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Ms. Tavishi
Macro Economics
Introduction to
Macroeconomics
Microeconomics examines the
behavior of individual decisionmaking unitsbusiness firms and
households.
Macroeconomics deals with the
economy as a whole; it examines the
behavior of economic aggregates
such as aggregate income,
consumption, investment, and the
overall level of prices.
Aggregate behavior refers to the
behavior of all households and firms
together.
Introduction to
Macroeconomics
Microeconomists generally
conclude that markets work
well. Macroeconomists,
however, observe that some
important prices often seem
sticky.
Sticky prices are prices
that do not always adjust
rapidly to maintain the
equality between quantity
Introduction to
Macroeconomics
Macroeconomists often
reflect on the
microeconomic principles
underlying macroeconomic
analysis, or the
microeconomic
foundations of
macroeconomics.
The Roots of
Macroeconomics
The Great
Depression was a
period of severe
economic contraction
and high
unemployment that
began in 1929 and
continued throughout
the 1930s.
The Roots of
Macroeconomics
Classical
economists
applied
microeconomic models, or market
clearing models, to economy-wide
problems.
However, simple classical models
failed to explain the prolonged
existence of high unemployment
during the Great Depression. This
provided
the
impetus
for
the
development of macroeconomics.
The Roots of
Macroeconomics
In 1936, John Maynard Keynes published The
General Theory of Employment, Interest, and
Money.
Keynes believed governments could intervene in
the economy and affect the level of output and
employment.
During periods of low private demand, the
government can stimulate aggregate demand to
lift the economy out of recession.
Recent Macroeconomic
History
Fine-tuning was the phrase used by
Walter Heller to refer to the
governments role in regulating
inflation and unemployment.
The use of Keynesian policy to finetune the economy in the 1960s, led
to disillusionment in the 1970s and
early 1980s.
Actual output
what is actually produced in a period
which may diverge from the potential
level
2. Initial Model
Prices and wages are fixed
At these prices, there are workers without a job
who would like to work and firms with spare
capacity they could profitably use
The actual quantity of total output is demanddetermined
this will be a Keynesian model
Government intervention to keep output close
to the potential output
For now, also assume:
no government
no foreign trade
Later topics relax these assumptions
3. Aggregate Demand
Given no government and no
international trade, aggregate demand
has two components:
Investment
firms desired or planned additions to physical
capital & inventories
for now, assume this is autonomous
Consumption
households demand for goods and services
so, AD = C + I
4. Consumption Demand
Households allocate their income
between CONSUMPTION and SAVING
Personal Disposable Income
income that households have for
spending or saving
income from their supply of factor
services (plus transfers less taxes)
5. The Consumption
Function
Consumption
C = 8 + 0.7 Y
Income
5. Saving Function
Saving is income not consumed.
When income is zero, saving is -A
Since a fraction c of each extra
pound is consumed , a fraction of 1
c of income is saved
MPC + MPS = 1
S = -A + (1-C)Y
5. Saving Function
Saving
S = -8 + 0.3 Y
Income
6. Aggregate Demand
In the simple model, aggregate
demand is simply consumption
demand plus investment demand
AD: add I to the previous
consumption function
The slope of AD is the MPC
Aggregate demand
Aggregate demand is
what households plan
to spend on consumption
and what firms plan to
spend on investment.
The AD function is
the vertical addition
of C and I.
(For now I is assumed
autonomous.)
Income
8. Equilibrium Output:
output
expenditure approach
Desired spending
8. Equilibrium Output
45o line
E
AD
Output, Income
Desired spending
8. Adjustment towards
Equilibrium
Suppose the economy
begins with a lower
output, AD > Y
45o line
E
AD
If firms have stock, they
can sell more by
unplanned
B
C
Output, Income
9. An Alternative
Approach
S, I
An equivalent view of
equilibrium is seen by
equating
S
planned investment (I)
E
I
to planned saving (S)
Output, Income
again giving us
equilibrium at E
10.
Demand
45o line AD
0
AD1
Y1
Y0
Output, Income
Notice that the change in equilibrium output is
larger than the original change in AD.
45o line AD
0
AD1
Y1
Y0
Output, Income
Y*
In equilibrium,
planned saving = planned
investment; A fall (rise) in
desire to save induces
a rise (fall) in output to
keep planned saving equal
to planned investment
Three-Sector Model
With the introduction of the
government sector (i.e. together with
households C, firms I), aggregate
expenditure E consists of one more
component, government expenditure
G.
E=C+I+G
Still, the equilibrium condition is
Planned Y = Planned E
Three-Sector Model
Consumption function is positively
related to disposable income Yd
C = f(Yd)
C= C
C= cYd
C= C + cYd
Three-Sector Model
National Income Personal Income
Disposable Personal Income
w/ direct income tax Ta and transfer
payment Tr
Yd Y
Yd = Y - Ta + Tr
Three-Sector Model
Transfer payment Tr can be treated as
negative tax, T is defined as direct
income tax Ta net of transfer payment
Tr
T = Ta - Tr
Yd = Y - (Ta - Tr)
Yd = Y - T
Tax Function
Autonomous Tax T
this is a lump-sum tax which is independent
of income level Y
Consumption Function
C = f(Yd)
C = C
C = C
C = cYd
C = c(Y - T)
C = C + cYd
C = C + c(Y - T)
T = T
Consumption Function
C = C + c(Y - T)
C = C + c(Y - T) C = C- cT + cY
slope of tangent = c
T = tY
C = C + c(Y - tY) C = C + (c - ct)Y
slope of tangent = c - ct
T = T + tY
C = C+c[Y-(T+tY)]C = C - cT + (c - ct) Y
slope of tangent = c - ct
Consumption Function
C = C + c (Y - T)
Y-intercept = C - cT
slope of tangent = c = MPC
slope of ray APC when Y
Consumption Function
C = C + c (Y - tY)
Y-intercept = C
slope of tangent = c - ct = MPC (1-t)
slope of ray APC when Y
Consumption Function
C = C + c [Y - (T + tY)]
Y-intercept = C -cT
slope of tangent = c - ct = MPC (1-t)
slope of ray APC when Y
Consumption Function
C = C - cT + (c - ct)Y
C OR T
y-intercept C - cT C shift
upward
t
c(1-t) C flatter
c
c(1-t) C steeper
y-intercept C - cT C shift
downward
Aggregate Expenditure
Function
E =C+I+G
given C = C + cYd
T = T + tY
I = I
G = G
E = C + c[Y - (T+tY)] + I + G
E = C - cT + I+ G + (c-ct)Y
E = E + c(1-t) Y
Aggregate Expenditure
Function
E = C - cT + I + G + (c - ct)Y
E = E + (c - ct)Y
given E = C - cT + I + G
E is the y-intercept of the aggregate
expenditure function E
c - ct is the slope of the aggregate
expenditure function E
Aggregate Expenditure
Function
Derive the aggregate expenditure
function E if T = T
E = C - cT + I + G + cY
y-intercept = C - cT + I + G
slope of tangent = c
Aggregate Expenditure
Function
Derive the aggregate expenditure
function E if T = tY
E = C + I + G + (c-ct)Y
y-intercept = C + I + G
slope of tangent = (c-ct)
Aggregate Expenditure
Function
Derive the aggregate expenditure
function E if T = T and I = I + iY
E = C - cT + I + G + (c + i)Y
y-intercept = C - cT + I + G
slope of tangent = (c + i)
Aggregate Expenditure
Function
Derive the aggregate expenditure
function E if T = tY and I = I +iY
E = C + I + G + (c - ct +i )Y
y-intercept = C + I + G
slope of tangent = (c - ct +i )
Aggregate Expenditure
Function
Derive the aggregate expenditure
function E if T = T + tY and I = I
+iY
E = C - cT + I + G + (c - ct +i)Y
y-intercept = C - cT + I + G
slope of tangent = (c - ct +i)
Output-Expenditure Approach
w/ T = T + tY
w/ C = C + cYd
C
2-Sector
C = C + cYd = C + cY
C = C - cT + c(1-t)Y
C -cT
Y
I, G, C, E, Y
Y=E
Y
Planned Y = Planned E
Output-Expenditure Approach
I = I exogenous function
E = C - cT + I + G
kE=
1
1 - c + ct
Output-Expenditure Approach
I= I+iY endogenous function
E = E + (c - ct + i) Y [slide 27]
In equilibrium, planned Y = planned E
Y = E + (c - ct + i) Y
(1- c + ct - i) Y = E
Y = E
1
1 - c - i + ct
E = C - cT + I + G
kE=
1
1 - c - i + ct
Output-Expenditure Approach
T = T exogenous function
I = I + iY
E = E + (c + i) Y [slide 25]
In equilibrium, planned Y = planned E
Y = E + (c + i) Y
(1 - c - i) Y = E
Y = E
1
1-c-i
E = C - cT + I + G
kE=
1
1-c-i
Factors affecting Ye
Ye = k E * E
In the Keynesian model, aggregate
expenditure E is the determinant of Ye
since AS is horizontal and price is rigid.
In equilibrium, planned Y = planned E
E = C - cT + I + G + (c - ct + i) Y
Any change to the exogenous variables
will cause the aggregate expenditure
function to change and hence Ye
Factors affecting Ye
Change in E
If C I G E E Y
If T C - c T E by - c TE Y
Y=E
I, G, C, E, Y
I, E, Y I
E = I
I
Y
Ye = k E E
G
G, E, Y
C
C, E, Y
T
C, E, Y
C by -cT
i
I, E, Y
Digression
Differentiation
y = c + mx
differentiate y with respect to x
dy/dx = m
Expenditure Multiplier k
Y=k
kE=
k
k
=
=
* E
1
E = C - cT + I + G
if I=I & T=T+tY
1 - c + ct
1
1 - c + ct - i
1
1-c-i
Expenditure Multiplier k
Tax Multiplier k T
Y=k
kT =
k
k
=
=
* ( C - cT + I + G)
-c
if I=I & T=T+tY
1 - c + ct
-c
1 - c + ct + i
-c
1-c-i
Tax Multiplier k T
Any change in the lump-sum tax T
will lead to a change in the national
income Ye by a multiple of k T in the
opposite direction since k T takes on
a negative value
Besides, the absolute value of k T is
less than the value of k E.
Balanced-Budget Multiplier
kB
G E E Ye by k E times
T E E Ye by k T times
If G = T , the change in Ye can be
measured by k B
Y/ G = k E
Y/ T = k T
kB=kE+kT
kB= + =1
1
-c
1-c
1-c
Balanced-Budget Multiplier
kB
Injection-Withdrawal
Approach
In a 3-sector model, national income
is either consumed, saved or taxed
by the government
Y=C+S+T
Given E = C + I + G
In equilibrium, Y = E
C+S+T=C+I+G
S+T=I+G
Injection-Withdrawal
Approach
Since S + T = I + G
SI
TG
I>ST>G
I<ST<G
(Compare with 2-sector model)
In equilibrium S = I
Injection-Withdrawal
Approach
T = T + tY
S = -C + (1-c) Yd
S = -C + (1 - c)[Y -_(T + tY)]
S=
S=
S=
S=
ctY
-C
-C
-C
-C
+
+
+
+
(1 - c)[Y - T - tY]
Y - T - tY - cY + cT + ctY
cT -T - tY + Y - cY + ctY
cT - (T + tY) + Y - cY +
Injection-Withdrawal
Approach
S + T = -C + cT -(T+ tY) + Y - cY + ctY
+T
S + T = -C + cT + Y - cY + ctY
In equilibrium, S + T = I + G
-C + cT + Y - cY + ctY = I + G
(1- c + ct)Y = C - cT + I + G
Ye = k E * E
E = C - cT + I + G
[slide 30]
Fiscal Policy
The use of government expenditure and
taxation to achieve certain goals, such as
high employment, price stability.
Discretionary Fiscal Policy
Expansionary Fiscal Policy (when Yf > Ye)
Contractionary Fiscal Policy (when Yf < Ye)
G E E Y
E=
E + (c-ct) Y
E = E + (c -ct) Y
G
Y= k E * E
Recessionary Gap
Ye
Yf
Y-line
E=
E + (c-ct) Y
E = E + (c -ct) Y
-cT
Y= k E * E = k T * T
Recessionary Gap
Ye
Yf
E=
E + (c-ct) Y
Y= k E * E
Yf
Ye
E=
-cT
E + (c-ct) Y
Y= k E * E = k T * T
Yf
Ye
Automatic Built-in
Stabilizers
Proportional /Progressive Tax System
Recession: governments tax revenue
Boom: governments tax revenue
Automatic Built-in
Stabilizers
Welfare Schemes
Unemployment benefits, public
assistance allowances, agricultural
support schemes
Recession: governments expenditure
Boom: governments expenditure
Increasing Debt
will increase the demand for loanable fund as
well as interest rate affect private investment
Thank You
Please forward your query
To: tavishie@amity.edu