Macroeconomics Theory 1

ECO – 221
Instructor – Piyali Banerjee
Monsoon, 2019
Chapter 1: The Demand Side

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This chapter focuses on the demand side of macroeconomics. Typically, this
chapter discusses the spending decisions of the economy (aggregate demand)
and how they influence the level of economic activity. At the end of this
chapter, you will learn:

What forms the demand side of the closed economy

The goods market equilibrium and the multiplier effect
The IS curve and its properties
Drivers of the components of demand

Question: In late 2000s, households and firms across the world cut back their
spending and the global economy went into the recession. Why?

Note that there are three stages of business cycle:

1. Normal – when the country’s output is growing normally (2% - 3% per

year).
2. Boom – when country’s output is growing excessively.
3. Recession – when the country’s output is falling ⇒ high rate of
unemployment ⇒ low aggregate income of the country.

Housing market boom during early and mid-2000s in U.S. economy.

More availability of housing loans from banks without proper mortgage
securities.
Loan default by some house owners.
Bankruptcy ⇒ less availability of money in the economy ⇒ less spending
on goods and services by households ⇒ more unsold goods ⇒ less
output is produced ⇒ recession.

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 Output Growth in India
12

10

8
OUTPUT GROWTH

YEAR

Output Gowth in U.S.

8

4
OUTPUT GROWTH

-2

-4
YEAR

Data Source: International Monetary Fund

(https://www.imf.org/external/datamapper/NGDP_RPCH@WEO/OEMDC/ADVEC/WEOWOR
LD/IND/USA)

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Example:

Balance Sheet of a Simple Bank

Asset Liability
Reserves (20%) – Rs. 20,000 Deposits – Rs. 60,000
Loans (70%) – Rs. 70,000 Debt – Rs. 30,000
Securities (10%) – Rs. 10,000 Bank owner’s capital/ Shareholder’s
equity – Rs. 10,000
Total – Rs. 100,000 Total – Rs. 100,000

Suppose 20% of loan takers default their loans.

Now bank gets return = Rs. 70,000 – (70,000 × 0.20) = Rs. 56,000

New Balance Sheet of a Simple Bank

Asset Liability
Reserve (20%) – Rs. 20,000 Deposit – Rs. 60,000
Loans (70%) – Rs. 56,000 Debt – Rs. 26,000
Securities (10%) – Rs. 10,000 Bank owner’s capital/ Shareholder’s
equity – Rs. 0
Total – Rs. 86,000 Total – Rs. 86,000

For loan default, total availability of money in the economy goes down.
Moreover shareholders of the bank get back nothing. Even the bank is unable
to pay back some of its debt holders and the bank defaults. Economy’s
investment falls, production falls and unemployment rises ⇒ recession.

Question: Why boom is also bad for the economy?

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 1. Aggregate Demand (AD) and Gross Domestic Product
(GDP)

Definition of Aggregate Demand (AD): AD is the real expenditure on

goods and services which are produced in the economy.
The Demand side captures the spending decisions of:
o Households: Domestic & Foreign (Open Economy)
o Firms
o The Government
Aggregate Demand (AD): 𝑦 𝐷 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)

Question: Why study this?

Fluctuations in AD affect unemployment and inflation
More AD ⇒ more output produced in the economy ⇒
unemployment ↓ ⇒ aggregate income of the economy ↑ ⇒ more
spending on goods and services ⇒ aggregate price level of the
country ↑ (inflation).

Less AD ⇒ less output produced in the economy ⇒

unemployment ↑ ⇒ aggregate income of the economy ↓ ⇒ less
spending on goods and services ⇒ aggregate price level of the
country ↓ (deflation).

Relevance to monetary and fiscal policy makers

Policy makers stabilize the fluctuations in AD since they affect
unemployment and inflation.

Monetary policy – policy adopted by Central Bank to stabilize

AD fluctuations, e.g. to combat recession, CB reduces the
interest rate.

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 Fiscal policy – government’s decision about the government
spending and tax. To stabilize the AD, government alters the its
spending and tax decision, e.g. to prevent the recessionary
effect, government either increases its spending or reduces the
tax burden from consumers to generate AD.

Understand the transmission mechanism of monetary and fiscal

policy

Recall the concept of Gross Domestic Product (GDP):

Definition of GDP - Gross domestic product (GDP) is the market value

of all final goods and services produced within an economy in a given
period of time.

Three methods of computing GDP:

1. Expenditure Method –
𝑦 𝐷 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀) ← 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑐𝑜𝑚𝑒 𝐼𝑑𝑒𝑛𝑡𝑖𝑡𝑦
Proof:

where, C is consumption - the value of all goods and services bought by

households. Includes:
a. Durable goods - last a long time. E.g., cars, home appliances
b. Nondurable goods - last a short time. E.g., food, clothing
c. Services - are intangible items purchased by consumers. E.g., dry
cleaning, air travel.

I is investment - spending on capital, a physical asset used in future

production. Includes:
a. Business fixed investment - Spending on plant and equipment

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 b. Residential fixed investment - Spending by consumers and
landlords on housing units
c. Inventory investment - The change in the value of all firms’
inventories.

G is government spending - G includes all government spending on

goods and services. G excludes transfer payments (e.g., unemployment
insurance payments) because they do not represent spending on goods
and services.

(X – M) is the net exports – i.e. (exports – imports)

a. Exports: the value of goods & services sold to other countries
b. Imports: the value of goods & services purchased from other
countries

Hence, (X – M) equals net spending from abroad on our goods & services.

2. Value Added Method –

𝐺𝐷𝑃 = 𝑉𝑎𝑙𝑢𝑒 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡 𝑠𝑜𝑙𝑑 − 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑟𝑎𝑤 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙𝑠 𝑎𝑛𝑑 𝑖𝑛𝑡𝑒𝑟𝑚𝑒𝑑𝑖𝑎𝑡𝑒 𝑔𝑜𝑜𝑑𝑠

Exercise 1 - Identifying value added:

A farmer grows a bushel of wheat and sells it to a miller for $1.00.

The miller turns the wheat into flour and sells it to a baker for $3.00.

The baker uses the flour to make a loaf of bread and sells it to an
engineer for $6.00.

The engineer eats the bread.

Compute value added at each stage of production and GDP.

Lessons of this problem:

1. GDP = value of final goods = sum of value at all stages of production

2. We don’t include the value of intermediate goods in GDP because their

value is already embodied in the value of the final goods.

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Answer: Each person’s value added (VA) equals the value of what he/she
produced minus the value of the intermediate inputs he/she started with.

Farmer’s VA = $1

Miller’s VA = $2

Baker’s VA = $3

GDP = $6

In-class Exercise 1. Suppose a farmer is growing oranges and sells them to

a juice making company at Rs. 300. The juice factory extracts the juice and
distributes to the wholesale sore at Rs. 500. The wholesale store sells the
orange juice to the retail store for Rs. 800. Compute the GDP.

3. Income Method –
𝐺𝐷𝑃 = 𝑆𝑎𝑙𝑎𝑟𝑖𝑒𝑠 𝑜𝑓 𝑤𝑜𝑟𝑘𝑒𝑟𝑠 + 𝑃𝑟𝑜𝑓𝑖𝑡𝑠 𝑜𝑓 𝑡ℎ𝑒 𝑜𝑤𝑛𝑒𝑟 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙

Rules of Computing GDP:

Rule 1. Income method ≡ Expenditure method.

Question: Why?? ← Because every transaction has a buyer and a seller.

Question: Why does income and expenditure method give same GDP when
households save?

Hint: Think about the potential buyer and seller of savings!

Rule 2: Used goods – The sale of used goods in not included as a part of GDP.

e.g. If I pay Rs.30,000 for a used computer for my business, then I’m
doing 30,000 of investment, but the person who sold it to me is doing
30,000 of disinvestment, so there is no net impact on aggregate
investment and GDP.

Rule 3: The housing issue

A consumer’s spending on a new house counts under investment, not

consumption.

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 A tenant’s spending on rent counts under services—rent is considered
spending on “housing services.”
So what happens if a renter buys the house she had been renting?
Conceptually, consumption should remain unchanged: Just because
she is no longer paying rent, she is still consuming the same housing
services as before.
In computing GDP, (the services category of) consumption includes the
imputed rental value of owner-occupied housing.

Rule 4. The treatment of inventories - When a firm increases its inventory of

goods, this investment in inventory is counted as an expenditure by the firm
owners. Thus, production for inventory increases GDP just as much as it does
production for final sale.

Exercise 2 - Suppose a firm:

produces Rs.10 million worth of final goods

only sells Rs.9 million worth
Does this violate the expenditure = output identity?
Answer

When firms sell fewer units than planned, the unsold units go into
inventory and are counted as inventory investment.
This explains why “output = expenditure”—the value of unsold output
is counted under inventory investment, just as if the firm “purchased”
its own output.

Note: Remember, the definition of investment is goods bought for future use.
With inventory investment that future use is to give the firm the ability in the
future to sell more than its output.

Note: Measurement error in computing GDP occurs due to tax evasion or existence
of black market. Hence, expenditure method and income method give different
numbers of GDP.

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2. A Closed Economy and IS (Investment-Savings) Curve

Closed economy ⇒ No foreign transaction i.e. 𝑋 − 𝑀 = 0

𝐺𝐷𝑃: 𝑦 𝐷 = 𝐶 + 𝐼 + 𝐺
The IS-curve is investment-savings curve that represents the aggregate
demand.
Definition of IS-curve: The IS-curve shows combinations of the real
interest rate (r) and output (y) under goods market equilibrium.

Consumption of U.S. Govt spending of U.S

10000.000 8000.000
8000.000
USD in Billion
USD in Billion

6000.000
6000.000
4000.000
4000.000
2000.000
2000.000
0.000 0.000
1967

1982
1947
1952
1957
1962

1972
1977

1987
1992
1997
2002
1947
1952
1957
1962
1967
1972
1977
1982
1987
1992
1997
2002

Year Year

Investment of U.S
3000.000
2500.000
USD in Billion

2000.000
1500.000
1000.000
500.000
0.000
2002
1947
1952
1957
1962
1967
1972
1977
1982
1987
1992
1997

10
Year
Question: Investment is more volatile than consumption, government
spending and GDP itself. Why?
Fact: Investment is negatively related with the real interest rate. Government
and the policy makers alter the real interest rate to modify the investment in
order to prevent the fluctuations in aggregate demand (AD) through the goods
market equilibrium and the IS-curve.

Assumptions:
1. Firms are willing to meet higher demand for their goods and services.
2. Workers are willing to take extra job or work for extra hours that are offered.
(1) + (2) ⇒ Supply of output adjusts to meet the demand for goods, services
and labors.

3. The Model of Goods Market Equilibrium (closed

economy) and Keynesian Cross
The goods market equilibrium is defined as:
𝑅𝑒𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡 (𝑦) = 𝑃𝑙𝑎𝑛𝑛𝑒𝑑 𝑒𝑥𝑝𝑒𝑛𝑑𝑖𝑡𝑢𝑟𝑒 (𝑦 𝐷 )
𝑤ℎ𝑒𝑟𝑒, 𝑦 𝐷 = 𝐶 + 𝐼 + 𝐺

First assume a Keynesian consumption function:

𝐶 = 𝑐0 + 𝑐1 (1 − 𝑡)𝑦

where 𝑐0 : autonomous consumption, not affected by income

t : tax rate
y : income
(1 − 𝑡) 𝑦 : disposable income, 𝑦 𝑑𝑖𝑠𝑝
∆𝐶
𝑐1 : marginal propensity to consume (MPC) and 𝑀𝑃𝐶 =
∆𝑦 𝑑𝑖𝑠𝑝

Question: 0 ≤ 𝑀𝑃𝐶 (𝑐1 ) ≤ 1, 𝑤ℎ𝑦? ?

So, the AD is given by: 𝑦 𝐷 = 𝑐0 + 𝑐1 (1 − 𝑡)𝑦 + 𝐼 + 𝐺 ← (1)

Goods market equilibrium is given by 450 line, representing 𝑦 = 𝑦 𝐷 ;
where 𝐴𝐷 = 𝑦.
At equilibrium:
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𝑦 = 𝑐0 + 𝑐1 (1 − 𝑡)𝑦 + 𝐼 + 𝐺 ← (2) ← 𝐾𝑒𝑦𝑛𝑒𝑠𝑖𝑎𝑛 𝑐𝑟𝑜𝑠𝑠 𝑒𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚
𝒄𝟎 +𝑰+𝑮
𝑖. 𝑒. 𝒚 = ← (3) ← 𝑇ℎ𝑒 𝑒𝑞𝑢𝑖𝑙𝑖𝑏𝑟𝑖𝑢𝑚 𝑙𝑒𝑣𝑒𝑙 𝑜𝑓 𝑜𝑢𝑡𝑝𝑢𝑡.
𝟏− 𝒄𝟏 (𝟏−𝒕)

Figure 1. Good’s Market Equilibrium

In-class Exercise 2: Suppose autonomous consumption in the year 2018

is Rs. 900 billion in India, with marginal propensity to consume (MPC) is
0.5 and tax rate is 0.2. In this year, the investment on capital goods in Rs.
300 billion and government spending is Rs. 600 billion. Find the
equilibrium output of the country.

3.1: The Multiplier:

1. The government purchase multiplier: Suppose government increases its
expenditure (𝐺 ↑) and the increase in G is denoted by ∆𝐺. Then in figure 1,
the planned output curve (𝑦 𝐷 ) shifts upward without changing the slope.
As a result, equilibrium output (y) will increase by,
1
∆𝑦 = ∆𝐺 (Taking derivative of equation 3 with respect to G )
1− 𝑐1 (1−𝑡)
1
𝑆𝑢𝑝𝑝𝑜𝑠𝑒, 1− 𝑐 = 𝑘, 𝑡ℎ𝑒𝑛 ∆𝑦 = 𝑘∆𝐺
1 (1−𝑡)

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The multiplier is greater than 1 since 0 ≤ 𝑐1 ≤ 1 and 0 ≤ 𝑡 ≤ 1.

Figure 2. Keynesian Cross – Increase in Government Spending

2. The autonomous consumption and investment multipliers:

An increase in autonomous consumption, 𝑐0 will shift the planned
output curve upward and the equilibrium output would increase by:
1
∆𝑦 = ∆𝑐0 (Taking derivative of equation 3 with respect to 𝑐0 )
1− 𝑐1 (1−𝑡)
1
𝑆𝑢𝑝𝑝𝑜𝑠𝑒, 1− 𝑐 = 𝑘, 𝑡ℎ𝑒𝑛 ∆𝑦 = 𝑘∆𝑐0
1 (1−𝑡)

An increase in investment, I will shift the planned output curve

upward and the equilibrium output would increase by:
1
∆𝑦 = ∆𝐼 (Taking derivative of equation 3 with respect to I )
1− 𝑐1 (1−𝑡)
1
𝑆𝑢𝑝𝑝𝑜𝑠𝑒, 1− 𝑐 = 𝑘, 𝑡ℎ𝑒𝑛 ∆𝑦 = 𝑘∆𝐼
1 (1−𝑡)

3.2: The Paradox of Thrift in Keynesian Cross Model:

The equilibrium in good’s market:
𝑦 = 𝑐0 + 𝑐1 (1 − 𝑡)𝑦 + 𝐼 + 𝐺
𝑦 − 𝑐0 + 𝑐1 (1 − 𝑡)𝑦 − 𝐺 = 𝐼

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 Subtracting and adding tax (T) in the above euation
{𝑦 − 𝑐0 + 𝑐1 (1 − 𝑡)𝑦 − 𝑇} + {𝑇 − 𝐺} = 𝐼

{𝐼𝑛𝑐𝑜𝑚𝑒 − 𝐶𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 − 𝑇𝑎𝑥} + {𝑇𝑎𝑥 − 𝐺𝑜𝑣𝑡. 𝑆𝑝𝑒𝑛𝑑𝑖𝑛𝑔} = 𝐼

𝑃𝑟𝑖𝑣𝑎𝑡𝑒 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 + 𝑃𝑢𝑏𝑙𝑖𝑐 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 = 𝐼

𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑆𝑎𝑣𝑖𝑛𝑔𝑠 = 𝐼 ⇒ 𝑺 = 𝑰

Question: Should savings be encouraged or discouraged in a recession?

↑ Savings ↑ Investment in capital stock ↑ AD

But ↑ Savings ↓ Consumption ↓ AD
In our model I and G are exogenous from 𝑺 = 𝑰 identity.
A rise in savings is modelled by a fall in c0 to c0 ′.
Since I and G are fixed, y must fall for the equation above to hold.
Paradox of Thrift: Higher savings causes output to fall.
Model-specific result: No mechanism for high savings to translate
into higher investment.

4. Deriving IS-curve from Keynesian Cross

Fisher Equation: 𝑟 = 𝑖 − 𝜋 𝐸

Assume that Consumption is independent of r, while investment is

given by: 𝐼 = 𝑎0 − 𝑎1 𝑟

Substituting this into the AD identity (3), we get the IS relation:

1
𝑦= [𝑐 + (𝑎0 − 𝑎1 𝑟) + 𝐺]
1 − 𝑐1 (1 − 𝑡) 0

𝑦 = 𝑘 [𝑐0 + (𝑎0 − 𝑎1 𝑟) + 𝐺]

𝑦 = 𝑘 [𝑐0 + 𝑎0 + 𝐺] − 𝑘𝑎1 𝑟

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 The larger the multiplier (k), or the larger the interest-sensitivity of
investment (𝑎1 ), the larger the effect of r on y (IS curve is flatter).

In the r-y space, plot the Investment

function.

Then add in 𝑐0 and 𝐺.

Finally, factor in the multiplier to get

the IS Curve.

Figure 3. Deriving the IS-curve

4.1. The Properties of IS-curve

Downward sloping
Low r ↑Investment ↑ Output

IS curve slope
Changes with multiplier, k and hence c1 and 𝑡.

Changes with 𝑎1 .

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 Shifts in the IS Curve:
When autonomous consumption c0 , autonomous investment a0 ,
or government spending G change.

When the multiplier changes.

Exercise 3:

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