MACRO ECONOMICS ECO2214

Introduction

Macroeconomics is concerned with the behavior of the economy as a whole. It is

concerned with booms and recessions, the economy’s total output of goods and
services and the growth of output, the rate of inflation and unemployment, the
balance of payment, level of savings (savings rate), level of investment
(investment rate), level of government revenue/ government expenditure, private
consumption and exchange rates. Macroeconomics deal with long run economic
growth with short run fluctuations that constitute the business cycle. It
concentrates on the general consequences of the individual actions of the
households, business, consumers, government and foreign sector. Hence it is
the study of the whole economy.

Macroeconomics also focuses on the economic behavior and policies that affect
current issues such as; consumption and investment, trade balance, changes in
wages and prices, monetary and fiscal policies, money stock, interest rate and
national debt. In brief macroeconomics try to deal with major economic issues
of the day. Therefore, we have to understand these issues as they lie in the
interactions among the goods, labour, assets and markets of the economy and
the interaction among the national economies whose residents trade with each
other. In dealing with these essentials we go beyond details of the behavior of
individual economic units such as households and firms and determination of
prices in particular markets which are subjects of micro economics. The major
difference between micro and macro is primarily one of emphasis and exposition.
For example, in studying price determination in an industry in micro economics
we assumed prices in other industries are constant whereas in macroeconomics
where we assume average price level it is more sensible to consider changes in
prices in other industries.

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The behavior of each individual representative should be identified before
aggregating for example the Marginal propensity to save for an individual is more
than 0 so we can assure the aggregate MPS to be greater than zero. Therefore 0
< 𝑀𝑃𝑆 < 1. After developing a theory of aggregating then there is need of
empirical analysis with the purposes of

1. Validation of empirical data (hypothesis testing)

2. Measurement of data which theoretical analysis has identified
3. Explaining an economic theory
4. Providing the basis for predictability of the likely future trend of the
economy.

ISSUES IN MACRO ECONOMICS

Macro-economic analysis is interested in the determination of the variables and

the factors affecting them at a particular moment of time. Therefore, macro-
economic is a time dimension analysis.

1. GDP/ GNP (New economic activity (growth) (How do we determine

economic growth)

The most important measure in macro-economics is the measure of economic

activity (GDP). It is the total monetary value of all economic activities which are
undertaken within the territory boundary of the economy regardless of the
citizenship. A similar measure GNP measure the monetary value of all economic
activities under taken by all nationals of a country irrespective of geographical
location.

2
 B
Trend
GDP
GNP
D
A

Time

The upward long run time trend is referred to a growth. But within the long run
there are short run ups and down points A & B are called peaks C & D are called
troughs. The movement from point A to B is called the business cycle.

2. UN-EMPLOYMENT (Level of unemployment (UNE) (how do we

explaining the high level and persistent unemployment)

This refers to the number of people out of jobs and are actively in search for jobs
as a proportion in labor force. Un employment is closely related to business cycle.
This because short run moments of unemployment are often observed to be
linked with short term activities in the level of economic activity. In Uganda
unemployment rate stands at 9.4% which translate to close 1million people.
Macroeconomic research focuses on persistent unemployment as a central
question. There are many theories why persistent high unemployment is
possible. There is a policy question of what need to be done about this
unemployment. Some say not much can be done and advocate a hands off
policy. Others view an active fiscal policy like cutting taxes. Or raising
government expenditure when unemployment is high so as to create demand
and hence jobs.

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 3. INFLATION (How do we explain inflation)

This is the measure of % change in average level of prices it is measured using

C.P.I. C.P.I measures the average price for the market of goods and services for
consumption.

𝐶𝑃𝐼𝑡 − 𝐶𝑃𝐼𝑡−1
𝜋= 𝑋 100
𝐶𝑃𝐼𝑡−1

4. External position of the economy (B.O.P)

Controversies in macroeconomic thought (Schools of Thought)

There are two major schools of thought namely the classical under Adam Smith
and the Keynesian under J. KEYNES. The fundamental difference between the
two that the Classicals believe that markets work when left on their own. (no
government intervention). The Keynes argues that government intervention can
significantly improve the operation of the economy.

CLASSICALS

The classical believe in the existence in the automatic mechanism in the system.
They believe that market forces work best when left on their own. They believe
that there is no unemployment. This school was built on inter related behaviors
which include;

1. SAY’S LAWS, which states that supply creates its own demand that is
whatever is supplied/produced will be demanded. This means that the
income derived from producing certain goods by some people, allows them
to purchase goods produced by others. Since all people have a need to
purchase goods, they will seek to produce some goods to derive income
and buy whatever they want. Therefore, there is no unemployment. Thus
the product markets will always necessarily be in equilibrium.
2. Quantity theory of money: QTM states

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 MV = PQ where M = money supply, v = velocity of money, P = Price level
and Q = real output.
3. Real theory of interests (Saving =investment)
This states that factors which determine interest rates are basically those
which affect real productivity of capital but not real monetary factors. The
real theory of interest by Fisher argues that real economic variables
determine the real interest rate. The theory says that the real interest rate
r adjusts so desired saving S equals desired investment
4. Wage and price flexibility

If prices and wages are flexible both in the upward and downward direction the
economy will be at full employment. The classical theory proposes that all
markets equilibrate because of adjustments in prices and wages which are
flexible. For instance, if an excess in the labor force or products exist, the wageSL2
or price of these will adjust to absorb the excess.

P
W SL1
Wage w2

w1 w2

w1
DL2

DL1
D2

L2 L1 L2 Labour
L1

KEYNESSIAN SCHOOL OF THOUGHT

This school of thought or model concentrates on the aggregate demand side of

the economy. Keynesian argues that unemployment was a consequence of
insufficient spending of government on goods and services and capital demanded
by the business sector.

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 e2
DD

DS DD2
AD1

e1

Yf Output
ye

When ye < 𝑦𝑓 then we have a recession, Keyness maintains that the only way
to reduce unemployment is by increasing output to yf by increasing aggregate
demand.

The new Keynesian

They don’t believe that markets clear all the time but they seek to understand
why markets can fail. They argue that markets sometimes do not clear even when
individuals are looking for their self-interest. Both information problems and cost
of changing prices lead to some price rigidities which may cause to some
economic fluctuation of output and unemployment. For example, in the labour
market if you decide to cut wages not only reduce the cost of labour but also may
attract low quality workers. Therefore, firms may remain reluctant in cutting
wages.

MONERERIST

This school was developed in 1960’s under the leadership of Milton ‘FREIDMAN’.
These economists advocated for monetary policy and stressed the work of money
markets in the economy. Higher interest rate lower money demand since money
supply is assumed to be fixed. they believe that controlling the supply of money

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directly influences inflation and that by fighting inflation with the supply of
money, they can influence interest rates in the future.

AD1
ms

i
i2 md

inter

st md
md

Monetarists believe that velocity (V) is constant and changes to money

supply (M) is the sole determinant of economic growth, a view that serves
as a bone of contention to Keynesians.

NEW/ NEOCLASSICALS/ RATIONAL EXPECTATION

This school developed in 1970’s under the leadership of ROBERT LUCAS and
others. These shared many policy views with Friedman. This school sees the
world as one in which individuals act rationally in their self-interest in markets
that adjusts rapidly to changing conditions. They claim that the government
slightly worsen the situation by intervening. The school is based on these major
assumptions.

1. Economic agents aim at maximization. Households and firms make

optimal decisions. This means that they use all available information in
making best decisions.
2. Decisions expectations are rational which means that they are statistically
the best prediction of the future that can be made using the available
information.
3. Markets clear. There is no reason why firms or workers would not adjust
wages or prices in the market if that would make them better off. This will
result into market supply equal to market demand.

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Therefore, there is no involuntary unemployment. Any unemployed person who
really wants to a job will offer to cut his or her wage until the wage is low enough
to attract an offer from some employer. The major assumption of new classical
is that markets are continuously in equilibrium.

KEY MACRO ECONOMIC CONCEPTS

GDP. Recall that the primary measure we use is the GDP, it can be considered
both income and output. GDP is the measure of the monetary value of goods and
services provided in an economy in given period of time. It can also be the
measure of all final goods and services produced in an economy in a given period
of time (quarter or year). There are three important distinctions that need to be
made

a) Nominal V’s Real GDP

b) Level of GDP (Nominal or real) vs the growth of GDP
c) GDP VS GDP per capita.

Normal GDP (current shilling GDP) measures the value of economy’s total output
at the prices prevailing in particular period. On the other hand, Real GDP
measures total output produced in any one period at the prices of some base
year. Real GDP which values output produced in different years at the same price
implies an estimate of a change in real or physical production between different
years. Uganda’s current GDP per capita $878 (Shs3.2m) annually.

GDP DEFLATOR

Is the ratio of nominal GDP to real GDP.

𝑁 𝐺𝐷𝑃
GDP def = 𝑅 𝐺𝐷𝑃

GDP Per Capita: Is the ratio of total GDP to total population of a country =
𝐺𝐷𝑃
𝑇𝑜𝑡𝑎𝑙 𝑃𝑜𝑝𝑛

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PRICE LEVELS & INFLATION

Price level is the overall level of prices in the country as usually measured
empirically by a price index. There are many indices of the price level but the
commonly sighted is the CPI: CPI is a price index measuring the value of a basket
of goods bought by consumers in a particular country. For example, consider the
following table below CPI =Cost of market basket of goods in a given year/cost of
market basket of goods in a base year *100%. CPI Measures inflation over time.

Good Mkt v.2017 Mkt v. 2018 Mkt v.2019

Beans 400 450 300
Maize 1000 1050 900
Juice 200 200 300
Total value 1600 1700 1500
CPI 100 106.25 93.75

= x 100 II = (CPIt – CPIt-1)*100/ CPTt-1

For example, inflation rate in year 2018 was 6.25%.

GDP Vs CPI

Prices of capital goods are included in the GDP deflator when are produced
domestically however they are excluded when calculating CPI domestically.

Prices of imported goods

There are included in CPI but excluded in GDP deflator calculations

The basket of goods is fixed under CPI but changes every year under GDP
INFLATION AND UN EMPLOYMENT & GROWTH

Macro-economic performance is judged by three broad measures we have

introduced i.e. inflation rate, the growth rate of output and the rate of

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unemployment. The high growth rates indicate that the production of goods &
services has increased and hence increased standard of living. The growth rate
of real GDP is the most important of all indicators of the performance of the
economy in the long run. Therefore, it is associated with lower unemployment
levels. However, there is a tradeoff between inflation and unemployment in the
short run as shown by the Philips curve.

𝜋𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

o Unemployment

The curve suggests that lesser/ lower unemployment can always be obtained by
allowing more inflation and vise-vasa.

STOCKs Vs FLOWs

A flow is can economic magnitude measured at a rate per unit of time such as
production of milk per week, consumption of wine per year, and total output of
the economy in a particular year. Stock on the other hand is a magnitude
measured at a point in time such as total number of buildings in Kampala. Most
of the previous concepts such as capital in the economy is a stock. The capital
of an economy is accumulated stock of residential buildings, factories and
equipment etc. investment spending is a flow of output in any given period and
is the difference in capital stock between two different periods. Wealth and
Saving and also represent stock-flow relationship where difference in wealth
represent saving.

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NATIONAL INCOME ACCOUNTING

National income. This is the amount of goods and services expressed in monetary
terms within a given accounting period basically one year.

There are three approaches of measuring national income namely:

a) Income approach which consider income received by all factors of

production
b) Expenditure approach. This divides GNP/ GDP according to who bought
the goods and services
c) Product/output approach which considers value added.

PRODUCT APPROACH

In this approach we measure GDP by measuring the value added in the

production of goods and services in different industries.

GDP = TR – TC. TC = Costs of intermediate inputs

Expenditure approach

We measure GDP by measuring total expenditure on final goods and services by

different groups. i.e households’ business, foreign sector and government

GDP = Y = C + I + G + EX ------(1)
Y = Cd + Id + Gd + EX ------- (2)
Y = (C – Cf) + (I – If) + (G – Gd) + EX
Y = C + I + G + EX – IM
Y = C + I + G + CA
CA = Current a/c
Y – (C + I + G) = CA  =

S = Y – (C + G) = CA + I

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The way the above equation is written (1) is not the usual way it should be
written. The more convectional way is writing it in two steps.

Y = (C – Cf) + (I – If) + G -Gf) + EX.

C = Cd + Cf I = Id + If + If, G = Gd + Gf
IM = Cf + If + Gf
Stage (2). Y = C + I + G + CA
CA = EX - IM

INCOME APPROACH

This is by measuring total income by different groups producing goods and

services. The incomes are in form of wage, rent, profit and interest. These are
pre-taxed income. They don’t include tax. It should be noted that

1) For the only goods and services that goes through organized markets are
included in GDP calculation.
2) Only final goods and services count in GDP.
3) Production within the geographical boundary of the country is considered.
4) GDP for a particular year includes only goods and services produced
within that particular year.

All the above three approaches should give the same measure of GDP as it can
be explained by circular flow of income.

MEASURING GDP THROUGH PRODUCTION

GDP is the value of the final goods and services produced in country within a
given year by both citizens and non-citizen’s. Emphasis is put on the word final
to avoid double counting. Value added = R – C=revenue earned by the firm minus
the amount it pays for products from other firms used as intermediate output.
In measuring GDP, we use the value of the market price of the goods and
services.

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Y = C + I + G + CA
S=Y–C–G
S = I + CA
S – I = CA
S = (Y – T) – C + (T – G)
Private public

Alternatively

National saving can be thought of as the amount of remaining income that is not
consumed, or spent by government. In a simple model of a closed economy,
anything that is not spent is assumed to be invested:

National Saving=Y-C-G=I

National saving can be split into private saving and public saving. Denoting T for
taxes paid by consumers that go directly to the government and TR for transfers
paid by the government to the consumers as shown here:

Y-T+TR-C)+(T-G-TR)=I

(Y − T + TR) is disposable income whereas (Y − T + TR − C) is private saving.

Public saving, also known as the budget surplus, is the term (T − G − TR), which
is government revenue through taxes, minus government expenditures on goods
and services, minus transfers. Thus we have that private plus public saving
equals investment.

The market prices of goods and services include indirect taxes such as sales and
exercise tax. The amount is greater than the amount licensed by factors of
production that produce the goods. The mount received by fop is net and indirect
tax and is called factor cost.

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GDPFC = GDPmp - Indirect taxes

Some useful identities

National income accounting is just a series of identities. Consider these two

useful identities

Y=C+I+G+X ……………………..1

Y=C+S+T+M……………………….2

The first identity mean that final output is is either consumed, invested,
purchased by government or exported. The second identity implies that
individuals may spend their income on either consumption consumed, saving,
paying taxes or on imports. Combining the two equations we get the following

X-M= S-I+T-G

EXAMPLE

Total spending on goods and services produced in a country during any given
period can be broken down as
C + I + G + NX = GDP where,
Y = 5950.7
I = 770.4
G = 1114.9
EX = 636.3
IM = 666.7
T = 837.9

C = 4095.9

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Find (i) CA and comment on it value
(ii) Level of National Saving
(iii) Level of Disposable income

CA = EX – IM = 636.3 – 666.7

= -29.6

(ii) S = (Y – T) – C + (C – G)
S=Y–C–G
5950.7-
S= CA + I

MEASURING GDP THROUGH INCOME

Residents of a country who produce GDP receive income for their work. The value
added in production which is the different between revenue and the cost of
intermediate output must be some body’s income in form of wages, interest profit
and rent but part of GDP goes as depreciation and thus cannot be counted as
part of part of income. Also GDP is valued at market prices which include indirect
tax. However, the income accruing to the producers doesn’t include indirect
taxes. This holds for defining net domestic income.

NDI = Wages +profits +rent + interest.

From the net domestic income, we can obtain personal income received by
household and incorporated business. We have to subtract corporation profit,
transfers, dividends and interest on government debt from NDI. Subtracting
taxes (indirect) from personal income and adding transfers gives disposable
income.

Yd = PI – Indirect taxes + TR

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EQUILIBRIUM OUTPUT DETERMINATION USING KEYNESSIAN APPROACH

According to Keynesian the level of national income is determined by the

aggregate demand for goods and services in the economy. He argued that the
major variables that determines of national income are those variables that are
exogenous (Government taxes and government expenditure). Therefore, fiscal
policy is the basis of the Keynesian approach to national income determination.
In the AD / AS model equilibrium output is determined when AD = AS

According to Keynesian Aggregate expenditure determines demand for goods and

services and AS measures total output produced by all sectors in the economy.
If AD > AS the economy experiences an inflation gap.

AS
recession

AS  AD AD = C+I+G+NX

00
AS
45⁰
ye O/P
The Keynesian believed that it is possible to be in equilibrium at less than full
employment level. This is because firms usually operate at less than optimal
capacity such that if there is any increase in AD, they can increase output
without undertaking any new investment. This was explained by Keynesian
multiplier concept in that a change in AD due to an autonomous change that
affects AD leads to a more proportionate change in output.

BASIC ASSUMPTIONS UNDERLYING MULTIPLIER

1) Basic domestic prices and exchange rates are fixed

2) Economy is operating at less than full employment so that an increase in
demand result in the expansion of output and employment.

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 3) The authorities adjust money supply to changes in money demand by
pegging/fixing domestic interest rate.
4) There is no inflation resulting from money supply expansion because it is
just a response to increase in money demand.

Basic assumption of the Keynesian model includes

1) Government expenditure (G), exports are assumed to be exogenous. G is

determined independently by politician and X is determined by foreign
Expenditure decision and foreign income.
2) Domestic consumption is partly Autonomous and partly endogenous and
a linear function of national income.
C= Co + bYd. Yd = (Y – T) + TR
0<b<1
3. Import expenditure is assumed to be endogenously determined and
depends on level of national income.
M = Mo + MY O<MPM < 1
4. Investment expenditure is partly autonomous and partly depend on
income
I = Io + iY
0< i< 1
5. Government tax is partly autonomous and positively related to national
income T = T – X + Y, 0 < t < 1, t= tax rate.

2- SECTOR MODEL

Y=C+I
C = CO + bY
I = Io
Y – bY = Co + Io
𝐶𝑜 + 𝐼𝑜
𝑌̅𝑒 =
1−𝑏
̅ = autonomous spending
Co + I = 𝑀

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1 – b = mps
𝐷𝑌 1 1
= = > 0
𝐷𝐼0 1−𝑏 𝑚𝑝𝑠

3- SECTOR MODEL

Y = C + I + G …………………. (1)
C = Co + bYd
Yd = Y – T + TR
I = To, G = Go
𝑏𝑇𝑅−𝑏𝑇𝑜 + 𝐼𝑜 +𝐺𝑜+𝐶𝑜
𝑌̅𝑒 =
𝐼+𝑏𝑡+𝑏

𝐶𝑜 + 𝐼𝑜 + 𝐺𝑜 + 𝑏𝑇𝑅 − 𝑏𝑇𝑜
𝑌̅ =
𝐼 + 𝑏 + 𝑏𝑡
𝐴̅ = 𝐶𝑜 + 𝐼𝑜 + 𝐺𝑜 + 𝑏𝑇𝑌 − 𝑏𝑇𝑜
𝐴̅
𝑌̅ =
𝐼−𝑏+𝑏𝑡
𝑑𝛾 1 𝑑𝑦 𝑑𝑦
= =n = > 0
𝑑𝐼𝑜 1−𝑏+𝑏𝑡 𝑑𝐶𝑜 𝑑𝐺𝑜

𝑑𝑌̅ −𝑏 𝑑𝑌 𝑏
= < 0 = >0
𝑑𝑇 1−𝑏+𝑏𝑡 𝑑𝑇𝑅 1−𝑏+𝑏𝑡

Example:
C = 300 + 0.8Y’, F = 200 + 0.23Y
TR = 100, I = 400, G = 500

Find (i) 𝑌̅e (ii) 𝐴̅ (iii) G’ Revenue (iv) G Budget position (v) equation
Consumption (vi) = APS (vii) APC
300+200+300−0.8 𝑋 200+ 0.8 𝑋 100
Ye =
1−0.8+0.25 𝑋 0.8

1120
𝐴̅ = = 2800
0.4
𝐴̅ = 1120
R = T = 200 + 0.25 x 2800 = 900

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(iv) R – E = 900 – (500 + 100) = 300
= 300 + 0.08 x (2……
C= 2540
2500
APC = = 0.907 ≂ 0.9
2800
𝑇𝑆
APS = = 0.093 ≂ 0.1
𝑋

4- SECTOR MODEL

Y=C+I+G+X–M
C = Co + bYd
Yd = Y – T + TR
T = 𝑇𝑜 + 𝑡𝑌
M = Mo _ MY
I = Io + iY
Y = Co + b(Y – T + TR) + Io + iY + Go + Xo – (Mo + MY)
Y = Co + bY – b(To + XY) + bTR + Io + iY + Go + X0 – M0 –MY
(1 – b + bt – i + m) Y = Co – bTo + bTR + Io + Go + xo – Mo
𝐶𝑜 + 𝐺𝑜 + 𝑥𝑜 −𝑏𝑇−𝑀𝑜 +𝑏𝑇𝑅
𝑌̅ =
1−𝑏+𝑏𝑡−𝑖+𝑚
𝐴̅
𝑌̅ -
1 + m−b(1 – t) – i

1 + m > b(1-t)
1–b>0
𝑑𝑦 −1
=
𝑑𝑚 1 − 𝑚 − 𝑏(1 − 𝑡) − 𝑙

̅
̅ (c) 𝐶̅ (d) APC & APS (e)T, (f) d 𝑑𝑌 , 𝑑𝑌
Qn. C = 400 + 0.75yd Find (a) 𝑌̅ , b = 𝐴,
𝑑𝐺𝑜 𝑑𝑇−0

(f) (GBD) d CA

T = 200 + 0.2Y
I = 600, G = 500, TR= 100
M = 200 + 0.1 Y, X = 500

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(e) If there is a change in government expenditure by 100, what is the new
government budget position

(f) What will be new of Y if i = 0.2

Explain the concept BDM and show that it is equal = 1 when I, G, T are
exogenous

National Income and The Foreign Trade Multiplier

In a closed economy equilibrium level of national income is determined at the

level where intended saving equals intended investment  S  1 . Equilibrium
level of national income in an open economy is determined at the level at which
total leakage, that is, savings plus imports  S  M  equal total injection, that is,
domestic investment plus exports  I  X  into the income stream. Thus, in an
open economy, national income is in equilibrium at the level at which
S  M  1 X

When a change in any of the above four variables occurs, then the change on the
left side of the above equation must equal the change on the right side if the new
equilibrium is to be achieved.

Hence S  M  I  X ……………………………………(1)

Now, change in saving, S  s.Y

Where s = marginal propensity to save and

Y  change in national income.

Likewise, change in imports, M  m.Y

where m = marginal propensity to import.

Thus, rewriting equation (l) we have

sY  mY  l  X

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or Y  s  m  l  X

1
Y   l  X  ----------------------------------------------- (2)
sm

It will be known from equation (2) that change in either investment or exports
1 1
will cause income to increase by the multiple, .Thus is the foreign
sm sm
trade multiplier which is generally denoted by K f . Thus, if exports increase by
1
X , the national income will rise by X .
sm

1
Hence, K f
sm

When there is increase in exports, it will cause the increase in income of the
exporters and those employed in the export industries. They will save some of
the increase in their incomes and will spend a good part of the increases in their
incomes on consumer goods, both domestic and imported ones. While savings
do not generate further income and represent leakage from the income stream,
expenditure on im-ports leads to the increase in the incomes of the foreign
countries from which goods are imported.

TAX RATE MULTIPLIER.

decrease in tax rate leaves the consumer with large proportion of income earned.
This will increase consumption which results into increase in national income.

2y bYe

2t 1  b  bt

N.B.

Government spending all taxes affect the level of income. Therefore, fiscal policy
can be used to stabilize the economy. When the economy has a recession, this
should be cut or government spending should be increased and vise versa.

BALANCED BUDGET MULTIPLIER

Balanced budget multiplier occurs when a given increase in government

expenditure is financed through an equal increase in the tax level. The question
therefore is whether there will be an impact on the economy when an increase

21
in taxes and increase in government expenditures are balanced. According to the
classical, balanced budget, neutral. According to the monetarist view balanced
budget has a net expansionary effect because a fall in AD due to an increase in
taxes is less than an increase in AD due to an increase in government
expenditure. Therefore, consumption will not decrease by the full amount of the
tax increase.

DERIVING BALANCED BUDGET MULTIPLIER

Consider a closed economy

Y=C+I+G
C = Co + b(Y – T)
T = To, I = Io, G = Go

Balanced budget implies that taxes – Government expenditure equals zero.

BB → T – G = 0

Assuming a change in government expenditure leads to a change in National

Income holding Consumption and investment expenditures constant. Then

Y = 𝐶𝑜̅ + 𝑏 (𝑌 − 𝑇𝑜 ) + 𝐼𝑜 + 𝐺𝑜
ΔY = ΔCo + b(ΔY – ΔTo) + ΔIo + ΔGo

ΔY = b(ΔY – ΔTo) + ΔGo

ΔT – ΔG = 0

ΔY = bDY – b DT0 + DG0

ΔY = b ΔY – bΔT0 + ΔT0 + ΔGo
𝐷𝑌
ΔY = b ΔY – ΔT0(b-1) =1
𝐷𝑇0

DT0(b-1) = b ΔY – ΔY
ΔT0(b-1) = (b – 1) ΔY ΔY = ΔT0 = ΔG

BDM = 1 implies than an increase in government spending is combined with a

simple increase in tax revenue such that budget position is unchanged. suppose

22
government tax revenue is endogenous show that the impact of balanced budget
multiplier on the level of national income is less than one.

Y=C+I+G
C = C0 + bYd
Yd = Y-T+TR0 0 < bt < 1
T = To + tY
I = Io, G = Go
DGo → DY
Y = C+I+G
Y = Co + b(Y-To-tY) + Io + Go
DY = DCo + b(DY – DTo-tDV) + DI0 + DG0
DY = b(DY – DG0 – tDY) + DG0
DY = bDY + btDY = -bDG0 + DG0
(1-b+bt) DY = (1-b) DG0
𝐷𝑌 (1 − 𝑏)
<1
𝐷𝐺𝑜 1 − 𝑏 + 𝑏𝑡

If BBM is less than one, it means that if government tries to raise the expenditure
by financing it with a further increase in the tax, the change in N/Y will be less
than the initial change in government expenditure.

23
STATIC EQUILIBRIUM INCOME DETERMINATION MODEL (IS-LM) MODEL

The strength of the IS-LM model lies in the integration of the real and monetary
factors in the determination of the aggregate demand in the economy. It contains
both real sector (goods market) and monetary sectors (market for financial
assets). Depending on whether prices are assumed fixed or flexible the IS-LM
frame work comes in the Neoclassical and Keynesian version. The goal of the IS-
LM model is to show what determines National income for any given price level.
There are two ways to show this. (1) look at the model as showing what caused
the Y to change in the short run when price level is fixed. (2) Look at the model
as showing what cause aggregate demand to change. This macroeconomic
model shows how the market for economic goods (IS) interacts with the loanable
funds market (LM) or money market. It is represented as a graph in which the
IS and LM curves intersect to show the short-run equilibrium between interest
rates and output.

Price level

AD

ASP ̅ SRA S

AD2
AD1

Y1 Y2 Y
For a given price level, national income fluctuates because of shifts in aggregate
demand curve. IS-LM model takes prices as given and shows what causes income
to change. Two parts of the IS-LM model include the IS curve and the LM curve.
IS → standard for investment and saving account the IS curve represents what
is going on in the goods market. The LM standards for liquidity and money and
LM represents what is going on in the money market. Previous chapter focused
on income and output determination by arguing that income affects spending.

24
In this chapter we introduce the effect of interest rates on spending and thus its
impact on income. the higher the interest rate, the lower the spending and lower
the income. Therefore, spending, interest rates and income are jointly
determined by equilibrium in the goods and assets market. This models provides
a more appropriate analysis of the effects of both the fiscal and monetary policy
on demand for output and on interest rate.

GOODS MARKET AND IS CURVE

The IS curve plots the relationship between interest rate and the level of income
that arises in the market for goods are services such that planned spending
equals income. This relationship is based on the Keynesian model for income
determination. In our analysis, investment is no longer exogenous but depends
on interest rate. Therefore, IS curve is a schedule showing a combination of
Interest rate and the level of income such that planned expenditure = income.
On the AD side or expenditure side the demand for goods and services can be
written as

AD = C(Y, i) + I (i,Y) + G(i)

C=C0+bYd G = G0 – gi
Yd = Y – T I = Io+ hY – di
T = tY h = marginal prosperity to invest
g = sensitivity of government expenditure to interest rate, d = sensitivity of
investment to interest rate.
INTEREST RATE, INVESTMENT AND IS-CURVE

According to the Keynesian cross model AD=Y and planned investment is

assumed to be exogenous the important macro-economic relationship under the
IS-LM model is that planned investment is a far of interest rate. Interest rate
therefore has an inverse relationship with the demand function for investment.

𝑑𝐼
I = I (i), <0
𝑑𝑖

25
With higher interest rate it becomes costlier for firms to borrow money to
undertake investment projects.

Deriving the IS curve graphically

AS AD1

DI AD2

Expenditure
45⁰
Y1 Y2 Y

i L1 i ӿ

L2 ӿ ӿ
IS

Y1 Y2 Y
I1 I2 I

Because interest rate is the cost of borrowing to finance investment project, an

increase in interest rate reduces planned investment. On the other hand,
decrease in interest rate increases planned investment. As a result, the I function
slopes down and if I is very sensitive/ responsive to interest rate small decrease
in interest rate will cause a large increase in investment. In that case the
investment function is almost horizontal.

26
A decrease in interest rate from I1 to I2 increases quantity of investment for I1 to
I2 and in turn shifts the planned aggregate expenditure upward. An increase in
planned expenditure causes the level of income to increase from y1 to y2. The I.S
curve therefore summarizes this relationship.

MONEY MARKET AND THE LM CURVE

The assets markets / money markets are markets in which money bonds stocks
are traded. In the previous chapter, the role of money market in affecting income
was not discussion. The LM curve plots the relationship between interest rate
and income that arises in the market for real money balances. To understand
this relationship, we begin by looking at the theory of interest (liquidity
preference theory). According to this theory interest rate adjust to equilibrate
supply and demand of the economy’s most liquid assets (money). Assuming M =
𝑀
money supply and P is price level then ( 𝑃 ) is the supply of real money balances.

The theory assumes a fixed supply of real money balances.

r ms

m/p
ASSUMPTIONS

The theory also assumes that interest rate is one determinant of how much
money people demand/ hold. The demand for the money is a demand for real
money balance is that people hold money for what it will buy. The higher the
price, the higher nominal balance a person has to hold to be able to purchase a
given quantity of goods. If price levels doubles then one need to double the

27
nominal balances. Therefore the demand for real money balances can be written
𝑀 𝑑
as ( 𝑃 ) = L(r)

IG

m/p

Income, money demand and the LM curve from the transactions motive money
demand can be written as a function of interest rate and income

𝑀 𝑑
( 𝑃 ) = 𝐿(𝑟, 𝑌) 𝐿𝑟 < 0, 𝐿′ 𝑌 > 0 and negatively related to interest rate and positively

related to Y.

𝑀 𝑑
( 𝑃 ) = 𝐿(𝑟, 𝑌) = 𝑘𝑌 − 𝑓𝑟
Interest rate

0 L
Demand for money

28
The demand for real balances as a function of the interest rate and real income.
The demand for real balance is drawn as a function of the rate of interest. The
higher the rate of interest, the lower the quantity of real balances demanded,
given the level of income. An increase in income raises the demand for money.
This is shown by a rightward shift of the money demand schedule.

DERIVATION OF THE LM CURVE.

We can show the combination of interest rate and income such that the demand
for real money balances matches the supply. Consider initial income Y1, the
corresponding demand for real money balances is L1 is shown in figure below.
money demand is a decreasing function of interest rate. The vertical line shows
the existing real money supply since it is given and independent of interest rate.
At interest rate i, the demand for real money balance is balanced with the supply.
Therefore, E1 is in equilibrium in the money market. Now consider an increase
in income to Y2, the higher the level of income causes a shift in the demand
curve for real money balances which raises interest rate. The interest rate must
increase to maintain equilibrium in the money market. Joining the
corresponding levels of interest rate and income arising from money market we
obtain the LM curve. Therefore, LM is a schedule of combination of interest rate
and income such that demand for real money balance is equal to supply. The
LM is positively sloped. Therefore, money market equilibrium implies that an
increase in interest rate must be accompanies by increase in income. When the
income level is Y1 , L1 Applies and the equilibrium interest rate is i1 This gives point

E1 on the LM schedule in part (a). at income level Y2 greater than Y1 , the

equilibrium interest rate is i2 , yielding point E 2 on the LM curve

29
 i LM
E2
E2
i2 i2
Interest rate

E1
E1
i1 i1 L2

L1

0 Y1 Y2 0 L
M /P
Income, output Real balances

EQUILIBRIUM IN THE GOODS AND ASSETS MARKET

The IS-LM schedule summarizes the conditions that have been satisfied in
order for goods and money market to be in equilibrium. The simultaneous
equilibrium can occur when interest rate and income for both goods market
and money market are in equilibrium. This is demonstrated in figure below.

30
31
32
HOW A FISCAL POLICY SHIFTS THE I.S CURVE?

The I.S curve is drawn for a given fiscal policy (government and taxes) assumed
fixed. Changes in fiscal policy that raise the demand for goods and services shifts
the I.S curve to the right and changes in fiscal policy that reduce the demand
curve for goods and services changes/ shift the I.S curve to the left.

AD2

DG
Exp

AD1

Y1 Y2 Y

i1
IS2

IS1

Y1 Y2 Y

Assume an increase in government expenditure, this increase in G increases

planned expenditure for any given interest rate. The upward shift in planned
𝐷𝐺
expenditure leads to an increase in income of . Therefore, the I.S curve shift
1−𝑏

to the right by the same amount.

A LOANABLE FUNDS MARKET INTERPRETATION OF THE I.S CURVE

33
Recall that the National income accounts identify can be written as Y -C-G=I.

National saving = Investment

National savings represent the supply of loanable fund and investment

represents the demand for these funds. substituting for C and I in the identity
he get the relationship between Y and Interest rate

= Y – C – G = I (Keynesian)
= Y – C (Y-T) – G = I(i) (I.S-LM framework)

The left hand equation shows that the supply of loanable funds shows that the
supply of depend of Y and fiscal policy.

The right had equation show that the demand of loanable funds depends on
interest rate.

i S (Y1) i

S (Y2)

L1

L2
I (i)

Y1 Y2 IS Y1 Y2 Y

For any given level of income interest rate adjusts to create an equation in the
loanable fund market. When income increases from Y1 to Y2, national savings
increase. Increase supply of loanable funds reduces interest rate from i1 to i2.
The I.S the summaries the above relationship. Fiscal policy effect is explained by
the fact that increase in G and decrease in taxes leads to decrease in savings.

34
Therefore, a decrease in NY saving leads to an increase in interest rate because
of the I.S curve shifts upwards for any given income level.

DERIVATION OF THE IS CURVE

Y = C(Y-R) + i(R) + G…………..(1)

C = C0 + b(Y-T)
T = tY, I = I0-dr, G= G0 ………..2

Substitute (2) in (1)

Y = C0 + b(Y-tY) + I0-dr+G0
Y-bY+btY = C0 + I0-dr+G0
𝑑 𝑟
(1-b + bt) Y = C0 + I0 + G0 - 1−𝑏+𝑏𝑡
𝐶0 + 𝐼0 +𝐺0 −𝑌
Y= 1−𝑏+𝑏𝑡
𝐶0 + 𝐼0 +𝐺0 −𝑌 1−𝑏+𝑏𝑡
r=( )
1−𝑏+𝑏𝑡 𝑑
𝐶0 + 𝐼0 +𝐺0 𝑟𝑏+𝑏𝑡
r=( )-( )Y
𝑑 𝑑

MONETARY POLICY AND LM CURVE

Factors Causing a Shift in LM Curve The LM curve is shifted by changes in the

money supply. An increase in the money supply shifts the LM curve to the right.
Only two factors can cause the LM curve to shift. Autonomous changes in money
Monetary and Fiscal Policies in IS-LM Framework 73 demand and changes in
the money supply. The LM curve shifts to the left if there is an increase in the
money demand function which raises the quantity of money demanded at the
given interest rate and income level. On the other hand, the LM curve shifts to
the right if there is a decrease in the money demand function which lowers the
amount of money demanded at given levels of interest rate. Figure 4.4 : Shifted
LM Curve to the Right The LM curve shifts to the right from LM1 to LM2 when
the money supply increases because, at any given level of aggregate output i.e.
Y1 , the equilibrium interest rate falls (Pt. A to A1 ) The LM curve shifts to the
left if the stock of money supply is reduced.

35
IMPACT OF MONETARY POLCIY ON THE ECONOMY

In an open economy, increase in money stock can be through central bank

buying bonds in exchange for money. This increases the stock of money. An
increase in the real money stock shifts the lm curve to the right. The assets
market adjusts immediately and interest rate decline. decline in interest rate
stimulate levels of investment and result into increased spending g and income
until the new equilibrium is attained. Therefore, the new equilibrium will be
attained with higher income and lower interest rate. The effectiveness of the
monetary policy will depend on how steep the LM curve is. When LM is steeper,
increase in money supply will cause a large increase in income with small impact
on investment spending. If money demand is very sensitive to interest rate then,
a given increase in money stock can be absorbed in the assets market with only
a small change in interest. By contrast if money demand is not very sensitive to
interest rate then a given change in money supply will cause large in interest
rate and have a bigger impact on investment demand. If the demand for money
is very sensitive to income, then a given increase in money stock can be absorbed
with small change in income and the monetary multiplier will be small.
Interest rate

IS

0 Y

Income, output
36
 FISCAL POLICY IMPACT ON THE ECONOMY

A change in autonomous factors that is unrelated to the interest rate such as

changes in autonomous consumer expenditure, changes in planned investment
spending unrelated to the interest rate, changes in government spending,
changes in taxes and changes in net exports unrelated to the interest rate all
these causes a shift in the IS curve. The I.S curve is drawn for a given fiscal
policy (government and taxes) assumed fixed. Changes in fiscal policy that raise
the demand for goods and services shifts the I.S curve to the right and changes
in fiscal policy that reduce the demand curve for goods and services changes/
shift the I.S curve to the left. Assume an increase in government expenditure,
this increase in G increases planned expenditure for any given interest rate. The
𝐷𝐺
upward shift in planned expenditure leads to an increase in income of .
1−𝑏

Therefore, the I.S curve shift to the right by the same amount. To meet increased
demand of goods and services, output must rise as shown by outward shift in
the IS curve.

Fiscal policy and crowding out effect

Crowding out effect occurs when expansionary fiscal policy causes interest rate
to rise thereby reducing private investment spending. Crowding impact will
largely depend on the nature of IS or LM.

a) Income increases more and interest rate increases less if the LM curve is
flatter.
b) Income increases less and interest rate increase more if the IS is flatter.
c) Income and interest rate increases more with a larger multiplier and when
IS is horizontal. All these cases can be explained by the liquidity trap.

The liquidity trap.

If the economy is in liquidity trap, the LM curve is horizontal and an increase in

government spending has its full multiplier effect on the level of income. There

37
will be no change in interest rate associated with increase in government
spending and thus no investment is cut off. Thus there is no
dampening/suppression effects of increased government spending on income.

LM
Interest rate

IS

0 Y

Income, output

OUTPUT COMPOSTION AND POLCIY MIX

We can now understand that monetary policy expansion increases income and
lowers interest rate while fiscal policy increase both income and interest rate. All
this can occur when the economy is not in liquidity trap. Now let us examine
both the impact of fiscal and monetary policy tools when applied to control
output. A fiscal policy expansion shifts the IS curve to the right and moves the
equilibrium of the economy from E to E”. because of higher level of income
increases money demand this causes interest rate to rise, there by crowding out
private investment spending. This can be overcome through increased money

38
supply and shifting the LM curve to the right resulting into a final equilibrium of
the economy and level of output rises. Therefore, monetary policy is
accommodative when in the course of fiscal expansion, the money supply is
increased in order to prevent interest rate from rising. This is also called
monetizing budget deficits meaning that the central bank prints money to buy
the bonds with which the government pays for its deficits. When both policies
are applied, output increases but interest rate does not rise and no adverse
effects on investment.
Interest rate

IS

0 Y

Income, output

39
EFFECTIVENESS OF MONETARY AND FISCAL POLICY

The relative effectiveness of monetary and fiscal policy, depending on the shape
of the LM curve and the economy’s initial position such as r1 , y1 an expansionary

monetary policy, shifting LM right, may have little effect on y, since at that low
interest rate the additional money would be absorbed by speculative balances
and not become available to finance a substantial increase in raising y, since a
small increase in the interest rate will release a substantial amount of funds
from speculative balances to support an increase in y. on the other hand, at r1 ,

y1 a shift in the IS curve will be relatively effective in raising y, since small

increase in the interest rate will release a substantial amount of funds from
speculative balances to support an increase in y.

At the other extreme, where the economy is very taut with high r and y at r2 , y2

a fiscal policy shift in IS will be relatively ineffective in changing equilibrium

demand-side y. with interest rates very high, speculative balances will be
squeezed to a minimum with most of the real money supply already financing
transactions. An increase in demand by, say an increase in g will raise the
interest rate enough that the initial g increase will be nearly fully offset by a drop
in investment demand, giving little increase in y. in this case however, an
expansion of the money supply will be very effective in shifting

r
M

40
y
As was the case with fiscal policy, the effectiveness of monetary policy will vary
with the cyclical position of the economy. Figure A shows, with a given slope of
the IS curve, a given shift in the LM curve due to an increase in the money
supply will have a greater effect on y at high levels of y and r than at low levels.

Now, if l ' is a very large negative number, approaching minus infinity, the
denominator of (16) will be very large, so that an increase in m will have very
little effect on y. from the four-quadrant diagram of Figure 5-14, it is

41
 Interest rate
Interest

Income, output Investment

42
Demand and supply in the labour market

The previous chapter of the IS-LM framework focused on the demand side of the
economy taking the price level to be constant. Therefore, changing the price level
will change the equilibrium interest rate and income through changes in real
money supply which in turn shifts to the LM curve.

Consider a simple production function y  f ( K , N ) where capital is fixed and N=

labour which is available factor. This imply that output (y) will increase to
increase in labour input.

Y2

Y1

N1 N2
0 N

We have so far developed to the following equation

IS (1) y  c( yD )  i(r )  g ………………………………………………………………………1

m
Lm   L  r   R  y  ………………………………………………………………………….2
pe

And y  f  K , N  ………………………………………………………………………………3

Equation 3 above represents a simple production function where out is a

function of labour which is a variable factor while capital is being fixed in the
short-run. Therefore, we need to determine the employment level required to
produce a fixed amount of output.

The above model has four unknown y, r, Pe and N. This requires four equations
to be solved. Therefore, this chapter will focus the discussion of Skelton macro-
economic model of the economy by introducing the demand and supply in the
labour market.

43
 The demand for labour

We have already introduced a simple production function where output is a

function of labour. This implies that Labour is a derived demand. This implies
that labour is demanded from the demand of output. From the above product
function under perfect competing firms faces a constant price P, it will offer a
wage equivalent to value of the marginal product.

y
Therefore MPL  …………………………………………………………………………..4
N

y
Value of MPL  p  w ………………………………………………………………………5
N

Nominal wage = w

y
w p ………………………………………………………………………………………..6
N

w y
Real wage   …………………………………………………………………………7
p N

We can develop the demand for labour from equation 6 in the following ways

Consider a perfectly competitive firm that is faced with marge wage that is fixed.
This implies that wo=P.MPL…………………………………………………………….8

In the above case if wage falls, the firm will increase employment to maintain
condition in equation 6. In case the real wage is less that the marginal product
of labour, the firm will hire additional labour to maximize profit.

Graphically

W1
thi

N1 N

W1

44

N1
 In general; Demand for labour w  pf  N  Or for real wage w  f  N 

The supply of labour:

We need to focus on how

(a) How rapidly and completely do workers expectations of the future price
level  pe  adjust to changes in the actual price level p?
(b) We need to consider whether Nominal wage rate fixed or flexible over time?

For the first case we shall consider immediate and correct adjustment of p e to
changes in p. for classical in which supply of labour depend on real wages only
and for case b under Keynesian assume no adjustment of p e to P. For classical
w
(T  S )  we T  S  where p
e
case, we consider ye  e
is price expected of CPI.
p

The individual work leisure decision under microeconomics. In this case workers
aim at achieving maximum satisfaction from leisure at income u  f  y e , s  the
individual has to allocate his total hours between work and leisure. The costing
w
in income y e  e (T  S )  we T  S  Where T is total hours available to the worker
p
such that T-S= working hours. Since we assume workers are uncertain about
price level, p e is used to calculate the expected real wage we resulting into
w  pf  N 
expected income

S= hour of leisure
e2

Income

e1

Y1

1

S
0 S2 S1 T
Time

45
 Therefore, labour supply curve is upward sloping

We

The individual labour supply curve will bend back ward

This suggests that once a wage reach a certain high level, increase in wage
may cause some workers to increase leisure rather than working time. This
is because income of higher wages over comes the substitution effect.
Aggregate labour supply will take the following shape

Nominal wage w  Pe g ( N )

Equilibrium in the labour market

The graphical solution of labour market equilibrium is obtained by the

intersection of demand and labour supply curves. This intersection results
into the equilibrium employment and the nominal and real wage rate as

46
 shown in the diagram below. the next section shall examine change in the
general price level effect on the equilibrium employment using the classical
case assumptions.

Supply of labour

Demand of Labour

Equilibrium in the labour market under classical case.

Classical assume a complete adjustment of worker’s price expectation to general

price level. (pe to P)

Under the above assumption, as P rises from Po, pe moves by the same proportion
leaving the ratio of (pe/ Po) unchanged. This implies that these changes will not
affect the general equilibrium in the labour market. Therefore, equilibrium wage
and employment level won’t be affected. Under the classical case labour demand
and supply move together as price level changes leaving employment and real
wage unchanged.

Supply side Equilibrium: Output and Price level

In the previous subsection we developed the skeletal macro model by considering

demand and supply in the labour market. In the above case equilibruim
emplyment depends on actual price level Po and the expected price level Pe. In
this section, we derive the aggregate supply curve from the analysis of the labour
market as well as the production function that relates the supply of output y to
emplyment N. The aggregate supply and demand can the be put together to
determione the economy wide equilibruim of the macro economic model.

Aggregate supply curve under classical case

47
Under the classical case, workers price expectation moves in the same proportion
as changes in the general price level. Therefore, from the diagram below,
changes in the general price level from P1 to P2, shifts the labour demand curve
upward. This in turn results into equal movement in pe from Pe1 to pe2 as a
result, labour supply curve shifts up proportionally to the demand curve shifts
holding equilibrium employment constant. The nominal wage rises
proportionally to the original increase in the price level P. therefore since
employment is fixed, the resulting supply curve becomes vertical. On the supply
side, equilibrium output and employment are insensitive to movements in the
price level under the assumptions of perfect foresight.

Aggregate supply under classical case

W0

W2

W1

0 N0 N

48
Aggregate supply under classical case

S
P2

P1

D
Y0

Equilibrium in the market for workers

The aggregate supply curve for labour becomes vertical with increasing wages.
This happens at some maximum level of employment which is the total labour
force L. the difference between the total labour force and the equilibrium level of
employment yields the unemployment level. This is indicated in the diagram
below (UO). this is the number of people who will be willing to work if a suitable
job were available. There can also be unemployment due to structural rigidities
of the economy., lack of information and cost of moving. the figure below gives
an explanation of unemployment of an economy operating near full employment.

U0 F(E)
E
E L

49
Equilibrium in the market for workers

But this view of unemployment will not hold up well in a case in which there is
clearly widespread involuntary unemployment, such as in the 1930s when
people would take work at almost any wage, but no work was available. The
labor market equilibrium pictures of Figure above include unemployment of
people who can’t find suitable work, not of people who can’t find any work. So
the model of Figure above can’t, by itself, explain the massive involuntary
unemployment of the 1930s, although it does represent the operation of the post
war economy fairly well. To explain aggregate, or economy-wide, involuntary
unemployment, we will introduce the notion of wage rigidity – when labor market
demand falls and wages don’t fall, so that the equilibrium labor market outcome
is off the labor supply curve.

We will look at the aggregate labor markets with rigid wages and the spillovers
that may occur as rigidities in one sector of the economy lead to distortions
elsewhere in subsequent chapters.

Equilibrium in the static model

Here we combine the demand and supply curve to determine the equilibrium
values of P, and output level y and for employment N and interest rate r. therefore
this model determines the general equilibrium of the above four variables. We
can take those equilibrium values back to IS-LM framework on the demand side
to determine the equilibrium interest rate and the labour market equation or the
production function on the supply side to find the equilibrium employment. This
chapter can carefully analysis the effect of monetary and fiscal policy and income
polices in the skeletal policy of the economy.

Consider the simplest case of the classical case

In the classical case worker’s price expectation adjust in the same proportion as
the general price level. Therefore, increase in the price level and interest rate
squeeze the initial increase in the demand completely out of the system. the
initial demand shift is the same as in the short run with p’ <1. In the figure
below, the IS curve shifts up to IS Figure 8-5 (a) the IS curve shifts up to I1 S1 with
the initial increase in investment demand. At the initial price level P0 ,
equilibrium output demanded rises to y1 . this is shown as a shift in the aggregate
demand curve of Figure below where the increase from y0 to y1 on the demand
side is the same as Figure (a)

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The shift of the demand curve produces an excess demand gap of y1  y0 so the
price level begins to rise. This shifts the LM curve in Figure (a) up raising the
interest rate further and reducing investment demand. In figure 8-5 (c), the
prices increase shifts labor demand up as firms bid for more employees to
increase output when they see prices rise. but with p '  1 , the labour- supply
curve shits up as much as demand, so that while an excess demand gap appears
on the labor market, pulling up the money wage, there is no movement in
employment or output, which remain fixed at N 0 , y0 this is seen explicitly in
Figure (b) where the ratio P e / P remain unchanged leaving N  N 0 .

How long does the price increase continue in this classical case? The price level
rises until demand is reduced to the original level y0 , as seen in figure 8-6. At
that point demand is again equal to the fixed supply, so excess demand is
eliminated. In figure 8-5(a), the LM curve shifts up until equilibrium output
demanded is back to y0 . In figure a below, the money wage W rises as much as
the price level, so that in figure b the real wage is unchanged.

What has happened to investment demand? From the product market

equilibrium condition (1), we again have y  c  y  t  y   i  r   g

If y remains unchanged at y0 and there has been no change in g, investment i,

must return to its original value before the exogenous shift. The price increase
to P2 raises the interest rate r just enough to move total investment back to its
original value. Only then is total demand equal to y0 .

This result follows from the classical assumption that p '  1 , which makes the
aggregate supply curve of figure below vertical at y0 . the vertical supply curve
in the classical case is just a graphical representation of the dichotomy between
labor market, where equilibrium N 0 is determined, and demand conditions in
the economy. It is this dichotomy that leads us to question the relevance of the
classical assumption for explaining short run macroeconomic developments. It
is clear in reality that exogenous shifts in demand, such as the i change
discussed above, will usually generate partially offsetting reductions in
investment demand through the money market. But wide fluctuations in the
level of employment and unemployment also have been observed in reality, with
unemployment reaching 25 percent in 1993 and varying between 10 and 3
percent since World War II. While the classical model says that the level of
employment is not sensitive to changes in demand conditions in the economy,

51
these fluctuations in the level of employment in reality have been related to
demand conditions. M1
r
I1

M0
I0

S1

S0
L1

L0

y
Y0 Y1
(a)
w

W0

N0
(b)
W

W1

W0

N
N0
52
 S
D1

D0

P2

P0

D1

D0

y
Y0 Y1

Growth models
Read about the various growth models using our
reference on the course outline.

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