5 most 5 most importaimporta

ntntpoints points

AggregAggregate ate

DemandDemandLRASLRAS

45˚ 45˚ lineline

Money Money Supply Supply

MultiplieMultiplier/r/

AcceleratAcceleratoror

KEYNESIAN & MONETARIST

Keynesian TheoryKeynesian Theory - Total Expenditure (or AMD) and the way in which the level an equilibrium level of income is achieved.

Total Expenditure is made up of: C+I+G+(X-M)

1. The Propensity to ConsumeAny determinant of C other than income changes - WHOLE C will shift.

Consumption

C

L

M

N

Income

Marginal Propensity to Consume

The relationship between a small change in Y and the corresponding change in C = (∆C/∆Y) is known

as:Marginal Propensity to

Consume

MPC = LM/LN

2. Consumption, Savings and Equilibrium Income

C = a+c(Yd) a= autonomous c= MPCConsumptio

nC

Income

Consumption C

Income

MPC is Constant

APC falls as Y risesAPC>MPC

APC=MPCconstant at all levels of

Y

Equilibrium Income - Two Sector Economy

X1

S = 0

S

Expenditure

Y=Exp

AMD(C + I)

C

IncomeYeqB

D

Q

P

Y = C

I

= S

= S

0

+

_

Dis-Saving

Dis-Saving

Common Errors:1. C and S are NOT parallel2. The income level at which Y=C is NOT the equilibrium level of Y which occurs where AMD crosses the 45˚ line.To Remember:1. OA is autonomous consumption.2. Any consumption up to C=Y must be financed.3. At OX1 all income is spent4. At OB consumption = BQ and saving= PQ5. Equilibrium level of Y shown in 2 waysa) where AMD crosses 45˚ lineb) Planned S = Planned I - point D

Remember the following equilibriums:2 sector - S=IWith Govt - S+T = I+GWith Govt and Trade - S+T+M = I+G+X

45˚

A

3. Investment

Spending on goods and services other than consumption - i.e. it involves the creation of new physical assets.

Marginal Efficiency of Capital - MECAs investment increases, the return on the last unit of capital employed will be less and less as a result of the law of diminishing returns. Profitable to invest as long as the MEC - % return - is greater than the rate of interest. Optimum - %MEC = the rate of interest

MEC

10%

BInvestment

% MEC and Rate of Interest

8%

A0

The marginal return on investment of 0A is thus 10%; if investment is increased to 0B, the marginal return falls to 8%

3. Investment - cont’d

Accelerator - relationship between net investment and the rate of change of national output. Assumes a constant capital to output ratio e. g. $3m of capital has to be purchased to increase output by $1m - accelerator co-efficient is said to be 3. Year Demand

Machines at start of year

Machines required

Replacement Investment

Induced Investment

Total Investment

1 800 8 8 1 0 1

3 1000 8 10 1 2 3

3 1600 10 16 1 6 7

4 1800 16 18 1 2 3

5 1800 18 18 1 0 1

6 1700 18 17 0 0 0Limitations of Accelerator:* Firms can meet output with stocks - may not need investment* Changes in technology may mean firms don’t need to invest in as much capital as before* Firms need to be convinced that demand is long-term to warrant investment* Limited supply of technology available

4. Circular Flow & MultiplierMost circular flow questions refer to the idea of Equilibrium Income. This occurs where injections = withdrawals:

I+G+X = S+T+M Injections Withdrawals

Calculations for MC.Example - C=10 + aY I=5 G=25 X=12 M=16 a=0.6

therefore Y = 10 +.6Y + 5 + 25 + (12-16).4Y = 40 - 4Y = 90

Multiplier - the number of times an initial change in expenditure (i.e. C or I or G) must be multiplied in order to arrive at the consequent change in income. Equations:

1 or ___1___ The higher the value of the MPC the greater the value (1 - MPC) MPS + MPT + MPM of the multiplier.

Example - Government increases its spending by $50m, Investment increases by $80m and exports increases by $70m. Out of any increase in income 3/4 is consumed, and the remainder saved, taxed or spent on imports.

Final increase in Y = ($50m+$80m+$70m) x 1 =$200m x 4 = $800m 1-0.75

Diagrammatic Representation of Multiplier

Y

C+I+G1

YY1

T

S C+I+G2

EXP

45˚

Multiplier =

∆Y∆J

YY1ST

Deflationary Gap Inflationary Gap

YActual

AMD1

YFE

b

aAMD2

EXP

45˚

AMD2

Y

b

a AMD1

EXP

45˚

YActual

FE

The deflationary gap is ab = the amount by which AMD must rise to increase Y to its Full Employment (FE) level.

The inflationary gap is ab = the amount by which AMD must be reduced to remove demand-pull inflation i.e. to make nominal Y at FE = real Y at FE

Questions often ask by how much must J (injections) be increased to eliminate a deflationary gap. “The full employment level of Y is $250m; the present level of Y is $200m. Four-fifths of any increase in Y is spent. By how much must investment (I) be increased to eliminate the gap?

Necessary final increase in Y = $250m - $200m = $50m

K = 1 = 1 = 5 therefore ∆ I = $50m = $10m (1 - 0.8) 0.2Demand for Money - Liquidity PreferenceIntere

st Rate

Money

T P

Liquidity Trap

S

Monetarist TheoryMonetarism is an economic school of thought that stresses the primary importance of the money supply in determining nominal GDP and the price level.

Characteristics - Monetarism is a mixture of theoretical ideas, philosophical beliefs, and policy prescriptions. Here we list the most important ideas and policy implications and explain them below.1. The theoretical foundation is the Quantity Theory of Money.2. The economy is inherently stable. Markets work well when left to themselves. Government intervention can often times destabilize things more than they help. Laissez faire is often the best advice.3. The Central Bank should be bound to fixed rules in conducting monetary policy. They should not have discretion in conducting policy because they could make the economy worse off.4. Fiscal Policy is often bad policy. A small role for government is good.

Quantity Theory of Money

M x V = P x TM= stock of money V = velocity of circulation P = Average Price Level T = Volume of transactions Calculation: if M=$60, V=4 and T=12, then P can be found.

P = MV = 60 x 4 = $20 T 12

Macro-questions should normally be tackled from a Keynesian standpoint unless otherwise advised. Principal monetarist propositions:

1. Money is a unique asset, and it can be distinguished from all other financial and real assets.2. Increases in the money supply (after a time lag) produce a proportionate increase in nominal income, at first in output, and later in the general level of prices.3. Monetary policy is an effective technique for controlling the economy; fiscal policy is ineffective and incomes policy is counter-productive.4. Effective monetary policy requires the adoption of a system of monetary base control, as well as a ‘monetary rule’ (where the annual rate of allowable monetary growth is equal to the expected rise in real output) with a view of influencing expectations in a downward direction.5. Reduction of Government borrowing reduces monetary growth and thus also inflation.6. Increases in Government spending simply increase inflation and not employment.7. Unemployment can only be maintained at a level below its natural rate at the cost of accelerating inflation.8. Excessive wage increases in tight monetary conditions increase unemployment.

Keynesian Monetarist

The economy is basically unstable. Markets do not function efficiently. Private expenditure is very volatile. Depressions and mass unemployment can persist - no automatic tendency to self-correction in the economy.

The economy is basically stable. Price changes efficiently allocate resources. Private expenditure is relatively stable. Full employment (or 'the natural rate of unemployment') is the normal condition - deviations are temporary.

Inflation is caused by independent cost-push factors (wages and output prices) and causes increases in the money supply.

Inflation is caused by excessive growth of the money supply

Governments use fiscal policy to manipulate the economy. Budget deficits act as stimulus to the economy via the multiplier. Monetary policy can only be used to influence interest rates. 'Money' is impossible to define and attempts to control the money stock at best irrelevant and at worst cause permanent loss of output.

Governments use of fiscal policy is doomed to failure. Reflation simply means inflation. No long-run trade off between inflation and unemployment. Budget deficits cause increase in money supply and/or increases in interest rates, crowding out private expenditure. Reduction in inflation is a precondition of success in other objectives.

Demand for money is interest-elastic (i.e. savings vary with interest rates). Investment is interest-inelastic

Demand for money is interest-inelastic (i.e. consumption and savings fairly stable). Investment is interest-elastic

Extreme Monetarist Extreme Keynesian

AMD

AMD1

PriceLevel

PriceLevel

Output(real income)

Output(real income)

AMD2

AMD1AMD

AS AS

P

P1

P

P1

Exam Questions

(b) Explain what is meant by liquidity preference and discuss how it might be affected by an increase in unemployment. [13] June 2010

Demand for money/liquidity preference based on transactions plus precautionary demand – the demand for active balances. Speculative demand - interest elastic - depends on expectations of future changes in bond prices. Price of Bonds and Rate of Interest inversely related.

It is determined by income; frequency with which people are paid; time of year; method of payment – use of credit cards reduces active balance demand; some influence on precautionary demand from the rate of interest – although this is likely to be more relevant to firms’ active balances than individuals. An increase in unemployment would affect income:

Less consumption but compensating change in the use of credit cards.People move more money out of precautionary into transactionary. The demand for precautionary tends to rise with income.Company profits/returns most likely reduced and liquidity preference change. More into transactionary.

Exam Questions

7 (a) Explain the factors influencing the level of investment in an economy. [10]

MEC theory - Business confidence - change in technology, lower taxes expected profits, stock levels (b) Discuss the extent to which national income is determined by private investment. [15] Nov 2008

Explanation of the multiplier process - graph to explainPrivate investment - job creation - consumption - AD etcAlso - political stability, natural resources, size of labour force, unrest and war.

Exam Questions

7 (a) For what purposes do people demand money? [10]

Liquidity Preference - explained. Active /Idle balances. Graphs (b) Discuss the effect of an increase in the supply of money on interest rates and national income (15). June 2008Money supply↑interest rates ↓Investment and borrowing ↑, Investment ↑ + multiplier affect = national income ↑.Liquidity Trap - Japan 1990’s. Today Central Banks rates extremely low.

Graphs to explain this - definition of multiplier and examples