004: Macroeconomic Theory

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004: Macroeconomic Theory

Lecture 2

Mausumi Das

Lecture Notes, DSE

July 25, 2014

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Characterization of the Equilibrium under the Classical System:

Equilibrium price and quantity in the Goods Market -P andY - are determined simultaneously by the intersection of the AS and the AD schedule:

Das (Lecture Notes, DSE) Macro July 25, 2014 2 / 15

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E¤ectiveness of Government Policies under the Classical System:

We shall talk about two kinds of government policies:

Fiscal Policy - which usually changes the amount of government expenditure (G¯)

Monetary Policy - which usually changes the amount of money supply (M)¯

There could be other forms of government policies (…scal, monetary, or directly interventionist policies) - e.g. taxes; government

borrowing; governement directly in‡uencing the wage rate or price level in the goods/labour market or the interest rate in the money market - which we shall talk about later.

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E¤ectiveness of Government Policies under the Classical System (contd.):

The standard Fiscal and Monetary Policies (which a¤ect only the demand side of the economy) are completely ine¤ectivein raising the equilibrium output and employment under the classical system:

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Proportional Income Tax - A Possible Exception?

So far we had not introduced taxes in our model. Let us now introduce a proportional income tax (t).

This changes the disposable income -available to the household for consumption:

C^d =C(Y tY) =C(Y^d); 0<C⁰(Y^d)<1 Thus the demand equation in the Goods Market now becomes:

Y =C(Y^d) +I(r) +G^¯;0<C⁰(Y^d)<1;I⁰(r)<0

The correspoding IS curve (representing the demand condition in the Goods Market in the Y-r plane) still looks the similar.

But a change in a tax rate will now shift the IS curve, but not the LM curve. Thus the AD schedule gets a¤ected too.

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Proportional Income Tax - A Possible Exception? (Contd.)

Suppose tax rate decreasesfromt tot⁰:

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Proportional Income Tax - A Possible Exception? (Contd.)

But this is not the end of the story!!

If incomes are taxed then so would be wage income!So the e¤ective wage rate - relevent for the households (and only for the households) is now (1 t)W - not W!

In other words, the supply equation in the labour market now becomes:

W = ^P

(1 t)^g(N); g⁰(N)>0

But the demand equation in the labour market remains unchanged (Why?).

Thus a change in a tax rate will now shift the labour supply schedule (in theW-N plane), but not the labour demand schedule. Hence the AS schedule gets a¤ected too!

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Proportional Income Tax - A Possible Exception? (Contd.)

Suppose tax rate decreasesfromt tot⁰:

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Proportional Income Tax - A Possible Exception? (Contd.)

Thus a proportinal income tax - in particular a tax cut - is e¤ective in raising the equilibrium output and employment under the classical system: (Why ‘proportional’? Why not lump sum?)

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The Classical System - A Comparative Statics

What happens if the stock of capital changes (increases) fromK¯ to K¯⁰?

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The Keynesian System (in equations)

The Goods Market:

Supply Equation:

Y =F(N,K¯);F_N_,F_K >0;F_NN,F_KK <0 (1) Demand Equation:

Y =C(Y) +I(r) +G;^¯ 0<C⁰(Y)<1;I⁰(r)<0 (2) The Labour Market:

Supply Equation:

W =W^¯ (3)

Demand Equation:

W =PF_N(N,K¯) (4) The Money Market:

Supply Equation:

M =M^¯ (5)

Demand Equation:

M =PL(Y,r);L_Y >0;L_r <0 (6)

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The Keynesian Labour Market

The only equation that di¤ers between the two systems is the labour supply equation.

The Keyenesian Sytem assumes that labour supply is perfectly elastic at a given wage rate W¯ .

The Labour Market:

Supply Equation:

W =W^¯ (7)

Demand Equation:

W =PF_N(N,K¯) (8)

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Equilibrium in Keynesian Labour Market & the

corresponding AS Schedule:

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Equilibrium in Keynesian Labour Market & the corresponding AS Schedule:

So the AS schedule is upward slopingunder the Keynesian system.

Question: What does this tell you about the e¤ectiveness of the standard monetary and …scal policies?

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Keynesian System: A Comparative Statics

What happens whenW¯ goes up?