Macroeconomics: The Demand Side

Vocabulary practice flashcards covering Chapter 1: The Demand Side from Wendy Carlin and David Soskice's Macroeconomics: Institutions, Instability, and Inequality. Concepts include the goods market equilibrium, the multiplier process, the derivation and shifts of the IS curve, forward-looking consumption (PIH, Euler equation, credit constraints, hand-to-mouth households), and forward-looking investment (Tobin's marginal and average q).

Aggregate Demand ($y^D$)

The total planned expenditure on goods and services across the economy, consisting of household consumption ($C$), aggregate investment ($I$), government spending ($G$), and net exports ($X - M$): $y^D = C + I + G + (X - M)$.

Expenditure Method of Measuring GDP

A technique for calculating gross domestic product by summing expenditures on final goods and services: $GDP \bumpeq C + I + G + (X - M)$, where government expenditure ($G$) includes spending on goods and services but excludes transfer payments.

Value Added Method of Measuring GDP

A method of measuring GDP by calculating the total value of output sold minus the cost of raw materials and intermediate goods used in production.

Income Method of Measuring GDP

A method of calculating GDP by summing all factor earnings generated in production, defined as the salaries of workers plus the profits of the owners of capital.

The Great Moderation

The period from approximately the mid-1980s until 2007 characterized by a sustained reduction in the volatility of real GDP growth in the United States and other advanced economies, attributed to economic luck, improved policy, and globalization.

Goods Market Equilibrium (GME)

The condition in the goods market where aggregate demand equals real output ($y^D = y$), shown graphically as the point where the aggregate demand curve intersects the $45^\circ$ line.

Keynesian Consumption Function

The behavioral relationship $C = c_0 + c_1(1 - t)y$, where total household consumption depends on autonomous consumption ($c_0$) and a constant fraction ($c_1$) of post-tax disposable income ($(1 - t)y$).

Autonomous Consumption ($c_0$)

The baseline level of household consumption spending that does not depend on current income, influenced instead by consumer expectations, wealth, and credit availability.

Marginal Propensity to Consume (MPC / $c_1$)

The proportion of an additional unit of disposable income that a household spends on consumption rather than saving: $c_1 = \frac{\Delta C}{\Delta y^{\text{disp}}}$, where $0 < c_1 < 1$.

Keynesian Cross Multiplier Diagram

A diagram mapping aggregate demand ($y^D$) against output ($y$) along a $45^\circ$ line ($y = y^D$), illustrating how an autonomous demand shift ($\Delta G$) induces successive rounds of spending ($c_1(1-t)\Delta G$) until a new equilibrium ($Z$) is established.

Short-Run Multiplier

The ratio measuring the total change in equilibrium output resulting from an autonomous increase in aggregate demand while holding the interest rate and policy responses constant, given by $k = \frac{1}{1 - c_1(1 - t)}$.

Paradox of Thrift

The proposition that an increase in planned private saving (modelled as a drop in $c_0$) causes aggregate output to fall, because investment and government spending are exogenous, meaning there is no automatic mechanism for increased savings to translate into higher investment.

Fisher Equation

The formula expressing the real interest rate ($r$) as the nominal interest rate ($i$) minus the expected inflation rate ($\pi^E$): $r = i - \pi^E$.

IS Curve

A downward-sloping schedule showing combinations of the real interest rate ($r$) and output ($y$) at which the goods market is in equilibrium, expressed mathematically as $y = k(a_0 + c_0 + G) - k a_1 r$.

Interest Sensitivity of Investment ($a_1$)

The parameter in the investment equation $I = a_0 - a_1 r$ that dictates how responsive investment expenditures are to changes in the real interest rate; higher values make the IS curve flatter.

Permanent Income Hypothesis (PIH)

A forward-looking theory of consumption where households maximize lifetime utility by allocating resources across time to achieve smooth consumption, consuming the annuity value of total expected lifetime wealth ($\Psi_t$) each period.

Life-Cycle Consumption Smoothing

A path predicted by the Permanent Income Hypothesis where an individual borrows during early career years, accumulates savings and repays debt after promotion during peak earning years, and runs down accumulated savings during retirement.

Euler Equation for Consumption

The intertemporal optimality condition $u'(c_t) = \left(\frac{1+r}{1+\rho}\right) u'(c_{t+1})$; when the real interest rate equals the rate of pure time preference ($r = \rho$), it implies a perfectly constant consumption path ($c_t = c_{t+1}$).

Excess Sensitivity

The empirical deviation from the Permanent Income Hypothesis where consumption spending responds to predictable, anticipated changes in income rather than remaining perfectly smooth.

Credit Constraints

Borrowing limits that prevent households from obtaining credit against future income, restricting their ability to smooth consumption and forcing spending to adjust only when income actually arrives.

Present Bias

A behavioral trait causing households to place excessive weight on current utility over future utility, resulting in insufficient saving today and a sharp drop in consumption when an anticipated fall in income occurs.

Precautionary Savings

Extra savings accumulated by risk-averse households above the level predicted by certainty-equivalent PIH to self-insure against unexpected negative shocks to income and employment.

Hand-to-Mouth (HTM) Households

Households that lack liquid assets and face credit constraints, causing them to spend almost all of any change in current disposable income ($MPC = 1$).

Hybrid Aggregate Consumption Function

A macroeconomic consumption function combining a share ($\lambda$) of forward-looking PIH households with a share ($1 - \lambda$) of hand-to-mouth households: $C = c_0 + \left[\lambda \frac{r}{1+r} + (1 - \lambda)\right] y^{\text{disp}}$.

Tobin's Marginal $q$

The ratio of the marginal benefit of an additional unit of capital to its marginal cost ($q = \frac{\text{Marginal benefit of investment}}{\text{Marginal cost of investment}}$), where firms expand capital stock when $q > 1$, disinvest when $q < 1$, and hold optimal capital when $q = 1$.

Tobin's Average $q$

An operational market-based measure of investment incentives defined as the stock market valuation of a firm divided by the replacement cost of its capital stock ($q = \frac{\text{Market value of firm}}{\text{Replacement cost of capital}}$).