Higher output price increases q.

Higher marginal product of capital increases q.
Lower interest rate increases q.
Lower depreciation rate increases q.

These factors will increase MB or decrease MC. This will lead to increase in output, which
shifts the IS curve to the right.

Chapter 2
Demand side: spending of economy
Supply side: production of economy.

Supply side: Philips curve and WS-PS unemployment model.

Philips curve: pi t = pi t-1 + a (yt-ye)

If the labor market does not clear: excess supply of labor implies unemployment.
Reason: efficiency wages. Firms set wage above the reservation level so that employees
work hard enough. Employers make it costly to lose job by setting wage higher at level the
employee wants to work for. Work hard to prevent losing your job.
Wage setting curve: Supply side of labor. upward sloping. What wage has to be paid to
secure adequate labor effort. Higher wage if unemployment is low. Wage setters expect
prices to rise, and adjust wages accordingly.

Price setting curve: Demand side of labor. Inverse L shape curve. How much labor will be
supplied. Inverse L shape because for workers to be willing to work the wage has to be
above unemployment benefit plus disutility of going to work.

Assumptions: labor is the only input, productivity/output per worker is constant, firms
require a fixed profit margin to find it profitable to employ workers

The horizontal gap between curves gives involuntary unemployment.

Firm: workers effort is important, so wage-setting curve is important. Therefore (involuntary)

unemployment becomes unavoidable.

Labor market equilibrium:

WS = PS
This is where the wage is consistent to secure sufficient labor (WS) and for production to be
profitable (PS).
Equilibrium unemployment = labor force – equilibrium employment.
 - Higher union power  higher wage set  higher WS curve (not if there is a
bargaining restraint)
- Efficiency wages: increase wage to increase productivity for higher profits.

Philips curve

The relationship between unemployment and inflation. Represents the equilibrium in the
supply side of the economy.

- Workers negotiate nominal wage contracts which leads to changes in input costs
- Input costs changes lead to fluctuation of prices
- If prices increase unexpectedly the real wage (W/P) goes down and labor is suddenly
cheap: firms hire more labor and unemployment goes down
- Inverse/negative relation between unemployment and (unexpected) inflation
Philips curve
Adaptive expectations: based on previous period.

Philips curve is upward sloping: Adaptive expectations  current inflation depends on

inflation in previous period and the output gap.

More output  less unemployment  higher wages (in next wage round)  higher prices.
(Compared to previous period)

Positive relationship between output and inflation.

Negative relationship between inflation and unemployment.

Price stickiness: Firm’s reluctance to change P when AD changes.

A: equilibrium. 2% inflation. Positive AD shock: increases output (Positive output gap). 

increases employment to Nh. Increase in output: wage setters set higher wage reflecting the
output gap: increase labor costs  Increase prices again 2%.
Inflation: 4% (point B in Philips curve).
Demand shock: shift IS curve right. Changes output to Yh (above equilibrium, output gap:
gap between WS and PS).
New employment level at point B: wagesetters increase wages to compensate for output
gap. Price setters increase prices to compensate increase in input costs. Higher inflation. Real
wage erodes. Another increase of the wage. Therefore another increase of prices.

Positive AD shock under no stabilizing policy (re constant/no change in interest rate) 
increase employment and continually rising inflation.
Reason for PS curve to shift: changes in productivity, markup or price-push factors
Reasons for WS curve to shift: changes in wage-push factors