Economics 3307

Main Points of Chapter 10

 

1.     One way macroeconomics differs from microeconomics is that in the microeconomic analysis of a single market, it is usually OK to assume that buyer income is exogenous.  The typical model assumes that changes in buyer income shift the demand curve, and that the intersection point of the demand and supply curves determines equilibrium price and quantity traded.  In macroeconomics, however, things are a bit more complicated. 

 

2.     The reason they are more complicated is that the aggregate "quantity" variable (Real GDP) in effect determines aggregate income.  This creates a kind of circularity that is a bit tricky:  total desired spending depends on income (as in a microeconomic model), but Real GDP and hence total income can also depend on total spending.  If total spending goes down and firms cut back on production, total income will go down -- which will lead to further declines in total spending.  One purpose of this chapter is to make some sense of all this.

 

3.     E = C+I+G is total planned spending.  E depends on income (Y) because consumption depends on after-tax income:  C = C(Y-T).  For a given level of production (Y), it is possible that the income created by that production generates a level of total planned spending E that is greater than, less than, or equal to Y.  When E < Y, firms have an unplanned accumulation of inventories and tend to decrease production, which makes Y decrease until E = Y.  When E > Y, firms have an unplanned decrease in inventories and tend to increase production until E = Y.

 

4.     An equilibrium condition in our model is therefore that E = Y.  When E = Y, the level of income created by production generates just the right amount of correct spending.  We can show this equilibrium point as the intersection of the two lines in the Keynesian cross diagram.

 

5.     E can change either because of (i) a change in Y, or (ii) for any other reason.  For example, E will rise with an increase in G, a decrease in T, and with an increase in I -- which could be caused by a decrease in r (the real interest rate).

 

6.     Suppose E = Y initially at some level Y = Y0.   If Y increases above Y0, E will also increase, but by less because MPC < 1.  At the higher level of Y, E < Y and firms have an unplanned rise in inventories.  Thus Y will tend to fall back to Y0.  Conversely,  if Y falls below Y0, E will also fall, but by less because MPC < 1.  At the lower level of Y, E < Y and firms have an unplanned decrease in inventories.  Thus Y will tend to rise back to Y0.    Thus a change in Y, by itself, does not change the one level of Y at which E = Y.

 

7.     Suppose E = Y initially at some level Y = Y0.  Now suppose that E rises for some reason other than an increase in Y.  (The reason might be a rise in G, a rise in I, or a fall in T.)  This causes E > Y, which makes firms begin to increase production.  As Y rises, E also rises but by less, because MPC < 1.  Eventually Y has risen enough so that it "catches up" with the increasing E, and E = Y at a higher level of Y.  The new level of Y at which E = Y exceeds the initial equilibrium by MORE than the initial change in E because of the multiplier effect.  Basically:

 

                                Change in Level of Y                                 1

                                at which E = Y                       =              ----------  x  (Initial change in E)

                                                                                                1 - MPC

 

8.     If G changes by an amount DG, then the initial change in E is DG.  If E changes because of a change in T, then the initial change in E is -MPC·DT.

 

9.     Because I = I(r), the initial change in E can also be caused by a change in investment spending I that has resulted from a change in the real interest rate r.  Thus  ¯ r   Þ  ­ I  Þ  ­ E  Þ  ­ Y :  a decrease in the real interest rate causes an increase in investment spending, which in turn increases E and (with a multiplier effect) increases Y.  Conversely,   ­ r   Þ  ¯ I  Þ  ¯ E  Þ  ¯ Y :  an increase in r causes a decrease in Y.

 

10.   The equilibrium condition Y = C + I + G implies I = S.  The "IS curve" shows combinations of the real interest rate ( r ) and output (Y) at which Y = C+I+G.  A change in the real interest rate ( r ) causes a movement along the IS curve.  As r decreases, we move down and right along the IS curve.  As r increases, we move up and left along the IS curve.

 

11.   The IS curve shifts with any change in E not caused by a change in the real interest rate ( r ) or by a change in income (Y).  An increase in E not due to a lower r or higher Y causes the IS curve to shift up and right.  A decrease in E not caused by higher r or lower Y causes the IS curve to shift down and left.  The IS shifts right with an increase in G and with a decrease in T.  The IS shifts left with a decrease in G and with an increase in T.  The IS shifts right with exogenous increases in C or I -- that is, with increases in C or I that are not caused by changes in r or Y.  The IS shifts left with exogenous decreases in C or I -- that is, with decreases in C or I that are not caused by changes in r or Y.

 

12.   The "money market" is in equilibrium when the people want to hold the existing quantity of money in their portfolios.  The "existing quantity of money" is the real money supply (M/P).  The amount of money people want to hold in their portfolios is money demand, which is given by (M/P)d.

 

13.   We assume that the nominal money supply (M) is exogenous, because it is determined by central bank policy. 

 

14.   For purposes of this chapter, we also take the price level (P) as given.  The reason we do this is because the basic purpose of this chapter is to help us understand the aggregate demand (AD) curve.  The AD curve shows the level of aggregate demand at any given price level (P).  Thus we take P as given to see what else can influence AD.

 

15.   We assume real money demand (M/P)d = L(r,Y).  L(·) is just a general function, so this expression simply says "money demand depends on the interest rate r and on income Y".)  We use the letter "L" because money is the most Liquid asset in the sense that it is easiest to get rid of without losing value.  (In contrast, a large house or yacht is not very liquid -- if you have to sell it very quickly, you may not be able to get its true value.) 

 

16.   In equilibrium, money demand = money supply:  L(r,Y) = (M/P).  Given M and P, the combinations of r and Y that satisfy this equilibrium condition make up the LM curve.  The LM curve slopes upward.  It shifts rightward with an increase in (M/P) and leftward with a decrease in (M/P).  Thus, for given M, a rise in P shifts the LM leftward and a fall in P shifts the LM rightward.

 

17.   The intersection point of the IS and LM curves gives the one combination of the real interest rate ( r ) and output (Y) at which both the goods market and money market are in equilibrium. 

 

18.   We assume that this equilibrium point is a good approximation of the actual position of the economy.  Thus to explain changes in r and Y, we must explain changes in the intersection point of the IS and LM curves.  We examine the effects of IS and LM curve shifts in Chapter 11.