Lecture 4 - Demand in the Long Run

Question 1

What are the 2 main assumptions in this demand model?

Answer 1

• closed economy (NX = 0)
• market clearing

Question 2

In this model, how do we view the components of AD (explain each one)?

Answer 2

• C = consumer demand for goods and services
• I = demand for investment goods
• G = government demand for goods and services

Question 3

Define disposable income

Answer 3

total income minus total taxes, Y - T

Question 4

Define the marginal propensity to consume

Answer 4

the increase in consumption caused by a one-unit increase in disposable income

Question 5

What is the consumption function?

Answer 5

• C = C(Y - T)
• shows that an increase in (Y - T) leads to an increase in C

Question 6

What is the gradient of the consumption function equal to?

Answer 6

gradient of the consumption function is the MPC

Question 7

What is the investment function?

Answer 7

• I = I(r)
• r denotes the real interest rate, the nominal interest rate corrected for inflation

Question 8

Define the real interest rate

Answer 8

• the cost of borrowing
• the opportunity cost of using one’s own funds to finance investment spending

Question 9

What is the relationship between I and r?

Answer 9

an increase in r leads to a decrease in I

Question 10

What does government spending include, and what does it exclude?

Answer 10

• G includes government spending on goods and services
• G excludes transfer payments

Question 11

What do we assume about government spending and total taxes in this model?

Answer 11

• we assume government spending and total taxes are exogenous
• G = G̅
• T = T̅

Question 12

Using the functions derived for the components of AD, what does aggregate demand equal? What is the equation for aggregate supply? What is the equilibrium? What does the real interest rate do?

Answer 12

• AD = C(Y̅ - T̅) + I(r) + G̅
• AS = Y̅ = F(K̅,L̅)
• Equilibrium: Y̅ = C(Y̅ - T̅) + I(r) + G̅
• the real interest rate adjusts to equate demanded income with supplied output

Question 13

What is the demand for loanable funds based on? The supply? The ‘price’ of funds?

Answer 13

• demand for funds: investment, I(r)
• supply of funds: saving
• ‘price’ of funds: real interest rate

Question 14

Where does the demand for loanable funds come from, explain? What is the relationship between this demand and r?

Answer 14

• the demand for loanable funds comes from investment. Firms borrow to finance spending on plant equipment, new office buildings, etc. Consumers borrow to buy new houses
• the demand for loanable funds depends negatively on r - the ‘price’ of loanable funds

Question 15

The supply of loanable funds comes from savings, from which 2 main bodies?

Answer 15

• households use their savings to make bank deposits, purchase bonds and other assets. These funds become available to firms to borrow to finance investment spending
• the government may also contribute to saving if it does not spend all the tax revenue it receives.

Question 16

What are the 3 different types of saving? What are the equations for each of these savings?

Answer 16

• private saving = Y - T - C(Y - T)
• public saving = T - G
• national saving = private saving + public saving = Y - C(Y - T) - G

Question 17

What does the supply curve for loanable funds look like? Why is this?

Answer 17

• the supply curve is vertical
• as we assume that national saving does not depend on r

Question 18

r adjusts to equilibrate the goods market and the loanable funds market simultaneously. Show how equilibrium in the loanable funds market implies equilibrium in the goods market, and vice versa.

Answer 18

• if the loanable funds market is in equilibrium, then national savings = investment
• this means Y - C - G = I
• add C + G to both sides to get
• Y = C + I + G (goods market equlibrium)

Question 19

Suppose the government increases government spending (without changing taxes): ΔG > 0. How does this lead to crowding out (using the equations for the loanable funds market)?

Answer 19

• saving goes down, savings curve shifts left
• as national saving = Y - C - G
• this means that investment decreases, and the interest rate increases (crowding out investment)