Lecture 4 - Demand in the Long Run Flashcards
What are the 2 main assumptions in this demand model?
- closed economy (NX = 0)
- market clearing
In this model, how do we view the components of AD (explain each one)?
- C = consumer demand for goods and services
- I = demand for investment goods
- G = government demand for goods and services
Define disposable income
total income minus total taxes, Y - T
Define the marginal propensity to consume
the increase in consumption caused by a one-unit increase in disposable income
What is the consumption function?
- C = C(Y - T)
- shows that an increase in (Y - T) leads to an increase in C
What is the gradient of the consumption function equal to?
gradient of the consumption function is the MPC
What is the investment function?
- I = I(r)
- r denotes the real interest rate, the nominal interest rate corrected for inflation
Define the real interest rate
- the cost of borrowing
- the opportunity cost of using one’s own funds to finance investment spending
What is the relationship between I and r?
an increase in r leads to a decrease in I
What does government spending include, and what does it exclude?
- G includes government spending on goods and services
- G excludes transfer payments
What do we assume about government spending and total taxes in this model?
- we assume government spending and total taxes are exogenous
- G = G̅
- T = T̅
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?
- 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
What is the demand for loanable funds based on? The supply? The ‘price’ of funds?
- demand for funds: investment, I(r)
- supply of funds: saving
- ‘price’ of funds: real interest rate
Where does the demand for loanable funds come from, explain? What is the relationship between this demand and r?
- 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
The supply of loanable funds comes from savings, from which 2 main bodies?
- 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.
What are the 3 different types of saving? What are the equations for each of these savings?
- private saving = Y - T - C(Y - T)
- public saving = T - G
- national saving = private saving + public saving = Y - C(Y - T) - G
What does the supply curve for loanable funds look like? Why is this?
- the supply curve is vertical
- as we assume that national saving does not depend on r
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.
- 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)
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)?
- 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)
