Macroeconomics in the Short run

Macroeconomics in the Short Run

Macroeconomics in the Short Run

1929

1933
Macroeconomics in the Short Run
• Business cycle peak in 1929 and trough in 1933.

• Real GDP declined by 27% .

• Investment spending fell by 81%,

• the S&P 500 stock index fell 85%.

Recession
• Unemployment rose from under 3% in 1929 to
over 20% in 1933.

• Unemployment was above 11% in 1939, six

years after trough.

• John Maynard Keynes developed an influential

business cycle model in 1936.
Great Depression: Primary Causes
1920s Booming Economy
• Wages up 40% after WWI
• Stock Market was soaring
• Many people investing – get rich quick schemes
• 1920s fashion – get into the market
• Between May 1928 and September of 1929 the average price of stocks increased over 40 percent
• trading grew from 2 or 3 million shares a day to 5 million… as high as 10 or 12 million
• brokerage firms encourage stock mania by offering easy credit to those buying stocks

• America has emerged as a world economic, industrial, and military

power
Great Depression: Primary Causes

1. Not Enough Buyers

2. Too Much Debt
3. Over-speculation in Stocks
4. Overproduction & Layoffs
5. Farming Crisis
6. Government Mistakes
STOCK MARKET CRASH OF 1929
 Black Thursday and Black Tuesday

October 21 and October 23 alarming declines in stock prices

both had recoveries
J.P. Morgan and other big bankers bought up a great deal of stock to restore public
confidence

Black Thursday, Oct. 24th, 1929 Black Tues Day, Oct. 29th, 1929
• Stocks fall drastically •Stocks plunge again
• Brokers panic •Value of market falls
• GE falls from $400 a share to $283 a •People sell what’s left to get some $
share •By the end of Oct. – over $30
• Brokers make margin calls – no one billion has been lost
can pay •Thousands lose everything
 Immediate Effects of the Crash
• Many lost life savings in the market crash
• Banks and Brokers call in loans – American people have no $
• Hundreds of banks close
• No $ to pay back loans = empty savings accounts
• Banks not prepared for people to withdrawal $ at the same time
• No bank insurance
• 9000 banks failed nation wide
• 9 million savings accounts vanish

➢ Unemployment: 25%
➢ Homelessness
➢ Hunger
➢ Psychological depression
➢ More Cooperation
Solutions
• At first, President Hoover favored the
traditional government approach—do little and
wait for things to get better.
• Private charities were responsible for helping
the poor
 Hoover’s Attitude
“I do not believe that the power and duty of the general
government ought to be extended to the relief of
individual suffering…though people support the
government, the government should not support the
people.”
--Herbert Hoover, 1930

What Hoover Did

• started some huge projects (like the Hoover dam)
• Tariffs were raised, but this backfired
• Hoover supported programs to help banks extend loans to
struggling businesses
Election of 1932
• By 1932, the American people
wanted new leadership.
• Democrat Franklin Delano
Roosevelt (FDR) easily defeated
Hoover.
• Roosevelt promised the American
people a New Deal.
FDR’s Inaugural address

“The only thing we have

to fear is fear itself”

“ We Must Act and Act Quickly”

FDR and The New Deal
• Day 1 of his office, The New Deal was FDR’s plan to
help the nation get through the great depression by
enacting many government programs designed to
provide:
Relief
Recovery
Reform

Examples of New Deal programs include…

Great Depression: Solution

Public Works Programs

1. Extended loan and relief to farmers.
2. National Industrial Recovery Act 1933: To
regulate Industrial Production
3. FDR endorsed deficit spending
4. Setting up FDIC: The Federal Deposit
Insurance Corporation guaranteed bank
deposits was set up
5. Wagnar’s Act: Guaranteed the right of workers
to join labor unions
6. Social Security Act: Pay Pension
 The Keynesian Model

The Keynesian
Theory
 Classical vs Keynesian Economics
Classical Economics(1770-1929) Keynesian Economics(1936 onwards):
• Long run Analysis. • Everything is in short run.
• Output Q: Problem of AS • Output Q: Problem of AD
• Role of Agg Supply in determination of Output and • Role of Aggregate Demand in determination of Output and
Employment
Employment
• P: Prices , Wages and Interest Rate are flexible.
• P:Prices, Wages & Interest Rates are Sticky.
• U: Full Employment
• U: No full Employment
• Assumes perfect competition in both Product (output) • Assumption of perfect competition in both Product (output)
and Factor(Labour) markets and Factor(Labour) markets is unrealistic.
• Says’ law i.e. supply creates it’s own demand, No • Says’ law failed during great depression. AS≠AD always. In fact
fluctuations is output . AS=AD. fall in AD lead to Business cycle ( fluctuation in Output)

• Labour is the only factor of production • Apart from Labour other factor of productions are also
important.
• LRAS is Vertical
• No Role of Govt. • SRAS is Upward sloping
• No Role of Money • Active Role of Govt.
• Active Role of Money.
Keynesian Premises
J.M. Keynes
➢Macroeconomic Equilibrium
1. Product (Goods) Market : AD=AS determines Output and Price

2. Factor(Labor) Market : DL= SL determines Wage rate

3. Capital (Money) Market : Md=Ms determines interest rates

➢ Assumption:

• Prices, Wages and Interest rates are fixed in the short-run.

• It implies that some markets need not clear.
A. The Goods/Product
Market Equilibrium
 A. The Product Market Equilibrium: AD=AS

• Question: How national income and output is determined?

• Keynesian Theory of Income Determination says, “the equilibrium level of national income
and Prices is determined at the level where aggregate demand (AD) for goods and services
equals their aggregate supply (AS)”.

Equilibrium: AD=AS

Model can be explained through

• Aggregate Supply(AS) Function
• Aggregate Demand (AD) Function
 a. Aggregate Supply Functions/Curve
Aggregate Supply (AS): Total volume of goods and services produced and supplied in an
economy, which depends on productivity.
AS=f(P)

Production Function: Y=f(K,N)

Where K is capital, fixed in short run
N is labor, variable in short run
LRASC

Price Level
SRASC

Output ( GDP)
 a. Aggregate Supply Functions/Curve

Real GDP and Price Level 1934-1940

• According to Keynesian
theory, in a depressed
economy an increase in
aggregate spending can
increase output without
raising prices.
b. Aggregate Demand of Income Curve
Aggregate Demand(AD): AD=f(P)
• AD is the total spending on goods and services in the economy.
• AD Curve is the total demand curve ( aggregate expenditure) of all economic agent.
• It is negatively related with the price level and hence slope downward from left to right.

AD=Z=C+I+G+(X-M)

Keynes explained macro economic equilibrium with

P1 Two, Three & Four sector model

P2

Y1 Y2
 The Goods Market Equilibrium: AD=AS
with Fixed vs.Flexible Prices

Fixed Prices Flexible Prices

According to Keynes, any change in AD will change Real GDP, thus output is demand determined. Price level doesn’t change
1. The Goods Market
AD=AD=AS Always
Y=Z=Q
Let For Keynes P is fixed
Y = AY= Aggregate (National) Income
Z = AD = Aggregate Expenditures
Through circular flow
Q = AS= Aggregate Output (Money Value)

AD(=AE) Y=E

E2

E1

450

Y1 Y2 AS(=AY)

(c) Aggregate demand ( or Expenditure)

= Aggregate supply ( Income)
1. The Composition of GDP Y=C+I+G+NX

• Consumption (C): goods and services purchased by consumers:

• Durable vs nondurable goods
• Services
• Investment (I):
• Business Fixed (nonresidential investment)
• Residential investment
• Inventory investment: difference between production and sales
• Government spending (G): purchases of goods and services by
• the federal, state, and local governments;
• excluding government transfers
• Net exports or trade balance(NX): X − IM
• Exports (X): purchases of domestic goods and services by foreigners
• Imports (IM): purchases of foreign goods and services by domestic consumers, Indian firms and the
Indian government
−
• Exports > Imports ֞ trade surplus
−
• Imports > Exports ֞ trade deficit
1. The Composition of GDP Z=C+I+G+NX
The Composition of U.S. GDP, 2014
Sl. No Components Billions of Dollars Percent of GDP
GDP (Y ) 17,348 100.0
1 Consumption (C) 11,865 68.3
2 Investment (I): 2,859 16.4
Non-residential 2,233 12.9
Residential 549 3.1
Inventory investment 77 0.4
3 Government spending (G) 3,152 18.1
4 Net exports −530 −3.1
Exports (X ) 2,341 13.5
Imports (IM ) −2,871 −16.6
2. The Demand for Goods

𝐴𝐷: 𝑍 ≡ 𝐶 + 𝐼 + 𝐺 + 𝑋 − 𝑀

• The above identity defines the total demand for goods (Z) as consumption,
plus investment, plus government, plus export, minus imports.

• In a closed economy (X = M = 0):

𝑍 ≡ 𝐶 + 𝐼 + 𝐺
2. The Demand for Goods
Law: Men or women are disposed, as a rule and on the average, to
a. Consumption (C): 𝐂 = 𝒄𝟎 + 𝒄𝟏 𝒀 increase their consumption as their income increases, but not as much as
0 < c1 < 1 the increase in their income

Let C = 100 + 0.75Y MPC = c1= 0.75 Higher APC signals greater economic activity as consumers are demanding
more goods and services
APC=C/Y
Aggregate
Aggregate Consumption,
Income, Y C APC=C/Y
0 100 0.00
80 160 2.00
100 175 1.75
200 250 1.25
400 400 1.00
600 550 0.92
800 700 0.88
1,000 850 0.85
2. The Demand for Goods: Change in Agg Demand
Round of Income Consumption (C ) Income
Generation Generation
• Let c1 =0.75 i.e. MPC,
• the multiplier would be 4. 1st 100.00

• Let initial investment is 100. 2nd 75.00 75.00

3rd 56.25 56.25

4th 42.19 42.19

5th 31.64… 31.64

…..
……. ….
last ….. 0.00

Total Income Total 400.00

2. The Demand for Goods
a. Savings (S): S = −𝒄𝟎 + 𝒔𝟏 𝒀
s1 =1- c1 =MPS
0<s1<1
=>MPC+MPS=1

Deriving the Saving Function

Y − C = S
Aggregate Aggregate Aggregate
Income Consumption Saving

0 100 -100
80 160 -80
100 175 -75
200 250 -50
400 400 0
600 550 50
800 700 100
1,000 850 150
2. The Demand for Goods
b. Investment (𝐼 = 𝐼 ) Planned Investment= 25
Actual Investment: actually how much invested + unplanned inventory changes

The Figures are Based on the Equation C = 100 + .75Y.

(1) (2) (3) (4) (5) (6)
Planned Unplanned
Aggregate Aggregate Inventory
Year
Output Aggregate Planned Expenditure (AE) Change Equilibrium?
(Income) (Y) Consumption (C) Investment (I) C+I Y − (C + I) (Y = AE?)

1990 100 175 25 200 − 100 No

1991 200 250 25 275 − 75 No
1992 400 400 25 425 − 25 No
1993 500 475 25 500 0 Yes
1994 600 550 25 575 + 25 No
1995 800 700 25 725 + 75 No
1996 1,000 850 25 875 + 125 No
2. The Demand for Goods
A. Two Sector Model Equilibrium: 𝐴𝐷: 𝑍 ≡ 𝐶 + 𝐼

a. Consumption (C)
C=C 𝑌
+ 𝐄𝐱𝐞𝐫𝐢𝐜𝐬𝐞
C = c0 + c1 𝑌 Let . C = 100+0.75Y, I=25
So equilibrium Y=500
0 < c1 < 1

b. Investment (Planned) 𝑰 = 𝑰
Since Y= Z
Z=Y= c0 + c1 𝑌 + 𝐼
𝟏
=> 𝒀 = 𝒄 + 𝑰 ……Equilibrium
1 − 𝒄𝟏 𝟎
2. The Demand for Goods
A. Two Sector Model Equilibrium: 𝐴𝐷: 𝑍 ≡ 𝐶 + 𝐼
𝐄𝐱𝐞𝐫𝐜𝐢𝐬𝐞
Let C = 100+0.75Y
a. Consumption (C) I=30+0.2Y
C=C 𝑌 a. If autonomous investment Io increases from 30
+ to 40 .
C = c0 + c1 𝑌 b. Find the equilibrium Y.
0 < c1 < 1
𝐴𝑛𝑠
b. Investment is Induced Investment a)Multiplier =1/(1-0.75-0.2)=20
𝐼 = 𝐼0 + α𝑌 b) dY/dI0=10*20=200
Since Y= Z 0< α <1
Z=Y= c0 + c1 𝑌 + 𝐼0 + α𝑌
𝟏 𝑆 = −𝑐0 + 𝑠1𝑌
=> 𝒀 = 𝒄 +𝐼 ……Equilibrium
1 − 𝒄𝟏 −α 𝟎 0 For Equilibrium: S=I
0<s1<1
𝟏
Super multiplier Necessary condition: c1+ α< 1 or s1> α 𝒀= 𝒄 +𝐼
s1 − α 𝟎 0
2. The Demand for Goods: Exercise
Problem:
A large multinational shipping company , Abhoy Sales Inc. has just decided to spend Rs. 10 cr. on new
storage space in Delhi, Rs.45 cr. on new aircraft and Rs.5 cr. on additional acquisition of kerosene. In addition
to these expenses, the company is producing 5 cr. parcel at a price of Rs 5 per parcel.
Now suppose that Abhoy Sales plans to have a tenth of that production in inventory. Over time , the
company’s parcels have met with increasing demand, but the inventory has only increased by Rs. 1 cr.

Q1. What is this firm total planned investment? Ans: Rs.10 + Rs.45 + 0.1(Rs.5*5 cr.) = Rs.57.5 cr.
Q2. How much did the firm actually invest? Ans: If the inventory increased only by 1 cr., thus the firm
invested 10+45+1=56 cr.
Q3.What is the difference between actual and planned investment? Ans: The difference is 57.5-56=1.5 cr.
the firm should produce more parcels
Q4. Should Abhoy sales produce more or fewer parcels? Why?
to cover the shortage
AS= 5*5 =25 cr.
AD=57.5 cr . As AS<AD the company should produce more parcels
2. The Demand for Goods
B. Three Sector Model Equilibrium: 𝐴𝐷: 𝑍 ≡ 𝐶 + 𝐼 + 𝐺
a. Consumption (C) and Disposable Income (YD) T could be lump-sum tax. A lump sum tax rate is a tax that is the same
value for all who pay the tax. It is the same regardless of income.
C = C YD … . . (1) Ex. Vehicle registration or DL fee. Low-income people are most affected.
+
C = c0 + c1 YD … . (2)

YD=Y-T

C = c0 + c1 Y − T … . (3)

b. Investment (I )

𝐼 = 𝐼 … … (4)

c. Government Spending (G) and Tax

Let G= is 𝐺 and T= is 𝑇 i.e. fixed
3. The Determination of Equilibrium Output
• Let assume X=M=0
So, 𝑍 ≡ 𝐶 + 𝐼 + 𝐺
• => Z = 𝒄𝟎 + c𝟏 𝒀 − 𝑻 + 𝑰 + 𝑮 … . 𝟓
𝒀 = 𝒁 … . . (𝟔)
• ⇒ 𝒀 = 𝒄𝟎 + 𝒄𝟏 𝒀 − 𝑻 + 𝑰 + 𝑮 … . . 𝟕
𝟏
• ⇒ 𝒀= 𝒄𝟎 + 𝑰 + 𝑮 − 𝒄𝟏 𝑻 … (𝟖) • Eq 8 is equilibrium condition, which implies that the
1 − 𝒄𝟏
1
government can choose the level of G or T to affect the level of
• ⇒Z = 𝑐0 + 𝐼 + 𝐺 − 𝑐1 𝑇 … . (9) output it wants
1 − 𝑐1

• Autonomous spending: [c0 + 𝐼ഥ + G – c1T]

• Autonomous spending is positive because if T = G (balanced budget) and c1is between 0 and 1, then (G – c1T) is
positive, and so is autonomous spending.
• The term 1/(1 – c1) is the multiplier, which is larger when c1 is closer to 1.
• If c1 equals 0.6, the multiplier equals 1/(1 – 0.6) = 2.5, meaning that an increase of consumption by 1 billion will
increase output by 2.5 x 1 billion = 2.5 billion.
3. The Determination of Equilibrium Output: Graphically
Ex. Suppose c0 increases by Rs.1 crore. An increase in autonomous spending has a more than one-for-one effect
on equilibrium output.
AB: first-round increase in production
BC: first-round increase in income
CD: second-round increase in demand
DE: second-round increase in production and
income
The total increase in production after n+1 rounds:
1 + 𝑐1 + 𝑐1 2 +⋅⋅⋅ +𝑐1 𝑛

which is a geometric series with a limit of

1/(1−c1).

The adjustment of output over time is called

the dynamics of adjustment.
The effects of an increase in autonomous spending on How long the adjustment takes depends on
output how and when firms revise their production
schedule.
3. The Determination of Equilibrium Output
Exercise:
Let C=200+0.75(Y-T), 𝐼ഥ=100, G=1000, T=1000
a. Find equilibrium level of income:
b. If G increasers to 125,what will be the new equilibrium?
c. What level of G is needed to achieve an income of 1600?

Ans:
a. Y=1300
b. Substituting G= 125, Y= 1400
c. G=175
3. The Determination of Equilibrium Output: Application
The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the
Consumption Function

Figure 2 Google Search Volume for “Great Depression,” January 2008 to September 2009
3. The Determination of Equilibrium Output: Application
The Lehman Bankruptcy, Fears of Another Great Depression, and Shifts in the
Consumption Function

o When people start worrying

about the future, they decide to
save more even if their current
income has not changed.

o News about Lehman Brothers

going bankrupt in September
2008 reminded people of the
Great Depression, as confirmed
by the number of searches for
“Great Depression” in Google.

o Consumption fell even if

disposable income had not yet
changed.

Figure 1 Disposable Income, Consumption, and Consumption Of Durables In the United

States, 2008:1 to 2009:3
4. Investment Equals Saving: An Alternative Way of Thinking about Goods—Market Equilibrium

• Alternative Model: S=I by J M Keynes.

• Private saving (S) is

S ≡ YD − C
S ≡Y−T−C
By definition,
• Private saving = Yd-C
• Public saving = T − G.
• National Saving = Private + Public
=>S= I + G − T
−
• Public saving > 0 ֞ Budget surplus
−
• Public saving < 0 ֞ Budget deficit
4. Investment Equals Saving: An Alternative Way of Thinking about Goods—Market Equilibrium

In equilibrium:
𝑌 =𝐶+𝐼+𝐺

Subtract T from both sides and move C to the left side:

Y−C−T=I +G −T

The left side of the equation is simply S, so S=I+G−T

Or equivalently 𝐼 = 𝑆 + 𝑇 − 𝐺 … . (10)

This is the IS relation, which stands for “Investment equals Saving”.

Two equivalent ways of stating the condition for equilibrium in the goods market:
(1) Production = Demand
(2) Investment = Saving
4. Investment Equals Saving: An Alternative Way of Thinking about Goods—Market Equilibrium

• We can also derive equation (8) using equation (10).

• Because consumption behavior implies that:
S = Y − T−C
= Y − T − c0 − c1 (Y − T)
⇒ 𝑆 = −𝑐0 + 1 − 𝑐1 𝑌 − 𝑇 … (11)

In equilibrium, I = S, so that equation (10) becomes:

𝐼 = −𝑐0 + (1 − 𝑐1 )(𝑌 − 𝑇) + (𝑇 − 𝐺)

1
Solve for output: 𝑌= 𝑐0 + 𝐼 + 𝐺 − 𝑐1 T … . . (12)
1 − 𝑐1

which is the same as equation (8).

5. The Multiplier
Change in Y = Multiplier * Change in C0, 𝐼 ,or G or GTr or T
Haavelmo Trygve (1945) there is no penalty at all
Equilibrium model solution: Y = 1 * (C0 + 𝐼 + G)
for higher public spending financed by an increase
1 – c1
in taxes and/or social security contributions
1
1. Autonomous Spending Multiplier: ΔY/ Δ 𝐼 =
1 1 – c1
2. Govt Expenditure Multiplier: ΔY/ ΔG = 1 – c
1

– c1
3. Govt Tax Multiplier : ΔY/ ΔT = 1 – c Where Yd=Y-T and T is lump sum tax
1 c1
4. Govt Transfer Payment Multiplier: ΔY/ ΔGTr= 1 − c
1 Where C = C0 + c * (Y-T +GTr)
−c1
5. Govt Income Tax Multiplier: ΔY/ ΔTy=
1 − c1 + c1t
T= T0+t*Y here Ty is Income tax, t is income tax rate
1
6. The Complete Fiscal policy Multiplier: ΔY/ ΔG= 1 − c + c t ∆𝑌 1 ∆𝑌 −c
1 1
∆𝐺
=1–c and ∆𝑇
= 1 – c1
If ΔY/ ΔG- ΔY/ ΔGTr=1, then So ΔY/ ΔG> ΔY/ ΔGTr 1 1

7. Balanced Budget Multiplier=1 if ΔG=ΔT ∆𝑌 ∆𝑌 1 −c1

+ = + =1
∆𝐺 ∆𝑇 1 – c1 1 – c1
6. The Paradox of Saving
“Savings is a virtue” I = S + (T − G)

‘A Penny saved is a penny earned’.

Those who save become reach and

prosperous.

Keynes criticized, the above sentence may

be true for an Individual but not for the
society

When all or most households become

thrifty, they consume less and save more,
the level of Income and savings declines.
Uses and Limits of the Multiplier
Limitations of working of multiplier
Applications
a. Multiplier process works only when there is adequate Less application in case of Less developed
availability of consumer goods.
countries due to low MPC.
b. Full value of multiplier is achieved only when various
increments in investments are repeated at regular intervals. • Vast agricultural sector

• Disguised unemployment
c. The full value of the multiplier can be achieved only when
there is no change in the MPC during the process of income
propagation. • Low level of capital equipment,
technology
d. Multiplier does not work well in case of leakages from MPC
a. Payments of the past debts • Vast non-monetised sector
b. Purchase of exiting wealth
c. Import of goods and services • Producing for self consumption
e. Does not work well in case of full employment of resources.
References

• Ch 3 : Macroeconomics by Oliver Blanchard, 7th ed. Pearson

• Ch 8. Principles of Macroeconomics by K. E. Case,R.C. fair and S.E.
Oster, 12th edition , Pearson
Thank You All