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```									                        Macroeconomic Theory

Chapter 2
Aggregate Demand, Aggregate

Macroeconomic Theory      Prof. M. El-Sakka   CBA. Kuwait University
Aggregate Demand
 Note that the short run is a period where prices and wages are given.
Why?
   institutional arrangements, i.e., wages are reviewed periodically.
   for prices, the costs associated with changing prices (menu costs)
 The standard model used to summarize the way in which the level of
output is determined by AD (with sticky wages and prices) is the IS/LM,
where the goods market is labeled IS (equity between planned I and S),
and the money market is labeled LM (equity between money demand
(liquidity) and money supply (money)
 At IS/LM equilibrium, output and interest rates are constant. The IS is
useful to analyze:
   shifts in C and I and changes in fiscal policy
 On the LM side we can analyze:
   shifts in MD and changes in monetary policy (ΔMS)

Macroeconomic Theory                Prof. M. El-Sakka               CBA. Kuwait University
The goods market: the IS curve

 AD refers to planned real expenditures on goods and services (yD). At
equilibrium (y=real output):
   yD = y                it can be rewritten as (A is non interest rate):
   yD = c(y ,t, wealth + I( r, A) + g                            (AD)
   Using a linear function for consumption (other factors are summarized
in autonomous consumption c0),
   c = c0 + cy (y - t)
   0< cy < 1 is the marginal propensity to consume.
   t is total tax revenue. The linear tax function
   t = ty y
   0< ty < 1 by substitution:
   c = c0 + cy (1 - t)y
   It is clear that consumption is affected by current level of activity in the
economy.

Macroeconomic Theory              Prof. M. El-Sakka             CBA. Kuwait University
 Investment is assumed to depend negatively on real interest rate and on
expected future profitability (determined by factors proxied by A).
   The idea is that firms are faced with an array of projects, which are
ranked by their expected returns. When i ↓ some projects would be
profitable than otherwise. If expected return increases, more projects
will be undertaken. The investment function is
   I = I (r, A).
   The linear form is
   I = A – ar . ( a is constant)
   Expectational or confidence factors are often considered crucial
determinants. Hence shifts in I due to A > than movements along the
curve.
   The IS curve is defined by the goods market equilibrium condition (yD =
y) or using the linear versions of C & I above:

Macroeconomic Theory           Prof. M. El-Sakka           CBA. Kuwait University
 yD = c = c0 + cy (1 - t)y + A – ar + g (planned expenditure)
 Rearrange using yD = y and replacing (1-cy) by the marginal propensity
to save, sy, to define the locus of interest rate and output:
 y =(co+A+g/1-cy(1-ty)-(a/1-cy(1-ty) . r
    =(1/1-cy(1-ty) . [c0 + (A-ar) +g]
    = 1/sy+cyty . [c0 + (A-ar) + g]        1/sy+cyty is the multiplier

 We know that savings and tax are leakages from the feedback
 The IS curve is derived graphically in fig. 2.1
 Note that low r generates high I and high y, and vice versa

Macroeconomic Theory             Prof. M. El-Sakka              CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
   Using the IS curve equation we can separate the determinants of the
slope and position of the IS into 3 groups:
1.   Changes in the size of the multiplier will change the slope of the IS curve.
e.g., ↑cy will make the IS flatter.
2.   Any change in interest sensitivity of I will change the slope of the IS curve.
Less sensitivity → steeper IS.
3.   Any change in c0 or g0 will cause the IS curve to shift by the change times
the multiplier. A change in A also shifts the IS
 Policy can be used to manipulate IS through 1 and 3. e.g., if income tax
is proportional (t=tyy). ↓ ty ↑ the multiplier and shifts the IS into a
flatter curve.
 Any change in g will shift IS as in 3 above.
 Quantities adjust through the multiplier process to take the economy
to a stable short run equilibrium. e.g., a fall in I → y ↓ → S ↓ to equal
the low I.
 The process can be shown, assuming ty=0, as follows;

Macroeconomic Theory                 Prof. M. El-Sakka               CBA. Kuwait University
 Initially y falls by ΔI → ↓ Δc=cy ΔI. This reduces y and in the next round
by ↓ Δc=cy (cyΔI) and so on. Therefore;
   Δy= ΔI+cy ΔI+cy2 ΔI+cy3 ΔI+…
   =(1+cy +cy2 +cy3 +…)ΔI
   =(1/1-cy) ΔI
   =1/sy ΔI = multiplier . ΔI

 Another way of focusing on quantity adjustment to a new goods market
eq is to characterize positions off the IS curve. Look at figure 2.2. At
point x with yx there is an excess demand in the goods market (r is low),
while planned expenditure is y1. stocks will fall and output will rise until
y=yD.

Macroeconomic Theory              Prof. M. El-Sakka            CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
Money market: the LM curve

 Demand for money
 Confusion between the decision to save and the decision to hold money. Saving
is a decision about the use of the flow of income. The demand for money is a
decision about the form in which to hold wealth (money or another asset).
 Money is notes and other interest bearing accounts. Money is fairly liquid. In
nominal terms money is capital safe.

 Money and bonds
 Bonds are not capital safe in nominal terms. If nominal interest i increases the
market value of bonds will fall. Why there is an inverse relationship.
 If there is a bond with a face value \$100 and pays a yield \$5, if the market rate
is 4%, the market value would be \$x where .04x=\$5 i.e., x=\$5/.04=\$125. if i is
lower 2%, x=5/.02=\$250 and vice versa with higher i.
 It is clear that only i=5% where the face value equals the market value.

Macroeconomic Theory               Prof. M. El-Sakka              CBA. Kuwait University
 Demand for money versus bonds
 money is needed to carry out transactions which is a function of
income, but holding assets as money will entail a cost, the
foregone interest income. The demand for money is;
 MD/P = L(y, i) where;
 dL/dy >0,    dL/di <0
 The linear demand for money is:

MD                                   1
 L( y , i )    l  li i           .y
P                                    vT
                   asset demand    transactions demand

 Where       l , vT and li are positive constants. The term l  li i reflects
1
the asset motive and term v . y reflects the transactions motive for
T

holding money. vT is the transactions velocity.
Macroeconomic Theory                    Prof. M. El-Sakka      CBA. Kuwait University
 In the quantity theory output is the only determinant of money demand;
i.e.; MD/P =1/v .Y, the overall relationship between money demand and
output is not constant, it will vary with changes in interest rate.

 Asset and speculative motives
 Two of the explanations of the –ve relationship between MD and i is the
asset motive and the speculative motive. For speculative demand Keynes
argued that if an individual believes that the current interest rate is
above normal he expects it to fall to normal in due course. He then will
choose to hold financial assets over money required for transactions in
the form of bonds. As there is a chance for a capital gain on bonds when
i falls such that there is an inverse relationship between i and the
demand for speculative balances.

Macroeconomic Theory           Prof. M. El-Sakka           CBA. Kuwait University
 A more general rationale was provided by Tobin, instead of
assuming that each individual is certain about what he expects the
future rate of i on bonds, Tobin focused on the implications of
investor uncertainty. Individuals allocate their portfolio between
riskless asset (money that pays no i) and risky assets that pay i.
 The individuals utility depends positively on the return and
negatively on risk. To maximize their utility individuals will hold
a mixture of the two assets trading off benefits of expected return
against the associate risk according to his preferences.

 Money market equilibrium
 MD/P = MS/P
 It is assumed that the supply of money is fixed by monetary
authorities at M S . Hence the equilibrium condition is:
 L(y, i) = M S

Macroeconomic Theory        Prof. M. El-Sakka         CBA. Kuwait University
 We can define an upward slopping LM curve as at low levels of y the
transactions demand is low which must be correspondent with a high
asset (or speculative) money demand. A low i will ensure this since the
return from bonds relative to the risk is low, and vice versa when
income is high and interest is high.

 Fig 2.3, shows how shifts in MD or changes in i sensitivity of MD or
changes in MS affect the LM. In step one look at the levels of MS and
corresponding MD for transactions and interest sensitive MD in order to
have an equilibrium in the money market.
 Having done that, the second step is to calculate y that is consistent with
that level of transactions demand for money as: Y=vT. transactions
demand at i.
 By joining points X and Y the LM curve is drawn.

Macroeconomic Theory            Prof. M. El-Sakka            CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
 From the derivation of the LM there are four ways in which the
position/slope of the LM can be affected
1. a change in transactions velocity of circulation. If vT↑ will make LM
flatter.
2. a change in interest sensitivity of asset demand for money. High
sensitivity will produce a flatter LM.
A special case arise when interest sensitive money demand is horizontal,
where no one believes that interest will fall below actual interest rate, the
speculation demand for money will be perfectly elastic. This is known as the
liquidity trap case.
3. a change in MS. ↑ MS shifts LM to the RHS.
4. a change in P. ↑ P given i will mean that available transaction balances
can only finance a lower y. the LM shifts to the LHS.

Macroeconomic Theory                Prof. M. El-Sakka              CBA. Kuwait University
 Look at fig 2.4. at point X, y is y0 and i is ix MS is too high for money
market equilibrium. This excess MS can be eliminated if y rises, or i
falls. Excess MS will raise the demand for bonds, bond prices will
increase and i will go down.
 The converse situation is true at point Z.

Macroeconomic Theory             Prof. M. El-Sakka             CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
Putting together the IS and the LM

 Real and nominal interest rates
 r is defined in terms of goods and i in terms of money. Thinking of goods and r,
how much extra of one good would have to be paid in order to have one of that
good today i.e.,
Today 1 goodt=(1+r)goodt+1.
   i is how much extra in \$ would have to be paid in the future in order to have
one \$ today i.e.,
1\$t=(1+i)\$t+1.
   If goods prices remain the same it is clear that r and i are the same. If you lent
\$1 today would be able to buy (1+r) goods in the future. In general
   1+r = (1+i).p/pE1+1.
   If we use the following of definition of expected inflation
   πE=(PEt+1-P)/P        then
   P/PEt+1 = 1/(1+ πE)
   By rearranging it follows that
   (1+r) = (1+i)/(1+ πE) and therefore r = (i- πE)/(1+ πE)
Macroeconomic Theory                Prof. M. El-Sakka                CBA. Kuwait University
 When πE is low, the denominator is close to 1 and the standard
approximation of the relationship between i and r is
 i = r + πE.

 The IS/LM model
 To avoid the problem that the IS depends on r and LM on i we shall
assume that r = i, i.e., inflation equals zero.
 The path adjustment of the economy will depend on the speed of
adjustment in each market. The money market diseq is cleared rapidly
(through the bond prices) than the goods market since it involves the
 Look at fig 2.5, there are two examples of government policy changes.
The first is ↑G, the new IS(g1), y and r is higher, higher y will mean a
higher MD, but since monetary policy is unchanged, (LM stays the
same) r will be higher to dampen the higher asset demand for money.

Macroeconomic Theory           Prof. M. El-Sakka           CBA. Kuwait University
 The adjustment process : ↑G → excess demand → unplanned inventory
depletion, if the rise in AD is sustained ↑ employment. The economy
moves from A to B.
 This boosts the MDT and → excess MD. At B bonds are sold causing
bond prices to fall and r to rise (B to C). This dampens excess demand
and → I ↓. At C there remains some excess demand due to ↑
consumption associated with the multiplier effect. The adjustment
process continues until A’. The full multiplier expansion doesn’t occur
because there is a fiscal expansion without any change in MS, as the rise
in r causes interest sensitive spending to fall.
 The second example is CB ↑MS. The LM curve shift to the right
LM(MS1/P). Lower r will be associated with higher I and y (A’).
 The adjustment process: there will be an excess MS, leading to more
demand for bonds and r ↓. The economy moves from A to B. the fall in r
creates excess demand ↑ AD and investment which ↑ y and employment
raising y from B to C. adjustment of output will continue until A’.
Macroeconomic Theory           Prof. M. El-Sakka           CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
 Fig 2.6 shows why expansionary monetary policy may not raise y even
in the short run. If interest is ihat the LM is flat. People believe that i will
rise they will sell bonds, bond prices will fall.
 The economy is in liquidity trap, the CB is powerless to use monetary
policy to shift y higher.
 The liquidity trap plays a role in the long Japanese slump in 1990s.

Macroeconomic Theory              Prof. M. El-Sakka              CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
Aggregate supply

Equilibrium in the competitive labor market.
 Demand and supply of labor depend on real wage. Given capital stock
 Y=f(E),                      E=employment
 The standard assumption is that the production function is
characterized by diminishing returns. i.e., ∂y/ ∂E (MPL) declines as E
rises.
 The demand for labor under perfect competition is MPL, as firms
employ up to the point where MPL=w.
 The supply of labor is upward slopping and is driven from households
optimization as they allocate their time between work and leisure.
 At eq the market clears. Any temporary displacement of the economy
from eq. is assumed to be eliminated by w. The only unemployed people
are those voluntarily unemployed. The competitive unemployment rate
is UCE/L, where L is the labor force.

Macroeconomic Theory          Prof. M. El-Sakka          CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
Supply side in the imperfect competition model.
 In an imperfect competition market, the wage is set either by employers
or unions.
Wage setting
 Under imperfect competition there is an upward slopping wage setting
(WS) curve which is the counterpart of the labor supply curve, which is
above the competitive labor supply curve. In fig 2.8, if wage = w1, the
competitive market employment is E1, but with imperfections it is E0,
and additional workers (E1-E0) would be prepared to work at that wage.
Again if E=E0 a higher wage w1 is set for that level of employment.

 Conditions in the labor market are the key determinants of the wage
setting real wage. The money wage equation is
 W=P.b(E)                   b is a rising function of employment.

Macroeconomic Theory          Prof. M. El-Sakka           CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
 When wage is set it is the nominal wage that is fixed, workers will
evaluate wage offers in terms of the real wage they are expected to
deliver, i.e., the money wage relative to expected price level.
   If expected and actual price levels are equal, the wage equation can be
written in terms of the real wages to define the upward sloping ws cuve
as:
   wWS=b(E),                    wage setting real wage
   wWS=W/P,
   The excess of w on the WS curve above that on the labor supply curve is
the mark up per worker. Two common interpretations of this mark up:

 Wage setting by unions.
 The simplified model is “Monopoly union”, the union set the wage. It
aims to strike a balance between (i) too high a wage, which decreases
employment and (ii) too low a wages, which lowers living standards of
employees. This results in a union setting a wage higher than the
competitive wage.
Macroeconomic Theory            Prof. M. El-Sakka           CBA. Kuwait University
 Efficiency wage setting by firms
 Here the firms set wages. Firms will set a wage above the minimum voluntarily.
By setting a higher wage, the employer is able to retain well qualified and
cooperative workforce, i.e., to allow the firm to efficiently solve its motivation,
recruitment, and/or retention problems. Employer sets a higher wage and this
efficiency wage arises as unemployment falls.

 Price setting
 Under perfect competition
 P = MC = W/MPL
 → W/P = MPL.

 Under imperfect competition, firms set a price to max profits. The mark up will
depend on elasticity of demand. As elasticity rises the mark-up falls until we get
the special case of perfect competition where elasticity of demand is infinite.

Macroeconomic Theory                Prof. M. El-Sakka                CBA. Kuwait University
 In the simplest case of monopoly, profits are maximized when MR=MC.
If ɛ is constant then the mark up is constant and greater than one of
(ɛ/ɛ-1)
   The standard monopoly pricing formula is
   P = (ɛ/ɛ-1) . (W/MPL)
   And the price-setting real wage is
   (W/P) = (ɛ-1/ɛ) . (W/MPL)

 Fig 2.9 illustrates the PS curve in the monopoly case: because (ɛ-1/ɛ)<1,
the PS real wage is a fraction of MPL.
 More generally any type of product market imperfection causes the PS
curve to lie below the competitive labor demand curve. The excess is
supernormal profits per worker. We shall use a horizontal rather than
downward-sloping PS curve. Some additional assumptions are required.

Macroeconomic Theory            Prof. M. El-Sakka            CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
 The flat PS curve offers a useful simplification (firms do not change P in
response to fluctuations in output). This is consistent with the sticky prices
assumption.
 In this baseline case, we assume a constant MP and a constant mark-up. Firms
thus set prices to deliver a specific profit margin. The fixed output per worker
is split into profits per worker and w per worker. w is therefore constant and
the PS curve is flat.
 Price setting can then be summarized as the marking up of unit labor cost by a
fixed percentage (  ) on unit labor costs.
ˆ

Macroeconomic Theory              Prof. M. El-Sakka               CBA. Kuwait University
 The marking up rule is:
 P = (1+  ) (W/λ)
ˆ                          λ = labor productivity
   Let μ =  / (1+  ) then the pricing rule can be written as:
ˆ       ˆ
   P=(1/1- μ).(W/ λ)       μ = mark up.
   As the extent of competition increases, the size of the mark-up falls. Divide both
sides by P and rearrange
λ = μ.λ + W/P
   In other words given μ, λ and W, the price level set by firms implies a specific
value of the real wage. This is the price setting real wage.
   wPS = W/P = λ . (1- μ )               (price setting real wage)
   See fig 2.10

Macroeconomic Theory                Prof. M. El-Sakka               CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
 Equilibrium in the labor market under imperfect competition
 The labor market is characterized by an upward sloping WS curve and a flat
or downward sloping PS curve. At eq.
 wWS = wPS
 b(E) = λ . (1- μ)        (labor market eq, imperfect competition)
 See fig. 2.11. the eq level of employment is EICE, the associated eq rate of
unemployment is ERU=UICE/L.

Macroeconomic Theory               Prof. M. El-Sakka                CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
 The contrast between competitive and imperfectly competitive eq rates
of unemployment is shown in fig. 2.12. WS lies above the labor supply to
reflect imperfection. The PS lies beneath MPL (firms make
supernormal profits). Unemployment will include some involuntary
unemployment. There are people who would be willing to work at WICE,
but are not employed at eq level EICE. Involuntary unemployment UICE
is not ideal.

Macroeconomic Theory           Prof. M. El-Sakka           CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
Aggregate demand and aggregate supply

 Aggregate demand: from the IS/LM to AD curve. Look at fig. 2.13, if
the economy is at A, if we hold M constant and lower P to P0, the new
money market eq is shown by LM(MS/P0), the increase in the value of
(M/P) creates disequilibrium in the money market. Households will buy
bonds, and r falls. This is know as the Keynes effect. The new eq at B
with higher y. the combined goods and money market eq for different
price levels produce the AD curve. Shifts in the IS or LM curves, apart
from a change in P shifts the AD curve.
 The AD represents two sets of equilibrium conditions. When P changes,
it disturbs the eq in the money market, which changes r, which creates
diseq in the goods market and output changes as eq is restored.
 In the liquidity trap case, shits of LM do not change r, and falling prices
fail to stimulate the economy.

Macroeconomic Theory             Prof. M. El-Sakka           CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
 Aggregate Supply: from the labor market to the AS curve
 Look at fig. 2.14, a rise AD due to a rise in A would be associated with
labor market eq. only at the unchanged yCE or yICE. The economy moves
from A to Z.
 This special case of immediate adjustment of w and P is summarized by
the AD curve combined with vertical AS curve. This economy will face
fluctuations in y only as a consequence of changes in the supply side, as
changes in AD will affect prices not output or employment.

Macroeconomic Theory           Prof. M. El-Sakka            CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
 Two approaches to business cycles
 The Real business cycle model: Supply shocks
 Fluctuations are due purely to supply side factors in RBC model such as
changes in technology. In fig. 2.15 the economy is initially at A. a
positive technology shock shits the MPL to the right and the economy
moves to B (boom). The opportunity for workers to earn higher wages
leads them to supply more labor, i.e. to move up the labor supply curve.
B is therefore a position of labor market eq.
 A negative supply shock (sudden scarcity in a raw material) takes the
economy into recession as MPL shifted left and eq is at C, workers
choose to supply less labor voluntarily, i.e., they shift the timing or the
labor supply in response to shifts in demand by working more in good
times and less in bad times. This is called the inter-temporal
substitution of labor. Technological progress plays the key role in
explanations of the long run growth of living standards. However, it
seems less plausible that technical progress lie behind the pattern of
booms and recessions that characterize economies.

Macroeconomic Theory            Prof. M. El-Sakka            CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
 As the economy recovers from a recession productivity rises relative to
long term trend, and the reverse in recession, this does not mean that
technological change that is causing the boom and recession.
 A simpler explanation consistent with AD-view of the business cycle is
that when AD falls firms hold on to workers (it is costly to hire and
fire), hence productivity will fall in recession (fall in y is > fall in
employment) and vice versa.
 Fig. 2.15, shows that RBC mechanism is able to explain the substantial
changes in employment over the BC. A small change n w must lead to a
large change in labor supply. However, this does not fit empirical
evidence, that inter-temporal elasticity of labor supply is low.

Macroeconomic Theory           Prof. M. El-Sakka           CBA. Kuwait University
 Business Cycles: aggregate demand shocks plus sticky wages and prices
 Suppose that wages and prices do not adjust at all in the short run. In
fig. 2.14 this means that the economy does not move directly from A to
Z in response to an AD shock. The short run adjustment due to the shift
of IS to the RHS is shown in the bottom panel as the movement from A
to B with unchanged w and P in the top panel. The middle panel shows
that the labor market is not in equilibrium when employment is at E1.
 The prevailing w (w0) is neither on the labor supply and demand in
competitive market, nor on WS or PS in the imperfectly competitive
interpretation.

Macroeconomic Theory           Prof. M. El-Sakka            CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University
Macroeconomic Theory   Prof. M. El-Sakka   CBA. Kuwait University

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