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economics ECO 2013

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Joseph Calhoun
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Brennon Lang

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This 238 page Bundle was uploaded by ew Notetaker on Monday November 16, 2015. The Bundle belongs to ECO 2013 at Florida State University taught by Joseph Calhoun in Fall 2015. Since its upload, it has received 66 views. For similar materials see Macroeconomics in Economcs at Florida State University.

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Date Created: 11/16/15
Sanjay Rode Advanced Macroeconomics Download free ebooks at 2 Advanced Macroeconomics © 2012 Sanjay Rode &Ventus Publishing ApS ISBN 978-87-403-0156-4 Download free ebooks at 3 Advanced Macroeconomics Contents Contents Preface 8 Acknowledgement 10 1 Introduction to Macroeconomics 11 1.1 Close to open economy 11 1.2 IS-LM Framework 25 1.3 Aggregate demand and supply 35 2 Consumption Function 44 2.1 Introduction 44 2.2 The Ando Modigliani Approach: The life cycle hypothesis 48 2.3 The Friedman approach: Permanent income 53 2.4 Friedman consumption function: Cyclical movement 56 2.5 The Duesenberry Approach: Relative income 57 2.6 Money: Definition and function 60 3 Aggregate supply, wages, prices and employment 74 3.1 Philips Curve 74 3.2 The aggregate supply curve (Dynamic) 78 The next step for top-performing graduates Masters in Management in Management provides specific and tangible foundations for a successful career in business.s Please click the advert This 12-month, full-time programme is a business qualification with impact. In 2010, our MiM employment rate was 95% within 3 months of graduation*; the majority of graduates choosing to work in consulting or financial services. As well as a renowned qualification from a world-class business school, you also gain access to the School’s network of more than 34,000 global alumni – a community that offers support and opportunities throughout your career. For more information visit, email or give us a call on +44 (0)20 7000 7573. *Figures taken from London Business School’s Masters in Management 2010 employment report Download free ebooks at 4 Advanced Macroeconomics Contents 3.3 The Production Function 79 3.4 The properties of aggregate supply curve 82 3.5 Long term adjustment 84 3.6 Inflation expectation and aggregate supply curve 85 3.7 Aggregate supply curve 87 3.8 The Modified Philips Curve 91 3.9 Expected augmented Philips Curve: 91 4 Open economy: Macro economy 96 4.1 Introduction 96 4.2 Open economy and goods market 99 4.3 The Mundell- Fleming model 103 4.4 Competitive depreciation 111 4.5 The role of prices in open economy 111 4.6 Automatic adjustment 113 4.7 Expenditure switching and reducing policies 114 4.8 Devaluation 115 4.9 Exchange rate and prices 115 4.10 Crawling peg exchange rate 116 4.11 J curve effect 117 4.12 The Monetary Approach to Balance of Payment (MABoP) 119 4.13 Exchange rate overshooting 126 Teach with the Best. Learn with the Best. Agilent offers a wide variety of affordable, industry-leading electronic test equipment as well as knowledge-rich, on-line resources —for professors and students. We have 100’s of comprehensive web-based teaching tools, lab experiments, application Please click the advert DVDs/ See what Agilent can do for you. CDs, posters, and more. © Agilent Technologies, Inc. 2012 u.s. 1-800-829canada: 1-877-894-4414 Download free ebooks at 5 Advanced Macroeconomics Contents 5 Modern Macroeconomics 137 5.1 Introduction 137 5.2 The efficiency wage hypothesis 137 5.3 The government budget constraint and debt dynamics 142 5.4 Rational expectation 149 5.5 The New Keynesian alterative 157 5.6 Ricardian equivalence 158 5.7 Search and matching model 162 7.3 Criticism 168 5.8 Implicit contracts 169 5.9 Insider –Outsider model 172 5.10 Real business cycle 174 6 International adjustments: Policy implications 184 6.1 Government budget constraints 184 6.2 Hyperinflation 186 6.3 Laffer curve 188 6.4 Controlling deficit 189 6.5 Debt management 190 6.6 The dynamic of deficit and debts 190 6.7 The Borrow Ricardo problem 193 6.8 Money and debt financing 193 You’re full of energy and ideas . And that’s © UBS 2010. All rights reserved. just what we are looking for. Looking for a career where your ideas could really make a difference? ▯UBS’s Graduate Programme and internships are a chance for you to experience for yourself what it’s like to be part of a global team that rewards your input and believes in succeeding together. Please click the advert Wherever you are in your academic career, make your future a part of ours by visiting Download free ebooks at 6 Advanced Macroeconomics Contents 6.9 The burden of debt 193 6.10 Government assets 194 6.11 The budget deficit 194 6.12 The size of debt /budget 195 6.13 Merged Bank Fund Model 196 6.15 Lags in the effects of policy 218 6.17 Credibility 223 References 225 Glossary 228 360° thinking . 360° thinking . 360° thinking . Please click the advert Discover the truth at Discover the truth at © Deloitte & Touche LLP and affili.ated entities. Discover the truth at © Deloitte & Touche LLP and affili.ated entities. © Deloitte & Touche LLP and affili.ated entities. Download free ebooks at Discover the7truth at © Deloitte & Touche LLP and affili.ated entities. Advanced Macroeconomics Preface Preface This book aims at fulfilling the curriculum requirement of the Masters students of Macroeconomics. Macroeconomics is one of the most practical subjects and is very useful for policy making. The domestic and international economy is subjected to different variations in saving, income, exchange as well as interest rate and balance of payment. This book attempts to explain the domestic and international factors responsible for creating the equilibrium of balance of payment, interest rate and inflation. The various dimensions of issues and logics form the basic core of this book. This book will help the students to think, analyze and apply the content of this book practically. Various industry related example such as data of exchange rate, inflation, domestic output etc. are mentioned to understand the macroeconomic issues.Italsoaimsatprovidinginsightstothestudents,teachersandpolicymakerstothinkaboutvariousmacroeconomic issues in broader way. Once the issues are known to the policy makers, planners and academicians, then it is easier for them to think in that direction and ultimately help them to solve some of these issues. The advanced macroeconomics book provides fundamentals of the basic macroeconomic identities. It will also assist the other educational stream students to understand macroeconomics who are studying it for the first time. This book is divided into two parts. The first part explains the topics related to the closed economy. Second part is related totheopeneconomywhereopeneconomyandmacroeconomyisexplained.Boththepartsareequallyimportantbecause the first part forms the basic crux for understanding the second part which needs higher comprehension levels. Some current issues such as foreign exchange, money and capital market are also explained in this book as such issues help students to understand the subject in greater depth. The first chapter explains the basic concepts of macroeconomics. The IS-LM model is explained with expansionary fiscal and monetary policy. The aggregate demand curve is derived from the IS-LM equilibrium. The aggregate demand and supply explains the price adjustment in the short and long run. Second chapter clarifies in detail, the consumption function. The lifecycle and permanent income hypothesis form the major parts of the chapter. The investment theories demand and supply of money and the money multiplier are also a part of this chapter. Third chapter elucidates the aggregate supply curve, inflation and Philips curve. The linkage of inflation, deficit, and debt; as well as deficit and debt financing is also depicted in the last part. Chapter four describes the open economy as well as the macro-economy. The chapter attempts to interpret the Mundell- Fleming model under fixed and flexible exchange rate, exchange rate fluctuation and the reserve bank policy. Chapter fifth defines the fundamentals of the modern macroeconomics. Rational expectations and real business cycle theory is explained in the latter part. Efficiency wage hypothesis explains the wage bargaining of the workers in industry. Download free ebooks at 8 Advanced Macroeconomics Preface Insider and outsider model explains how workers perform the wage bargaining in the industry. Search and match model explains the asymmetric information and moral hazard problem of selection of workers and employment issues. Chaptersixclarifiesthemonetaryandfiscalpolicymixforinternalstabilityindetails.Exchangerateanddebtmanagement of government is discussed in the second section. Rules versus discretion and the Polak Fund model are also discussed in this chapter. Download free ebooks at 9 Advanced Macroeconomics Acknowledgement Acknowledgement The researchers and academicians are unique in their contribution to Macroeconomics. Nobody can correspond with each other in terms of their contribution. My work is just a piece of paper and is subjected to various limitations but sincere efforts are made to study the domestic and international factors affecting on macroeconomics. Words fall short to express my deep sense of gratitude to my research guide, Dr. Neeraj Hatekar, Professor, Department of Economics, University of Mumbai, Mumbai, India. His continuous support in my research endeavor was a source of inspiration. He taught me various principles of macroeconomics – theoretically as well as practically. I am lucky to work with him as a research student. I am inspired by Dr. Indira Hirway, Professor and Director of Center for Development Alternatives (CFDA), Ahmedabad, India. Her work in labor and gender economics, time use study has helped me understand the various macroeconomic issues in detail. She took many efforts to teach me the theory and advanced macroeconomics topics in her office and in the field work. IwishtoexpressmyheartfeltgratitudetoDr.SangitaKohli,Principal,S.K.SomaiyaCollegeofArts,ScienceandCommerce for continuous support and encouragement starting right from the planning of the research to the eventual writing of this book. I am thankful to Dr. Mahadeo Deshmukh, Department of Economics, S.K.Somaiya College, University of Mumbai, for having provided consistent support for research work. I would like to thank Dr. Sindhu Sara Thomas from the Department of English for the valuable suggestions and help during the research work. I owe very special gratitude to Mrs. Smitha Angane, Department of Statistics and Mathematics who has always lent a helping hand. I would like to record my deep appreciation for the administrative staff of S.K. Somaiya College, University of Mumbai, particularly to Mr. Sanam Pawar, Librarian and Mr. Mane for their immense help in meeting the requirements smoothly. I am thankful to my friend Mr. Srinivasan Iyar for some very fruitful discussions on various aspects and part of this book. Mr. Amit Naik and Mr. Anant Phirke have been a continuous source of inspiration and help at need. Their affection and encouragement has helped me throughout this research work. I must also acknowledge the support of my numerous friends Mr. Rajesh Patil, and associates Mr. Rajendra Ichale to name only a few. Finally, I would like to express my affectionate appreciation of my mother and father. It is difficult to explain how much efforts they have taken in order to pursue my study. I am especially thankful to my uncle and aunt. Without their co- operation and help I would have not completed this book. My brother, Mr.Shantaram Rode constantly provided moral support in difficult times. The continuous inspiration from Sushma and Rani was an advantage. I am thankful to many of my friends and colleagues without their help, this work would not have seen the light of day. Last but not the least, I would like to thank to my postgraduate and undergraduate students whom I teach economics. Sanjay Jayawant Rode Download free ebooks at 10 Advanced Macroeconomics Introduction to Macroeconomics 1 Introduction to Macroeconomics 1.1 Close to open economy Theproductiveactivitieshavebeenanactivepartofhumancivilizationsinceancienttimes.Moderneconomieshavemore diversion in form of production function. Now, skilled labors and advanced computerized machineries are used in the production process. The production system, at the first instance satisfies the consumption need of the people. Therefore in a closed economy, without government sector, all income which is generated from all natural resources is consumed by people. In terms of equations, it is presented as follows - Y=C (1.1) Where, Y: Production C: Consumption All consumption is equal to the income or production. If we assume that no external sector exists, then exports and imports are not possible. In case of lower consumption and more income, some income can be saved; the equation can be presented as - Y=C+S (1.2) Where, Y: Production C: Consumption S: Saving Ultimately, saving can be converted in to investment (S=I) after some time. It can be interpreted as - Y=C+I (1.3) Where, Y: Production C: Consumption Download free ebooks at 11 Advanced Macroeconomics Introduction to Macroeconomics I: Investment If equation (1.2) and (1.3) are combined then it can be computed as follows- C+I ≡ Y ≡ C+S (1.4) Income which is either consumed or invested is equivalent to income consumed and saved. This is because savings become investments in the long run. We live in a democracy and government forms an important part in economy. If we add government in the above equation then government does expenditure on various infrastructure projects and welfare schemes. It imposes direct taxes on people’s income. Hence, the total disposable income is affected by government expenditure. Further, the equation becomes - Y=C+I +G (1.5) Where, G = Government levied taxes Government not only finances various development projects but also provides subsidies and maintains defense, law and orderinsociety.Suchactivitiesrequireexpenditureanditisregularlymaintainedineconomywithadditionalexpenditure. The total income of the population declines after imposing direct taxes, deducing the current equation to - YD= C+S (1.6) Where, YD: Disposable income of people C: Consumption S: Saving In the modern world, all the economies are open economies and we cannot neglect external sector. Foreign trade is a must in the globalized world and it is increasing with increase in openness of a country’s economy. Including these factors, it can be interpreted as follows- Y=C+I +G+(X-M) (1.7) Where, (X-M): Net exports to other countries Download free ebooks at 12 Advanced Macroeconomics Introduction to Macroeconomics All governments encourage export and try to minimize imports. The aim is to increase the foreign capital flow and reserves. Including net exports is not enough for equilibrium in the balance of payment. Capital flow is also taken into consideration. It can be interpreted as - Y=C+I +G+ (TR-TA) 1.8) Where, TR- Total Receipts TA- Total Payments A total receipt comprises the capital flow and net exports. Similarly, the total payments comprises of the capital outflow and payment for import. If we combine the equation (1.6) and (1.7) then C+S ≡ YD ≡ Y+TR-TA (1.9) C ≡ YD-S ≡ Y+TR –TA –S (1.9a) S-I≡ (G+TR –TA) + NX (1.10) Please click the advert Download free ebooks at 13 Advanced Macroeconomics Introduction to Macroeconomics Where, NX: Net Exports Therefore,saving,investmentgovernmentbudgetandforeigntradehasfollowingmacroeconomicidentity,itispresentedas C+I +G+NX≡ Y ≡ YD + (TA-TR) ≡ C+S+ (TA-TR) (1.11) Left hand side of the equation shows the output component of economy. Output supply is measured in terms of money; it is the national income of the country. Right hand side of the equation shows the disposal income, it is equivalent to the Gross Domestic Product (GDP) plus transfer payment and taxes. 1.1.1 Income and spending Aggregate income in the economy comprises the consumption, income, government expenditure and net exports. It is explained as AD= C+I+G+ (NX) (1.12) Where AD: Aggregate Demand NX: Net Exports Figure 1.1 Income and spending in economy ▯ ▯ ▯ ▯ ▯ ▯ ▯▯▯▯▯▯▯▯▯▯▯▯<▯ ▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯<▯ ▯ ▯ ▯ ▯ ▯ ▯▯(▯ ▯ ,8!▯▯ $'▯ ▯▯▯▯▯▯▯▯▯$'▯ ,8▯▯▯▯ ▯ ▯ ▯ ▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ;▯ ▯ ▯ ▯ ▯ ▯ <▯ 2XWSXW▯ Download free ebooks at 14 Advanced Macroeconomics Introduction to Macroeconomics Figure 1.1 shows that the aggregate demand is a horizontal line. It shows that the aggregate demand in the economy is independent. Point E shows that the income is equal to the aggregate demand. In the economy, if output is more than incomethenthefirmsreduceproduction.Inthelongrun,whenthereislessproduction.Theoutputremainsinequilibrium. Thus the output and equilibrium income is achieved. In an economy, goods are produced up to the point where they are adjusted to aggregate demand. Therefore, AD=C+I+G+NX=Y (1.13) Ifthereislessdemandforgoodsproducedthenfirmswillholdthestockofgoodsandproduceless.Inthiscaseunplanned inventories are working in direction to control supply. It can be written as - IU=Y-AD (1.14) In scenarios where unplanned inventories control the aggregate demand in the economy, the aggregate demand equals income. It can further be deduced as- Y=AD (1.15) Sometimes, the producer expects more demand in future. It is their regular exercise to forecast the aggregate demand. Hence they invest more economic resources in their firm and find a market for their products in the long term. In such case, planned spending is equal to planned output in an economy. Therefore the planned spending is also equal to the planned income. This is a direct relationship between the income and the spending in an economy. But an opposite situation is also possible which is commonly known as recession. We will discuss this issue in detail in the next section. 1.1.2 The consumption function There is direct relationship between disposable income and consumption. In general, the higher the disposal income, then higher is the consumption. We must understand that consumption of individual cannot be zero. It always increases with increase in age. Consumption in simple terms is defined as - C= ܥcY (1.16) Where C: Consumption Y: Income Consumption is depending up on income and average consumption remains same for a long period of time. Alternatively we can redefine consumption as - Y=C+S (1.17) Download free ebooks at 15 Advanced Macroeconomics Introduction to Macroeconomics In the above equation, income is equally divided in consumption and saving. In a different way, it is defined as - Y-S=C (1.18a) In order to get the saving out of income and consumption, we can reorganize the above equation as - S=Y-C (1.18b) Some households have minimal income thus they cannot save out of their income regularly. Their income is equal to their consumption. If the household income increases and the consumption remain constant then the saving occurs. But it is usual that income rises with the rise in consumption. If we substitute equation (1.15) into (1.18b) then, S=Y- ( +cY) (1.18) ܥ = -ܥҧ(1-c)Y (1.19) Where savings depend on the average consumption and change in income, there is regular investment in the economy by the government. Aggregate demand depends on the consumption and planned average investment. It is explained as follows - − AD =C +I (1.20) Aggregate demand is equal to aggregate consumption and average investment. It is very dynamic in nature, thus it can be inferred as – − − AD =C+I +cY (1.21) − As per the equation (1.15), we have substituted consumption with c+cY . We assume that autonomous investment in economy should be equivalent to average consumption. Therefore, the investment will take care of the aggregate consumption in the economy. If the income level rises then the propensity to consume can rise. Therefore there is need to increase in autonomous investment. − − − AD =C+I (1.22) If the economy is capitalistic economy, and there is no government intervention, then autonomous investment takes care of rising consumption. But in a welfare state, government regularly invests in economy. If commodities are short in supply then the government takes initiatives to supply them. If overall production is less then government imports commodities from various countries. Therefore, government and external sector cannot be ignored. Y=AD (1.23) Download free ebooks at 16 Advanced Macroeconomics Introduction to Macroeconomics If we minus consumption from both sides of the above equation then, the above equation can be written as - Y-C=AD-C (1.24) Thus the equation becomes - − S = I (1.25) Where, the saving is almost equal to the planned investment in economy. The following figure 1.2 shows planned saving and investment in the economy. The diagram shows that consumption − remains constant at C point. But with rise in aggregate consumption, inventories need to increase investment. Therefore, − aggregate investment increases up to A . Where demand increases and equilibrium aggregate gets achieved at E. When inventory invests in the economy then output increases up to Y. If more output is produced then there is decline in the income. Therefore, final output is achieved with Y and equilibrium at E. Figure 1.2 Change in aggregate demand ▯ ▯ ▯ <▯ ▯ ▯ ▯ ▯ ▯ $' $▯F< ▯ ▯ ▯ ▯ ▯ ▯ ▯ (▯▯▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯,8▯!▯▯ ▯ ▯ ▯ ▯ $ ▯ ▯▯▯▯▯▯▯▯,8▯▯▯▯ ▯ ▯ ▯ ▯▯▯▯& &▯ F< ▯ ▯ ▯ ▯ F ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ;▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯▯ ▯ ▯ ▯ ▯▯▯▯<▯ ▯ ▯ ▯ ▯ 1.1.3 The Multiplier − The autonomous investment (A) is equal to average ( A ) autonomous investment where income is at equilibrium level. As the autonomous investment increases, it leads to increase in the income. If the income increases then expenditure also increases. As the expenditure increases, firstly output starts increasing and then income. It can be explained by the following equation as - − − − 2 3 − AD = ∆ A+C∆ A+C A+C ∆ A (1.26) − 2 3 = ∆ A+[(1+C)+C +C (1.27) Download free ebooks at 17 Advanced Macroeconomics Introduction to Macroeconomics − = ∆ A+[(1+C +C +C ] 3 (1.28) If we solve the above equation through geometric method, then it is simplified as 1 − ∆ AD = ∆ A 1−c (1.29) =∆Y0 (1.30) Consequently, the change in aggregate demand is equivalent to the change in income. Therefore (1/1-c) is called the multiplier. The multiplier is defined as the amount at which equilibrium output changes when autonomous demand increases by one unit. In simple equation it can be defined as - − A 1 − Y0 = = ∆Y /∆ A 1 c(1 t) 1−c (1.31) If we exclude government and external sector from the above equation then multiplier can be defined as - 1 α = 1−c (1.32) your chance to change the world Here at Ericsson we have a deep rooted belief that the innovations we make on a daily basis can have a profound effect on making the world a better place for people, business and society. Join us. In Germany we are especially looking for graduates Pleasas Integration Engineers for • Radio Access and IP Networks • IMS and IPTV We are looking forward to getting your application! To apply and for all current job openings please visit our web page: Download free ebooks at 18 Advanced Macroeconomics Introduction to Macroeconomics Multiplier is influenced by autonomous spending. If the output change is more, then autonomous investment is also more. It can be explained in two ways as - − − ∆ A≡ A'− A (1.33) Where there is a change in present to past, the autonomous investment also leads to change in multiplier. Similarly, ∆Y0=Y’0-Y0 (1.34) The above equation explains that past and present income also shows the change in income. The change in the aggregate demand is explained as follows - Figure 1.3 The multiplier effect and aggregate demand In figure 1.3, the aggregate demand exceeds from Y to Y . Therefore the firms will respond to the change and expansion 0 1 resulting in production. It will lead to increase in induced expenditure. Such expansion in the production increases the induced expenditure; hence the outcome is an increase in aggregate demand to the A . TheGexpansion reduces the gap betweenaggregatedemandandoutputtotheverticaldistanceFG.TheequilibriumoutputandincomeisY’ .Thechangein 0 income is defined as Y . The PE equal to PE’. It exceeds the increase in autonomous demand EQ. In the diagram, multiplier 2 exceeds 1 because consumption demand increases with the change in output. It finally leads to change in the demand. 1.1.4 The government sector Duringinflationandrecession,theroleofgovernmentisimportantinawelfarestate.Governmentdecisionsdirectlyaffect disposable income of people. The change in income occurs by two ways. Firstly, government produces or purchases goods and services from the market. It provides goods to the people at lower prices. It is done through the public distribution system. Therefore disposable income of people increases. Secondly, government reduces the taxes and it leads to increase in the disposable income of people. Similarly, government spends on defense, infrastructure facilities and law and order. The expenditure in all welfare schemes is always higher. The equation can be rewritten as - AD= C+I +G (1.35) Download free ebooks at 19 Advanced Macroeconomics Introduction to Macroeconomics Consumption depends on disposable income. Therefore, C can be replaced with YD. Similarly net income to households is transfer payment of taxes. Therefore, consumption function can be rewritten as follows - − − c = c+cYD = c+c ( Y +TR −TA ) (1.36) Where, YD=Y+TR-TA If we assume that government spends in the economy at an average rate, there is average transfer from the government to the public. Government collects average taxes from people, then − − G =G,TR =TR TA =tY (1.37) Now TA is replaced with tY. Therefore, above equation can be rewritten as - − − C =C+C (Y +TR−tY ) C =C (1.38) − − C =C+CTR+C (1−t ) Y (1.39) The above equation shows that taxes reduce the disposable income and thereby affecting consumption. Net transfer also affects consumption. The higher the net transfer from the government then consumption expenditure of people is also higher. Marginal propensity to consume is related to C (1-t). It means people consume income after paying taxes. If we combine above equations then − − − − AD =C+ (TR+I+G)+c(1−t)y − = A+ c(1−t)Y (1.40) Now aggregate demand is related to the autonomous investment in the economy, consumption and disposal income. 1.1.5 Government and aggregate demand In figure 1.4, aggregate demand curve is shown as the consumption, average consumption and income. The new AD is Download free ebooks at 20 Advanced Macroeconomics Introduction to Macroeconomics denotedasflatslope.Theslopeisflatbecausegovernmentputtaxesonincomeandwhateverisincomeleftafterdisposable income is used for consumption. Therefore propensity to consume out of income is now c (1-t) instead of c. If we define income as follows Y=AD We can substitute AD in the above equation as follows - − Y = A+c(1−t )Y (1.41) − − Government purchases goods and services from private sector. It spends G and the transfer payment is denoted as TR . The taxes are assumed constant. In this case government expenditure shifts the intercept of the aggregate demand curve up and flattens the curve. Figure 1.4 Aggregate demand and equilibrium ▯ ▯ $'▯ ▯ ▯ ▯ <▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯▯▯$' &▯ , ▯F< ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ $' &▯ , ▯F< ▯ ▯ ▯ ▯ ▯ ▯ ▯▯▯▯▯▯▯▯▯ ▯▯▯▯▯▯▯▯▯▯,QFRPH▯▯ ▯ ▯ <▯ ▯ Now aggregate demand is equal to as follows - − Y[1−c(1−t)] = A − − − − Y = 1 [c +TR I G + + 0 1 −(1 t)− − A Y 0 = 1 c(1 t)− (1.41) Government expenditure substantially makes the difference in economy. Government expenditure, purchase and net Download free ebooks at 21 Advanced Macroeconomics Introduction to Macroeconomics transfer affect the income of people in the economy. The government spending, taxes, government purchase is explained in detail in the next part. 1.1.6 The Budget Thegoodbalancedbudgetisonethattakescareofreceiptsandpayments.Balancedbudgetmanagegovernmentexpenditure and increases income. Budget surplus consists of more revenue and less expenditure. Government budget consists of total expenditure of goods and services as well as transfer payments. S=TA-G-TR (1.42) The budget is surplus if the total government payments are less than government receipts. Alternatively, if expenditure exceeds the total taxes the budget is in deficit. Now, we can substitute the TA as Ty then S=Ty-G-TR (1.43) The aim of each government is to maximize the tax collection and increase tax base. The tax rate is not given much importance. But it depends on the tax efforts and collection of each government. Each government has different capacity and efforts but it tries to minimize the expenditure. But increase in gover0menG purchase is equal to increaseinincomeisintheformoftaxes.TaxrevenueincTα ∆Gsb.Thechangeinbudgetsurplusisdefinedas- G ▯e Graduate Programme IjoinedMITASbecause for Engineers and Geoscientists Iwanted real responsibili▯ Month 16 Iwas aonstruction supervisorin Please click the advert theNorthSea advisingand Real work helpingforemen International opportunities ▯ree work placements solveproblems Download free ebooks at 22 Advanced Macroeconomics Introduction to Macroeconomics − ∆S = ∆TA−∆G − − ∆S = tα GG−∆G t − =[ 1− (1− )t −1]∆ G (1−c)(1−t) − = ∆G (1 −c)(1−t ) (1.44) The above equation shows that increase in government purchase will reduce the budget surplus. It is further explained in the following Table 1.1- Download free ebooks at 23 Advanced Macroeconomics Introduction to Macroeconomics Table 1.1 Budget of Government of India at a Glance (In crore of Rupees) 2009-2010 2010-2011 2010-2011 2011-2012 No. Details Actuals@ Budget Revised Budget Estimates Estimates Estimates 1 Revenue Receipts 572811 682212 783833 789892 2 Tax Revenue (net to centre) 456536 534094 563685 664457 3 Non-Tax Revenue 116275 148118 220148 125435 Capital Receipts 4 451676 426537 432743 467837 (5+6+7)$ 5 Recoveries of Loans 8613 5129 9001 15020 6 Other Receipts 24581 40000 22744 40000 Borrowings and other 7 418482 381408 400998 412817 liabilities* 8 Total Receipts (1+4) $ 1024487 1108749 1216576 1257729 9 Non-Plan Expenditure 721096 735657 821552 816182 10 On Revenue Account of 657925 643599 726749 733558 which, 11 Interest Payments 213093 248664 240757 267986 12 On Capital Account 63171 92058 94803 82624 13 Plan Expenditure 303391 373092 395024 441547 14 On Revenue Account 253884 315125 326928 363604 15 On Capital Account 49507 57967 68096 77943 Total Expenditure 16 1024487 1108749 1216576 1257729 (9+13) 17 Revenue Expenditure 911809 958724 1053677 1097162 (10+14) 18 Of which, grants for creation of Capital Assets 31317 90792 146853 19 CapitalExpenditure(12+15) 112678 150025 162899 160567 20 Revenue Deficit (17-1) 338998 276512 269844 307270 -5.2 -4 -3.4 -3.4 21 Effective Revenue Deficit (17-18)# 245195 179052 160417 -3.5 -2.3 -1.8 22 Fiscal Deficit 418482 381408 400998 412817 {16-(1+5+6)} -6.4 -5.5 -5.1 -4.6 23 Primary Deficit (20-11) 205389 132744 160241 144831 -3.1 -1.9 -2 -1.6 Source: Budget 2011, GOI Download free ebooks at 24 Advanced Macroeconomics Introduction to Macroeconomics 1.2 IS-LM Framework Introduction In an economy, the production of goods depends on a number of factors. But the average supply of goods in the economy is considered as aggregate supply. Such average supply keeps the prices at a constant level. The aggregate supply of goods decides the equilibrium of price. The average price level decides the aggregate demand. If the prices change then aggregate demand is affected. Aggregate demand is related to the average price and supply. If the aggregate demand rises, it reflects on the aggregate supply. 1.2.1 Goods and Money market The economy is divided into goods and money market. The money and goods market have different equilibriums. Graph 1.1 Equilibrium of goods and money market in economy *RRGV▯PDUNHW▯ ▯ ▯ ▯ ▯ ▯ 0RQH\▯PDUNHW▯▯ ▯ ▯ ▯ ' J 6J S ▯ ▯ ▯ ▯ ▯ ▯ ' P 6 P L ▯ ▯ ▯ ' J!6 J3▯ ▯ ▯ ▯ ▯ ▯ ' P6 P ,▯▯ ▯ ▯▯▯▯▯▯▯▯J'' J▯ ▯ ▯ ▯ ▯ ▯ ' PV P 3▯ ▯ We will turn your CV into an opportunity of a lifetime Please click the advert Do you like cars? Would you like to be a part of a successful brand? Send us your CV on We will appreciate and reward both your enthusiasm and talent. Send us your CV. You will be surprised where it can take you. Download free ebooks at 25 Advanced Macroeconomics Introduction to Macroeconomics Goods market is in equilibrium when the demand for goods is equal to the supply of goods. The price level remains equilibrium. The prices of commodities can change if the demand for goods rises faster and supply remains constant resulting in price rise of the commodities. The rise in price will have effect on demand of the commodity. It is inversely related when the supply of goods rises and demand remains constant. Therefore, prices of commodities declines or falls. If we consider money market equilibrium then the demand for money is equal to the supply of money. The interest rate remainsconstantinthelongrun.Ifthedemandformoneyincreasesfastduetonumberofreasonsandthesupplyremains constant then the interest rate start rising. It is opposite when the supply of money rise and demand for money declines. The interest rate declines but it is a short term adjustment. Figure 1.5 Flowchart of goods and money market ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯▯▯▯,QFRPH▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯▯▯▯▯▯▯▯*RRGV▯PDUNHW▯ ▯▯▯$VVHW▯PDUNHW▯ ▯ ▯ ▯ ▯ ▯ ▯▯▯▯▯▯▯▯▯▯$JJUHJDWH▯RXWSXW▯GHPDQG▯▯ 0RQH\▯0DUNHW▯▯▯▯%RQGV▯PDUNHW▯ 'HPDQG▯ ▯▯▯▯▯'HPDQG ▯ 6XSSO\▯▯▯▯▯▯▯▯▯▯▯▯▯▯6XSSO\▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯,QWHUHVW▯UDWH▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯▯▯▯▯0RQHWDU\▯SROLF\▯ ▯ ▯ ▯ ▯ ▯ ▯▯)LVFDO▯SROLF\▯ ▯ ▯ ▯ ▯ ▯ Source: Dornbusch and Fischer (1994) In the long run, demand and supply of money remains e qual to the supply of money and interest rate remains unchanged. At the same time, the demand for goods is also equal to the supply of goods. The prices remain constant and the goods and money market remain in equilibrium with stable prices and stagnant interest rate. Such equilibrium in goods and money market may change after expansion or contraction monetary and fiscal policy in the short run. In the long run both markets remain in equilibrium. The detail of each market is explained as follows - Download free ebooks at 26 Advanced Macroeconomics Introduction to Macroeconomics 1.2.2 Goods market equilibrium The goods market is in equilibrium when desired investment and desired national saving are equal or equivalent, when theaggregatequantityofgoodssuppliedequalstheaggregatequantityofgoodsdemanded(Bernanke,2003).Alternatively, in the goods market, the demand for goods and supply of goods remains at equilibrium. Prices of goods remain in equilibrium. In other words, prices of goods remain constant. The aggregate demand curve is related to the interest rate and income level. As the aggregate demand shifts upward the interest rate falls and the aggregate income increases. The planned investment increases in the economy with increase in output and income. In a closed economy, the output is equal to expenditure. Y = C+I+G (1.45) Now we will classify each variable in to different categories. C= c(Y, r) (1.46) Consumption is related to income and interest rate. As the level of income rises, the consumption expenditure increases. It is a positive relation between consumption and income. The income is negatively co-related to the interest rate. As the interest rate starts rising, the consumption expenditure start declining. The income is further categorized as - Y =Y +TD (1.47) Now consumption function can be written as follows - C = c(Y−T,i−π ) e + − (1.48) The linear version of consumption function is written as - C = c +c (Y−T)−c (i−π ) e 0 1 2 (1.49) Where, c0 is the autonomous consumption and it is independent of income. C is th1 responsiveness of consumption to a change in disposal income. The C i2 the responsiveness to a change in the ex-ante real rate of interest. Now investment function is defined as I=a-b(i-π ) (1.50) Where, a is shorthand for business confidence and the productivity of investment. The b is the parameter that explains how much investment declines in response to an increment in the ex-ante real interest rate. The government expenditure is defined as - Download free ebooks at 27 Advanced Macroeconomics Introduction to Macroeconomics − G = G (1.51) Government expenditure in the economy is considered as the average expenditure. The IS curve is derived as follows - Figure 1.6 Derivation of IS curve ▯ ▯ ▯ ▯ ▯ ▯ ▯▯▯▯▯▯(▯▯ ▯ $' ▯▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ $' ▯ ▯ ▯ (▯ ▯ ▯ $' &▯,▯*▯ ▯ ▯ $' ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯ ▯▯▯▯▯▯▯▯▯,▯ ▯ ▯▯▯▯D▯ ,QWHUHVW ▯ 5DWH▯ ▯ ▯ ▯ ▯ E▯ ▯ ▯ ▯▯▯▯▯L ▯ ▯ ▯ ▯ ▯ ▯ ▯ <▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯▯< ▯ ▯ ▯ ▯ ▯ ▯ ,QFRPH▯ Figure1.6showsthattheaggregatedemandofinvestmentisequaltotheaggregatesupply.Theinterestrateisconstant.The interest rate is related to the aggregate demand. At point E, the aggregate demand curve shows interest rate and income. Aggregate demand curve remains equilibrium with income and interest rate. In the long run, consumption expenditure increases due to increase in disposable income. Fall in interest rate leads to rise in the investments and it also leads to rise in income and investment by the government and private sector. The government expenditure (infrastructure projects, defense, law and order) increases in the economy due to the concept of welfare state every year. Such developmental and social welfare expenditures increase the aggregate demand in the economy. In figure 1.6, the rise in aggregate demand leads to shift in equilibrium from E to E’. Therefore the interest rate falls from i to i1. The fall in interest rate leads to rise in income. If we join point a and b it results in the downward sloping IS curve. Download free ebooks at 28 Advanced Macroeconomics Introduction to Macroeconomics Properties and shift of IS curve


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