6.

The economy
in the short run
6.1 Aggregate demand and supply the short-
and the long-run
6.2 Income and expenditure
6.3 The multiplier principle
6.4 Investment and interest rates
Second Examination

11 August 2013
3 p.m. UPSE Premises
 Differences between
short- and long-run
In the long-run prices are flexible and
respond to changes in supply and
demand.
In the short-run prices are sticky at
some predetermined level.
No single reason why prices are sticky:
contracts fixed over certain periods
costs of changing menus or price tags
preserving market share against competitors
6.1.1 Aggregate demand
 Quantity equation as
aggregate demand
Recall the quantity theory:
M/P = kY
Y = (M/P)(1/k)
Suppose M = M. Then there is a negative
relationship between P and Y. The higher
is P, the lower is Y, and vice versa.
 One interpretation
Think of M/P as a proxy for wealth (because it is
part of wealth).
Call YD the amount of output people want to buy or
to spend on.
Then one can say that spending, YD, depends on
their wealth (M/P). The higher is real wealth, the
more people are willing to spend.
But real wealth is inversely related to the price
level P. So aggregate demand or spending is
inversely related to the price level.
An aggregate demand curve
P

1/k(M/P) = AD

YD
6.1.2 Aggregate supply
 Aggregate supply
Aggregate supply is the relationship
between the price level and the amount of
real output people are willing to sell at that
price level.
We distinguish between long-run and short-
run aggregate supply.
 Long-run aggregate supply
In the long run, aggregate supply is given by
YF = F(K, L).
It does not depend on the price level, since
we assumed prices are flexible. Real
wages W/P and real profits R/P will be
maintained at full employment levels,
since whatever the price, W and R will
adjust accordingly.
So the supply curve is vertical.
Long-run full employment
MPL

W/P1 but nominal wages also fall

If
andprices fall,the
restore thereal
realwage
wageto
rises
the and
W/P unemployment
full-employmentthreatens.
level

MPL

L Labour
 Long-run aggregate supply
P LRAS

raises
prices but
not output

An increase in
P1 aggregate demand

AD

YF YD
 Short-run aggregate supply
In the short-run however, prices and wages
are fixed. This implies there can be some
unemployment.
If W and P are set so that W/P yields
unemployment, then supply can increase
without any change in prices.
Hence the short-run aggregate supply curve
is horizontal.
 Short-run aggregate supply
Example: A factory wants to produce 500,000
widgets and sell them at P10 each.
Total expected revenue = P5,000,000
It signs a contract to pay 100 workers P8,000
monthly for a year.
Annual wage bill: P960,000
(= 8,000 12 mos. 100 workers)
Expected annual profits: P4,040,000.
 Short-run aggregate supply
Suppose it finds out it can sell only 200,000
widgets at P10 each.
Total expected revenue = P2,000,000.
But it is already committed to pay the 100 workers,
for the whole year, so the total wage bill is still
P960,000.
Actual profits: P1,040,000.
Important: If suddenly demand falls, the firm will
not change the price of P10 but simply produce
less.
 Short-run aggregate supply
5000

Revenues
Revenue and cost

rise as more
is produced
(000 pesos)

Costs are constant

for =
Output output
500 less
than 500
Profits = 4040

2000
Output = 200
Profits = 1040
960

200 500 Output (000)

Short-run aggregate supply
P

No need to
change price for
output below a
certain level.

P SRAS

YS
Short-run aggregate supply
P
An increase in
aggregate demand

P SRAS

AD

Y Y1 YD
increases output
but not prices
 Summary
Over long periods of time, prices are flexible,
aggregate supply is vertical, and changes
in aggregate demand affect only the price
level, not output.
In the short run, prices are sticky, aggregate
supply is horizontal, and aggregate
demand changes affect real output.
 6.2 Spending and
income in the short run
Expenditure determines income
Recall E = Y (where E = C + I + G + X M)
E depends on Y, since people spend what
they earn as income [E = E(Y)]
But Y also depends on E. Because how
much is produced and how many are
employed also depends on what
producers think can be sold hence
especially on what firms spend.
 Expenditure determines income
In equilibrium, income will always equal
spending. But which comes first?
Claim: In the short run, output is determined
by aggregate demand.
Recall that in the short run the price level
does not vary regardless of the level of
output.
Therefore, aggregate demand (spending)
determines the level of output.
Income, output, spending
Spending
Y=E

Along the 45O line Y = E

C B because OA = AB = OC

45O
0 A Income
Spending depends on income
Spending

E (Y)

DE As income rises, spending rises,

but by less than the increase in
DY income. DE < DY, or DE/ DY < 1.

0
Income
Expenditure determines income
E
Y=E

Y>E E (Y)
D Inv > 0
E2
E*
E1
Y<E
DInv < 0

45o

Y1 Y* Y2 Y
Expenditure determines income
When E > Y, inventories run down faster
than producers desire. Production is
stepped up; output and income rise until
E = Y.
When E < Y, inventories accumulate faster
than producers want. Production is slowed
down; output and income fall until
E = Y.
When E = Y, there is no reason for Y to
change.
Expenditure determines income
If spending determines income and output
in the short run, it remains to find out what
determines spending.

Spending E = C + I + G + X M.

So whatever affects C, I, G, X, and M will

affect E and therefore affect Y.
 Consumption
Consumption depends on disposable income
and real wealth Z/P
C = C(Y T, Z/P)
So spending E also depends on disposable
income and wealth
E = E(Y T, Z/P, )
But since E = Y, we can omit Y and just write:
E = E(T, Z/P, )
, +
 Consumption, investment,
and income
Take the simplest situation: let spending
consist only of consumption and
investment, and that
(1) Consumption depends only on income
C = C(Y) = a + bY.
(2) Investment is exogenous:
I = I.
 Consumption, investment,
and income
Then
E =C+I
= a + bY + I
= (a + I) + bY.
Graphically, this is the function E(Y) we
have been drawing.
Expenditure determines income
E
Y=E

E (= a + I + bY)

C (= a + bY)
E0

a
45o

Y* Y
An increase in investment
E
Y=E
C+I

E1 C+I

C
E0

45o

Y0 Y1 Y
 Government consumption
Lets add government spending and taxes
E=C+G+I
C = a + b(Y T)
Putting these together:
E = (a + I bT + G) + bY
Again, this shows spending as a function of
income.
 Expenditure with government
E Y=E

E1

E1 Eo

E0 Higher government
spending raises
Income.

a + I + G - bT

45o

Y* Y1 Y
 Summarising
The intercept is a + I + G bT
A higher I will raise spending and income.
A higher G will raise spending and income.
A higher T will lower spending and income.
6.3 The multiplier effect
 The multiplier
An increase in autonomous spending A like
investment (I) or government consumption (G)
will raise equilibrium income Y by a multiple m of
the original increase in spending.
The relation between the change in autonomous
spending and equilibrium income is given by
DY = mDA
where m > 1 is the multiplier.
Alternatively, one can say that DY > DA.
Changes in autonomous spending
E Y=E

E1

E1
Eo
DA

E0
DY
Obviously DY > DA
or DY/ DA > 1
a + I + G - bT

45o

Y0 Y1 Y
 Some algebra
E =C+G+I
C = a + b(Y T)
E =Y
Solution:
E = a + b(Y T) + G + I
Y = a + b(Y T) + G + I
(1 b)Y = a + I bT + G
Y = [1/(1 b)] (a + I bT + G)
Y = m (a + I bT + G)
m = 1/(1 b), the multiplier.
Because b < 1, 1 /(1 b) > 1.
 Some algebra
Note that m = 1/(1 b) > 1.
For example, let b = 3/4
Then m = 1/(1/4) = 4. Then a 1-peso
increase in autonomous spending results
in a 4-peso increase in aggregate income.
 Why?
which raises Y

E = A + bY = Y which gives Y an added boost

A higher A is
an increase in E but a higher Y raises E again

So the original increase in A raises Y

by a larger amount than itself.
 Algebraically
DSpending DIncome
DA DA
bDA bDA
b(bDA) b2DA
b(b2DA) b3DA

DA(1 + b + b2 + b3 + ) = DA 1/(1 b)
 Summary
Any increase in autonomous spending will cause
an increase in income greater than itself.
The magnitude of the income-increase depends
on the proportion of income ploughed back into
the spending stream (i.e., the marginal
propensity to consume, MPC)
The larger the MPC, the larger is the multiplier.
6.4 Investment and
interest rates
 Investment
If investment is exogenous, i.e.,
I=I
then its effect on Y can be analysed in the
same manner as one would an increase in
G (with a multiplier effect, etc.)
But we know that more generally:
I = I(r) , e.g., I = I hr.
A solved model with investment

Y =E
E=C+G+I
C = a + b(Y T)
G = G; T = T
I = I hr
A solved model with investment
Plug in all components of E:
E = a + b(Y T) + G + I hr
E = (a + G + I bT hr) + bY
Y = (a + G + I bT hr) + bY
(1 b)Y = (a + G + I bT) hr.
Then equilibrium income is given by
Y = m(a + G + I bT) mhr.
where m = 1/(1 b)
A solved model with investment
Y = m(a + G + I bT) m(hr).

Note that if r increases, Y falls. (The effects

of the other components are the same.)
 Investment and interest rates
If the real interest rate rises, investment
falls.
which reduces total spending
which reduces equilibrium income/output
Therefore, higher interest rates reduce
equilbrium income and output.
Expenditure and interest rates
E Y=E

E (r1)

E1 E (r0)

E0 Lower interest rates

raise spending
and income.

Let r1 < r0

45o

Y0 Y1 Y
 Income and interest rates
Recall the solution for equilibrium Y:
Y = m(a + G + I bT) m(hr).
This gives a relationship between the
interest rate and output.
For every r, there is a level of I and of E that
determines Y.
Higher levels of r lead to lower levels of Y.
 The IS-curve
r

which reduces spending,

which reduces income.

r1
A higher interest rate
reduces investment
r0

IS
Y
Y1 Y0
Another explanation of the IS curve
Equilibrium income requires that saving equals
investment. Saving is a function of income;
investment a function of the interest rate:
S(Y0) = I(r0)
If r increases, I becomes smaller, so that
S(Y0) > I(r1).
To restore equality, Y must fall to Y1, so that S falls
and once more:
S(Y1) = I(r1).
 Saving equals investment
S = (Y T) C + (T G)
= (Y T) (a + b(Y T)) + (T G)
= Y T a bY + bT + T G
= Y a bY + bT G
= ( a G + bT) + (1 b)Y
So, saving rises with income.
 Saving equals investment
Saving must equal I = I hr in equilibrium:
( a G + bT) + (1 b)Y = I hr
(1 b)Y = (a + G bT + I) hr
Y = m(a + G bT + I) mhr
which is the same solution obtained using
the other approach. Hence the name IS
curve: combinations of r and Y that equate
saving and investment.