Demand Side In Long Run CLOSED ECONOMY

Question 1

What determines demand in the LONG RUN CLOSED ECONOMY?

Answer 1

Consumers -Decisions are forward looking as well as present. Seen in ‘life cycle model’ (reduce consumption overtime to save for retirement)

Firms - base capital investment on present value of current/future expected profits. (Investment can determine prices or quality affecting demand for G&S)

Governments - decisions on tax/expenditure impacting G&S demand.

Question 2

Consumption formula

Answer 2

C=b(Y-t)
b= MPC
Y=income
T=taxes paid

If we write T=ty then C=b(1-t)Y
(t is average rate of tax)

Question 3

Nominal and real interest rates

Answer 3

Nominal (i) expresses return on investment

Real (r) expresses return we get in terms of goods we can buy (real accounts for inflation)

Question 4

Real interest rate formula

Answer 4

1+r = (1+i)Pt / Pt+1

Pt is the price of the good.

Works out to be…
Ln(1+r)=ln(1+i)-ln(1+π)

Question 5

What if we assume r i and π are small numbers

Answer 5

R= i - π

Question 6

When do firms invest

Answer 6

when opp cost < real return of project

Question 7

Government expenditure - what is not included

Answer 7

transfer payments (benefits etc) , as used to make C

Question 8

How are deficits funded? (2)

Answer 8

Borrowing through bonds or money creation

Question 9

What do we assume in the supply function in the long run

Answer 9

Labour L and capital K are fixed in the long run at N* and K, and so output Y is also fixed.

Y=F(N,K*)

Question 10

Aggregate demand function

Answer 10

Y=C+I+G

C= b(Y-t)
I = I(r)

So substitute those to make
Y= b(Y-T) + I(r) + G

Question 11

From this substituted equation we can rearrange to create a LFM graph.

We rearrange to make I(r) investment the subject.
This also gives us household and government saving, which part is which?

Answer 11

I(r)= (1-b)(Y-T)+T-G

(1-b)(Y-T) is household saving

T-G government saving

Together = national saving

Question 12

Learn the LFM model

Answer 12

Y axis is R (interest rate)
X axis is investment/saving

Saving is constant.
Desired investment is downward sloping as when R is low, invest more

Question 13

So using the LFM, when national saving=capital investment what do we have?

Answer 13

We find the real interest rate, which delivers the correct amount of investment demand.

Question 14

What would be the effect of an increase in government purchases (G)

(A form of expansionary fiscal policy)

(READ ALL!!!)

Answer 14

G would increase. However, we have said that output is fixed at Y* (since we said NK is fixed in LR).

This means the increase must be met by an equal fall It can’t be C(Y-T unchanged). So it will be met by a fall in investment. How?

G spending causes crowding out, (fall in national saving) pushing interest rate up and reduces investment!!

Question 15

How is this visualised?

Answer 15

LFM model.

As G increases, less saving. Fall in in saving pushes r up.

Question 16

So these (fall in taxes, increase in g) look at how fiscal policy impacts national saving.

We can now consider impacts on demand investment. What influences investment demand? (2)

Answer 16

Technological innovation leads to an increase in investment demand.

Incentives through tax breaks for innovation etc.

Question 17

What is the impact of an increase in investment demand? (2 possible outcomes)

Answer 17

If saving (S=Y-C-G) is independent of interest rate, an increase in demand will only increase the interest rate.

If saving is dependent on the interest rate, we get an upward sloping saving. And so an increase in investment demand will increase quantity of investment and the interest rate.

(We learnt these 2 possible outcomes dependent on our assumptions we make last year in principles)

Question 18

So what do we use to show the demand side in the long run, what graph do we use.

Answer 18

We use national income identity and rearrange to make I(r) subject to find national saving in the LFM model.