Macroeconomics Test 4 Review

Government's Role and Unemployment

• The lecture will cover the role of government and introduce the concept of unemployment.

• Governments and central banks are unique institutions, unlike firms or households.

• Topics include new models like the aggregate demand model, the multiplier process, automatic stabilizers, the external sector, unemployment, and the discouraged worker effect.

Recap of Economic Growth

• Economic growth, measured by increases in GDP, is considered important for increasing living standards.

• In the long run, output is determined by technology.

• The focus is on short-term responses in the macro economy, particularly related to monetary policy and the business cycle.

Aggregate Demand Model

• The aggregate demand model focuses on the very short term (months to a year or two), assuming fixed prices.

• All measurements in the model are in real terms.

• The aggregate demand model is also known as the Keynesian cross model or the 45-degree line model.

GDP Components

• The model starts with the GDP equation: $y = c + I + g + (x - m)$, where all terms are in real terms.

• GDP can be measured in three ways: total expenditure, total income, and total output.

Consumption Function

• The consumption function is represented as $c = c<em>0 + c</em>1y$, where:

  • $c_0$= autonomous consumption, the amount of consumption that you undertake even when your income is assumed zero, what you HAVE to spend on goods and services

  • $c_1$ is induced consumption (dependent on income), is occuring when current income is rising as you natural spend more income on consumption

  • $y$ is current income.

• $c_1$ is = to marginal propensity to consume (MPC), with a typical value around 0.7 to 0.75.

Aggregate Demand Model Mechanics

• Output (Q) and income (Y) are measured on the x-axis, representing the output and income methods of calculating GDP.

• Aggregate demand (AD) is measured on the y-axis, representing the expenditure method of calculating GDP.

• A 45-degree line represents the equilibrium where aggregate demand equals aggregate output and income.

Equilibrium and Investment

• The aggregate demand line is represented as $AD = c<em>0 + c</em>1y + \bar{I}$, where $\bar{I}$ is a fixed amount of investment.

• The equilibrium occurs where the aggregate demand line intersects the 45-degree line.

• Adding investment increases output from point A to point B, leading to an increase in aggregate demand.

The Multiplier Process

• The multiplier process (K) describes how small increases in spending can lead to large increases in economic output.

• One person's spending becomes another person's income, leading to induced spending and savings.

• The process is similar to the fractional reserve banking model, where money is deposited, lent, and reserved.

• The multiplier process converges as the amount of money passed on decreases due to leakages (savings).

Multiplier Effect

• The total change in output can be greater than the initial change in aggregate demand.

• The multiplier works with injections into the system (e.g., investment, government expenditure).

• Taxes or imports can reverse the multiplier effect, taking money out of the system.

Calculating the Multiplier

• In a simple model, aggregate demand equals consumption plus investment: $AD = c<em>0 + c</em>1y + \bar{I}$.

• The slope of the aggregate demand curve is equal to the marginal propensity to consume (MPC).

• The multiplier is calculated as $k = \frac{1}{1 - MPC} = \frac{1}{MPS}$, where MPS is the marginal propensity to save.

Paradox of Thrift

• Increasing savings (S) reduces the size of the multiplier because savings are a leakage from the system.

Paradox of Thrift

• The lecture suggests a role for government intervention to address insufficient spending.