Lec Notes 104-5 - Economics 104B - Lecture Notes -...

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Economics 104B - Lecture Notes - Professor Fazzari Topic V: Demand-Side Macroeconomic Theory: Keynesian Economics (Updated March 23, 2007) A. Equilibrium of Output and Aggregate Demand Over the past several weeks in the class, we have looked at the components of the economy that cause them to change. We saw how households and firms make consumption and investment decisions based on a variety of factors such as the interest rate and income. We explored the determination of international trade and talked briefly about how government activity influences the economy. There is now a shift in the class. We will now look in some detail and systematically at how various changes in the economy affect business cycles, inflation, and growth. (Remember the main macro issues discussed in the very beginning of the class.) To meet this goal, we will use “models.” These are abstractions that hopefully capture the major features that are most important in driving macroeconomic activity. These models will be built upon the components we have studied in recent weeks. The first model we discuss explains how the demand side operates, that is, the model describes “Keynesian” macroeconomics. On that note, here we go…. 1. The “Keynesian Cross” (income-expenditure diagram) a) Firms produce what they expect to sell Firms produce what they expect to sell. As we discussed while summarizing demand-side theory, production is motivated by sales expectations. This observation leads to the behavioral assumption that firms produce what they expect to sell . Therefore, if we graph Expected Sales versus Production (Y), we will get the aggregate supply curve (AS), a line with a slope of +1. (“Supply” is another piece of jargon economists use for the concept of production.) A slope of +1 means that for every point on the AS curve, production equals expected sales. A slope of +1 is equivalent to saying the AS line makes a 45 degree angle with either axis.
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(1) The 45 degree line as the aggregate supply curve. Here is the picture: Expected AD AS 45 o Output (Y) b) The aggregate demand curve: positive slope and the MPC We will derive the aggregate demand curve from the consumption function. The consumption function shows one component of AD (C) as a function of income. (Remember income and output are conceptually the same thing at the macro level.) To get to the AD curve from the Consumption Function, simply add the other components of AD. This will result in a shift upwards . Note that theoretically the AD curve could be below the consumption function if Imports was large enough, but in reality this would not happen. The slope of the AD curve is the same as the slope of the Consumption Function because we are assuming that I, G, Ex, and Im do NOT vary with income—they are purely exogenous variables (at this point). Therefore, the slope of the AD curve is still the MPC . (Later on, we will make the model more complicated, however.)
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AD
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Lec Notes 104-5 - Economics 104B - Lecture Notes -...

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