Introduction lecture
,Week 1
1.1: Repetition of the Keynesian Cross model
Keynesian Cross (don’t have to know it by heart!):
•Output = income determined by the demand side (=central in this model, below is where it consists
of) of the economy
•Aggregate expenditures = planned expenditures = AE = C + I + G + EX –IM (because C, I and G all
partly consist out of import, the total of import has to be subtracted from AE!)
•Output = (real) income =(real) GDP = Y
•Both C (also partly consists of import, everything that is consumed!) and IM depend positively on Y
•If Y > AE, there are unplanned investments (adding to inventories) →output ↓ employment ↓
(“bust”)
•If Y < AE, there are unplanned disinvestments →output ↑ , employment ↑ (“boom”)
- = firms produce more than the total demand for your goods
• (short-term) Equilibrium if Y = AE
•Note: prices play no role here, quantities (firms) adjust to the position of the AE-line →short-run
analysis
Changes in spending have a multiplier-effect on Y
Examples:
•change in G
•change in T
•change in autonomous consumption, investments, exports, ...
Note: the multiplier-effect can be different for e.g. G and T!
Keynesian Cross Example: G ↑
green line = 45 degrees line!
If income rises, consumption (that’s
why it is included in C(Y,…)) rises and
import rises. The sum of AE goes up, so
that’s why AE-line is an upward sloping
line. The slope of the line depends on
the MPC (derivative C/derivative Y)
and derivative IM/derivative Y.
Due to a rise in G, we can draw a new
line which shifts parallel (slope does
not change!). The increase in Y is
greater than the increase in G. That is called the multiplier effect. This multiplier effect depends on
how steep or flat the AE line in the steeper, the bigger the multiplier effect. Extreme case: is the
AE line is horizontal, than Delta G = Delta Y
,Exercise to practice
Small letter c is the MPC! It is a closed economy, so Export and
Import are not included in the AE! (and investments are autonomous).
1) Equilibrium says that AE should be equal to Y, that’s why Bas write that Y above in the formula at
the end
Bas solves for Y, so everything to the left after solving the brackets. Than he divides every term by (1-
C). so the multiplier of G is 1/(1-C). we assume that C is between 0 and 1, so the result of that is that
the multiplier of G > 1
2) before T stand – C/(1-C)
The effect of a change in T is less strong than a change in G because a part of T
is saved, while the addition on G is fully consumed
Lecture 1.2: repetition of Money and interest rates
Money demand:
•Real money demand: L(i,Y) so L depends on income and interest rate
- L↑ if Y↑
- L↓ if i↑ (interest rate is opportunity cost of holding money, something you can earn is interest)
In the graph you can see this
back: the higher i, the lower the
money demand.
The shift of the line indicates that
for the same interest rate with a
higher level of income, people
want to hold more money.
The money market:
•Real money demand: L(i,Y)
- L↑ if Y↑
- L↓ if i↑
,•Real money supply: M/P (how much money there is in the economy)
→ let’s assume for the moment that the price level P = 1 and constant
→M is influenced by the central bank
•LM: all combinations of income (Y) and interest rate (i) for which there is equilibrium in the money
market
→money demand = money supply: L(i,Y) = M/P
Real money supply does not depend on i, so it is a vertical line. If Y increases and i would remain the
same, than demand is larger than supply (see the arrow to the right in the right graph). So that’s why
i needs to go up. So when income increases, i also increases to get an equilibrium.
The money market: LM curve
Expansionary monetary policy: M ↑
Increase of M implies shift of money
supply to the right. This results in a
lower interest because if there is
more money supply, there must also
be more money demand.
, we saw above that due to a rise of M, i gets
lower. So we have a new LM-curve. Vice versa: if
you reduce the money supply, than the LM-
curve goes up. So any level of M has its own LM-
curve!
Interest rate targeting: (he will not ask for this in the exam)
The central bank usually sets the interest rate →target rate curve is horizontal
The interest rate must be at this level no matter what the level of income is, so that is why the “lm
curve” is horizontal. The central bank than knows that the LM-curve must cross through the point
where Y1 and the “lm curve” cross.
What if income increases?
