Context Chapter 9 introduced the model of aggregate demand and aggregate supply .ong run prices flexible output determined by factors of production technology unemployment equals its natural rate Short run prices fixed output determined by aggregate demand unemployment is negatively related to output CHAPTER 10 Aggregate Demand I slide 1
CHAPTER 10 Aggregate Demand I slide 1 Context ▪ Chapter 9 introduced the model of aggregate demand and aggregate supply. ▪ Long run – prices flexible – output determined by factors of production & technology – unemployment equals its natural rate ▪ Short run – prices fixed – output determined by aggregate demand – unemployment is negatively related to output
Context This chapter develops the IS-LM model, the theory that yields the aggregate demand curve. We focus on the short run and assume the price level is fixed CHAPTER 10 Aggregate Demand I slide 2
CHAPTER 10 Aggregate Demand I slide 2 Context ▪ This chapter develops the IS-LM model, the theory that yields the aggregate demand curve. ▪ We focus on the short run and assume the price level is fixed
The Keynesian Cross a simple closed economy model in which income is determined by expenditure due to J.M. Keynes) Notation I planned investment E=C+I+G= planned expenditure Y= real GDP actual expenditure Difference between actual planned expenditure: unplanned inventory investment CHAPTER 10 Aggregate Demand I slide 3
CHAPTER 10 Aggregate Demand I slide 3 The Keynesian Cross ▪ A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) ▪ Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure ▪ Difference between actual & planned expenditure: unplanned inventory investment
Elements of the Keynesian Cross consumption function C=c-7 govt policy variables for now, nvestment is exogenous planned expenditure: E=C-T)+I+G Equilibrium condition Actual expenditure= Planned expenditure CHAPTER 10 Aggregate Demand I slide 4
CHAPTER 10 Aggregate Demand I slide 4 Elements of the Keynesian Cross C C Y T = − ( ) I I = G G T T = = , E C Y T I G = − + + ( ) Actual expenditure Planned expenditure Y E = = consumption function: for now, investment is exogenous: planned expenditure: Equilibrium condition: govt policy variables:
Graphing planned expenditure E planned expenditure E=C+I+G MPC income, output, Y CHAPTER 10 Aggregate Demand I slide 5
CHAPTER 10 Aggregate Demand I slide 5 Graphing planned expenditure income, output, Y E planned expenditure E =C +I +G MPC 1
Graphing the equilibrium condition E planned E=Y expenditure 45° income, output, Y CHAPTER 10 Aggregate Demand I slide 6
CHAPTER 10 Aggregate Demand I slide 6 Graphing the equilibrium condition income, output, Y E planned expenditure E =Y 45º
The equilibrium value of income E planned E=Y expenditure E=C+I+G income, output, Y Equilibrium Income CHAPTER 10 Aggregate Demand I slide 7
CHAPTER 10 Aggregate Demand I slide 7 The equilibrium value of income income, output, Y E planned expenditure E =Y E =C +I +G Equilibrium income
An increase in government purchases At Y1, E=C+I+G2 there is now an unplanned drop E=C+I+Gr in inventory △G so firms increase output and income rises toward a new equilibrium E1=Y1 △ E2=y2 CHAPTER 10 Aggregate Demand I slide 8
CHAPTER 10 Aggregate Demand I slide 8 An increase in government purchases Y E E =C +I +G1 E1 = Y1 E =C +I +G2 E2 = Y2 Y At Y1 , there is now an unplanned drop in inventory… …so firms increase output, and income rises toward a new equilibrium G
Solving for△Y Y=C+i+G equilibrium condition △y=△C+△+△ G in changes △c+△G because I exogenous MPC×△y+△ G because△C=MPC△y Collect terms with△y Finally! solve for△y on the left side of the equals sign △》= △G (1-MPC)x△y=AG 1-MPC CHAPTER 10 Aggregate Demand I slide 9
CHAPTER 10 Aggregate Demand I slide 9 Solving for Y Y C I G = + + = + + Y C I G = + MPC Y G = + C G (1 MPC) − = Y G 1 1 MPC Y G = − equilibrium condition in changes because I exogenous because C = MPC Y Collect terms with Y on the left side of the equals sign: Finally, solve for Y :
The government purchases multiplier Example: MPC =0.8 △y △G 1- MPC 084G=1 △G=5△G 0.2 The increase in g causes income to increase by 5 times as much CHAPTER 10 Aggregate Demand I slide 10
CHAPTER 10 Aggregate Demand I slide 10 The government purchases multiplier Example: MPC = 0.8 1 1 MPC 1 1 5 1 0 8 0 2 . . Y G G G G = − = = = − The increase in G causes income to increase by 5 times as much!