Week 2: The Short Run [Goods Market, Kenesian Cross, IS]

Question 1

IS-LM - economy in the short run

Answer 1

-IS-LM describes an economy though the interplay between two markets

Markets for goods (IS part, ‘Investment-Savings’)
Market for money (LM part, ‘Liquidity-Money’)

• short-run model is assumed to have fixed prices (‘sticky prices’)

Question 2

Simplifies IS- set up
- also known as the ‘Keynesian cross’ (after J.M. Keynes)

Answer 2

Real total expenditure: Exp = C + I + G;

Consumption C = c0 + c1Y ^ D

Y D = (Income − T) is disposable income; T – taxes (more on them in a minute);
c0 > 0;
0<c1 <1;

Mathematically c0 describes consumption in the absence of income, it captures the level of consumer confidence and acts as a conduit for shocks in an economy

Question 3

Investment

Answer 3

■ Real total expenditure:
Exp = c0 + c1 (Income − T) + I + G;

• Investment:
  For now assume that it does not change: I = I ̄

Question 4

Taxes, government spending

Answer 4

Real total expenditure:
Exp=c0 +c1(Income−T)+I ̄+G;

Taxes:A constant value (lump-sum): T = T ̄
Government spending: A constant value: G = G ̄

• taxes and government spending are policy instruments used to affect the economy

Question 5

Keynesian cross complete

Answer 5

Real total expenditure or “Z”

Exp = c0 + c1 (Income − T ̄)+ I ̄+ G ̄

Production:
Output=Income;
In equilibrium Output =Expenditure.

GDP magic: Y=Exp. =Income=Output

Y = c 0 + c 1 Y − T ̄ + I ̄ + G ̄

Question 6

Keynesian Cross - Solution

Answer 6

Y = c 0 + c 1 ( Y − T ̄ ) + I ̄ + G ̄

Y = c 1 Y + ( c 0 − c 1 T ̄ + I ̄ + G ̄ )
Y = c1Y + Autonomous spending

Autonomous spending = c0 − c1T ̄ + I ̄+ G ̄

Y= (1/1-c1) (c0+I ̄+G ̄−c1T ̄)

Question 7

Changes in inventories (stock building)

Answer 7

When expenditure exceeds current production, we withdraw from existing stocks and vice versa;
Changes in inventories is a form of non financial investment alongside fixed investment

We want to expand production to equal spending, rather than raise prices because we are in the short-run

Question 8

Why IS?

Answer 8

Y = C + I ̄ + G ̄

Y − T ̄ + T ̄ = C + I ̄ + G ̄
Y − T ̄ − C + T ̄ − G ̄ = I ̄ Y −T ̄−C=YD −C=SPriv isprivatesavings;
T ̄ − G ̄ = SPub is public savings

SPriv + SPub = S = I ̄

Interpretations: Savings (supply of investment funds) must be equal to investment , one value of Y sets in equilibrium both the markets for goods and the market for investment and savings.

Question 9

Keynesian Cross- Highlights & Policies

Answer 9

• No prices, because of the short-run. Equilibrium is achieved through the macro equivalence of income, expenditure and output.
  Multiplier effect: more Exp. -> more Output -> higher Income -> more Exp.
• Gov. policies are but one more gust of wind competing with other gusts (coming through c0). The main short-run policy aim is this stabilization.

Question 10

Investments…

Answer 10

-split into non financial and financial

Non financial - fixed investment and stock building
Financial - investment in various financial assets

Question 11

Return on fixed investment

Answer 11

Rate of return = income/asset value

Fixed investment adds to fixed assets (capital);
Capital is used in production and generates capital income, so return on fixed investment is a return on capital:

Return on capital = capital income/capital value

Question 12

Return on financial investment

Answer 12

Relate of return = income/asset value

• Financial investment is made by lending or borrowing in financial markets, return is the interest rate

Interest rate: (future value-current value) / current value

Question 13

Full-blown IS

Answer 13

Investment is variable now : I(Y;i)=I(Y+;−i)=b0+bY ·Y−bi·i

i – interest rate, return on saving and the cost of borrowing;
b0 >0,bi >0,bY >0,bY +c1 <1
■ b0 is, again, ‘autonomous investment’, but we think of it as
another shock channel;
■ bY and bi are sensitivity parameters;

Question 14

What happens to investment?

Answer 14

I(Y;i)=I(Y+;−i)=b0+bY ·Y−bi·i

Investment I(Y ; i) decreases in i

Investment is spednging on capital/housing
The alternative is directing assets to financial markets, i is the return, when i is higher, financial markets become more attractive than investing

Question 15

Y is again the level of expenditure/output for which the market for goods and the market for investment are in equilibrium; depending on i

Answer 15

Plug (Y;i) into Y =c0+c1 (Y −T ̄)+I ̄+G ̄

Y =c0 +c1 (Y −T ̄)+b0 +bY ·Y −bi ·i+G ̄ (3)

Y = 1/1-c1-bY (c 0 − c 1 T ̄ + b 0 − b i · i + G ̄ )

Question 16

What shifts the IS curve?

Answer 16

1. Government Spending (G): An increase in government spending shifts the IS curve to the right, leading to higher output and income.
2. Taxes (T): A decrease in taxes or an increase in transfer payments raises disposable income, boosting consumption and shifting the IS curve to the right.
3. Investment (I): Changes in business confidence, interest rates, or expectations about the future can alter investment levels, causing shifts in the IS curve.
4. Exports (X) and Imports (M): Changes in foreign demand for a country’s goods and services (exports) or shifts in domestic demand toward imported goods can affect net exports, influencing the IS curve.
5. Consumer Confidence: Positive changes in consumer confidence may lead to increased consumption, shifting the IS curve to the right.
6. Technology and Productivity: Improvements in technology and productivity can stimulate investment and output, causing the IS curve to shift.
7. External Shocks: Events such as global economic crises, natural disasters, or geopolitical events can impact the overall economy, causing shifts in the IS curve.
8. Monetary Policy: Changes in interest rates or other monetary policy tools by the central bank can influence investment and consumption, leading to shifts in the IS curve.
9. Fiscal Policy: Changes in government fiscal policy, such as adjustments to tax rates or public spending, can directly impact the IS curve.
10. Expectations: Shifts in expectations about the future economic conditions, inflation, or policy changes can affect consumption and investment, causing the IS curve to move.

Question 17

How do those shifts impact the outcomes (Y)

Answer 17

1. Output (Y): An increase in government spending, a decrease in taxes, or an increase in investment typically leads to an increase in output. Conversely, reductions in these components tend to decrease output.
2. Interest Rates (i): The direction of the change in interest rates is ambiguous. An increase in output might increase the demand for money, putting upward pressure on interest rates. However, it depends on the relative strengths of the effects on the goods market (IS curve) and the money market (LM curve).
3. Consumption (C): Changes in government spending and taxes can influence disposable income and, subsequently, consumption. An increase in government spending or a decrease in taxes tends to boost consumption.
4. Investment (I): Changes in interest rates and overall economic conditions affect investment. Higher output and lower interest rates generally stimulate investment, while lower output and higher interest rates may have the opposite effect.
5. Net Exports (NX): Shifts in the IS curve can impact the trade balance. An increase in output might lead to higher imports, affecting net exports. Conversely, a decrease in output could improve the trade balance.
6. Unemployment: As output changes, employment and unemployment levels are likely to be affected. Higher output tends to reduce unemployment, while lower output can increase unemployment.
7. Price Level (P): The IS-LM model typically assumes a fixed price level in the short run. Therefore, shifts in the IS curve do not directly affect the price level in this model.
8. Aggregate Demand: The IS curve represents the relationship between output and interest rates at which aggregate demand equals aggregate supply. A shift in the IS curve reflects a change in aggregate demand, influencing the overall level of economic activity.

Question 18

IS - highlights

Answer 18

• The cornerstone equation in short-run macro
• Establishes the link between output Y and interest rate i
• A higher interest rate depresses investment, which reduces overall spending

In the short run, controlling the interest rate creates and instrument for affecting the real economy

Question 19

Key notions - Fluctuations, Keynesian cross and IS

Answer 19

Fluctuations:
Shock – an unpredictable change in the macroeconomic environment. It is modelled as a change in a model’s exogenous variable;

Sticky prices (nominal rigidities) – the inability of nominal prices to adjust instantly to changes in an economy;

Menu costs – costs associated with changing prices. It is one of mechanisms behind the phenomenon of sticky prices;

Keynesian cross and IS;

Multiplier – in macroeconomics, the indicator that shows by how many times the scale of the response in an endogenous variable is larger than the scale of the preceding change in an exogenous variable;

Multiplier effect – the situation when the multiplier is greater than 1 (i.e., the scale of the response is greater than that of the original change);

Disposable income – income net of taxes paid;

Autonomous consumption – consumption independent of disposable income’s size. It is a way of introducing shocks into the Keynesian cross/IS;

Fiscal policy – a macroeconomic policy based on changing the level of taxation or government spending (or both);