Intermediate Macroeconomics: Lecture 1 – IS curve: Introduction:

- The macroeconomy is the product of millions of individual decisions o Households decide:

§ What to consume § How much to save § How much to work

o Firm decide § How much to produce § How many workers to hire § How much capital to employ

o Decisions are implemented in markets, where prices are set - Understanding individual decisions only partially explain macroeconomic phenomenon

o Output growth o Business cycle fluctuations o The price level and inflation o Trade

- We need to develop dedicated macroeconomic models Demand vs supply side macro:

- The evolution of GDP is considered as the sum of two components: o The long run trend o The short run fluctuations

- The evolution of GDP can be explained by: o Supply side factors: how much goods and services the economy is able to produce by

combining human capital, physical capital and technology o Demand side factors: the spending of individuals, firms, government and foreign

sector - According to the mainstream view in macro:

o The business cycle is determined by demand side factors o The trend is determined by supply side factors

- In the first part of the subject, we will look at the business cycle while the trend will be studied in the second part (growth model)

GDP: output and income:

- The focus is on GDP, unemployment and inflation - GDP is the amount of final goods and services produced within a country in a given period of

time - The selling of the goods and services generate income for all the subject involved in

production - As a consequence, we will use Y as the symbol for GDP to indicate both output and income

Demand-side macro: origins:

- Until the ‘30s the focus of economists was on the supply side - The great depression imposed a change of paradigm: low output relative to the recent past and

high unemployment o Output is not driven by economic potential o Input resources need not always be put to use (much less efficient use) o The economy may be subject to the “animal spirits” of public sentiment

- Keynes: role of effective demand - Keynesian model:

o Subsequently elaborated to formalise Keynes’ ideas o Demand-driven model of economic activity o It captures deviations from potential without really explaining the failures that

generate the deviations

A Simple Keynesian Model:

- Aggregate Demand (AD) is the sum of the four different sources of demand for economic output:

o C: Consumption from individuals o I: Investment from firms o G: Government expenditure o NX: Net exports (Exports minus imports)

- Formally: § AD= C + I + G + NX (1)

- The economy is in equilibrium when output Y equals demand § Y = AD (2)

- Deviations result in changes to inventory, referred to as unplanned inventory § UI = Y-AD (3)

 A  Simple  Keynesian  Model  1:  

- Consumption  is  the  sum  of  two  components:  o The  amount  that  is  spent  on  consumption  goods  independently  from  the  level  of  

income  of  the  population:  Autonomous  Consumption  (C  >  0)  o The  amount  that  depends  on  the  level  of  income:  c  *  YD  where  

§ c  is  the  Marginal  Propensity  to  Consumer  (MPC):  how  much  C  increases  for  each  dollar  of  additional  income  (with  0  <  c<  1)  

§ YD  is  the  disposable  income:  government  collects  lump  sum  taxes  (TA)  and  makes  transfer  payments  (TR)  such  as  unemployment  benefits.  Thus:  

o YD  =  Y  +  TR  –  TA  (4)  • The  Fraction  of  YD  that  is  not  consumed  is  saved.  Savings  S  are  

given  by:  o S  =  YD  –  C  =  sYD    

§ S  =  1-­‐c  marginal  propensity  to  save  • Therefore  the  equation  for  consumption  is:  

o C  =  C  +  cYD  (5)    A  Simple  Keynesian  Model  2:  

- In  the  simplest  version  I,  G,  NX  are  all  autonomous  (independent  from  income  and  exogenously  set  to  a  fixed  value)  

§ I  =  I(bar)  (6)  § G  =  G(bar)  (7)  § NX  =  NX(bar)  (8)  

                                 

                                                                   

- Consumer  sentiment,  in  the  form  of  optimism  and  pessimism,  will  move  the  economic  equilibrium  

o An  optimistic  consumer  will  save  less  and  consumer  a  greater  portion  of  their  income  

§ Optimism  =  Increase  in  C  =  AD  shifts  up  =  Increase  in  Y  o A  pessimistic  consumer  will  save  more  (as  precaution  against  future  decline  in  

income)  and  consume  less  of  their  income  § Pessimism  =  Decrease  in  C  =  AD  shifts  down  =  Decrease  in  Y  § The  “Paradox  of  Thrift”:  Increase  s  =  Decrease  c  (flatter  AD)  =  decrease  

in  Y  =  Decrease  in  S  o The  impact  is  magnified  through  the  multiplication  process  o The  sentiment  is  self-­‐fulfilling  (a  self  fulfilling  prophecy).  Optimism  is  

substantiated  by  the  resulting  increase  in  output,  pessimism  substantiated  by  the  resulting  fall  in  output  

o Other  factors  that  influence  spending;  Wealth  (as  opposed  to  income)  expectations  about  the  future    

 - Investor  sentiment,  in  the  form  of  optimism  and  pessimism,  will  move  the  economic  

equilibrium:  o Optimistic  (pessimistic)  firms  will  increase  (decrease)  investment  in  capital:  

         

o The  impact  is  magnified  through  the  multiplication  process  o As  with  consumers,  investor  sentiment  is  self-­‐fulfilling  

 - Changes  in  Net  Exports  lead  to  changes  in  the  equilibrium  output  

o Exports  are  driven  by  relative  prices  and  foreign  income            

o The  impact  is  magnified  through  the  multiplication  process      

- Government  Fiscal  Policy,  implemented  through  spending,  can  move  aggregate  output  o An  increase  (decrease)  in  gov  spending  stimulates  (dampens)  aggregate  

demand          

o The  impact  is  magnified  through  multiplication  process    

- Government  Fiscal  Policy,  implemented  through  taxes,  indirectly  move  aggregate  output  through  consumer  spending    

o An  increase  (decrease)  in  gov  spending  stimulates  (dampens)  aggregate  demand  

       

o The  impact  is  magnified  through  multiplication  process  

 Keynesian  Fiscal  Policy:  

- In  this  model,  changing  public  sentiment  is  one  of  the  main  sources  of  economic  fluctuations:  there  is  a  role  for  activist  government  fiscal  policy  to  smooth  the  excesses  brought  about  by  public  sentiment,  to  keep  Y0  near  Y*  

o Stimulating  the  economy  during  periods  of  pessimism  o Dampening  the  economy  during  periods  of  euphoria  

 - Budgetary  implications  of  activist  fiscal  policy:  

o During  a  recession,  an  activist  policy  would  have  government  employ  some  combination  of  increasing  G  (or  TR)  and  decreasing  TA  in  order  to  stimulate  the  economy.  The  budget  surplus  is:  

• BS  =  TA  –  TR  –  G  o A  balanced  budget  before  the  recession  becomes  a  deficit  as  the  government  

stabilises  output  o The  reverse  is  true  during  a  boom  with  the  government  generating  a  surplus  

from  low  G  and  high  TA  to  dampen  the  economy  § The  Gov  could  set  G  and  TA  such  that  they  are  balanced  on  average  over  

the  course  of  the  business  cycle  § This  would  require  spending  restraint  and  higher  taxes  during  a  boom  § The  likely  result  is  activist  policy  only  during  recessions  

                                       

- The  multiplier  is  smaller  in  the  presence  of  an  income  tax  –  automatic  stabilisation  o Tax  revenues  are  high  when  income  is  high  while  transfers  (unemployment  

benefits)  are  low,  dampening  output  o Tax  revenues  are  low  when  income  is  low  while  transfers  are  high,  stimulating  

output  o Automatic  stabilisation  is  undermined  if  the  government  pursues  a  balanced  

budget  policy      

                           Duality:  

- Goods  market  in  equilibrium:  Y  =  AD  =  C  +  I  +  G  +  NX  - Rearranging  and  substituting  for  G  from  (11):  

§ Y(1-­‐t)  –  C  +  TR  =  I  –  BS  +  NX  o From  which:  

§ S  =  I  –  BS  +  NX  - Goods  markets  in  equilibrium  =  savings/  investment  market  in  equilibrium    

 Investment  and  interest  rates:  

- Investment  can  be  considered  as  a  function  of  the  interest  rate  r:  let  us  replace  I  =  I(bar)  with  I  =  I(bar)  –  br,  with  b  >  0  

o This  is  roughly  consistent  with  the  more  sophisticated  investment  decision  to  be  developed  later  

o We  can  rewrite  the  aggregate  demand  equation  as:          

o Using  (12)  we  can  find  the  points  for  which  AD  =  Y  for  any  possible  interest  rate;  o These  points  represent  the  IS  curve  o Note:  here,  investment  depends  on  the  real  interest  rate.  

                                 

 The  IS  curve:  

- The  IS  curve  o All  (Y,  r)  combinations  that  represent  equilibrium  in  the  Goods  market  o Equilibrium  in  the  Goods  market  means  there  is  equilibrium  in  the  market  for  

investment  § From  the  duality  between  the  two  markets;  I  =  S  therefore  the  curve  is  

labelled  the  IS  curve    Movements  along  the  curve:  

- Movement  from  one  equilibrium  to  another  based  on  an  unchanged  relationship  between  r  and  Y  

     

             Shifts  in  the  IS  curve:  

- The  result  of  some  event  that  changes  the  relationship  between  r  and  Y  

- Move  to  a  new  equilibrium  because  the  old  equilibrium  no  longer  exists  

o E.g.  an  increase  in  consumer  optimism  shifts  AD  even  though  r  remans  the  same  

§ ^C  =  ^AD  =  ^Y  (for  same  r)  

o Other  examples  include  ^G,  ^NX,  ^I  (for  reasons  other  than  a  change  in  r)  

       Mathematical  representation: