Type author
Carlin
& Soskice
names here
Topic
The Demand Side
© Wendy Carlin and David Soskice, 2015. All rights reserved.
Objectives:
Chapter 1: The Demand Side
By the end of this chapter, students should understand
the following:
 What forms the demand side of the closed economy
 The goods market equilibrium and the multiplier effect
 The IS curve and its properties
 Drivers of the components of demand
 Forward-looking consumption behaviour and the Permanent
Income Hypothesis.
 Forward-looking investment behaviour and Tobin’s q.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
 The Demand side captures the spending decisions of:
• Households: Domestic & Foreign (Open Economy)
• Firms
• The Government
• Spending decisions are complex:
– For the consumer they involve both a static component (what shall I
buy today given my current income and prices of goods and services?)
– An intertemporal one (how do I allocate my spending over time given
my expectations about how my income will evolve in the future?).
– Decisions making for firms and the government also involve an
intertemporal aspect.
• Firms make decision to purchase machinery and equipment based on business
plan that include forecast.
• Government must also forecast demographic trends when making plans for
building schools and hospital.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Overview:
Aggregate Demand (AD):
Chapter 1: The Demand Side
𝑦 𝐷 = 𝐶 + 𝐼 + 𝐺 + (𝑋 − 𝑀)
 Why study this?
• Fluctuations in AD affect unemployment and inflation
• Changes in economic activity entails changes in output and income.
• Relevant to monetary and fiscal policy makers
• Understand the transmission mechanism of monetary and fiscal
policy
• Monetary policy affect the AD directly through interest rate and affect AD
indirectly because interest rate affect incentives to save which shift spending
decisions over time.
• Fiscal policy AD directly through changes in G. It also affects AD indirectly
through it influence on HH income and thus affect HH spending.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
• The reason why we study the demand side is
to construct model of transmission
mechanism by which monetary and fiscal
policy, via the spending decisions of HHs,
firms, government, affect the economy.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Facts about the demand side and business
• shares of GDP
cycles
– Usually consumption makes up the largest proportion of
GDP in most countries. E.g. it about 43% in China and
70% in the US.
• A large part of this cross-country variation can be explain by the
differences in the contribution of investment.
– Relative volatility: Investment is the most volatile of all the
components of GDP.
• This is because investment depends on expected post-tax profits
and is very dependent on how optimistic firms are. It thus tends to
flourish during boom periods and collapse in recession.
• Investment can also be postponed in recessions whereas
government and consumption expenditure cannot be easily
delayed.
• A high standard deviation means higher volatility.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Overview:
Chapter 1: The Demand Side
Demand side facts: Components of AD over time
Investment is
more volatile
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Overview:
Chapter 1: The Demand Side
Business Cycle facts: Growth & Fluctuations
Recession Periods
(Shaded Areas)
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Overview:
Chapter 1: The Demand Side
Business Cycle facts: Volatility and Policy
The Great
Moderation:
Did better policymaking reduce
volatility?
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Growth and cycles
• Does output need to be stabilized or should output
be allowed to have its own path?
– Not all economist agree on stabilization: Robert
Lucas for instance, believe that fluctuations are
optimal responses to current shocks
– The Keynesian believe in stabilization but are the
suggested stabilization policies effective in
smoothing economic fluctuation?
• The application of monetary and fiscal policy
• Is there a need for harmonization between the
policies?
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
The demand for money
• Why do people hold money even though it does not
earn interest?
• There are two reason why people hold money.
– Transaction motive
• To bridge the gap between cheque pays
• To reduce the transaction cost of going to the bank to with draw
money but this involves transactions cost and loss of valuable time
for leisure.
• HHs decide on optimal cash management problem: choose the
number of trips to the bank such that the marginal costs and
benefits of saving account are equated.
• Cash management problem leads to an interest sensitivity of
money demand, since interest repayments represents the income
foregone when wealth is held in the form of money.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
– The transaction demand for money also depend positively
on real stream of transactions that HH wishes to conduct.
• Another motive for holding money is the speculative
motive or demand for money to hold asset.
– Money has two important properties: (1) it is very liquid
and it is risk free in the absence of inflation. (2) other
assets such shares and bonds fluctuate in value are
regarded risky and less liquid.
– Keynes and Modigliani suggests regressive expectation
as a rationale behind the liquidity preference.
– If the rate of interest is very low then prices of bonds are
very high: 𝑃𝐵 = (1 + 𝑅)−1 + (1 + 𝑅)−2 + ⋯ = 1 𝑅
– Bond prices and interest rate move in opposite direction.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
– Invest expect that high prices of bond cannot persist forever and thus
anticipate that bond prices will fall.
• In other words, they expect a capital loss on bonds which prompt them to hold
most of their wealth in the form of money: however we do not envisage a corner
solution.
• The speculative demand for money thus motivated depends on negatively on
interest rate, i.e. 𝑙𝑅 ≤ 0.
• Thus, if the rate of interest is very high (𝑅 ≥ 𝑅𝑀𝐴𝑋 ) HHs will not hold any cash
for speculative purposes.
• Bond are very low and capital gains on bonds are expected.
– Other on the other hand Keynes argues that if the rate of interest is very
low (𝑅 ≤ 𝑅𝑀𝐼𝑁 ) then people would become indifferent between
holding their wealth in terms of money or bonds.
• In this case the liquidity preference function would become perfectly elastic at that
minimum rate of interest. This is known as liquidity trap
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Overview:
Chapter 1: The Demand Side
 How do we model the demand side?
The IS (Investment -Savings) Curve
Features:
- Downward Sloping
(high int rate  lower AD)
- Affected by expectations of
the future
(pessimistic expectations 
lower AD at every int rate)
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
The Goods Market Equilibrium (GME)
 The IS Curve shows combinations of the Real interest
rate (r) and Output (y) under goods market equilibrium.
 Goods Market Equilibrium: 𝑦 𝐷 = 𝑦
“Aggregate Demand = Output / Income”
 Recall closed economy AD: 𝑦 𝐷 = 𝐶 + 𝐼 + 𝐺
•
Consumption demand (C): Expenditure by individuals on goods and
services; on durables and non-durables.
•
Investment demand (I): Firm expenditure on capital goods, Household
expenditure on new houses, Government expenditure on infrastructure.
•
Government purchases (G): Government expenditure on salaries, goods
and services.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
GME and the Multiplier
Goods Market Equilibrium & the Multiplier:
 First assume a Keynesian consumption function:
where 𝑐0 : autonomous consumption, not affected by income
t : tax rate
y : income
1 − 𝑡 𝑦 : disposable income, 𝑦 𝑑𝑖𝑠𝑝
𝑐1 : marginal propensity to consume (MPC)

Here, AD is given by:
(┼)
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
GME and the Multiplier
 Goods market equilibrium is given by the 45°
line: 𝑦 𝐷 = 𝑦 where AD = Output.
The Multiplier effect:
Δ G  Δ 𝑦𝐷  Δ 𝑦
 Δ 𝐶 = 𝑐0 + 𝑐1 1 − 𝑡 𝑦
 Δ 𝑦𝐷  Δ 𝑦  …
(┼)
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
The Multiplier
 The Multiplier determines the change in output due to a change
in autonomous demand (ΔG in Fig 1.5).
 Rearranging (┼) in terms of y, we get:
(▲)
 The multiplier is greater than 1 since 0 < c1 < 1 and 0 < 𝑡 < 1.
 Short-run multiplier: response of output to a change in
autonomous demand, keeping the interest rate and policy
responses constant.
 If c1 = 0, then the 𝑦 𝐷 line is horizontal. The multiplier equals 1
and the effect of ΔG on output is not amplified.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Application:
Paradox of Thrift
 Should savings be encouraged or discouraged in a recession?
• ↑ Savings  ↑ Investment in capital stock  ↑ AD
• But ↑ Savings  ↓ Consumption  ↓ AD
 In our model I and G are exogenous & by rearranging (▲):
 A rise in savings is modelled by a fall in c0 to c0 ′.
 Since I and G are fixed, y must fall for the equation above to hold.
 Paradox of Thrift: Higher savings causes output to fall.
 Model-specific result: No mechanism for high savings to translate
into higher investment.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
The IS Curve
Deriving the IS Curve (Mathematical):
 Fisher Equation:
 Assume that Consumption is independent of r, while investment
is given by:
 Substituting this into the AD identity (┼), we get the IS relation:
 The larger the multiplier (k), or the larger the interest-sensitivity
of investment (𝑎1 ), the larger the effect of r on y.
(IS curve is flatter)
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
The IS Curve
Deriving the IS Curve (Graphical):
In the r-y space, plot the
Investment function.
s
Then add in 𝑐0 and 𝐺.
Finally, factor in the multiplier
to get the IS Curve.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
The IS Curve
IS Curve Properties:
 Downward sloping
• Low r  ↑Investment  ↑ Output

IS curve slope
• Changes with multiplier, k and hence c1 and 𝑡.
• Changes with 𝑎1 .

Shifts in the IS Curve:
• When autonomous consumption c0 , autonomous investment a0 ,
or government spending G change.
• When the multiplier changes.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Forward-Looking Behaviour
Forward- Looking Behaviour:
 Spending decisions today are influenced by expectations of the future.
This means there is intertemporal component to both consumption and
investment
• Households adjust current spending based on expected future income;
Consumption Smoothing and able to borrow and lend.
• Firms make investment decisions based on expected future profits.
 Present value calculation: PV of the flow of income or profit received in
future periods.
• Firm Profits:
• Household Lifetime Wealth:
Resources
available at t
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
PV of expected lifetime
labour income, post-tax
Consumption
• Keynesian consumption function: indicates
that consumption depends on current
income.
– Consumption is taken as a constant positive
component which is called autonomous
consumption and assumed to be an exogenous
constant and increases linearly with income with
a MPC of less than 1.
• Consider a Keynesian consumption :
𝑐 = 𝑐 + 𝑐𝑦 (𝑦 − 𝑡)
 This consumption function provides two
important things
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
1. Aggregate consumption is volatile rather than
smooth because any change in current income is
reflected in a change in consumption.
2.There should be no difference between the
effect on consumption of transitory changes in
personal income and permanent changes.
– In the Keynesian consumption function, the
change in consumption is predicted by the
change in measured income irrespective of
whether it is expected to be temporary or
permanent.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
• These predictions seem extreme for three reasons:
– First has to do with the preferences of the
consumers.
– The second relates to the ability of people to
look ahead and form a view about their future
income prospects.
– Third hinges on the ability of people to borrow.
• Alternative views of consumption taking
these factors into account were proposed:
– Permanent income hypothesis (M. Friedman)
– Life-cycle hypothesis (F. Modigliani and R.
Blumberg)
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
• The PIH and LCH suggest that consumption was a
function of not measured income as in the
Keynesian consumption function but of average or
expected income or of the lifetime resources.
• The PIH and LCH make the following predictions:
– The use of saving and dissaving to even out the
fluctuations in measured income in order to produce a
much smoother flow of consumption.
– Consumption is unresponsive to income changes that are
perceived to be transitory in nature.
• PIH use the expectations of feature income while the
LCH predicts changes in income based life cycle of
a person.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Forward-Looking Behaviour
Forward- Looking Consumption:
 People desire to smooth consumption in the face of
fluctuating incomes is captured by the assumption of:
• Diminishing marginal utility of consumption
• Requires taking into account the future, and the ability to save
and borrow.
 Permanent Income Hypothesis (PIH)
• Individuals optimally choose consumption by allocating
resources (assets & PV of income) across their lifetimes.
• Consumption is forward looking, as opposed to the Keynesian
consumption function:
(ie. depends on r, 𝐴0 , expected future income and taxes.)
• PIH predicts that optimal C is smoother than income.
(eg. consumers save when earning income and draw on savings
when retired)
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Permanent Income Hypothesis
Consumption Smoothing Behaviour:
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Permanent Income Hypothesis
Permanent Income Hypothesis:
 The household chooses a path of consumption to maximize
its lifetime utility:
 subject to a lifetime budget constraint:
 Optimization, and assuming ρ = 𝑟, gives us a PIH
consumption function:
* The consumer consumes a constant fraction of their expected lifetime
wealth (Ψ𝑡𝐸 ), i.e. they borrow/ save to maintain this level of 𝐶𝑡 for all 𝑡. *
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Problems of empirical consumption function
• The excess sensitivity of consumption to current
income
– one strong prediction of the simple PIH model
states that changes in income that predictable from
past information should have no effect on current
consumption.
– However, empirical evidence indicate that
consumption responds to a change in past income
and this is referred to us excess sensitivity of
consumption.
– Policy implication: changes in tax can effect
consumption.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Permanent Income Hypothesis
Permanent Income Hypothesis:
 Predictions of the PIH:
1. Anticipated changes in income should have no effect on
consumption when they occur
 This would have been incorporated into consumption through the
recalculation of PI. When the change in current income is recorded the
MPC is predicted to be zero.
2. Unanticipated changes should affect consumption as
permanent income (Ψ𝑡𝐸 ) needs to be recalculated.
 News of a temporary increase in income will increase consumption by
the extent to which this raise PI.
 News of a permanent increase in income. If there is news that current
income is higher from now and for every future period by one unit,
then permanent income and hence consumption rise by the full one
unit.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
 Excess sensitivity’: 𝐶𝑡 changes with anticipated changes in
income.
 The first testable hypothesis suggests that there should
be no change in consumption at the time income
changes, if the change in income was known in advance.
 Campbell and Mankiw (1989) tested this hypothesis
econometrically using aggregate data on consumption
and income from the G7 countries. The study rejected a
model in which all consumers were following the PIH but
could not reject a model in which half of all consumers
were simply following the rule of thumb of spending their
income.
 This is referred to as excessive sensitivity of consumption
and is evidence against the strong predictions of the PIH.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
 Excess smoothness’: 𝐶𝑡 changes too much with a change in
Ψ𝑡𝐸 .
 Consumption over-respond to temporary income shocks and this
violates the PIH.
 Example was the large consumption response of US veterans after
the WW II to an unexpected windfall payout of the National Service
Life Insurance.
 the facts that people respond to a windfall by raising spending
suggests that discount rates are higher than assumed in the PIH:
people appear to be more impatient than the hypothesis suggests.
 It is likely that uncertainty about whether observed income changes
are temporary of permanent prevents households from acting exactly
as PIH would predict. For example if HH mistakenly thought a
temporary change in their current income was permanent, then they
would consume more of the income change than would be consistent
with PIH behavior.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
 Why PIH might fail:
1. Credit constraints: Inability to smooth consumption
by borrowing
2. Impatience: Reluctance to save for consumption
smoothing
3. Uncertainty about future income: Leads to
precautionary savings above the level predicted
by the PIH.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Permanent Income Hypothesis
1) Credit Constraints: ‘Excess sensitivity’
PIH households can
increase C by borrowing,
as soon as the news
arrives.
Credit-constrained
households cannot do so,
and can only increase C
when actual income rises.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Permanent Income Hypothesis
2) Impatience: ‘Excess Smoothness’
PIH households start
saving as soon as the
news arrives, allowing for
smooth consumption
when income falls.
Impatient households do
not do so, so consumption
falls when income falls.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Forward-Looking Investment
Forward- Looking Investment:
Tobin’s q Theory of Investment:
𝑞=
𝑀𝐵 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
𝑀𝐶 𝑜𝑓 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
=
𝑃𝑓𝐾
δ+𝑟
(marginal 𝑞 model)
•
𝑞 = 1 (MB=MC): Investment is optimal
•
𝑞 > 1 (MB>MC): Firms should increase investment
•
𝑞 < 1 (MB<MC): Firms should disinvest

𝑞 is higher if:
i.
Output price (𝑃) is higher
ii.
Marginal product of capital (𝑓𝐾 ) is higher
iii.
Interest rate (𝑟) is lower
iv.
Depreciation rate (𝛿) is lower
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Forward-Looking Investment
Tobin’s q :
 Marginal q is difficult to measure (𝑓𝐾 is usually unknown).
 Therefore, the ‘average Q’ model is used to operationalize this
theory, where:
𝑄=
𝑀𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑓𝑖𝑟𝑚
𝑅𝑒𝑝𝑙𝑎𝑐𝑒𝑚𝑒𝑛𝑡 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙
 Stock market value is forward-looking and indicates how well
the firm is able to implement the investment.
 If Q>1 (market value > replacement cost of firm), then the firm
should invest and vice versa.
 In reality, credit constraints and uncertainty also help explain
firm investment behaviour, not just Tobin’s q, Q.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Chapter 1: The Demand Side
Consumption, Investment and the IS Curve:
 Consumption and investment behaviour affects the multiplier
and the IS curve.
 Factors affecting the Multiplier =
1
1−MPC (1−t)
r
)
1+r
•
Temporary income shocks: Multiplier ≈ 1 (MPC =
•
Permanent income shocks: Multiplier > 1 (MPC =1)
•
Credit constraints & Impatience: Multiplier > 1
(Changing the multiplier shifts and changes the slope of the IS)
 Other factors affecting the slope of the IS:
Interest sensitivity of consumption and investment.
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Chapter 1: The Demand Side
 Other factors shifting the IS:
Consumption: PIH predicts that changes in expected
lifetime wealth (ΨtE ) shifts the IS. Empirical findings:
i.
Role of Uncertainty: ↑ unemployment → ↑ precautionary
savings → IS shifts leftwards
ii.
Housing Price Boom: If home equity loans obtainable →
↓ Credit constraints → IS shifts rightwards;
If home equity loans unobtainable → ↑ down-payments for
mortgages → IS shifts leftwards
iii.
Financial innovation or deregulation → ↑ household access
to credit → IS shifts rightwards
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Modelling:
Chapter 1: The Demand Side
 Other factors shifting the IS:
Investment: Tobin’s q predicts that the following factors
will shift the IS curve rightwards:
i.
Increase in prices (𝑃)
ii.
Increase in the marginal productivity of capital (𝑓𝐾 )
iii.
Reduction in the depreciation rate (𝛿)
The average Q equation highlights the role of expected future
profits as a shift factor for the IS curve:
“ ↑ Stock market value→ ↑ Firm value relative to replacement
cost → ↑ Fixed Investment → IS shifts rightwards ”
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System
Summary:
Chapter 1: The Demand Side
 The IS curve shows the combinations 𝑟 and 𝑦 under GME.
 A temporary rise in income affects spending based on the
type of model used:
Keynesian consumption function: spend a fixed proportion of the
rise in income this period
PIH: small increase in consumption for this and all future periods
 The multiplier determines how much 𝑦 increases from a rise
in autonomous demand:
Keynesian consumption function: multiplier always > 1
PIH: multiplier greater than one if shock is permanent, close to one
if temporary (unless there are credit constraints etc.)
 Effect of 𝑟 on Investment:
Tobin’s q: ↑ 𝑟 → ↑ MC → ↓ I (extent of fall depends on how fast 𝑓𝐾
rises as the initial disinvestment is made)
Carlin & Soskice: Macroeconomics: Institutions, Instability, and the Financial System