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Outline
Macroeconomic Theory and Policy
Chapter 9 – Aggregate Demand and Economic
Fluctuations
Section 1 – Business Cycle
Section 2 – Macroeconomic Modeling and
Aggregate Demand
Section 3 – Keynesian Model
Aggregate Demand and Economic Fluctuations
Remember: macroeconomic goals of good living
standards, sustainability and stabilization
Now focusing on stabilization
One key aspect: understanding how the amount
people would like to spend overall is
influenced by and influences all other
macroeconomic variables.
overall spending = aggregate demand
Keynesian vs. classical -> need for intervention
Business Cycle
Business cycle – fluctuations in the level of
national production, alternating between
booms and recessions.
Macroeconomic policy aims to maintain
stabilization to smooth out variations
Business Cycle
Stylized Facts – important but not always literally
true!
Fact 1: During an economic downturn (recession,
contraction), unemployment increases.
Rule of thumb: Okun’s Law
Empirical inverse relationship btw unemployment
rate and real GDP growth. (e.g. 1 per cent drop
in unemployment rate is associated with approx.
3 per cent boost to real GDP)
Not always perfect relation! e.g. jobless recoveries
Business Cycle
Fact 2: An economic recovery or expansion, if it is
very strong, may lead to an increase in the
inflation rate.
Why? As economy “heats up”, more competition
over the resources -> prices/wages increase,
intensifying inflation.
Remember: Philips curve
Evidence: business-cycle-led
variations in competition
is only one cause of variations
in inflation – will discuss later!
Business Cycle
Stylized business cycle – based on overall growth
trend in GDP.
Full employment output
Assumed to correspond
to a case of no excessive
unemployment
The goal of stabilization
policy is to keep the economy in this “band”,
avoiding the threats of inflation and
unemployment
Macroeconomic Modeling and AD
Model: “thought experiment” using variables, based
on certain assumptions
Remember: traditional model – simplified form of
economic activites taking place btw 4 sectors
Further simplification:
- Assume FE output does not grow.
- Actors: households&businesses (only for Ch 9)
- Keynesian view: recession + rising unemployment
due to potentially insufficient aggregate demand
Macroeconomic Modeling and AD
Y = output/income (will be used interchangeably)
Incomes from production
give rise to spending that
stimulates producers to
produce the original level
of output
Equilibrium->income=spending
C = consumption decisions by hh
II = intended investment by biz.
AD = C + II
Macroeconomic Modeling and AD
Y = C + I -> accounting identity with actual levels
AD = C + II -> behavioural equation with intended
levels, whether or not this planned level matches
with what is actually achieved.
Link from Y to AD - potentially weak: people with
incomes do not just automatically go and spend it
all!
Leakages: savings!!
Saving: part of income that is not spent on
consumption Y= C + S => S = Y - C
Macroeconomic Modeling and AD
Businesses also need funds to buy investment goods.
Assume: firms must borrow from the savings put
aside by hh to finance investment projects
Intended investment: injection!
Equilibrium: leakages = injections; S = II => Y = AD
When economy is in equilibrium, this means that
spending is exactly sufficient tu buy the output
produced.
What if hh or business changes their minds??
Macroeconomic Modeling and AD
Suppose businesses decide to cut back future
plans for expansion (reduce II) or households
decide to consume less (increase S).
Leakages exceed injections (S > II => Y > AD)
Planned spending is not sufficient to support
existing level of output (or vice versa)
Need for adjustment!
Solution??? Classical vs. Keynesian
Different solutions for adjustment
Macroeconomic Modeling and AD
Classical Solution to Leakages
Q: how does an economy (assumed to run in FE)
keep leakages into saving exactly equal to the
injections coming from intended investment?
Flexible markets! Which market??
Market for loanable funds: supply comes from
households (S), demand comes from firms (II);
price = interest rate
Equilibrium = FE balance
Macroeconomic Modeling and AD
Classical Solution to Leakages
Imbalance: suppose firms decide to cut back II,
demand for loanable funds decrease, excess
supply of funds at the equilibrium rate, price falls,
households choose to save less and consume
more until new demand
equates supply.
AD still equal to FE level, S = II
Less II balanced by more C
Self-sustaining economy at FE
level thanks to price adjustment
Aggregate Demand and Economic Fluctuations
Production
generates
income
Income (Y* )
Output (Y* )
leakage
Consumption (C )
Spending
stimulates
firms to
produce
Spending sufficient
to sustain full
employment
AD = Y*
Saving (S )
Equilibrium in
the market for
loanable
funds
injection
Intended Investment
(II ) is equal to S
Remember: Classical view on macroeconomic
equilibrium
Keynesian Model of AD
Assume: simple closed economy, no government
Consumption: households are able to spend on
consumption when income is generated
Consumption function – autonomous part and a part
that depends on the level of aggregate income
C = C0 + mpc . Y
C0 : autonomous consumption, not related to income
minimum level of consumption that people feel required to
spend for survival
mpc: marginal propensity to consume, the amount of
additional consumption people make for each additional
income they receive
Keynesian Model of AD
Logically 0 <mpc < 1
Remember: saving is the part of income not spent on
consumption by households.
S = Y – C = Y – (C0 + mpc . Y) = - C0 + (1-mpc) Y
mps: marginal propensity to save = 1 – mpc
Additional saving when income increases
Plot consumption = income line (45 degree line)
Consumption function – increasing in income
Distance between C and 45 degree line is savings
Keynesian Model of AD
Consumption =
Income Line
500
Consumption (C )
Consumption (C )
(= C + mpc Y)
400
340
300
Saving (S)
Slope = mpc
200
100
C = 20
45
0
100
400
Income (Y )
Keynesian Model of AD
Consumption function may shift due to
- wealth: if feel wealthier, may tend to spend more
- consumer confidence: if less confident about future
(e.g. political instability, war etc.), tend to spend less
- attitudes: if many people decide to spend less due to
health or environmental concerns, overall
consumption may slow down
- government policies: any policy to raise savings (as a
source of capital) may lower C
- income distribution: poorer may tend to spend more;
a more egalitarian distribution of income raises C
Keynesian Model of AD
Investment : cost of borrowing is only factor in
amount of investment, but an important
determinant of level of investment
“animal spirits” – optimism / pessimism of investors
about future
intended investment is autonomous: II = II0
Aggregate Demand
AD = C + II
Any increase in consumer and investor desired
spending increases AD
Consumption, Investment, and
Aggregate Demand
Keynesian Model of AD
Aggregate Demand (AD )
= C + II
Consumption (C )
400
Intended Investment (II )
340
C +II = 80
400
Income (Y )
Keynesian Model of AD
Unintended investment? Occurs when AD is
insufficient; in other words when the
inventories build up unexpectedly
Actual investment: I
I = II + excess inventory accumulation or
depletion
Plot output = income line (45 degree line)
Difference between 45 degree line and AD is
unintended investment
Aggregate Demand and Output
Keynesian Model of AD
Output =
Income Line
Aggregate Demand (AD )
1000
800
unintended
investment
(build up of
inventories)
700
720
600
500
E
400
300
200
100
80
45
0
100
400
800
Income (Y )
Keynesian Model of AD
Movement to equilibrium – will cut back production
until excess inventories are used up
When economy arrives at equilibrium, balance
between S & I has been restored – due to changes
in income!!
Persistent unemployment? Keynesian view: there is
no automatic mechanism that settles the economy
Great Depression: stock market crash, cut back
investment spending, contraction, low income high
unemployment equilibrium – need for stimulus
Output (Y* )
Production
generates
income
Income goes
to households
Income (Y* )
Lower Income
Lower Spending
Lower Output
AD = lower Y
If leakages
are larger
than
injections…
Insufficient Spending
AD < Y*
Keynesian Model of AD