Week 1
Chapter 1: The demand side
Demand side = refers to the side which concerns the spending decisions of households,
firms and government
Supply side = refers to the production activities
Spending decisions influence the level of economic activity.
Level of activity = output or income
If output increases, employment also increases (and thus income).
3
Spending decisions involve a static component (what shall I buy today, given my current
income and current prices?) and an intertemporal one (how do I allocate in the future given
expectations about income?).
Monetary and fiscal policy:
Policy makers use monetary and fiscal policy to influence the demand side as they worry
about fluctuations in the aggregate demand as they affect unemployment and inflation.
Monetary policy changes interest rates which affect investment decisions. An increase in
interest rates increases the cost of financing and creates an incentive to save, therefore
decreasing spending. Fiscal policy uses taxation to influence the demand side.
Facts about the demand side
Country C I G X-M
China 43 37.5 15.1 2.9
Germany 58.6 18.7 19 3.5
Japan 57.1 23.7 17.7 1.4
U.K. 65.3 16.7 20 -2.5
U.S.A. 69.9 19 15.3 -4.5
G rises as a proportion of GDP, when measured in current prices, because in sectors with
comparatively slow productivity growth, prices rise relative to the rest of the economy.
Three methods to calculate GDP:
The expenditure method
Y = C + I + G + (X - M) -> aggregate demand
GDP = consumption + investment + government spending + (export - import)
Aggregate demand does not include second-hand products. Also, a house is considered an
investment. Furthermore, G only includes G on goods (ammunition for the army),
expenditures on salaries (wages of civil servants) and services (waste disposal), not on
transfers (e.g. pensions or social security payments). Consumption includes both durable
(laptop, car) and non-durable goods (theatre show, groceries). Also, a closed economy does
not include export and import.
The value added method
Y = value of output sold - costs of raw materials and intermediate goods
It only includes final goods
1
,The income method
Y = salaries of workers + profits of the owners of capital
GDP under all three methods should be equal, however they may differ due to measurement
error. This error may stem from black markets or tax evasion. These will cause the greatest
problem of underestimation of GDP when measured by incomes.
Investment is much more volatile (higher stdv) than consumption and government spending.
Investment depends on post-tax profits and is very dependent on how optimistic firms are.
They flourish in boom periods and collapse in recessions. Also, investment can be more
easily delayed than C and G. Recessions start at the peak of a business cycle and end at
the trough. Economic activity is contracting in recessions.
The great moderation = the calmer macroeconomic conditions from the 1980s (fewer and
shorter recessions), GDP volatility was lower
The goods market equilibrium
In the closed economy model, we ignore export and import:
Yd = C + I + G
All variables are in real terms
Goods market equilibrium:
Yd = y
➔ planned real expenditure is equal to real output
➔ y can be seen as either output, income or expenditure
Keynesian consumption function:
C = c0 + c1 * (1- t) * y
T = total taxes net of transfers: it is a constant proportion of income, where 0 < t < 1
c0 = autonomous consumptions: if disposable income is 0, consumption equals c0, however,
then the household must either have savings or borrow
c1 = the marginal propensity to consume, where 0 < c1 < 1
(1- t) * y = disposable income
In this function, households spend a fixed proportion of any extra income they receive
Marginal propensity to consume (c1) = ΔC / ΔYdisp
where Ydisp = (1 - t) * y
Saving = y - C
Marginal propensity to save = 1 - c1
Aggregate demand becomes:
Yd = c0 + c1 * (1- T) * y + I + G
➔ the intercept of the curve will be (I + G + c0)
➔ the slope of the curve will be c1 * (1 - t) (endogenous variable, influenced by a
variable in the equation), where 0 < slope < 1 as this is also the case of t and c1
➔ the market equilibrium can be drawn with a 45 degree line, the intersection between
this line and the aggregate demand shows the level of output where planned real
expenditure on goods equals the level of goods being supplied.
2
,The multiplier
Multiplier effect = an effect which causes total output to be greater than the change in
spending which caused it. It causes increases in many other related factors:
If there is e.g. an increase in G (of ΔG), it will
shift the demand curve upwards by ΔG. If G
increases spending on goods, from that specific
good, inventory levels drop. This fall in inventory
triggers an increase in production: output
increases. And in turn, incomes rise and thus
consumption (of [c1 * (1 - t) * ΔG]), increasing
aggregate demand further by the same amount.
This will go on ([c1 * (1 - t)]2 * ΔG) etc. until a
new equilibrium is reached at point Z, where
output equals aggregate demand.
Thus, the final difference in y (Δy) = multiplier *
ΔG Keynesian cross
Multiplier = 1 / [(1 - c1) * (1 - T)] -> multiplier is greater than 1
Autonomous demand = c0 + G + I -> exogenous variables
➔ an increase in autonomous demand by 1%, increases output by more than 1% (the
aggregate demand curve is flatter than the market-clearing condition). This is the
short-run multiplier as we keep all other policy responses constant.
➔ if c1 is 0, there is no multiplier process amplifying the effect of a change in
autonomous demand. yd is a horizontal line.
The paradox of thrift
If there is a recession, the question is if saving should be encouraged or discouraged. If
saving is encouraged, and more is saved and invested in new capital stock, this would help
recovery. However, if more savings means less consumption and there is no increase in
investment, demand will fall and worsen the recession.
(1 - c1 * (1 - t)) * y - c0 = I + G
Where the first term equals planned saving and the second term planned I and G
3
, If we encourage savings, consumption falls, and the multiplier process work in the downward
direction. The intention to save more did not lead to higher savings as income fell. If greater
savings are not matched by higher investment, income will fall and there will be no overall
increase in the economy. The aggregate demand falls, and thus output and thus the
recession deepens.
The IS curve
This 3-equation model represents the demand side, the supply side and the policy maker.
The IS (investment and saving decisions) curve represents the demand side. The IS
summarizes the way that aggregate output in the economy is affected by changes in
spending decisions. E.g. if a firm increases spending on equipment, production increases in
the producing sector which leads to a higher employment. The higher employment leads to
more wages, increasing consumption and thus increasing output in these sectors. Thus,
employment and output have increased until the point that I and S equal each other again.
The X axis regards the output and the Y axis regards the interest rate. IS is a downward
sloping line. If the interest rate is high, consumption and investment is low (low output).
If there exist depressed profit expectations, we
expect firms to postpone investment. The result
is, lower investment at any interest rate, the IS
curve shifts to the left. If the government launches
an expenditure programme, this will shift the IS
curve to the right. By how much G increases
output depends on the multiplier. The larger the
multiplier, the larger the shift associated with G,
and the flatter the IS curve (as a larger multiplier
causes a cut in interest rates to have a larger
effect on output). If the central bank lowers the
interest rate to stimulate investment (cost of financing goes down), it can be seen as a move
along the IS curve.
The level of aggregate demand will be affected by:
- income
- expectations about the future
- for firms, better expectations about the future, leads to higher investment. For
households, better expectations lets them revise their estimate upward of how
much they can spend each period. In order to spread consumptions (smooth
consumption) they take the life-cycle in consideration.
- the extent of credit constraints
- credit constraints arise due to asymmetric information. Households and
businesses that cannot borrow as much money as they would like are credit-
constrained. Access to credit is often dependent on the amount of collateral.
An increase in the value of collateral can relax credit constraints, and vice
versa.
- interest rate
- if interest rates increase, mortgages become more expensive, the cost of
financing increases, reducing investment. Spending will decrease due to
4
