National Accounts, Income-Expenditure, Financial Markets, and IS-LM Model
National Accounts
GN = C + I + G + XQ, Y = C + S + T = C + I + G + XQ, (S-I) = (G-T) + (XQ), Yd = Y-T = C + S
Income-Expenditure Model (The Multiplier)
C = Co + C1(Yd), S = -Co + (1-C1)(Yd); On balance… Y = (1/(1-C1))(Co – C1*T + I + G)
Z = Co + C1(Yd) + I + G, C1 proportional to 1/(1-C1) consumption, 1-C1 proportional to savings
In equilibrium Z = Y, if Z > Y excess demand increases and, x is first consumed. Accumulated surplus stocks last, and consumption decreases.
1. Declining investment: Since it is the most volatile component, a decline in investment directly causes a drop in demand of equal magnitude and generates a multiplier process. Consumer income will drop by shrinking the balance. The fall in private saving must equal the decline in investment.
2. Tax reduction (increase current transfers): There is a direct effect on production by consumption, increasing the Yd and with increasing effect induced by the consumption. Income rises, consumption and savings, the (G-T) and (S-I), which finances the first.
3. Increased GP and T in the same amount: This is a balanced budget increase. The increase in GP affects production and income, then the multiplier effect on consumption will dominate the expansionary effect on income of GP increased over the contractionary effect of taxes. As a result, income rises, the government deficit remains constant, and private surplus has remained constant, consumption and savings are constant, and Yd is unchanged.
4. Increased household savings: The economy is in equilibrium initially. Increasing the propensity to save at the equivalent income level of consumption will decrease and businesses adjust their production. There will be a contraction of income, which will drop private saving nor total saving. Private or total savings have been altered and coincide with the final equilibrium shown. Individuals save a higher fraction of income, but the decrease is the final result, not changed from the initial.
Financial Markets’ Adjustment via Prices
Income: payment received for inputs in forms of labor income, business profits, interest; flow is variable.
Saving: share of income after that is not consumed (taxes); variable flow.
Wealth: Net asset value, stock or fund; variable stock.
Money used in financial asset purchases; variable stock.
Bd = (W / P) – Ld [Ld: demand for money, Bd: demand for bonds, W: wealth]
M (money supply) = Cash + Deposits; D.vista = E + M1, M2 = M1 + D.savings, M3 = M2 + D.term; Liquid assets in public = M3 + treasury bills, and (currency/deposit ratio) = E / D; (reserve/deposit ratio) = R / D
H (monetary base) = E + R; Monetary Multiplier = (1 + e / e + ?), M / P = MM * (H / P)
Relationship between ?, e, and MM: ? increases ? decreases MM; ?e increases ? decreases MM
1. Increase money supply: By increasing the money supply, and income levels do not vary, money demand will remain constant, and there will be excess supply. The public will get rid of excess money balances by buying bonds. There will be demand for bonds, increasing their price and reducing interest rates (i), removing the excess demand for bonds and money supply.
2. Increase of income: They increase the demand for money on account of transactions. There will be excess supply of bonds, raising their yield.
3. Central bank policies: a) OMA, which consists of the purchase and sale of bonds that increase/decrease the money supply. The purchase of bonds reduces interest rates, and selling increases them.
b) The central bank can also alter the reserve ratio; raising it shrinks the money supply and increases the interest rate.
IS-LM Model
IS: Changes in interest rate shift the demand function for goods and services (IS) and determine the income levels above the 45-degree line. Variations in the level of income or interest rate movements are along the IS curve. Any parameter variations in the goods market curve shift the IS curve, because the interest rate is given for all points.
LM: Variations in income shift the money demand function and determine different equilibrium interest rates (i) on the LM curve. Changes in income or i are movements along the LM curve. Changes in any money market parameter shift the money demand function and determine a new i, and the curve has to be moved.
All points of the IS curve are in equilibrium in the goods market. The points of M/P are in financial market equilibrium. The economy always lies on an LM curve, which is why i will adjust instantly.
Case 1. Effects on the IS-LM by increasing public spending: Increasing government spending increases aggregate demand directly, and there is excess demand in the goods market. As production increases, the demand for money grows for transaction reasons, and there is excess demand in this market, and the interest rate increases, which reduces investment and demand, mitigating the initial expansion. As a result, income and the interest rate increase, as do consumption and savings; the investment is indeterminate. The growing public deficit is due to increasing constant G and T, and the private surplus has grown.
Case 2. Effects of a tax cut: Cutting taxes increases disposable income (Yd), increasing market demand for goods, and incomes grow. Increased production increases the demand for money and the interest rate. As a result, income and the interest rate have increased, and consumption and savings have risen. Investment is indeterminate. The public deficit increases, as does the private surplus.
Case 3. Effects of a bond sale: Selling bonds increases supply and lowers their price, which increases the bond yield. The increase of i reduces investment and generates unwanted inventories, which decreases the level of production and income, as well as consumption. By reducing transactions in the goods market, the market demand for money is reduced, and the interest rate decreases, which cushions the initial impact.