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Y = F (K, L),
where K is aggregate capital stock and L is aggregate labor supply.
F
(K, L) = F (K, L + 1) F (K, L)
L
MP K =
F
(K, L) = F (K + 1, L) F (K, L)
K
and
F (K, L) = K L1 ,
where
0 < < 1.
For given supply of labor L = L and given supply of capital K = K, we
thus obtain the aggregate supply of goods and services:
Y = F (K, L).
Here we take the production technology to be invariant; however, we shall
remove this assumption when we analyze economic growth.
F
(K, L) = w/p = real wage.
L
F
(K, L) = r/p = real rental price of capital.
K
3.1
Consumption
Disposable income:
Y T.
C = C(Y T ),
C
= c1 .
(Y T )
3.2
Investment
because the firm could instead decide to invest its funds in bank
deposits at interest rate r
the higher r, the smaller the number of investments projects that are
more attractive than investing in bank deposits
Nominal interest rate: the rate that investors pay to borrow money
Real interest rate: nominal interest rate corrected for the eects of inflation.
4
Investment function:
I = I(r),
3.3
Government purchases
G = G;
T = T.
Balanced budget if and only if:
G = T.
Budget deficit if
G > T;
Budget surplus if
G < T.
Market equilibrium
The condition for equilibrium on the market for goods and services is
simply:
Y = C + I + G,
(1)
where
1. the left-hand side of (1) is the aggregate supply of goods and services
determined by the production function, that is by:
Y = F (K, L);
2. consumption demand is determined by:
C = c0 + c1 (Y T );
3. investment demand is determined by:
I = I(r);
4. and G is the amount of government purchases, which we fix at G.
1
[c0 + I(r) + G c1 T ],
1 c1
where:
1. the term in brackets represents the demand for goods if output were
equal to zero; this term is called autonomous spending, to capture
the idea that it is the component of demand that does not depend
on the level of output;
1
2. the factor 1c
, which is a number greater than one, is called the
1
multiplier; it captures the fact that in the short run, that is for
fixed price, an increase in autonomous spending, e.g from increases
in government spending or from tax reductions, induces an increase
in output which is bigger than the increase in autonomous spending. The idea is that the increase in autonomous demand leads to an
increase in production and income, which in turn increases consumption demand and therefore income... but remember that here we are
primarily interested by the long run where prices are flexible and
therefore income supply is ultimately determined by factor supply,
fixed at
Y = F (K, L).
(2)
The left-hand side of (2) is the output that remains after the demands of
consumers and government have been satisfied; it is called national savings
or simply savings. This equation is thus of the form:
Savings = Investment,
or the IS relation.
Going one step further, let us rewrite (2) as:
(Y T C) + (T G) = I,
where the first term on the left-hand side is disposable income minus
consumption, which is private savings, and the second term on the left
hand side is government revenue minus government spending, which is
public savings. The equation thus says that the flows into the financial
markets (private and public savings) is equal to the flow out of the financial
markets (investment).
6
Equilibrium interest rate when capital stock and labor supply are fixed:
then we have
Y = Y = F (K, L),
and, from (2):
Y c0 c1 (Y T ) G = S = I(r)
= Figure 3-8.
Comparative statics:
1. An increase in government purchases G shifts the Savings line to
the left (it reduces total savings) which in turn reduces the supply
of funds, and thus pushes the interest rate upward so as to reduce
investment demand accordingly. Thus the increase in government
purchase causes the interest rate to rise and private investment demand to decrease. We say that government purchases crowd out
investment demand. See Figure 3-9
2. A reduction in taxes raises disposable income and therefore consumption demand, namely by the reduction in taxes times the marginal
propensity to consume c1 . Again, this leads to a lower level of total
savings, which therefore must be met by lower investment demand
and therefore by a higher interest rate.
3. An increase in investment demand (for example because of a new
technological innovation or because government encourages investment through tax credits), shifts the investment curve upward, and
therefore simply raises the equilibrium interest rate.
= Figure 3-11
4. A simple variant of this latter case, is to assume that savings also depends on the interest rate (a higher interest rate encourages savings);
then an increase in investment demand raises both, the interest rate
and the equilibrium investment.
= Figure 3-12.
Short-run equilibrium: in the short run prices are rigid and therefore output Y is not determined by factor supply but instead by aggregate demand.
In this case, equilibrium on the goods market is expressed by the equation:
S(Y ) = I(r),
where
S(Y ) = Y co c1 Y G.
Equation (2) is referred to as the IS curve.
(3)