Macroeconomics in the Short run

Macroeconomics in the Short Run

1929

1933
Macroeconomics in the Short Run
US Real GDP Percapita
Macroeconomics in the Short Run
• Business cycle peak in 1929 and trough in 1933.

• Real GDP declined by 27% .

• Investment spending fell by 81%,

• the S&P 500 stock index fell 85%.

Recession
• Unemployment rose from under 3% in 1929 to
over 20% in 1933.

• Unemployment was above 11% in 1939, six

years after trough.

• John Maynard Keynes developed an influential

business cycle model in 1936.
The Keynesian Model of Income Determination
The Keynesian
Theory
 Classical vs Keynesian Economics
Classical Economics(1770-1929)
• Long run Analysis.
• Output Q: Problem of AS
• Role of Agg Supply in determination of Output and
Employment
• P: Prices , Wages and Interest Rate are flexible.
• U: Full Employment
• Assumes perfect competition in both Product (output)
and Factor(Labour) markets
• Says’ law i.e. supply creates it’s own demand, No
fluctuations is output . AS=AD.
Keynesian Economics(1936 onwards):
• Everything is in short run.
• Output Q: Problem of AD
• Role of Aggregate Demand in determination of Output and
Employment
• P:Prices, Wages & Interest Rates are Sticky.
• U: No full Employment
• Assumption of perfect competition in both Product (output)
and Factor(Labour) markets is unrealistic.
• Says’ law failed during great depression. AS≠AD always. In fact
fall in AD lead to Business cycle ( fluctuation in Output)

• Labour is the only factor of production • Apart from Labour other factor of productions are also
important.
• LRAS is Vertical
• No Role of Govt. • SRAS is Upward sloping
• No Role of Money • Active Role of Govt.
• Active Role of Money.
Keynesian Premises

J.M. Keynes Assumption:

• Prices, Wages and Interest rates are fixed in the short-run.

• It implies that some markets need not clear.

1. Product (Goods) Market : AD=AS determines Output and Price

2. Factor(Labor) Market : DL= SL determines Wage rate

3. Capital (Money) Market : Md=Ms determines interest rates

A. The Goods/Product
Market Equilibrium
 A. The Product Market Equilibrium: AD=AS

• Question: How national income and output is determined?

• Keynesian Theory of Income Determination says, “the equilibrium level of national income
and Prices is determined at the level where aggregate demand (AD) for goods and services
equals their aggregate supply (AS)”.

Equilibrium: AD=AS

Model can be explained through

• Aggregate Supply(AS) Function
• Aggregate Demand (AD) Function
 a. Aggregate Supply Functions/Curve
Aggregate Supply : The total supply of goods and services in an economy which the economy
produces by utilizing all its resources. It depends on productivity.

Production Function: Y = f (K , N )
Where K is capital, fixed in short run
N is labor, variable in short run

LRASC

Price Level
SRASC

Output ( GDP)
 a. Aggregate Supply Functions/Curve

Real GDP and Price Level 1934-1940

• According to Keynesian
theory, in a depressed
economy an increase in
aggregate spending can
increase output without
raising prices.
b. Aggregate Demand of Income Curve
Aggregate Demand(AD):
• AD is the total spending on goods and services in the economy.
• AD Curve is the total demand curve ( aggregate expenditure) of all economic agent.
• It is negatively related with the price level and hence slope downward from left to right.

AD=C+I+G+(X-M)

Thus Keynes tried to explain the economic

P1 equilibrium with
Two, Three & Four sector model
P2

Y1 Y2
 The Goods Market Equilibrium: AD=AS
with Fixed vs.Flexible Prices

SRAS

Fixed Prices Flexible Prices

According to Keynes, any change in AD will change Real GDP, thus output is demand determined. Price level doesn’t change
1. The Goods Market

• When economists think about year-to-year movements in

economic activity, they focus on the interactions among
production, income, and demand:

• Changes in the demand for goods lead to changes in

production

• Changes in production lead to changes in income

AD=AY=AS Always
i.e. Z=Y=Q
• Changes in income lead to changes in the demand for goods
1. The Goods Market

Let
Y = AY= Aggregate (National) Income
Z = AD = Aggregate Expenditures
Q = AS= Aggregate Output (Money Value)

AD(=AE) Y=E

E2

E1

450

Y1 Y2 AS(=AY)

(c) Aggregate demand ( or Expenditure)

= Aggregate supply ( Income)

Through circular flow

1. The Composition of GDP Y=C+I+G+NX

• Consumption (C): goods and services purchased by consumers:

• Durable vs nondurable goods
• Services
• Investment (I):
• Business Fixed (nonresidential investment)
• Residential investment
• Inventory investment: difference between production and sales
• Government spending (G): purchases of goods and services by
• the federal, state, and local governments;
• excluding government transfers
• Net exports or trade balance(NX): X − IM
• Exports (X): purchases of domestic goods and services by foreigners
• Imports (IM): purchases of foreign goods and services by domestic consumers, Indian firms and the
Indian government
−
• Exports > Imports ֞ trade surplus
−
• Imports > Exports ֞ trade deficit
1. The Composition of GDP Z=C+I+G+NX
The Composition of U.S. GDP, 2014
Sl. No Components Billions of Dollars Percent of GDP
GDP (Y ) 17,348 100.0
1 Consumption (C) 11,865 68.3
2 Investment (I): 2,859 16.4
Non-residential 2,233 12.9
Residential 549 3.1
Inventory investment 77 0.4
3 Government spending (G) 3,152 18.1
4 Net exports −530 −3.1
Exports (X ) 2,341 13.5
Imports (IM ) −2,871 −16.6
2. The Demand for Goods

𝐴𝐷: 𝑍 ≡ 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀

• The above identity defines the total demand for goods (Z) as consumption,
plus investment, plus government, plus export, minus imports.

• In a closed economy (X = M = 0):

𝑍 ≡ 𝐶 + 𝐼 + 𝐺
2. The Demand for Goods
a. Consumption (C): 𝐂 = 𝒄𝟎 + 𝒄𝟏 𝒀
0 < c1 < 1
Let C = 100 + 0.75Y c1=MPC =0.75

Aggregate Aggregate
Income, Y Consumption, C

0 100
80 160
100 175
200 250
400 400
600 550
800 700
1,000 850
2. The Demand for Goods: Change in Agg Demand
Round of Income Consumption (C ) Income
Generation Generation
• Let c1 =0.75 i.e. MPC,
• the multiplier would be 4. 1st 100.00

• Let initial investment is 100. 2nd 75.00 75.00

3rd 56.25 56.25

4th 42.19 42.19

5th 31.64… 31.64

…..
……. ….
last ….. 0.00

Total Income Total 400.00

2. The Demand for Goods
a. Savings (S): S = −𝒄𝟎 + 𝒔𝟏 𝒀
1- c1 = s1=MPS
=>MPC+MPS=1
0<s1<1
Deriving the Saving Function

Y − C = S
Aggregate Aggregate Aggregate
Income Consumption Saving

0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1,000 850 150
2. The Demand for Goods
b. Investment (𝐼 = 𝐼 ) Planned Investment= 25
Actual Investment: actually how much invested + unplanned inventory changes

The Figures are Based on the Equation C = 100 + .75Y.

(1) (2) (3) (4) (5) (6)
Planned Unplanned
Aggregate Aggregate Inventory
Year
Output Aggregate Planned Expenditure (AE) Change Equilibrium?
(Income) (Y) Consumption (C) Investment (I) C+I Y − (C + I) (Y = AE?)

1990 100 175 25 200 − 100 No

1991 200 250 25 275 − 75 No
1992 400 400 25 425 − 25 No
1993 500 475 25 500 0 Yes
1994 600 550 25 575 + 25 No
1995 800 700 25 725 + 75 No
1996 1,000 850 25 875 + 125 No
2. The Demand for Goods
A. Two Sector Model Equilibrium: 𝐴𝐷: 𝑍 ≡ 𝐶 + 𝐼

a. Consumption (C)
C=C 𝑌
+ 𝐄𝐱𝐞𝐫𝐢𝐜𝐬𝐞
C = c0 + c1 𝑌 Let . C = 100+0.75Y, I=25
So equilibrium Y=500
0 < c1 < 1

b. Investment (Planned) 𝑰 = 𝑰
Since Y= Z
Z=Y= c0 + c1 𝑌 + 𝐼
𝟏
=> 𝒀 = 𝒄 + 𝑰 ……Equilibrium
1 − 𝒄𝟏 𝟎
2. The Demand for Goods
A. Two Sector Model Equilibrium: 𝐴𝐷: 𝑍 ≡ 𝐶 + 𝐼
𝐄𝐱𝐞𝐫𝐜𝐢𝐬𝐞
a. Consumption (C) Let C = 100+0.75Y
I=30+0.2Y
C=C 𝑌 a. If autonomous investment Io increases
+ from 30 to 40 , what will be the
C = c0 + c1 𝑌 multiplier?.
0 < c1 < 1 b. Find the equilibrium Y.
𝐴𝑛𝑠
b. Investment is Induced Investment a)Multiplier =1/(1-0.75-0.2)=20
b) dY/dI0=10*20=200
𝐼 = 𝐼0 + α𝑌
Since Y= Z 0< α <1
Z=Y= c0 + c1 𝑌 + 𝐼0 + α𝑌 𝑆 = −𝑐0 + 𝑠1𝑌
𝟏 For Equilibrium: S=I
=> 𝒀 = 𝒄 +𝐼 ……Equilibrium 0<s1<1
1 − 𝒄𝟏 −α 𝟎 0
𝟏
𝒀= 𝒄 +𝐼
Super multiplier Necessary condition: c1+ α< 1 or s1> α s1 − α 𝟎 0
2. The Demand for Goods: Exercise
Problem:
A large multinational shipping company , Abhoy Sales Inc. has just decided to spend Rs. 10
cr. on new storage space in Delhi, Rs.45 cr. on new aircraft and Rs.5 cr. on additional acquisition of
kerosene. In addition to these expenses, the company is producing 5 cr. parcel at a price of Rs 5 per
parcel.
Now suppose that Abhoy Sales plans to have a tenth of that production in inventory. Over
time , the company’s parcels have met with increasing demand, but the inventory has only increased
by Rs. 1 cr.

Q1. What is this firm total planned investment? Ans: Rs.10 + Rs.45 + 0.1(Rs.5*5 cr.) = Rs.57.5 cr.
Q2. How much did the firm actually invest? Ans: If the inventory increased only by 1 cr., thus the firm
invested 10+45+1=56 cr.

Q3.What is the difference between actual and planned investment? Ans: The difference is 57.5-56=1.5 cr.
the firm should produce more parcels to
Q4. Should Abhoy sales produce more or fewer parcels? Why? cover the shortage
AS= 5*5 =25 cr.
AD=C+I= 5cr. ( Kerosene)+57.5 cr =62.5cr. As AS<AD the company should produce
more parcels
2. The Demand for Goods
B. Three Sector Model Equilibrium: 𝐴𝐷: 𝑍 ≡ 𝐶 + 𝐼 + 𝐺
a. Consumption (C) and Disposable Income (YD)
T could be lump-sum tax which is one of the various modes
used for taxation: income, things owned (property taxes),
C = C YD … . . (1)
money spent (sales taxes), miscellaneous (excise taxes), etc.
+
C = c0 + c1 YD … . (2)

YD=Y-T

C = c0 + c1 Y − T … . (3)

b. Investment (I )

𝐼 = 𝐼 … … (4)

c. Government Spending (G)

and Tax
Let G= is 𝐺 and T= is 𝑇 i.e.
fixed
3. The Determination of Equilibrium Output
• Let assume X=M=0
So, 𝑍 ≡ 𝐶 + 𝐼 + 𝐺
• => Z = 𝒄𝟎 + c𝟏 𝒀 − 𝑻 + 𝑰 + 𝑮 … . 𝟓
𝒀 = 𝒁 … . . (𝟔)
• This is an equilibrium condition.
• ⇒ 𝒀 = 𝒄𝟎 + 𝒄𝟏 𝒀 − 𝑻 + 𝑰 + 𝑮 … . . 𝟕
𝟏
• ⇒ 𝒀= 𝒄𝟎 + 𝑰 + 𝑮 − 𝒄𝟏 𝑻 … (𝟖)
1 − 𝒄𝟏
1
• ⇒Z = 𝑐0 + 𝐼 + 𝐺 − 𝑐1 𝑇 … . (9)
1 − 𝑐1
In equilibrium, production (Y) is equal to demand, which
in turn depends on income (Y), which is itself equal to
• Autonomous spending: [c0 + 𝐼ഥ + G – c1T] production.

o Autonomous spending is positive because if T = G (balanced budget) and c1is between 0 and 1, then (G –
c1T) is positive, and so is autonomous spending.
o The term 1/(1 – c1) is the multiplier, which is larger when c1 is closer to 1.
o If c1 equals 0.6, the multiplier equals 1/(1 – 0.6) = 2.5, meaning that an increase of consumption by 1 billion
will increase output by 2.5 x 1 billion = 2.5 billion.
3. The Determination of Equilibrium Output: Graphically
Ex. Suppose c0 increases by $1 billion. An increase in autonomous spending has a more than one-for-one effect
on equilibrium output.
AB: first-round increase in production
BC: first-round increase in income
CD: second-round increase in demand
DE: second-round increase in production and
income
The total increase in production after n+1 rounds:
1 + 𝑐1 + 𝑐1 2 +⋅⋅⋅ +𝑐1 𝑛

which is a geometric series with a limit of

1/(1−c1).

The adjustment of output over time is called

the dynamics of adjustment.
The effects of an increase in autonomous spending on How long the adjustment takes depends on
output how and when firms revise their production
schedule.
3. The Determination of Equilibrium Output
Exercise:
Let C=200+0.75(Y-T), 𝐼ഥ=100, G=1000, T=1000
a. Find equilibrium level of income:
b. If G increasers to 125,what will be the new equilibrium?
c. What level of G is needed to achieve an income of 1600?

Ans:
a. Y=1300
b. Substituting G= 125, Y= 1400
c. G=175
3. The Determination of Equilibrium Output: Application
The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the
Consumption Function

o When people start worrying

about the future, they decide to
save more even if their current
income has not changed.

o News about Lehman Brothers

going bankrupt in September
2008 reminded people of the
Great Depression, as confirmed
by the number of searches for
“Great Depression” in Google.

o Consumption fell even if

disposable income had not yet
changed.

Figure 1 Disposable Income, Consumption, and Consumption Of Durables In the United

States, 2008:1 to 2009:3
3. The Determination of Equilibrium Output: Application
The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the
Consumption Function

Figure 2 Google Search Volume for “Great Depression,” January 2008 to September 2009
4. Investment Equals Saving: An Alternative Way of Thinking about Goods—Market Equilibrium

• Alternative Model: S=I by J M Keynes.

• Private saving (S) is

S ≡ YD − C
S ≡Y−T−C

By definition,
• Public saving = T − G.
−
• Public saving > 0 ֞ Budget surplus
−
• Public saving < 0 ֞ Budget deficit
4. Investment Equals Saving: An Alternative Way of Thinking about Goods—Market Equilibrium

In equilibrium:
𝑌 =𝐶+𝐼+𝐺

Subtract T from both sides and move C to the left side:

Y−C−T=I +G −T

The left side of the equation is simply S, so S=I+G−T

Or equivalently 𝐼 = 𝑆 + 𝑇 − 𝐺 … . (10)

This is the IS relation, which stands for “Investment equals Saving”.

Two equivalent ways of stating the condition for equilibrium in the goods market:
(1) Production = Demand
(2) Investment = Saving
4. Investment Equals Saving: An Alternative Way of Thinking about Goods—Market Equilibrium

• We can also derive equation (8) using equation (10).

• Because consumption behavior implies that:
S = Y − T−C
= Y − T − c0 − c1 (Y − T)
⇒ 𝑆 = −𝑐0 + 1 − 𝑐1 𝑌 − 𝑇 … (11)

In equilibrium, I = S, so that equation (10) becomes:

𝐼 = −𝑐0 + (1 − 𝑐1 )(𝑌 − 𝑇) + (𝑇 − 𝐺)

1
Solve for output: 𝑌= 𝑐0 + 𝐼 + 𝐺 − 𝑐1 T … . . (12)
1 − 𝑐1

which is the same as equation (8).

5. The Paradox of Saving
“Savings is a virtue” I = S + (T − G)

‘A Penny saved is a penny earned’.

Those who save become reach and

prosperous.

Keynes criticized, the above sentence

may be true for an Individual but not for
the society

When all or most households become

thrifty, they consume less and save
more, the level of Income and savings
declines.
6. The Multiplier
Change in Y = Multiplier * Change in C0, 𝐼 ,or G or GTr or T
Equilibrium model solution: Y = 1 * (C0 + 𝐼 + G) T could be lump-sum tax which is one of the various modes
1 – c1 used for taxation: income, things owned (property taxes),
money spent (sales taxes), miscellaneous (excise taxes), etc.
1
1. Autonomous Spending Multiplier: ΔY/ Δ 𝑰 =
1 1 – c1
2. Govt Expenditure Multiplier: ΔY/ ΔG = 1 – c
1

– c1
3. Govt Tax Multiplier : ΔY/ ΔT = 1 – c Where Yd=Y-T and T is lump sum tax
1 c1
4. Govt Transfer Payment Multiplier: ΔY/ ΔGTr= 1 − c
1 Where C = C0 + c * (Y-T +GTr)
−c1
5. Govt Income Tax Multiplier: ΔY/ ΔT=
1 − c1 + c1t
T= T0+t*Y here T is Income tax, t is income tax rate
1
6. The Complete Fiscal policy Multiplier: ΔY/ ΔG= 1 − c + c t ∆𝑌 1
1 1 =
∆𝐺 1 – c1 Haavelmo Trygve (1945) there is no
If Δ Y/ ΔG- ΔY/ ΔGTr=1, then So ΔY/ ΔG> ΔY/ ΔGTr penalty at all for higher public
∆𝑌 −c1
= spending financed by an increase in
7. Balanced Budget Multiplier=1 if ΔG=ΔT ∆𝑇 1 – c1
∆𝑌 ∆𝑌 1 −c1 taxes and/or social security
+ = + =1 contributions
∆𝐺 ∆𝑇 1 – c1 1 – c1
Uses and Limits of the Multiplier
Limitations of working of multiplier
Applications
a. Multiplier process works only when there is adequate Less application in case of Less developed
availability of consumer goods.
countries due to low MPC.
b. Full value of multiplier is achieved only when various
increments in investments are repeated at regular intervals. • Vast agricultural sector

• Disguised unemployment
c. The full value of the multiplier can be achieved only when
there is no change in the MPC during the process of income
propagation. • Low level of capital equipment,
technology
d. Multiplier does not work well in case of leakages from MPC
a. Payments of the past debts • Vast non-monetised sector
b. Purchase of exiting wealth
c. Import of goods and services • Producing for self consumption

e. Does not work well in case of full employment of resources.

References

• Ch 3 : Macroeconomics by Oliver Blanchard, 7th ed. Pearson

Thank You All