Lecture 1 Econ 421 Spring 2021

Carlin
Type author
& Soskice
names here
Macroeconomics: Institutions,
Instability, and the Financial System
Chapter 1:
The Demand Side
© Wendy Carlin and David Soskice, 2015. All rights reserved.

The Global Economy 1990 - 2015
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Objectives: Chapter 1: The Demand Side
By the end of this chapter, students should understand the

following:
 What forms the demand side of the closed economy

 The goods market equilibrium and the multiplier effect
 The IS curve and its properties
 Drivers of the components of demand
 Forward-looking consumption behaviour and the Permanent
Income Hypothesis.
 Forward-looking investment behaviour and Tobin’s q.
Overview: Chapter 1: The Demand Side
 The Demand side captures the spending decisions of:

• Households: Domestic & Foreign (Open Economy)
• Firms
• The Government
Aggregate Demand (AD):
 Why study this?

• Fluctuations in AD affect unemployment and inflation
• Relevant to monetary and fiscal policy makers
• Understand the transmission mechanism of monetary and
fiscal policy
Demand side facts: Components of AD over time
Investment is
more volatile
 The Demand side captures the spending decisions of:

• Households: Domestic & Foreign (Open Economy)
• Firms
• The Government
Aggregate Demand (AD):
 Why study this?

• Fluctuations in AD affect unemployment and inflation
• Relevance to monetary and fiscal policy makers
• Understand the transmission mechanism of monetary and
fiscal policy
Business Cycle facts: Growth & Fluctuations
Recession Periods
(Shaded Areas)
Business Cycle facts: Volatility and Policy
The Great
Moderation:
Did better policy-

making reduce
volatility?
How do we model the demand side?

The IS (Investment -Savings) Curve
• It refers to planned investment and savings
decisions; hence the I and the S.
Historical context:
• It was originally formulated as a simple shorthand
version of John Maynard Keynes’s description of the
demand side in his “General Theory of Employment,
Interest and Money” (See Keynes, 1936).
• The IS curve also underlies the famous IS/LM model,
which was introduced by John Hicks in 1937 ( "Mr
Keynes and the Classics: A Suggested
Interpretation," Econometrica, 1937).
 How do we model the demand side?

The IS (Investment -Savings) Curve
Features:
- Downward Sloping
(high int rate  lower AD)
- Affected by expectations of
the future
(pessimistic expectations 
lower AD at every int rate)
Modelling: The Goods Market Equilibrium (GME)
 The IS Curve shows combinations of the Real interest

rate (r) and Output (y) under goods market equilibrium.
 Goods Market Equilibrium:

“Aggregate Demand = Output / Income”
 Recall closed economy AD:

• Consumption 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.
Modelling: GME and the Multiplier
Goods Market Equilibrium & the Multiplier:
 First assume a Keynesian consumption function:
where : autonomous consumption, not affected by income

t : tax rate
y : income
: disposable income,
: marginal propensity to consume (MPC)
 Here, AD is given by: (┼)
Modelling: GME and the Multiplier
 Goods market equilibrium is given by the 45°

line: where AD = Output.
The Multiplier effect:

ΔGΔ Δ
Δ
ΔΔ …
(┼)
Modelling: The Multiplier
 The Multiplier determines the change in output due to a change

in autonomous demand (ΔG in Fig 1.5).
 Rearranging (┼) in terms of y, we get:
(▲)
 The multiplier is greater than 1 since and .

 Short-run multiplier: response of output to a change in
autonomous demand, keeping the interest rate and policy
responses constant.
 If , then the line is horizontal. The multiplier equals 1 and the
effect of ΔG on output is not amplified.
Application: Paradox of Thrift
 Should savings be encouraged or discouraged in a recession?

• ↑ Savings  ↑ Investment in capital stock  ↑ AD
• But ↑ Savings  ↓ Consumption  ↓ AD
 In our model I and G are exogenous & by rearranging (▲):
 A rise in savings is modelled by a fall in to .

 Since I and G are fixed, y must fall for the equation above to hold.
 Paradox of Thrift: Higher savings causes output to fall.
 Model-specific result: No mechanism for high savings to translate
into higher investment.

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Carlin

© Wendy Carlin and David Soskice, 2015. All rights reserved.

By the end of this chapter, students should understand the

 What forms the demand side of the closed economy

 The Demand side captures the spending decisions of:

Aggregate Demand (AD):

 Why study this?

Demand side facts: Components of AD over time

 The Demand side captures the spending decisions of:

Aggregate Demand (AD):

 Why study this?

Business Cycle facts: Growth & Fluctuations

Business Cycle facts: Volatility and Policy

Did better policy-

How do we model the demand side?

 How do we model the demand side?

 The IS Curve shows combinations of the Real interest

 Goods Market Equilibrium:

 Recall closed economy AD:

Goods Market Equilibrium & the Multiplier:

 First assume a Keynesian consumption function:

where : autonomous consumption, not affected by income

 Here, AD is given by: (┼)

 Goods market equilibrium is given by the 45°

The Multiplier effect:

 The Multiplier determines the change in output due to a change

 The multiplier is greater than 1 since and .

 Should savings be encouraged or discouraged in a recession?

 A rise in savings is modelled by a fall in to .

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