CarlinSoskice PPT ch01

Carlin
Type author
& Soskice
names here
Macroeconomics: Institutions,
Instability, and the Financial System
Chapter 1:
The Demand Side
These slides are authored by Hillary Wee,
UCL, Cambridge
© Wendy Carlin and David Soskice, 2015. All rights reserved.

Objectives: Chapter 1: The Demand Side
By the end of this chapter, students should understand the

following:
 What forms the demand side of the closed economy

 The goods market equilibrium and the multiplier effect
 The IS curve and its properties
 Drivers of the components of demand
 Forward-looking consumption behaviour and the Permanent
Income Hypothesis.
 Forward-looking investment behaviour and Tobin’s q .
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Overview: Chapter 1: The Demand Side
 The Demand side captures the spending decisions of:

• Households: Domestic & Foreign (Open Economy)
• Firms
• The Government
Aggregate Demand (AD):
 Why study this?

• Fluctuations in AD affect unemployment and inflation
• Relevant to monetary and fiscal policy makers
• Understand the transmission mechanism of monetary and
fiscal policy
Demand side facts: Components of AD over time
Investment is
more volatile
 The Demand side captures the spending decisions of:

• Households: Domestic & Foreign (Open Economy)
• Firms
• The Government
Aggregate Demand (AD):
 Why study this?

• Fluctuations in AD affect unemployment and inflation
• Relevance to monetary and fiscal policy makers
• Understand the transmission mechanism of monetary and
fiscal policy
Business Cycle facts: Growth & Fluctuations
Recession Periods
(Shaded Areas)
Business Cycle facts: Volatility and Policy
The Great
Moderation:
Did better policy-

making reduce
volatility?
 How do we model the demand side?

The IS (Investment -Savings) Curve
Features:
- Downward Sloping
(high int rate  lower AD)
- Affected by expectations of
the future
(pessimistic expectations 
lower AD at every int rate)
Modelling: The Goods Market Equilibrium (GME)
 The IS Curve shows combinations of the Real interest

rate (r) and Output (y) under goods market equilibrium.
 Goods Market Equilibrium:

“Aggregate Demand = Output / Income”
 Recall closed economy AD:

• Consumption demand (C): Expenditure by individuals on goods and
services; on durables and non-durables.
• Investment demand (I): Firm expenditure on capital goods, Household
expenditure on new houses, Government expenditure on infrastructure.
• Government purchases (G): Government expenditure on salaries, goods
and services.
Modelling: GME and the Multiplier
Goods Market Equilibrium & the Multiplier:
 First assume a Keynesian consumption function:
where : autonomous consumption, not affected by income

t : tax rate
y : income
: disposable income,
: marginal propensity to consume (MPC)
 Here, AD is given by:

(┼)
Modelling: GME and the Multiplier
 Goods market equilibrium is given by the 45°

line: where AD = Output.
The Multiplier effect:

ΔGΔ Δ
Δ
ΔΔ …
(┼)
Modelling: The Multiplier
 The Multiplier determines the change in output due to a change

in autonomous demand (ΔG in Fig 1.5).
 Rearranging (┼) in terms of y, we get:
(▲)
 The multiplier is greater than 1 since and .

 Short-run multiplier: response of output to a change in
autonomous demand, keeping the interest rate and policy
responses constant.
 If , then the line is horizontal. The multiplier equals 1 and the
effect of ΔG on output is not amplified.
Application: Paradox of Thrift
 Should savings be encouraged or discouraged in a recession?

• ↑ Savings  ↑ Investment in capital stock  ↑ AD
• But ↑ Savings  ↓ Consumption  ↓ AD
 In our model I and G are exogenous & by rearranging (▲):
 A rise in savings is modelled by a fall in to .

 Since I and G are fixed, y must fall for the equation above to hold.
 Paradox of Thrift: Higher savings causes output to fall.
 Model-specific result: No mechanism for high savings to translate
into higher investment.
Modelling: The IS Curve
Deriving the IS Curve (Mathematical):

 Fisher Equation:
 Assume that Consumption is independent of r, while investment
is given by:
 Substituting this into the AD identity (┼), we get the IS relation:
 The larger the multiplier (k), or the larger the interest-sensitivity

of investment (, the larger the effect of r on y.
(IS curve is flatter)
Deriving the IS Curve (Graphical):
In the r-y space, plot the

Investment function.
s
Then add in and .

Finally, factor in the multiplier
to get the IS Curve.
IS Curve Properties:
 Downward sloping
• Low r  ↑Investment  ↑ Output
 IS curve slope
• Changes with multiplier, k and hence and .
• Changes with .
 Shifts in the IS Curve:

• When autonomous consumption , autonomous investment , or
government spending change.
• When the multiplier changes.
Modelling: Forward-Looking Behaviour
Forward- Looking Behaviour:

 Spending decisions today are influenced by expectations of the
future:
• Households adjust current spending based on expected future
income; Consumption Smoothing.
• Firms make investment decisions based on expected future profits.
 Present value calculation:

• Firm Profits:
• Household Lifetime Wealth:
Resources PV of expected lifetime

available at t labour income, post-tax
Modelling: Forward-Looking Behaviour
Forward- Looking Consumption:

 People desire to smooth consumption
• Diminishing marginal utility of consumption
• Requires taking into account the future, and the ability to
save and borrow.
 Permanent Income Hypothesis (PIH)

• Individuals optimally choose consumption by allocating
resources (assets & PV of income) across their lifetimes.
• Consumption is forward looking, as opposed to the
Keynesian consumption function:
(ie. depends on r, , expected future income and taxes.)
• PIH predicts that optimal C is smoother than income.
(eg. consumers save when earning income and draw on
savings when retired)
Modelling: Permanent Income Hypothesis
Consumption Smoothing Behaviour:
Permanent Income Hypothesis:

 The household chooses a path of consumption to maximize
its lifetime utility:
 subject to a lifetime budget constraint:
 Optimization, and assuming gives us a PIH consumption

function:
* The consumer consumes a constant fraction of their expected lifetime

wealth (), i.e. they borrow/ save to maintain this level of for all . *
Permanent Income Hypothesis:

 Predictions of the PIH:
1. Anticipated changes in income should have no effect on consumption
when they occur
2. Unanticipated changes should affect consumption as permanent
income () needs to be recalculated
 ‘Excess sensitivity’: changes with anticipated changes in income.

 ‘Excess smoothness’: changes too little with a change in .
 Why PIH might fail:

1. Credit constraints: Inability to smooth consumption by borrowing
2. Impatience: Reluctance to save for consumption smoothing
3. Uncertainty about future income: Leads to precautionary savings
above the level predicted by the PIH.
1) Credit Constraints: ‘Excess sensitivity’
PIH households can

increase C by borrowing,
as soon as the news
arrives.
Credit-constrained
households cannot do so,
and can only increase C
when actual income rises.
2) Impatience: ‘Excess Smoothness’
PIH households start

saving as soon as the
news arrives, allowing for
smooth consumption
when income falls.
Impatient households do
not do so, so consumption
falls when income falls.
Modelling: Forward-Looking Investment
Forward- Looking Investment:

Tobin’s q Theory of Investment:
(marginal model)
• (MB=MC): Investment is optimal
• (MB>MC): Firms should increase investment
• (MB<MC): Firms should disinvest
 is higher if:
i. Output price () is higher
ii. Marginal product of capital () is higher
iii. Interest rate () is lower
iv. Depreciation rate () is lower
Modelling: Forward-Looking Investment
Tobin’s q:
 Marginal q is difficult to measure ( is usually unknown).
 Therefore, the ‘average Q’ model is used to operationalize this

theory, where:
 Stock market value is forward-looking and indicates how well

the firm is able to implement the investment.
 If Q>1 (market value > replacement cost of firm), then the firm
should invest and vice versa.
 In reality, credit constraints and uncertainty also help explain

firm investment behaviour, not just Tobin’s q, Q.
Modelling: Chapter 1: The Demand Side
Consumption, Investment and the IS Curve:

 Consumption and investment behaviour affects the multiplier
and the IS curve.
 Factors affecting the Multiplier =

• Temporary income shocks: Multiplier ≈ 1 (MPC = )
• Permanent income shocks: Multiplier > 1 (MPC =1)
• Credit constraints & Impatience: Multiplier > 1
(Changing the multiplier shifts and changes the slope of the IS)
 Other factors affecting the slope of the IS:

Interest sensitivity of consumption and investment.
 Other factors shifting the IS:

Consumption: PIH predicts that changes in expected
lifetime wealth () shifts the IS. Empirical findings:
i. Role of Uncertainty: ↑ unemployment → ↑ precautionary

savings → IS shifts leftwards
ii. Housing Price Boom: If home equity loans obtainable →
↓ Credit constraints → IS shifts rightwards;
If home equity loans unobtainable → ↑ down-payments for
mortgages → IS shifts leftwards
iii. Financial innovation or deregulation → ↑ household access
to credit → IS shifts rightwards
 Other factors shifting the IS:

Investment: Tobin’s q predicts that the following factors will
shift the IS curve rightwards:
i. Increase in prices ()
ii. Increase in the marginal productivity of capital ()
iii. Reduction in the depreciation rate ()
The average Q equation highlights the role of expected future

profits as a shift factor for the IS curve:
“ ↑ Stock market value→ ↑ Firm value relative to replacement

cost → ↑ Fixed Investment → IS shifts rightwards ”
Summary: Chapter 1: The Demand Side
 The IS curve shows the combinations and under GME.

 A temporary rise in income affects spending based on the
type of model used:
Keynesian consumption function: spend a fixed proportion of the
rise in income this period
PIH: small increase in consumption for this and all future periods
 The multiplier determines how much increases from a rise in

autonomous demand:
Keynesian consumption function: multiplier always > 1
PIH: multiplier greater than one if shock is permanent, close to one
if temporary (unless there are credit constraints etc.)
 Effect of on Investment:
Tobin’s q: ↑ → ↑ MC → ↓ I (extent of fall depends on how fast
rises as the initial disinvestment is made)

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Carlin

© Wendy Carlin and David Soskice, 2015. All rights reserved.

By the end of this chapter, students should understand the

 What forms the demand side of the closed economy

 The Demand side captures the spending decisions of:

Aggregate Demand (AD):

 Why study this?

Demand side facts: Components of AD over time

 The Demand side captures the spending decisions of:

Aggregate Demand (AD):

 Why study this?

Business Cycle facts: Growth & Fluctuations

Business Cycle facts: Volatility and Policy

Did better policy-

 How do we model the demand side?

 The IS Curve shows combinations of the Real interest

 Goods Market Equilibrium:

 Recall closed economy AD:

Goods Market Equilibrium & the Multiplier:

 First assume a Keynesian consumption function:

where : autonomous consumption, not affected by income

 Here, AD is given by:

 Goods market equilibrium is given by the 45°

The Multiplier effect:

 The Multiplier determines the change in output due to a change

 The multiplier is greater than 1 since and .

 Should savings be encouraged or discouraged in a recession?

 A rise in savings is modelled by a fall in to .

Deriving the IS Curve (Mathematical):

 The larger the multiplier (k), or the larger the interest-sensitivity

Deriving the IS Curve (Graphical):

In the r-y space, plot the

Then add in and .

 Shifts in the IS Curve:

Forward- Looking Behaviour:

 Present value calculation:

• Household Lifetime Wealth:

Resources PV of expected lifetime

Forward- Looking Consumption:

 Permanent Income Hypothesis (PIH)

Consumption Smoothing Behaviour:

Permanent Income Hypothesis:

 subject to a lifetime budget constraint:

 Optimization, and assuming gives us a PIH consumption

* The consumer consumes a constant fraction of their expected lifetime

Permanent Income Hypothesis:

 ‘Excess sensitivity’: changes with anticipated changes in income.

 Why PIH might fail:

1) Credit Constraints: ‘Excess sensitivity’

PIH households can

2) Impatience: ‘Excess Smoothness’

PIH households start

Forward- Looking Investment:

 Therefore, the ‘average Q’ model is used to operationalize this

 Stock market value is forward-looking and indicates how well

 In reality, credit constraints and uncertainty also help explain

Consumption, Investment and the IS Curve:

 Factors affecting the Multiplier =

 Other factors affecting the slope of the IS:

 Other factors shifting the IS:

i. Role of Uncertainty: ↑ unemployment → ↑ precautionary

 Other factors shifting the IS:

The average Q equation highlights the role of expected future