Okay, let's uh let's start. Um
So, what you have there in that picture
is uh is the result of a survey to a
bunch of economists
on which are asked to assess the
probability that there is a recession
within the next 12 months.
Recession means essentially a decline in
aggregate output.
Um and well, the first thing to notice
here is that you know, it's not very
good news. There is a very high chances
at at least according to
this expert that that the US enters a
recession within the next 12 months or
so. Pretty high probability.
You can see that that number typically
is very very low and it goes very high
sort of real next to recessions.
And now we're not in a recession, but
but there is a sort of very high per se
probability that we may
go into recession in the near future.
So, how is that these people come up
with this forecast? Well,
at some level, either explicitly or
implicitly, they must have some model
uh
that of the determination of equilibrium
output. I mean, you know, they need to
understand
they need to see certain things that
suggest
when you go through a model that output
will decline.
Um so, that's what we're going to start
doing today. And
and in fact, that's what we're going to
do
throughout this course. It's we're going
to try to find ever more complex perhaps
or or richer models of
uh output determination, aggregate
output determination. So, that's
essentially what this course is about.
Uh
and so, and understanding sort of we're
going to try to understand what is it
that drives that equilibrium output and
how is it that we get to one specific
level of output.
That's what it means to find the
equilibrium level of output.
Um and we're going to do it sort of in
three stages.
In the first part of the course, that is
up to quiz one,
uh we're going to focus on on on the
very short run. How output is determined
in the very short run, say within a year
or so.
Uh
uh
well, a little more even, but but that
type of frame time frame.
Then we're going to focus on the medium
run. That's sort of is
at the beginning of
of of the second part of the course.
Uh
and by the medium run, simply we're
going to mean by the time in which
prices begin to adjust sufficiently.
Okay? Before that, is most of the action
happens in in quantities. There is
little movement in goods prices. There's
lots of movement in asset prices, but
little movement in goods prices.
And in the last part of the course,
we're going to look at how output is
determined over the long run, which is
quite different from how output is
determined in the short run.
The determination of output in the short
run is what we mostly mean by business
cycle analysis. Okay? And short or
medium run, the way we're going to
define it here, is what we mean by
business cycle. The country's in a
recession, it's in a boom, it's an
expansion. Those are all terminologies
of the short run
or short or medium run.
The determination of equilibrium output
in the long run is when we think about
growth. When we talk about why is it
China grows faster than the US today?
Well, that's a that's a question not
about the business cycle. It's a
question about the long-run determinants
of output growth. Okay? And and they're
even different class of models.
In more advanced models, if you were
doing a PhD, those things are a lot
closer to each other and and and but but
in this course, they're going to be very
different type of models. It's easier to
analyze these things with different type
of models than trying to integrate all
in one big machine. Okay? But let's
start with the the simple part. In the
short run,
the key mechanism, something that will
will keep showing up uh in all the
models and sub models we analyze
uh
in the first eight lectures or so or
seven lectures of the next seven
lectures or so, is this mechanism. In
the very short run,
output, that is equilibrium output, the
thing that these economists are
forecasting that will decline in the
next 12 within the next 12 months,
is determined primarily
by act what we call demand.
Okay?
So, demand will determine output. That's
the change in demand that will change
production.
But when production changes, that will
also change income. That you know from
national accounts. Remember we said that
we could measure output from the
production side, but we also could
measure the income side. And they're
exactly the same. More production,
somebody has to receive the proceeds of
that. Workers and owners, capital
owners, the government, whatever.
But so, changes in in So, the second
step we're going to make is those
changes in production that were brought
about by the changes in demand will lead
to a change in income.
But when income changes, that will
change demand again.
And so on and so forth. Okay? So, that's
essentially that's quintessential
short-run macro. It's to to try to
understand this
aggregate demand, because that's the
main driver, and then how it gets
multiplied
uh in the short run. Okay? And
in this lecture, we're going to talk
about just about that.
You know, primarily about that. Okay?
But that's that's when So, when I mean
short-run macro, that's the structure I
have in mind and that's the structure
most people have in mind. Something
where aggregate demand will determine
that. That's the reason why in the short
run you worry a lot about whether
consumer confidence is high or low.
That's demand. If consumers are very
depressed, they tend to reduce demand.
If consumers are very bullish, that will
tend to increase
demand. And since in the short run
output is determined by demand, the
business cycle, whether we have got a
recession or not, depends on about how
demand feels. So, if somebody's
forecasting a recession within the next
12 months, he's forecasting really that
demand will decline within the next 12
months. Okay?
Why they're forecasting that, that's
something we're going to learn in the
steps
uh as we go through the course. What
what are the kind of things that they
may be thinking about? What are the
drugs on aggregate demand that are
likely to depress demand?
Uh and so on and so forth. But that
we'll we'll get there. Okay?
Anyways, first let me tell you about the
components of aggregate demand.
Uh
the first and one of the and the largest
component of aggregate demand is
consumption. Okay? And when I mean
aggregate demand, okay,
I'll be
I'll pause for a for a slide. Let me let
me go over the definition. Consumption,
we're going to denote by C,
is the goods and services purchased by
consumers. Okay? Households and so on.
Investment, which we're going to denote
by I,
is the sum of non-residential and
residential investment. So, equipment
and establish and and and you know,
factories
on one side, and then residential
investment is houses.
Stuff like that, apartment buildings and
so on.
Which is also these are goods and
services as well. They're just capital
goods and so on, but they're also goods
and services.
Government spending, that's what we're
going to denote by G, are purchases of
goods and services by the federal,
state, and local government. Okay?
Excluding, and that's important,
government transfers.
What is a government transfer? Many of
you may have received that during COVID.
You know, the government sent you a
check, for example. Okay?
Well, that check that is not part of
government expenditure. That check is
like a
it's a negative tax and it's going to
enter somewhere else.
When we mean government
expenditure is is things the government
purchases, services the government
acquires and so on. Okay?
Um
then exports, X, which will play no role
until seven lectures or eight lectures
from now, or actually 10 lectures from
now probably,
is purchases of US goods and services,
that is goods produced by US factories,
uh
by foreigners. Okay?
I am is the other side of the story.
Imports is the purchase of foreign goods
and services by US consumers, US firms,
US government. Okay? So, when you buy
something that is produced in Germany,
well, that's an import. When the Germans
buy something that is produced in the
US, that's an export. Okay?
And then the last component is something
we're going to going to pay any
attention whatsoever in this course,
which is inventory investment. Inventory
investment is certainly
it's almost accidental. There is some
planning on it, but but there is a lot
of it's just from the difference between
sales and production. And over the very
short run, there's lots of difference. I
mean, you're not
producing unless you're in a bakery, you
know, you're not producing and selling
immediately. There is there is certain
certain lags.
That's a small thing. It it's volatile,
but it's a small thing, so we're going
to ignore it
for this this course. We're going to
assume actually, unless we explicitly
say the contrary, and that could show up
in a piece that it would never show in a
quiz,
because it's not that important, we're
going to assume that this inventory
investment is equal to zero.
Also, for this part of the course, until
further notice, we're going to assume
that exports and imports are equal to
zero as well.
That's not realistic, but it's easier to
analyze what we call a closed economy.
Okay? An economy that is not interacting
with the rest of the world. In the in
again, 10 lectures from now, we're going
to open the economy to the rest of the
world, and then we're going to have to
talk about
things like import, export, exchange
rates, things of that kind. But for now,
let's keep it simple. Okay?
So, now you So, you get a sense this is
for 2018, but I I mean the the totals
change, but the composition doesn't
change very much
of GDP.
Okay.
Of of GDP
output
aggregate demand they're all the same
in equilibrium, but we'll get there.
GDP you see that consumption accounts
for a big chunk close to 70% of
aggregate demand. That's the reason
people worry so much about consumer
sentiment and so on. The
University of Michigan
has many claims to fame, but one of them
is they produce this index of consumer
sentiment, and everyone is watching that
thing. Anyone that worries about macro
or finance is watching that thing
because it tells you a lot about one of
the main drivers of output equilibrium
output. Then you see investment is
substantially smaller, but it's large in
particular non-residential investment.
Government expenditure is a big
component of aggregate demand. And then
I'm not going to worry too much about
for a country like the US the open
openness part is is relatively small.
If you go to uh you know
small a small economy typically will
have sort of very large exports relative
to GDP and so on. But that's not the
case of the US.
And there you see why we're going to set
in inventory investment to zero. It's a
small thing. It it moves a lot more than
than its size, so it can account for for
fluctuations in in
sort of the monthly level of GDP, but
it's not that important
in a slightly longer periods of time.
Okay. So, that's more or less the story.
So, now this is the this is the model.
Please stop me say if you Is there
anything here you don't understand
because any everything that we'll build
from here to
quiz one
will build on understanding this what
I'm about to say. Very simple, but if
you miss a step here everything is going
to be confusing in the next few
lectures. So,
and you're not supposed to understand it
in the first run. So, so it's okay that
you ask me. But let's make sure that you
understand what's going on here.
Okay. So, that's aggregate demand. First
definitions. We're going to denote
aggregate demand by this Z, okay? Letter
Z.
And aggregate demand is going to be When
we say aggregate demand, remember what
what what is the exercise we're trying
to do. Ultimately, what we want to
determine is the output the production
of the US economy, say.
So, when we mean when we talk about
aggregate demand, we're trying to
determine the demand for domestically
produced goods for goods produced in the
US.
That's what we're trying to pin down.
And so,
that's the reason aggregate demand looks
like that. It's well, consumers.
Consumers are going to demand goods.
Investment
G plus exports. If foreign demand US
goods, that's also increases US
production.
Minus imports because imports is
uh goods and services that consumers,
firms, and governments sort of buy from
foreigners, but they're not produced by
by US companies. So, they are not affect
the determination of equilibrium output
in the US. Okay? That's the reason you
subtract it. Now, that distinction is
not going to matter
uh until 10 lectures from now because
we're going to set X and IM equal to
zero from the point of view of modeling.
So, all demand is demand for
domestically produced goods in this part
of the course. Okay? So, aggregate
demand for us will be this C plus I plus
G. So, we need to understand what
determines C plus I plus G.
And at least initially, we're going to
keep it very very simple. We're not
going to think too much about what
determines investment. In fact, we're
going to assume it's a constant is
given. So, it's determined somewhere
else not in the model I'm about to
solve.
Government expenditure
the same. I'm going to assume you know,
it's determined by some other
priorities, you know, green agendas and
stuff like that. It has very little to
do with with with what we're doing here.
And then taxes is something that doesn't
show up there, but it will show up very
shortly. We're also going to assume that
they're being determined somewhere else.
In pieces and later on in the course
we're going to endogenize all that, but
not now. Let's assume I'm trying to come
up with a the simplest possible model of
aggregate demand.
And I'm making two of these terms
trivial just constants. Okay? And I'm
going to focus all my effort here in
this component here, which I already
told you is the most important component
of aggregate demand, which is
consumption. Okay?
So, we're going to assume here we're
going to have a function. Something has
to move so for the model to be
interesting. So, this this this we're
going to assume that consumption
is an increasing function of disposable
income. I'm about to define what
disposable income is, but you can
imagine what it is. It's something you
can use to consume and so on. So, very
naturally, if you have a higher
disposable income, you're going to
consume more. That's what this says.
Okay?
In reality, that consumption function is
a lot more complex. There are lots of
things that enter there that that we're
not modeling for now. But let's
start from the basics. Okay? So, that's
going to be the only behavioral
assumption we're going to make for a
while.
That that the consumers consume more
when they have more disposable income.
Okay.
And I'm going to make it even simpler.
I'm going to assume that consumption is
a linear function of disposable income.
Okay? So, there's going to be some
constant C0, which captures lots of
things that we're not modeling here. For
example, the fact that for any given
level of disposable income,
if you know, if you if you
if you're richer, suppose you have some
shares and now the shares double in
value, you probably are going to consume
more as well.
Okay? There are lots of other things
that affect
consumption, which are different from
aside from your disposable income.
But we're not going to model that. So,
that's we're going to call it
autonomous. Autonomous in the sense that
we're not going to determine it here.
We're going to take it as a parameter
that comes from somewhere else. We may
do some experiments moving that variable
around, but it's not going to
be part of what we model.
C1 is a more interesting parameter for
this part of the course, and it's what
we call the marginal propensity to
consume
out of disposable income in this case.
That is C1 tells you the share if you
get an extra dollar of disposable
income, how much of that do you spend in
consumption? Okay? So, say you get an
extra dollar of income, if you spend
60 cents in in the things you normally
consume of that extra dollar, well, then
your C1 is .6. Okay? That's the marginal
propensity to consume.
And that's what gives us our increasing
function. You get an extra dollar,
you're going to do you're going to save
part, but some of it you're going to
spend. That part you're going to spend
is the C1 that we have there. Okay?
Good.
Uh
And I
Now, let me tell you what how we define
disposable income. Disposable income is
just equal to income, which is equal to
production, you
minus taxes. That's disposable income.
Okay? It's whatever you earn as a either
as a worker as a capital owner,
well, then the government takes its
something out of it. That's your
disposable income, and that's where you
have to decide how much to save and how
much to consume.
Okay?
That's
So, so that means that our consumption
function is
can be written that way
after all these assumptions I made, you
know, equal to this autonomous component
plus C1 the marginal propensity to
consume times
uh income output minus taxes.
Is it clear?
Yes?
So, all these are assumptions. Now,
they're not crazy assumptions in the
sense that you know, that we know that
that there is a relationship between
these two things. Again,
the consumption function in practice is
much richer than that.
And there is lots of randomness random
terms around and so on, but that's not
what we're about here.
But that's if you want to start with a
consumption function, this is a pretty
reasonable one to start with. Okay?
Okay. So, that's going to look in the
space of disposable income or income. I
could have put income there not
disposable income. So, it's going to
look like that.
Okay?
So, C0 is that autonomous consumption is
some something you're going to consume
regardless of your level of disposable
income. I mean, there is a minimum
consumption you have to have. You know,
say. And then
and then
the slope of that is is the marginal
propensity to consume, which is C1,
which is a number between zero and one.
Okay. So, let's let's determine
equilibrium output.
So, we have aggregate demand, which is C
plus I plus G. Okay?
There we are.
That's that was our definition of
aggregate demand.
Uh I'm going to stick in now the
functional forms. Well, these guys are
very boring. They're constants. And I'm
plugging in here the the consumption the
consumption function. Okay? So, what we
have here is that aggregate demand
is an increasing function of output or
income. Okay?
It's also a function of taxes,
investment, and so on, but but it's an
increasing function of output. And And
this is important because I'm Remember,
the the goal of this is to find
equilibrium output.
So, here I have on the right hand side
of my aggregate demand
output. That's good. I have one equation
in which output shows up.
Okay? Now, I cannot find equilibrium
output just from this equation. Why is
that?
So, I'm Remember, we're trying to build
a model
to find
equilibrium output.
That's our goal. That's what will tell
us whether we're in a recession or not.
Output is low, recession. Output is
high, we're in a boom.
Obviously, I cannot solve it from this.
I have two unknowns.
What are my two unknowns?
Two unknowns, one equation.
What is my second unknown there?
Aggregate demand, of course. We have to
determine Z and Y.
Okay?
So, how are we going to do that?
Well,
using a second equation, which is the
equilibrium condition. It's not a
function. This is a function. This is
not a function. This is an equilibrium
condition. It says, "In equilibrium, not
outside equilibrium. In equilibrium,
output is equal to aggregate demand."
Okay?
That's what this
equilibrium condition tells us. Off
equilibrium, this doesn't hold. That's
the reason this is not a function. This
holds everywhere. It's a function.
This is an equilibrium condition. It
says, "At equilibrium, aggregate demand
is equal to output."
So, now we're done because we have two
equations with two unknowns. Okay?
Good.
And the reason I post on this is that I
see that mistake made often.
Okay?
That this is interpreted as a function.
It's not. It's an equilibrium condition.
At equilibrium, it holds. And that you
can see, actually, I'm going to
illustrate the same point in in the
diagram. So, this is the
Let me Let me keep going. So, this is
clear, no? So, this is This is just a
summary of what we had in the previous
slides. It's
And this is the new thing here, which is
in equilibrium, output is equal to
aggregate demand.
And and and the and the
And again, that's what makes
this a really a short
short-run model. You see, I'm saying
output in the short run is whatever
demand wants it to be.
Which is different from from from
the long run that says, "No, no. Hold on
a second. I mean, but you
How much output you can produce is a
function of the capital you have, of the
workers you have." Yeah, yeah, that's
true in the long run. But in the short
run, you have lots of flexibility
because you have lots of unused capacity
and so on.
Okay? So, this is pretty It's a big
assumption, and there is schools of
thoughts within microeconomy that split
by this assumption, whether you believe
that that that in the short run, output
is aggregate demand determined or not.
At MIT, we tend to believe that in the
short run. The long run, no. But in the
short run, that's what it does.
Now, sometimes the long run gets to you
very quickly. And at this point, we're
in a situation like that. That's the
reason we're seeing inflation and so on,
but that's something you'll understand
later on.
Okay? But but but for now, so this is
this is important. We're going to We're
saying here
output I don't need another equation. I
could have done aggregate demand like
this, and then output a function of
capital, labor, lots of things.
I'm not going to even do that. I'm going
to say, "No, no. Output will be whatever
demand wants it to be." Okay?
And that means in equilibrium, they have
to be equal.
Good.
You had a question.
No, they are the same for us.
That's our definition. GDP for us is
output.
So, when I say aggregate output, I mean
GDP.
Remember? Real GDP. We're talking all
about real GDP. Okay?
Uh
And it's also equal to income. Not
disposable, but it's equal to income.
Remember when we did those little tables
where we look on our
the three different ways of doing it?
Well, the first two were output.
And the last one was income, and they
had to be the same.
Okay?
So, why is real GDP for us?
That's real GDP.
What happens in the table I show you,
I already used the fact that real GDP is
equal to aggregate demand, and that's
the reason I show you the different
components of Z.
I show you that, that, and that.
Okay? But in equilibrium, they're equal.
There's really a figure that that will
clarify, I think, a lot of that. But
let's Let me keep solving this. So,
we have that And so, what I'm going to
do next is just solve it. So, we have
this equilibrium condition. I'm going to
plug in my aggregate demand function
here,
and so I can solve out for equilibrium
output. And here we have the first for
the first time in this course, an
equation for equilibrium output.
There you are. That's your equilibrium
output in this economy.
Okay?
Now, this guy here
is very famous,
and is very macro.
Doesn't happen in micro. It happens in
macro only. Okay? This guy here.
Another guy there is called the
multiplier.
Okay?
And it's a very important macro concept.
A huge concept in macro.
Now, why do you think it's called a
multiplier?
Well, obviously, it multiplies
something, but a multiplier sounds like,
you know,
that multiplies that makes something
bigger, no?
So, what happens if C1 is
uh greater than zero?
Is What happens if C1 is greater than
zero? Remember, it's between zero and
one. But what happens if it's greater
than zero? What happened with that
number there, one over one minus C1?
It's greater than one. That's what this
is. It multiplies. Okay? So, that's the
reason we call it a multiplier. There's
not nothing deep there. Uh okay? So,
this thing here is sort of autonomous
stuff, you know? It's what the
government spends, what firms are
spending, capital.
This is autonomous consumption. Uh
And this Actually, this is a typo there.
There should be a C1 in front of that.
Typo.
It comes from there. C1 times
T.
So, fix that typo, please. I I'm going
to upload the slides again with with the
typo fixed. Okay?
I'm just It comes from here. C1 times T.
Okay, so that's what this does. It
multiplies. So, whatever it is that that
is happening here, whatever it is that
the government is spending or whatever,
this term multiplies it. And that's a
huge thing. Uh There was a big debate uh
almost always when you're trying to get
out of a recession and the governments
are spending, a big question is, "Well,
how big is the multiplier?" If the
multiplier is small, you're going to
have to spend a lot to get the economy
out of the recession. If the multiplier
is large,
then then uh
you you're going to have have to spend
very little, and then the multiplier
will take you away from from that
recession.
So, what is it that makes the multiplier
large or small?
Well, mechanically, when is it that
multiplier large?
When C1 is closer to one. So, when when
people are spending more of their income
on Exactly. When C1 is large.
And that that gives you the logic, and
that's very important in macro. It's
Why is it that a big multiplier? Well,
because think what happens in macro. If
the government spends,
that increases output.
But now, output increases income. And if
consumers spend a big share of their
extra income
in output and consumption again, then
that increases output again, which
increases income again, and
you keep going.
Okay?
So, that's the sequence. On the
contrary, if consumers are very scared,
they don't want to spend any extra
dollar they receive, anything of the
extra dollar they receive, then you
don't get any multiplier because this
initial increase in output that comes
from the government expansion, that does
lead to increase in income, but if
consumers don't spend it, it doesn't
recirculate into the economy, and then
you don't get a multiplier. Okay? So,
that's that's the reason we call it the
multiplier.
So, that diagram is is an important
diagram. I'm just
uh
doing this, actually. In that diagram,
I'm plotting the aggregate demand
function,
and then this equilibrium condition,
output equal to aggregate demand,
in the space
of
uh
aggregate demand and output, production,
and income here. But remember, income is
equal to production. Okay?
So, there's your aggregate demand,
and that's your 45 degree line because
this output equal to So, whatever is in
this axis is equal to that axis. That's
the 45 degree line.
Okay? That's your equilibrium condition.
It says, "At equilibrium, this guy here,
aggregate demand Z, will have to be
equal to Y." Those are That's straight
there.
This is aggregate demand.
Why is this line flatter than that?
Why is aggregate demand flatter than
Uh because people don't spend their
entire dollar on Exactly. Because C1 is
less than one.
So, the slope of the aggregate demand in
this space is C1.
It's the marginal propensity to consume.
How much more they demand if they get an
extra dollar? Well, And don't get They
don't demand one one extra unit they
demand C1 unit and C1 is less than one.
Okay, that's the reason this.
So, if C1 is very small,
this line is going to be very flat.
If C1 is very large, very high marginal
propensity to consume, this is going to
be very steep,
the red line.
The other one doesn't change, the 45°
line.
Okay? And what I said is that
at equilibrium So, you see if I take an
off-equilibrium level of output, say
this,
aggregate demand is different from
output.
It's only at equilibrium that these two
things will hold.
Okay?
This function I can plot it everywhere.
But this one will hold only at
equilibrium.
Okay?
That's when these two things are equal.
So, what I solve here,
here I just found this point.
Okay?
So, parameters here are C0,
uh
C1 * T, and G. They all shifters of this
aggregate demand up and down.
Okay?
And and that point here
is exactly that. And those all those
things are parameters in my aggregate
demand.
I really want you to internalize this
diagram.
Any questions about
Just stare at this little bit because
it's going to show up repeatedly.
And and later on it's not going to show
up, but whenever you get confused, the
way to get yourself out of that
confusion is going to be to go back to
the diagram.
You'll see. I'll remind you when when
when that's likely to happen.
Okay? So, so you better understand
this diagram. Play with it. Move
Here the only thing you can move around
is the ZZ, the the the aggregate demand
curve. Okay?
The other thing is our equilibrium
condition. You can't move that that 45°
line. But ZZ you can move it around. So,
let's do a a few exercises. Well, one,
the most obvious.
Suppose that C0 increases by 1 billion.
Okay? So, autonomous consumption, that
is that level of consumption which is
independent of income, goes up by 1
billion.
And that could be, you know, we're all
in a better mood. You know, okay,
disposable income is whatever it is
today, but you know, there's great
expectation that that in the that the
economy will enter a boom next year.
And so, then you feel richer and so on,
and you may decide to consume not wait
until next year, you may decide to
consume more today. That kind of thought
experiment can be captured by a C0 type
shift, go up. And that's when you I talk
about consumer sentiment. Well, consumer
sentiment is about a lot about C0. For
any given level of income, will
consumers are likely to to to consume
more than they would otherwise or or
less.
And that's what C0 captures.
So, let's go
everything in this model, there's no
dynamics
in this simple model, so we immediately
but we know is if just were to solve the
equation,
and I tell you what happens to if output
what happens to output if C0 goes up by
1 billion,
you know that output will rise by how
much?
Let's keep it simple.
I
just staring at that equation. If I tell
you autonomous consumption goes up by 1
billion,
what happens to equilibrium output? Goes
up by more or less than 1 billion?
Or or exactly 1 billion?
Exactly. And the multiplier is greater
than one. So, we know that the output
will increase by more than 1 billion.
Will increase by 1 billion times the
multiplier.
If C1 is .5, then it will increase by 2
billion dollars equilibrium output.
Now, I'm going to get you to from the 1
billion to the 2 billion in a steps
using the diagram. That's what I intend
to do next.
Okay? So,
this shift here, so we're starting from
this equilibrium output here.
This shift here,
boom,
is increasing C0. That's a 1 billion.
So, distance A to B is 1 billion. That's
it will be because what I did is for any
given level of output I shift this
aggregate demand up by 1 billion. That's
autonomous consumption up.
Okay?
Well,
because output is whatever demand wants,
that immediately increases output
by 1 billion. So, B, the distance
between B and C is also 1 billion.
Okay?
Demand increase by 1 billion, boom,
output immediately catches up.
So, output increases by 1 billion.
But if output increases by 1 billion,
what has happened to income?
It also increased by 1 billion. Income
is the same as output.
So,
income has increased by 1 billion.
Well, if income has increased by 1
billion and C1 is different from zero,
that means part of that extra billion is
going to be spent
in consumption, second round.
So, say C1 is .5, then now you get 500
million dollars more of expenditure.
But if it's of consumption, and if
there's 500 dollars that's that's a C
CD.
Shift, that's 500 million.
Obviously, this C1 here is is less than
.5 because otherwise
you know, this would be half of that,
but but it's not. Anyway,
you get 500 million more.
But if you if now there's 500 million
more of demand, since output does
whatever production does whatever demand
wants, then you get 500 more of
production.
And if you have 500 more million dollars
more of production, then you have 500
million more of income.
And if you have 500 more of income and
so your C1 is greater than zero,
say .5, you're going to spend 250
million more.
But 250 million more will generate 250
million dollars of production, which
also will generate 250 million dollars
more
of
income,
which will generate 125 million more
of consumption, and blah blah blah blah
blah. You you you get your Okay?
So, that's and that's what is happening
here.
Boom.
Yeah.
From C
to D. Okay. So, this is initial
shift in aggregate demand up, 1 billion.
That
lead to leads to
uh
1 billion more of production as well,
which means 1 billion more of income.
Okay? But now these consumers not only
have this C0 1 billion higher in C0, but
they also have 1
uh billion more of income.
And since they have 1 billion income and
they're going to spend part of it, C1
times that, and I assume C1 was .5,
that's what gives me CD.
That's the the extra five 500 million
dollars.
And then this that thing here there is
also 500 million dollars, and then there
was 250 million, 250 million, 125, 125,
62 and a half, blah blah blah.
That's that's the way you get there.
There's an alternative way of
finding equilibrium output, which is
entirely equivalent. And it's the way it
was initially done, by the way.
Uh and and and you'll see later on a
very important curve in this course will
be
the IS curve, which is a curve that
describes all the equilibrium in goods
markets. We'll get there.
But but the reason it's called IS is
because of this alternative way of
deriving the same I have derived,
which is
through you you can arrive to the same
equilibrium by saying, "Look,
equilibrium output is that output at
which investment is equal to saving."
That's the reason that curve is going to
be called IS, investment equal to
saving, S.
So, let me very quickly do it for you
and and then make a point and connect
the two things.
So, say private saving is, you know,
what con- sumers do and so on,
and firms, is just disposable income
minus consumption. That's your saving.
Okay?
So, it's equal to Y minus T, that's
disposable income, minus C.
Government saving is taxes minus
government expenditure. So, if the
government has a deficit, that thing is
negative. Governments often have
negative saving. Okay? If you have a
surplus, then taxes are greater than G,
then you have a fiscal surplus. Again,
rarely happens in the US
or in the Americas in general. Okay?
Happens a lot in Asia, but not doesn't
happen very much in this part of the
world.
But there we are. So, in equilibrium,
investment, I,
has to be equal to saving. So, that's
what you are going to use the saving
for, to invest. Okay?
So, investment is equal to the sum of
savings.
I can replace all that in here, and you
see that I get exactly the same
equilibrium condition I had before.
Output equal to aggregate demand.
Okay? So, this is an entirely equivalent
way
of deriving this, and I just want to
show you this
because it's the way it was originally
done, and and and and and you'll
understand better the terminology we use
later on
if you see that this is an equivalent
way. This is also a nice way of
illustrating something why macro can be
counterintuitive sometimes.
Microeconomics is very intuitive. I
mean, things make sense.
It's like physics, it makes sense. Macro
is can be confusing.
For example, there's the well-known
paradox of saving in the short run, not
in the long run. In the short run, you
have the paradox of saving.
So, you know, we all think that you save
more is a good thing. Our parents teach
us that it's a good thing to save more
and so on.
And in general,
that is true. You'll do better in life
if you save a little more and so on.
But it's not true for the macro in the
short run.
You know, it's not good for
macroeconomics in the short run
unless you are in a overheated economy.
Now, it could help.
But otherwise, it's not very good for
equilibrium output. Let me show you that
very quickly with the expression I just
showed you. Remember that I said
equilibrium output is pinned down by
investment equal to saving. And saving
of the private saving here is an
increasing is an increasing function of
output, okay? It is equal to actually 1
- c The function has a slope of 1 - c1.
C1 is the share of income that you spend
in consumption. Therefore, 1 - c1 is the
share of your income that you spend in
saving, okay? So, this function is
increasing with a slope of 1 - c1.
So, suppose I tell you now that all we
decided to to we learn the lessons of
our parents and say, "Okay, we should
all save more."
So, that means for any for any given
level of income, now we all decide to
save more. That means the the S function
shifts up.
For any given level of income,
we save more. But
we have a problem there because now we
have more saving than investment.
So, how how do we restore equilibrium?
That's not an equilibrium.
How do we restore equilibrium?
So, now we all decide to be more prudent
and save a little more.
At the level of the economy as a whole,
now we have more saving than investment.
That can happen. It can It's not an
equilibrium.
What restores equilibrium?
Well,
in this very simple model, our
investment is fixed. So, I nothing can
adjust on the investment side because
it's fixed. Later on, it's going to
move, but now it's fixed.
Nothing can adjust in the public saving
part because, you know, it can't move.
We assume that it's exogenous.
So, something has to happen endogenously
here that that reverses the increase in
savings. That's the only thing that can
happen. And the only thing that can
happen endogenously here is a declining
output.
Output declines, saving declines.
So, here you end up in a situation in
which we all decided to be sort of, you
know, better people, save a little more,
and we end up sinking the economy in a
recession.
Yeah,
output declines.
Okay, that's the reason it's called the
paradox of saving.
That's not going to happen to you
individually, but to an economy as a
whole, that's the reason I said it's
counterintuitive.
It it can happen.
I get
So, I
Look, if you don't like this way of
uh
and it's not the main way we're going to
use. If you don't like this way of
finding equilibrium output, just ignore
it. I I just wanted you to know it. Go
back to The thing you really need to
understand is not this, it's it's this,
that, that that you need to understand.
So, let me
illustrate the paradox of saving
in in the model we're using, in the one
I want you to really remember.
Well,
the paradox of saving, I can capture by
a declining c0.
Okay? For any given level of income, now
we decide to consume less. If we consume
less for any given level of income, that
means we're saving more.
Okay?
So, I can capture in this diagram
uh
the the fact that we all all become sort
of more prudent by a declining aggregate
demand.
But if aggregate demand declines, so
suppose we start at this equilibrium
level of output and then all of a sudden
we say, "Okay, enough is enough. We need
We need to start saving more."
Then,
what happens? Well, aggregate demand
declines.
I mean, for any given level of income,
if you're going to save more, that means
you're going to consume less. So,
aggregate demand declines.
But what happens when aggregate demand
declines?
Output declines.
What happens when out when output
declines?
Income declines.
What happens when income declines?
Well, part of that income you consume,
so you're going to consume less.
C1 times that. So, then and then you get
the multiplier working against you. So,
not only if now we all decide to save
more, not only output falls
by the same amount that that we increase
savings,
but actually it declines by more than
that because you get the multiplier
working against against you.
Okay?
That's the reason I'm a big role of
policy makers really in recession is to
try to maintain the calm, the you know,
because you can get into this kind of
things. If everybody gets scared and and
you know, we all get scared, so the
economy can implode just out of bad
sentiment. Uh
and so on.
Now, we're on the opposite side of the
cycle. We would want output to decline a
little because we are having other
problems, inflation and so on, again,
something we'll discuss later.
So, now you may want to scare consumers
a little. And in fact,
uh
the the governors of the Federal
Reserve, and the same is happening in
other places in the world, are doing
just that. I mean, when they go out
there, say the economy is too hot,
uh we're going to have to mess up this
economy a little. And then they're
telling us that.
And and and the first ones to listen to
these things are is the financial
markets. So, every time they come out
and make a speech of that kind, equity
markets decline.
Well, equity markets capture before the
mood that consumers will have in the
future. They capture it early. But
that's the message.
Okay? So, they're trying to At this
moment, really,
uh
policy makers, at least the the central
banks, are trying to do just that.
Depress a little bit consumers.
So so so we can
cool off the economy a bit.
Okay?
Any questions?
Again, very important lecture because
we're going to build on on this and and
later on this is going to be always in
the background.
And
of this until we actually go to the
third part of the course,
the key model will be this. This will be
in the background. More More things will
be happening on top,
but but whenever I ask you a question,
for example, later on, one example, what
else would produce a
this a situation like this?
What else would What What could have
What kind of policy
would generate
that
that movement? Well, at this point, we
haven't introduced monetary policy, so
you cannot talk about monetary policy.
But we do we do have
other kind of policy we could talk
about.
Remember?
Here.
Fiscal policy.
Okay?
Fiscal policy, G and T. Those are fiscal
parameters.
When when G goes down or T goes up, we
call that contractionary fiscal policy.
Why contractionary? Because it contracts
aggregate demand.
If If G goes down, clearly aggregate
demand goes down immediately. If T goes
up, well, disposable income for any
given level of income goes down, and
therefore consumption goes down. So, so
we call an increase a declining G or an
increasing T a contractionary fiscal
policy.
The opposite, if G goes up and T goes
down, we call that an expansionary
fiscal policy.
So, I take you back to this diagram
here,
and I ask you the question again.
What kind of fiscal policy will generate
this type of
this picture?
Contractionary or expansionary?
Contractionary. Contractionary. I mean,
good mnemonic, the output declined.
You know? So, contractionary So, that is
a declining a reduction in G, in
government expenditure,
or an increase in taxes
will shift that curve down, and then the
multiplier will make it even more
contractionary than the initial fiscal
impulse.
Very good.
I'll see you on Wednesday.