Macroecon 9

Macroecon 9

1. Keynesian Cross

   • • • Definition: The multiplier indicates the increase in income resulting from a £1 increase in G.
         • • The tax multiplier …is negative: A tax increase reduces C, which reduces income. …is greater than one (in absolute value): A change in taxes has a multiplier effect on income. …is smaller than the government spending multiplier: Consumers save (as opposed to spend) the fraction (1 – MPC) of a tax cut so that the initial boost in spending from a tax cut is smaller than from an equal increase in G.
   • E = C + I + G (planned expenditure)
     • Y = actual expenditure
       • Y - E = unplanned inventory investment
     • C = C(Y-T)
     • Equilibrium conditions: E = Y
   • The main difference between macro and micro  Macro is a system of many households, firms and the government: “My spending is your income, and your spending is my income.”  Thus, if a lot of households, firms or the government cut spending, then this will negatively affect the income of other agents in the economy. In micro, however, we typically take the actions of others (other households, other firms) as given and do not model the systemic response.

2. IS Curve

   • Definition: The IS curve is a graph of all combinations of the interest rate r and output Y that ensure an equilibrium in the goods market, i.e., all combinations that ensure Actual expenditure (output) = Planned expenditure
     • The equation underlying the IS curve is: Y =C(Y-T)+I(r)+G,, Note: Investment I is no longer exogenous.
       • • We can use the IS-LM model to see how fiscal policy (G and T) affects aggregate demand and output.

3. The Theory of Liquidity Preference

   • A simple theory in which the interest rate is determined by money supply and money demand.
     • The supply of real money balances is fixed: (M/P)s = M/P
       • • The interest rate adjusts to equilibrate the supply and demand for money, ie (M/P)s = L(r)
           • The LM curve is a graph of all combinations of r and Y for which the supply of real money balances equals the demand for real money balances.
       • • • An increase in income raises money demand.  Since the supply of real balances is fixed, there is now excess demand in the money market at the initial interest rate.  The interest rate must rise to restore equilibrium in the money market
             • • The short-run equilibrium is the one combination of r and Y that simultaneously satisfies the equilibrium conditions in the goods market and in the money market:

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