Lecture_2_post_mid.ppt

5 most
important
points
Aggregat
e
Demand
LRAS
45˚ line
Money
Supply
Multiplier/
Accelerator
KEYNESIAN & MONETARIST

Keynesian Theory
Keynesian 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 Consume
Any 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= MPC
Consumption
C
Income
Consumption
C
Income
MPC is Constant
APC falls as Y
rises
APC>MPC
APC=MPC
constant at all
levels of Y

Equilibrium Income - Two Sector
Economy
X1
S = 0
S
Expenditure
Y=Exp
AMD
(C + I)
C
Income
Yeq
B
D
Q
P
Y = C
I
= S
= S
0
+
_
Dis-
Saving
Dis-Saving
Common Errors:
1. C and S are NOT parallel
2. 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 spent
4. At OB consumption = BQ and
saving= PQ
5. Equilibrium level of Y shown in 2
ways
a) where AMD crosses 45˚ line
b) Planned S = Planned I - point D
Remember the following
equilibriums:
2 sector - S=I
With Govt - S+T = I+G
With Govt and Trade - S+T+M =
I+G+X
45˚
A

Spending on goods and services other than
consumption - i.e. it involves the creation of new
physical assets.
Marginal Efficiency of Capital - MEC
As 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%
B
Investment
% MEC and
Rate of
Interest
8%
A
0
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 0
Limitations 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 & Multiplier
Most 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 - 4
Y = 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

Diagrammatic Representation of Multiplier
Y
C+I+G1
Y
Y1
T
S
C+I+G2
EXP
45˚
Multiplier =
∆Y
∆J
YY1
ST

Deflationary Gap Inflationary Gap
Y
Actual
AMD1
Y
FE
b
a
AMD2
EXP
45˚
AMD2
Y
b
a AMD1
EXP
45˚
Y
Actual
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) 0.2
Demand for Money - Liquidity Preference
Interest
Rate
Money
T P
Liquidity Trap
S

Monetarist Theory
Monetarism 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 T
M= 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 Demand for money is interest-inelastic

Extreme Monetarist Extreme Keynesian
AMD
AMD1
Price
Level
Price
Level
Output
(real income)
Output
(real income)
AMD2
AMD1
AMD
AS AS
P
P1
P
P1

(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 explain
Private investment - job creation - consumption - AD etc
Also - 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

Lecture_2_post_mid.ppt

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