11 19 2012 MacroEconomic Models The classical model Dominant before the great depressions Smith Ricardo Malthus JsMill Marx Edgeworht Pareto Marshall Pigou Resurgence during 1980s Faith in Markets Self Adjusting mechanisms to bring economy to full employment Little role for government Long run model Relies on Microeconomics Keynesian Model 1936 John Maynard Keynes o The general theory Markets may not always be in equilibrium because wages prices and interest rates might be sticky Aggregate Demand Aggregate Supply More modern treatment Both output and spending adjust to bring economy to full employment Classical Keynesian S Labor S Labor W Bar No Involuntary Unemployment Classical Says that you can reach equilibrium and that they are flexible while Keynesian says they might be sticky and there is a floor cant reach equilibrium Classical Model Assumptions o Rational Self Interest Firms maximize profits Households maximize utility o Wages Prices and Interest Rates are flexible so that markets always clear o No money illusion nominal variable o Law of diminishing returns Economic decisions are based on real variables not Productions Function Y Real GDP L Quantity of Labor K Quantity of Capital P Price Level W Real Wage w nominal wage price level YF Full employment GDP y F K L Labor Market Demand for labor o Firms hire labor to maximize profits supply of labor o households supply labor to maximize utility o o W L o Su p pl y of Demand of Labor Product Markets Aggregate demand Desired Spending o The quantity of real GDP that spenders in the economy are willing and able to purchase at different price levels 11 19 2012 o SPENDING GRAPH INSERT HERE MISSED WEDNESDAYS NOTES 11 19 2012 The role of interest rates in the classical model r real interest rate loanable funds markets s Saving supply of loanable funds I Investment demand for local funds Real interest rates adjust in the loanable funds market so saving investment Saving R Investment I S Change in spending doesn t have effect on saving in this model In the classical model a change in one category of spending leads to equal offsetting changes in another category of spending Changes in spending do not effect aggregate demand I Investment I If we increase investment spending led to invrease of r which was increase in s wich decrease in c Less consumption spending Increase in consumption spending S S I As we increase consumption spending is decline of saving increase in Changes in government spending or taxes to influence some r Decrease in I Fiscal Policy in the classical model Fiscal Policy macroeconomic variable Deficit G T in a given year National Debt Cumulative deficit Fiscal Cliff Tax increases Spending cuts set for Jan 1 2013 S I Deficit I Increase of saving decrease in consumption spending Complete crowding out effect In classical model any increase in government spending is exactly offset by declines in private consumption investment spending P AD M Y PPC Monetary policy in the classical model Changes in money supply or interest rates to influence some Monetary Policy macroeconomic variable Quantity theory of money Money supply M times Velocity V P Y MV PY Any change in money supply leads to a proportionate change in prices AD M AD M Changes in the money supply only affect nominal variables but not Money neutrality real variables Economic growth Determinants of economic growth Quantity of labor Marginal Product of Labor Quantity of capital Marginal product of capital 11 19 2012 Wages Prices and interest rates may be sticky so that markets Importance of business and consumer confidence Fixed Price Keynesian Model John Maynard Keynes The General Theory The Classical Critique don t always clear Money illusion may exist Short Run Fluctiations Macroeconomics o Aggregate Variables Importance of expenditures o Demand Side model Aggregate Output GDP Aggregate Expenditures National Income NI Classical Model says law Spending adjusts to putput Keynesian model o Output adjusts to spending Rule for Government Fixed price keynesian model Assumstions o Rational Self interest o Prices Wages Interest rates are fixed o Money iullusion may exist o Nominal Variables matter o Consumer spending depends on income consumption is endogenous or induced o Investment Government and net exports are fixed exogenous or autonomous o Taxes 0 Consumption function A model that shows the relationship between consumption spending and disposable income in the economy C consumption C0 Autonomous consumption Yd disposable income Y real GDP T Taxes Yd Y t B MPC Marginal propensity to consumers MPC change in c chage in Disposable income S Saying C C0 bYd S Yd C S C0 1 b Yd Autonomous Dissaying MPS Marginal Propensity to save MPS change in s change in Yd MPC MPS 1 Graphically Consumption function S 0 C0 4 5 d e Yd Dissaving spending more than income Yellow Area Saving income greater than spending S is greater than zero Graphically Saving Function S C0 Example Mathematically C 100 9Y S 100 1Y c 100 Yd 45 degrees where s 0 Yd 100 Aggregate expenditure function AE C I G X M C C0 bYd AE C0 bYd I G X M AE AE0 bYd Look at graphs on page 180 Assume Taxes 0 meaning Yd Y Y AE Output Spending Y AE0 By Y 1 b AE0 Y 1 1 b AE0 Graphically Look on page 181 In equilibrium when 45 degree line AE Spending is greater than output on left Inventorys falling SPendign is less than output on right 11 19 2012 Fixed Price Keynesian Model Spending Multiplier Change in I change in AE 100 MPC 5 Spending Multiplier formula Change in Y 1 1 b Change in AE Leakages and Injections S T M I G X Income received by households not spent on current domestic output spending by other sectors Example of Keynesian spending multiplier Change in I 100 Change AE0 MPC 5 MPS 5 Change in Y 100 5 100 5 2 100 Change in Y Change in I bchange in I b 2change in I Alternative Concept of Keynesian Equilibrium Leakages Injections S T M I G X sectors Circular flow model Other Sectors Household income not spent on current domestic output Spending in other Firms Households Look in Textbook Y AE AE AE0 Y Leakages greater than injections I G X S increased C decreased Y decreased Extending the fixed price Keynesian model Import function M M0 dYd Taxes 0 Yd Y T M0 Autonomous Import spending D MPIM Marginal Propensity to import Find AE function AE C I G X M AE C0 bYd I G X M0 dyd 11 19 2012 Extending the fixed price Keynesian model Consumption function C C0 bYd Import function M M0 dyd Autonomous import spending d MPIM Marginal