Advanced Macroeconomics (805)

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Advanced Macroeconomics (806) Assignment # 1

Name: Komal Almas Roll# AI-544589

Q1: (a) Show that a given change in money stock has a larger effect on output the less interest sensitive the demand for money? The demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits. It can refer to the demand for money narrowly defined as M1 (non-interest-bearing holdings), or for money in the broader sense of M2 or M3. Money in the sense of M1 is dominated as a store of value by interest-bearing assets. However, money is necessary to carry out transactions; in other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money and the interest advantage of holding other assets. The demand for money is a result of this trade-off regarding the form in which a person's wealth should be held. In macroeconomics motivations for holding one's wealth in the form of money can roughly be divided into the transaction motive and the asset motive. These can be further subdivided into more micro economically founded motivations for holding money. Generally, the nominal demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate. The real demand for money is defined as the nominal amount of money demanded divided by the price level. For a given money supply the locus of income-interest rate pairs at which money demand equals money supply is known as the LM curve. The magnitude of the volatility of money demand has crucial implications for the optimal way in which a central bank should carry out monetary policy and its choice of a nominal anchor. Conditions under which the LM curve is flat, so that increases in the money supply have no stimulatory effect (a liquidity trap), play an important role in Keynesian theory. This situation occurs when the demand for money is infinitely elastic with respect to the interest rate. A typical money-demand function may be written as 1

Advanced Macroeconomics (805)

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Where Md is the nominal amount of money demanded, P is the price level, R is the nominal interest rate, Y is real output, and L (.) is real money demand. An alternate name for L(R, Y) is the liquidity preference function. (b) How does the response of interest rate to a change in money stock

depend on the interest sensitivity of money demand? The increase in government spending leads to an outward shift in aggregate demand. Given that the economy is at full employment, the price level increases. The effect on real output is determined by the assumption made concerning the aggregate supply curve. Using a long-run or a classical aggregate supply function that is vertical at the full employment output level real output is unchanged. However, it would not be wrong to argue that the economy can operate, in the short run, above full employment. With this approach, a contrast between full-employment output and potential output must be shown. Alternatively, a contrast between long-run and short-run aggregate supply can be used. In these cases, real output could increase, at least in the short run. The increased government spending will lead to an increase in the nominal interest rate. With a higher nominal GDP, the transactions demand for money will increase. Also, increased government borrowing raises the demand for loanable funds and increases the interest rate. With an increased supply of government bonds to fund the debt, the price of bonds falls and the rate of interest rises. Higher inflationary expectations will pressure upward the nominal interest rate. The real interest rate is equal to the difference between the nominal interest rate and the rate of inflation. With both the nominal interest rate increasing and the expected price level increasing the change in the real interest rate is indeterminate. The government deficit is the difference between inflows (taxes and other government revenues) minus outflows (expenditures and transfer payments) for some period of time (typically a year). The national (or federal, for the U.S.) debt is the sum of accumulated government deficits (minus repayments) at some point in time. 2

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An increase in the economy's potential to produce output is captured by an outward shift in the long-run aggregate supply function. A tax policy that: a) Increases the return or profitability from supplying inputs and stimulates a greater use of inputs (at each aggregate price level) or b) Increases the productivity of inputs will lead to an outward shift in the aggregate supply curve. Examples of such tax policies are investment tax credits, reduced corporate profits taxes, and educational tax credits. For each tax policy, a specific linkage to economic growth must be developed. For instance, an investment tax credit will lead to increased net investment and an increase in the capital stock; with more capital the aggregate supply function shifts outward. Economic growth leads to an outward shift in the economy's production possibilities frontier or boundary. Relationship between the quantity of a commodity that producers have available for sale and the quantity that consumers are willing and able to buy. Demand depends on the price of the commodity, the prices of related commodities, and consumers' incomes and tastes. Supply depends not only on the price obtainable for the commodity but also on the prices of similar products, the techniques of production, and the availability and costs of inputs. The function of the market is to equalize demand and supply through the price mechanism. If buyers want to purchase more of a commodity than is available on the market, they will tend to bid the price up. If more of a commodity is available than buyers care to purchase, suppliers will bid prices down. Thus, there is a tendency toward an equilibrium price at which the quantity demanded equals the quantity supplied. The measure of the responsiveness of supply and demand to changes in price is their elasticity. A fundamental economic concept, which holds that the price is set at an amount where the quantity supplied and quantity, demanded clear the market. From that intersection, higher prices will increase supply, reduce demand, or both. Lower quantities demanded will reduce prices.

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Example: The prices of rents and real estate products are set in the market by supply and demand. However, the amount of real estate adjusts slowly to market forces because of the long planning and development period and the lengthy physical life of improvements. ____________________________________ Q2: Derive from standard Keynesian model the fiscal (government

expenditures) and money multiplies and discuss the circumstances in which these multipliers are respectively equal to zero. Explain n words why this can happen and how likely you think this is. Money multiplier: In monetary macroeconomics and banking, the money multiplier measures how much the money supply increases in response to a change in the monetary base. The multiplier may vary across countries, and will also vary depending on what measures of money are considered. For example, consider M2 as a measure of the U.S. money supply, and M0 as a measure of the U.S. monetary base. If a $1 increase in M0 by the Federal Reserve causes M2 to increase by $10, then the money multiplier is 10. Fiscal multipliers: Multipliers can be calculated to analyze the effects of fiscal policy, or other exogenous changes in spending, on aggregate output. For example, if an increase in German government spending by 100, with no change in taxes, causes German GDP to increase by 150, then the spending multiplier is 1.5. Other types of fiscal multiplier scan also be calculated, like multipliers that describe the effects of changing taxes (such as lump-sum taxes or proportional taxes). Keynesian multiplier: Keynesian economists often calculate multipliers that measure the effect on aggregate demand only. (To be precise, the usual Keynesian multiplier formulas measure how much the IS curve shifts left or right in response to an exogenous change in spending.) Opponents of Keynesianism have sometimes argued that Keynesian multiplier 4

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calculations are misleading; for example, according to the theory of Ricardian equivalence, it is impossible to calculate the effect of deficit-financed government spending on demand without specifying how people expect the deficit to be paid off in the future. American Economist Paul Samuelson credits Alvin Hansen for the inspiration behind his seminal 1939 contribution. The original Samuelson multiplier-accelerator model (or, as he belatedly baptised it, the "Hansen-Samuelson" model) relies on a multiplier mechanism which is based on a simple Keynesian consumption function with a Robertsonian lag: Ct = c0 + cYt 1 So present consumption is a function of past income (with c as the marginal propensity to consume) Investment, in turn, is assumed to be composed of three parts: It = I0 + I(r) + b (Ct Ct 1) The first part is autonomous investment, the second is investment induced by interest rates and the final part is investment induced by changes in consumption demand (the "acceleration" principle). It is assumed that 0 < b. As we are concentrating on the income-expenditure side, let us assume I(r) = 0 (or alternatively, constant interest), so that: It = I0 + b(Ct Ct 1) Now, assuming away government and foreign sector, aggregate demand at time t is: Ytd = Ct + It = c0 + I0 + cYt 1 + b(Ct Ct 1) Assuming goods market equilibrium (so Yt = Ytd ), then in equilibrium: Yt = c0 + I0 + cYt 1 + b(Ct Ct 1) But
1

we

know

the

values

of Ct and Ct

are

merely Ct = c0 + cYt

and Ct

= c0 + cYt 2 respectively,

Then substituting these in, Yt = c0 + I0 + cYt 1 + b(c0 + cYt 1 c0 cYt 2)

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Or, rearranging and rewriting as a second order linear difference equation: Yt (1 + b)cYt 1 + bcYt 2 = (c0 + I0) The solution to this system then becomes elementary. The equilibrium level of Y (call it Yp , the particular solution) is easily solved by letting Yt = Yt 1 = Yt 2 = Yp , Or: (1 c bc + bc)Yp = (c0 + I0) Yp = (c0 + I0) / (1 c) The complementary function, Yc is also easy to determine. Namely, we know that it will have the formYc = A1r1t + A2r2t where A1 and A2 are arbitrary constants to be defined and where r1 and r2 are the twoeigenvalues (characteristic roots) of the following characteristic equation: r2 (1 + b)cr + bc = 0 Thus, the entire solution is written as Y = Yc + Yp In economics, the fiscal multiplier is the ratio of a change in national income to the change in government spending that causes it. More generally, the exogenous spending multiplier is the ratio of a change in national income to any autonomous change in spending (private investment spending, consumer spending, government spending, or spending by foreigners on the country's exports) that causes it. When this multiplier exceeds one, the enhanced effect on national income is called the multiplier effect. The mechanism that can give rise to a multiplier effect is that an initial incremental amount of spending can lead to increased consumption spending, increasing income further and hence further increasing consumption, etc., resulting in an overall increase in national income greater than the initial incremental amount of spending. In other words, an initial change in aggregate demand may cause a change in aggregate output (and hence the aggregate income that it generates) that is a multiple of the initial change.

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However, multiplier values less than one have been empirically measured, suggesting that certain types of government spending crowd out private investment or consumer spending that would have otherwise taken place. This crowding out can occur because the initial increase in spending may cause an increase in interest rates or in the price level. The existence of a multiplier effect was initially proposed by Richard Kahn in 1930 and published in 1931. It is particularly associated with Keynesian economics. Some other schools of economic thought reject or downplay the importance of multiplier effects, particularly in terms of the long run. The multiplier effect has been used as an argument for the efficacy of government spending or taxation relief to stimulate aggregate demand. Various types of fiscal multipliers: The following values are theoretical values based on simplified models, and the empirical values corresponding to the reality have been found to be lower (see below). Note: In the following examples the multiplier is the right-hand-side equation without the first component. y is original output (GDP) bC is marginal propensity of consumption (MPC) bT is original income tax rate bM is marginal propensity to import y is change in income (equivalent to GDP) aT is change in lump-sum tax rate bT is change in income tax rate G is change in government spending T is change in aggregate taxes I is change in investment X is change in exports ________________________________________ Q3: Considering the model, draw the short run aggregate supply curve under these cases: Aggregate supply 7

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Aggregate Supply (AS) measures the volume of goods and services produced within the economy at a given overall price level. There is a positive relationship between AS and the general price level. Rising prices are a signal for businesses to expand production to meet a higher level of AD. An increase in demand should lead to an expansion of aggregate supply in the economy. Short-run aggregate supply curve Aggregate supply is determined by the supply side performance of the economy. It reflects the productive capacity of the economy and the costs of production in each sector.

Shifts in the AS curve can be caused by the following factors:

changes in size & quality of the labour force available for production changes in size & quality of capital stock through investment technological progress and the impact of innovation changes in factor productivity of both labour and capital changes in unit wage costs (wage costs per unit of output) changes in producer taxes and subsidies changes in inflation expectations - a rise in inflation expectations is likely to boost wage levels and cause AS to shift inwards

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In the diagram above - the shift from AS1 to AS2 shows an increase in aggregate supply at each price level might have been caused by improvements in technology and productivity or the effects of an increase in the active labour force. An inward shift in AS (from AS1 to AS3) causes a fall in supply at each price level. This might have been caused by higher unit wage costs, a fall in capital investment spending (capital scrapping) or a decline in the labour force.

-----------------------------------------------------------Q4: In the Keynesian model, how will an increased desire by the public to hold money balances affect prices, income, and employment? How your answers would differ in classical model? KEYNESIAN MODEL: A macroeconomic model based on the principles of Keynesian economics that is used to identify the equilibrium level of, and analyze disruptions to, aggregate production and income. This model identifies equilibrium aggregate production and income as the intersection of the aggregate expenditures line and the 45-degree line. The Keynesian model comes in three basic variations designated by the number of macroeconomic sectors included--two-sector, three-sector, and four sector. The Keynesian model is 9

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also commonly presented in the form of injections and leakages in addition to the standard aggregate expenditures format. This model is used to analyze several important topics and issues, including multipliers, business cycles, fiscal policy, and monetary policy. The Keynesian model, commonly presented as the Keynesian cross-intersection

between the aggregate expenditures line and the 45-degree line, was the standard macroeconomic analysis throughout the mid-1900s, from the Great Depression to the early 1980s. While it was largely replaced by aggregate market analysis (or AS-AD analysis) in the 1980s, it continues to provide important insight into the workings of the macro economy. A Keynesian Overview Keynesian economics is a theory of macroeconomics developed by John Maynard Keynes based on the proposition that aggregate demand is the primary source of business-cycle instability and the most important cause of recessions. Keynesian economics points to discretionary government policies, especially fiscal policy, as the primary means of stabilizing business cycles and tends to be favored by those on the liberal end of the political spectrum. The basic principles of Keynesian economics were developed by Keynes in his book, The General Theory of Employment, Interest and Money, published in 1936. This work launched the modern study of macroeconomics and served as a guide for both macroeconomic theory and macroeconomic policies for four decades. The three key assumptions of Keynesian economics are: Rigid Prices: Keynesian economics presumes that prices are inflexible or rigid, especially in the downward direction. This can prevent markets from achieving equilibrium.

Effective Demand: Keynesian economics is also based on the notion of effective demand, the principle that consumption expenditures are based on the disposable income actually available to the household sector rather than income that would be available at full employment. 10

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Saving and Investment Determinants: Keynesian economics also presumes that factors in addition to the interest rate influence on saving and investment, household saving is based on household income and business investment is based on the expected profitability of production.

A few highlights of Keynesian economics include:

One, the macro economy is a distinct entity operating by its own set of principles and that standard microeconomic market principles do not necessarily apply. Two, the primary source of business-cycle instability is changes in aggregate demand (or aggregate expenditures) especially investment expenditures. Three, markets, especially resource markets, do not automatically achieve equilibrium, meaning full employment is not guaranteed. Four, persistent unemployment problems, especially those occurring during the Great Depression, result due to the lack of aggregate demand. Five, the recommended way to maintain full employment is through government intervention, especially fiscal policy changes in government purchases. _________________________________

Q5: Suppose that real money supply increases in the economy due to decrease in the price level. Show the effect of their change on the position of LM and AD curves. The AD-AS or Aggregate Demand-Aggregate Supply model is a macroeconomic model that explains price level and output through the relationship of aggregate demand and aggregate supply. It is based on the theory of John Maynard Keynes presented in his work The General Theory of Employment, Interest, and Money. One of the primary simplified representations in the modern field of macroeconomics, and is used by a broad array of economists, from libertarian, Monetarist supporters of laissez-faire, such as Milton Friedman to Post-Keynesian supporters of economic interventionism, such as Joan Robinson.

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Advanced Macroeconomics (805)

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Modeling The AD/AS model is used to illustrate the Keynesian model of the business cycle. Movements of the two curves can be used to predict the effects that various exogenous events will have on two variables: real GDP and the price level. Furthermore, the model can be incorporated as a component in any of a variety of dynamic models (models of how variables like the price level and others evolve over time). The AD-AS model can be related to the Phillips curve model of wage or price inflation and unemployment. Aggregate demand curve Aggregate Demand The AD curve is defined by the IS-LM equilibrium income at different potential price levels. The equation for the AD curve in general terms is: where Y is real GDP, M is the nominal money supply, G is real government spending, T is an exogenous component of real taxes levied, P is the price level, and Z1 is a vector of other exogenous variables that affect the location of the IS curve (exogenous influences on any component of spending) or the LM curve (exogenous influences on money demand). The real money supply has a positive effect on aggregate demand, as does real government spending (meaning that when the independent variable changes in one direction, aggregate demand changes in the same direction); the exogenous component of taxes has a negative effect on it.

Aggregate supply curve

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Aggregate Supply The aggregate supply curve may reflect either labor market disequilibrium or labor market equilibrium. In either case, it shows how much output is supplied by firms at various potential price levels. The equation for the aggregate supply curve in general terms for the case of excess supply in the labor market, called the short-run aggregate supply curve, is Where W is the nominal wage rate (exogenous due to stickiness in the short run), Pe is the anticipated (expected) price level, and Z2 is a vector of exogenous variables that can affect the position of the labor demand curve (the capital stock or the current state of technological knowledge). The real wage has a negative effect on firms' employment of labor and hence on aggregate supply. The price level relative to its expected level has a positive effect on aggregate supply because of firms' mistakes in production plans due to mis-predictions of prices. The long-run aggregate supply curve refers not to a time frame in which the capital stock is free to be set optimally (as would be the terminology in the microeconomic theory of the firm), but rather to a time frame in which wages are free to adjust in order to equilibrate the labor market and in which price anticipations are accurate. In this case the nominal wage rate is endogenous and so does not appear as an independent variable in the aggregate supply equation. The long-run aggregate supply equation is simply Y = Ys(Z2) and is vertical at the full-employment level of output. In this long-run case, Z2 also includes factors affecting the position of the labor supply curve (such as population), since in labor market equilibrium the location of labor supply affects the labor market outcome. Shifts of aggregate demand and aggregate supply The following summarizes the exogenous events that could shift the aggregate supply or aggregate demand curve to the right. Of course, exogenous events happening in the opposite direction would shift the relevant curve in the opposite direction. Shifts of aggregate demand The following exogenous events would shift the aggregate demand curve to the right. As a result, the price level would go up. In addition if the time frame of analysis is the short run, so the aggregate supply curve is upward sloping rather than vertical, real

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output would go up; but in the long run with aggregate supply vertical at full employment, real output would remain unchanged. Aggregate demand shifts emanating from the IS curve: An exogenous increase in consumer spending An exogenous increase in investment spending on physical capital An exogenous increase in intended inventory investment An exogenous increase in government spending on goods and services. An exogenous increase in transfer payments from the government to the people An exogenous decrease in taxes levied An exogenous increase in purchases of the country's exports by people in other countries An exogenous decrease in imports from other countries Aggregate demand shifts emanating from the LM curve: An exogenous increase in the nominal money supply An exogenous decrease in the demand for money (in liquidity preference)

Shifts of aggregate supply The following exogenous events would shift the short-run aggregate supply curve to the right. As a result, the price level would drop and real GDP would increase. An exogenous decrease in the wage rate An increase in the physical capital stock Technological progress improvements in our knowledge of how to transform capital and labor into output The following events would shift the long-run aggregate supply curve to the right: An increase in population An increase in the physical capital stock Technological progress

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