Macro Notes Part I

# Macro Notes Part I - LECTURE NOTES A BASIC MODEL OF THE...

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LECTURE NOTES A BASIC MODEL OF THE MACROECONOMY: PART I (DRAFT: NOT FOR QUOTATION) Prepared by Prof. Theodore Tolias

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2 AGGREGATE DEMAND THE BASIC MACROECONOMIC IDENTITY Notation: C = consumption expenditures, G = government expenditures, TA = taxes, TR = transfers X = exports, M = imports, I = investment expenditures, YD = disposable income, S = savings Ex-post analysis - The basic macroeconomic identity Keynes’s Theory of national income Planned Expenditure: Assume: Price level (P) is fixed, NX=X-M=0 Let E= planned expenditure Ex-ante analysis: The model: E C I G C a bYd C a b Y T T TA T I c G G E a b Y T c G = + + = + = + = = = = = + + + or where b is the marginal propensity to consume out of disposable income. - TR Combining the above equations we obtain (1) ( ), ( ) Equilibrium Condition: The economy is in equilibrium when actual expenditure equal planned expenditure Y=E (2) Combining equations (1) and (2) we can find the equilibrium income: Y a b Y T c G Y a bY bT c G A a bT c G Y b A = + + + = + + + = + + = ( ) * Let denote the autonomous expenditures. Equilibrium income is 1 1
3 The 45-degree line represents the points where this equilibrium holds. The equilibrium is at point A, where Y=E. Diagram 1 The planned expenditure again: E A bY = + . This implies that if income increases by \$1 planned expenditures will increase by b(\$1). The slope of the planned expenditure function is b(the marginal propensity to consume). The adjustment to equilibrium Inventories play an important role in the adjustment process. For a given planned expenditure function, if income is below the equilibrium level of income there will be an excess demand since planned expenditures exceed production and inventories will be depleted. The firms will respond to the depletion of the inventories by increasing production at an increasing rate to both replace the inventories and meet demand. This increases income and the process stops when planned expenditures equals income. See diagram 2 , for income Y 2 . Diagram 2 The opposite is true for income level Y 2 . At Y 2 production exceeds planned expenditures and firms see their inventories rising. This induces firms to lay off workers and reduce production. This process reduces the income level and stops until the unplanned inventory accumulation is zero. E E Y Y 0 0 Y* Y* Y=E E=C+I+ G E=C+I+G Y 1 Y 2 Y=E

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4 Proportional income taxes and equilibrium level of income Proportional income taxes are given by TA tY t T tY C a b Y tY TR C a b t Y bTR E A b t Y Y b t A b t = = = + + = + + = + = where is the tax rate, and - TR and the consumption function can be written as Planned Expenditure change: Note that proportional taxes reduce the proportion of income that goes to consumption expenditures. This is shown by a decrease in the slope of E scedule. See diagram 3.
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