Macro Session 4

7/27/2019 Macro Session 4

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Macroeconomics & The Global Economy Ace Institute of Management

Session 4: National Income-where it comesand where it goes?(Contd....)

InstructorRijan Dhakal

[email protected] 98510 69004
mailto:[email protected]:[email protected]


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Demand for goods & servicesComponents of aggregate demand:

C = consumer demand for goods & services

I = demand for investment goods

G = government demand for goods &services

(closed economy: no NX )


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Consumption, C def: disposable income is total income minus total

taxes: Y T

Consumption function: C = C (Y T )Shows that (Y T ) C

def: The marginal propensity to consume is theincrease in C caused by a one-unit increase indisposable income.

Meaning: If MPC is 99%, then

1 unit ( Y T ) will cause 0.99 unit C MPC = C / ( Y T )

Or, C = MPC ( Y T )


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The consumption function

C

Y T

C (Y T )

1

MPC The slope of theconsumption functionis the MPC.


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Investment, I Investment: firms + households

(Eg. add stock of capital + new houses) Depends upon interest rate: cost of borrowing funds

to finance investment spending.

Interest rates:borrowing and lending

(since both interest rates work together, we assumean average interest rate for simplicity)


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Investment, I Nominal interest rate: Interest rate in market value

Real Interest rate: Interest rate in terms of purchasing power (nominal interest rate correctedfor inflation)

The true cost of borrowing is the real interest ratenot the nominal interest rate. Why?

Since, r I

The investment function is I = I (r ),where r denotes the real interest rate


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The investment function

r

I

I (r )

Spending oninvestment goodsis a downward-sloping function of the real interest rate


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Government spending, G

G includes government spending on goodsand services raised by Tax revenue

Classical theory assumes that governmentspending and total taxes are exogenous:

andG G T T


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Budget surplus and deficit

When T > G ,budget surplus = (T G )> 0 and public saving ispositive.

When T < G ,budget deficit = (T G ) < 0and public saving is negative.

When T = G ,budget is balanced and public saving = 0.


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Equilibrium in the market for goods & services

The real interest rate adjusts

to equate demand with supply in the goodsmarket.

Agg. demand: ( ) ( )C Y T I r G

Agg. supply: ( , )Y F K L

Equilibrium: = ( ) ( )Y C Y T I r G


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Equilibrium in the Financial Market:The loanable funds market

A simple supply-demand model of the financial system.

One asset: loanable funds demand for funds: investment demands

supply of funds: savings (Public + Private)


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Supply of the fund: Saving private saving = (Y T ) C

public saving = T G

national saving or Saving , S = private saving + public saving

= (Y T ) C + T GS = Y C G

We know, Y = C + I + G such that S = C + I + G C G

S = I (equilibrium condition goods market relating to

financial market)

Rewriting, ( )S Y C Y T G = I (r )


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Loanable funds market equilibrium

r

S, I I (r )

( )S Y C Y T G

Equilibrium realinterest rate, r

Equilibrium levelof investment

National savingdoes notdepend on r ,so the supplycurve isvertical.


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An Increase in Government Purchases (G) by G :

Total demand for goods and services General price level and demand for money

(Since Total Output ( Supply) is fixed) Govt. spends more money from its savings.

Savings

Interest rate (Banks have less money for public)

Investment level

Fiscal Policy Operations: Increase/Decrease in G or T

Thus, government purchases are said to crowd out

investment


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The Crowd-out effect

r

S, I

1S

I (r )

r 1

I 1

r 2 2. which causes the realinterest rate to rise

I 2

3. which reduces thelevel of investment.

1. The increase in thedeficit reduces saving 2S


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Macroeconomic Assumption onConsumption and Saving

Disposable income (Y-T) has two functions:

Consumption and Savings

( Y T ) = C + S

( Y T ) = C + S

For any given amount of (Y T),

Increase in C leads to decrease in S


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A Decrease in Taxes: Disposable (Y-T) income

Consumption (C)

Saving decreases

Interest rate (r)

Investment (I)

Like an increase in government purchases, tax cutscrowd out investment and raise the interest rate.

Fiscal Policy Operations: Increase/Decrease in G or T


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An increase in the demand forinvestment goods shifts the investmentschedule to the right. At any giveninterest rate, the amount of investmentis greater. The equilibrium moves

from A to B. Because the amountof saving is fixed, the increase in

investment demand raisesthe interest rate while leaving

the equilibrium

amount of investmentunchanged.

But, what if interest rates are even higher?

Investment, Saving, I, S

I1

Realinterestrate, r

Saving, S

S

I2A

B

Two reasons: Technological changes and Tax Policy


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When saving is positively related to the interest rate, it results in theupward-sloping S(r) curve.

A rightward shift in the investment schedule I(r)increases the interest rate (r) and the amount of investment (I).

Investment, Saving, I, S

I1

Realinterestrate, r

S(r)

I2 AB

Upward sloping savingsThe higher

interest rateinduces people

to decreaseconsumptionand increasesaving, whichin turn allowsinvestment to

increase.


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Numerical Exercise

Consider an economy described by the following equations:

Y = C + I + GY = 5,000G = 1,000T = 1,000,C = 250 + 0.75(Y T) I = 1,000 50r. a. In this economy, compute private saving, public saving andnational saving.b. Find the equilibrium interest rate.

c. Now suppose that G rises to 1,250. Compute private saving,public saving, and national saving.d. Find the new equilibrium interest rate

Note: r is in %


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Solution to Numerical Exercise

a) Private Saving = Y T C =

= 5,000

1,000

(250 + 0.75(5,000

1,000)) = 750.Public Saving = T G = 1,000 1,000 = 0S = S(private) + S(public) = 750 + 0 = 750.

b) S = I

750 = 1,000

50 r. Therefore, r = 5%. c) S(private) = 750 and S(public) = T G = 1,000 1,250 = 250.Thus, S = S(private) + S(public) = 750 + ( 250) = 500.

d) S = I500 = 1,000 50 r. Therefore, r = 10%.


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Thank You

Macro Session 4

Documents

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