Ch. 20: Keynesian Framework & IS Model Determination of Output

1. Ch. 20: Keynesian Framework & IS ModelDetermination of Output

2. The Circular Flow Diagram

3. Domestic Production, Y =100 Foreign Production, M=17 D Unplanned inventory investment Planned Expenditures C + I + G + X 70 + 17 +19 +11 Inventory GDP (production) • Flow concept • = planned expenditure + D unplanned inventory

4. Chapter 20: How is Aggregate Output determined? IS Curve – describes relationship between real interest rates and aggregate output when the Goods/Services market is in equilibrium. G/S Market Equilibrium Y = Y AD (Total quantity of G/S output = Total quantity of G/S demanded) (No unplanned inventory investment) Components of Planned Spending Y AD = C + I + G + X – M Rewrite Equilibrium Condition Y = C + I + G + NX I = planned investment spending • Fixed investment spending (equipment, structures, housing) • Inventory investment (raw materials, parts, finished goods)

5. Determine Aggregate Output, Y Y = C + MPC[Y(1- t) - T] + I – d (r + f) + G + NX – x r C = autonomous consumption expenditure (independent of disposable income). Is a function of future income and household wealth. MPC = marginal propensity to consume = 0 < DC / DDI < 1 Y = income (aggregate output) t = marginal income tax rate T = taxes minus net transfers (fixed amount of exogenous taxes) I = Autonomous investment (independent of output and interest rate variables). I is a function of business optimism and expectations about the future (“animal spirits”). I represents unstable exogenous fluctuations in planned investment spending.

6. Determine Aggregate Output, Y Y = C + MPC[Y(1- t) - T] + I – d (r + f) + G + NX – x r d = parameter indicating responsiveness of investment to the real cost of borrowing. d = D I / D rc where rc = (r + f) r = real interest rate on default free bonds f = financial frictions = additional interest cost of borrowing due to asymmetric information problems in financial markets G = fixed amount of exogenous government purchases NX = autonomous net exports which can change due to exogenous factors such as X and M preference changes, economic growth in the rest of the world, etc. x = parameter that indicates how net exports respond to real interest rates, r. [D NX / D r ] < 0 {  r =>  E =>  X,  M} where E = exchange rate.

7. Solving for G/S Market Equilibrium Y* = [C + I + G + NX – d f – MPC T] x 1 – (d + x) x r 1 - [mpc(1-t)] 1 - [mpc(1-t)] An Expression for Equilibrium Real GDP IS Curve – shows relationship between Y and r when G/S market is in equilibrium. • Downward sloping curve. { r =>  planned investment,  NX =>  AD =>  Y} • Changes in 6 autonomous factors shift the curve for any given r.

8. D Autonomous Expenditure (Intercept) => multiple D Y Consumption: • Household Wealth  P Assets =>  Wealth =>  C • Expected Future Income  YEt+1 =>  C • Price level  P =>  W/P (real wealth) =>  C • Interest rate r =>cost of borrowing => C durables Investment: • PE(t+1) Animal Spirits, business confidence • Cost of Capital Real long-term interest rates • Taxes • Cash flow Retained earnings, profits Net Exports: 1. PLU.S./PLROW PL U.S. =>  NX 2. (DY/Y)U.S. / (DY/Y)ROW (YU.S. / YROW ) =>  NX 3. Exchange rate (e/$ ) =>  NX

9. Total average growth = 3.3% (Furniture, appliances, autos) average growth = 6.0% (14%) (Food, clothing, energy) average growth = 3.4% (29%) Services average growth = 2.8% (57%) (Housing, transportation, medical care, recreation)

13. Falling Home Prices Negative Downward Spiral Falling Household Wealth Falling Household Spending • Salaries • Commissions • Bonuses • Tips • Self-reinforcing spiral • Feedback Loop • Multiplier Effect • Sum of an Infinite Geometric Series Lower income Rising Inventories Lower Factory Production Increase unemployment

14. Econ 330 Chapter 20 HomeworkDue Friday, April 25 Chapter 20 Questions & Applied Problems 4, 12, 14, 17, 21, 22, 24, 25