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Chapter 1 - The Demand SIde

Macroeconomic Theory and Policy (University College London)

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Chapter 1 – The Demand Side

1.1 – Overview
 If a period of depressed spending is forecast, there is much discussion about whether the central bank will
intervene and offset the likely recession by cutting the interest rate
o The central bank would cut the interest rate, because it expects this to encourage spending and help
return the economy to stability
 If a boom in spending was forecast, the central bank would try to dampen it down by raising the interest rate
o As well as the CB, the government also needs to know how spending patterns are likely to evolve and
affect output
 A recession will depress tax revenue and increase spending on unemployment benefits
 Forecasting patterns of spending is therefore a priority, not only for businesses, but also fore the monetary and
fiscal policy makers

Aggregate demand and spending decisions

 Spending decisions are complex – they involve:
o A Static component – i.e. what shall I buy today given my current income and the prices of the goods
and services that are available
o An Intertemporal component – i.e. How do I allocate my spending over time given my expectations
about how my income will evolve in the future
 Components of aggregate demand:
o C - Household spending decisions add up to aggregate consumption
o I - Firms’ investment decisions add up to aggregate investment (note that I refers to spending on
machinery, equipment and new houses and other building
o G - Government spending on different goods and services adds up to a single number
 Including the purchase of new housing as part of investment highlights the difference between aggregate
demand, which refers to spending on goods and services, and the purchase of assets such as company shares or
second-hand property
o The purchase of a second-hand house does not contribute to aggregate demand – it is the transfer of the
ownership of an asset from one household to another
o In contrast, the building and selling of a new house uses resources and produces income, hence it
influences aggregate demand
 Thus, we can write:
y D=C + I +G+ ( X−M )
Where X is the expenditure of foreigners on home output, and M is the spending of home agents on output
produced abroad

Aggregate demand and government policy

 Monetary and fiscal policy work by influencing different elements on the demand side
 Policy makers worry about fluctuations in aggregate demand because they affect unemployment and inflation
 Monetary policy seeks to stabilize aggregate demand by changing interest rates, which affect the investment
decisions of firms and the purchase of durable goods like new cars and houses by households
o A rise in the IR increases the cost of financing investment projects, which may then be
cancelled/postponed
o It also has indirect effects, as the IR affects incentives to save and therefore shift spending decisions over
time e.g. a higher IR would encourage households to postpone consumption due to increased returns on
savings
 Fiscal policy affects aggregate demand directly, through G
o It can also be used to affect demand indirectly through its influence on household incomes and spending
o This can be through changes in taxation and government transfers in the form of pensions, disability and
unemployment benefits

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Introducing the IS curve

 The IS curve is a downward-sloping relationship

o Think of the combination of a high interest rate and low output
 When the interest rate is high, spending on housing, consumer durables, machinery and
equipment will be low – this means that aggregate demand will be low, and a low level of
output will satisfy the low demand
o Now take the situation of a low interest rate and high output
 Higher spending on new houses, consumer durables and investment goods generates a high
level of output for households

 Changes in profit or income growth expectations, uncertainty and the value of collateral can also be shown in
the diagram by a shift of the IS curve (holding the interest rate constant)

 In a situation of depressed profit

expectations, we would expect
firms to postpone new
investment
 The result is lower investment
spending at any interest rate –
the IS curve shifts to the left
 In a situation where the business
environment becomes more
pessimistic, the CB could lower
the interest rate to stimulate
investment – this is shown as a
move along the IS curve from
Figure 1.4 – Effects of changes in optimism and economic policy point A to point B

 The larger the government multiplier:

o The larger is the rightward shift of the IS curve associated with any given amount of additional
government spending
o The flatter is the IS curve, since with a larger multiplier, a given cut in the interest rate has a larger effect
on output

1.2 – Modelling
Goods market equilibrium
 The aggregate demand for goods and services consists of:
o Consumption demand – Expenditure by individuals on goods and services, on both durable goods (e.g.
car, laptop) and on non-durable goods (e.g. theatre show, food)
o Investment demand – Expenditure on capital goods (e.g. machinery, equipment, housing, infrastructure)
o Demand stemming from government purchases – Government expenditure on salaries, goods and
services

The model of goods market equilibrium

y D=C + I +G

 To start, we assume that aggregate consumption is a simple linear function of after-tax or disposable aggregate
income

C=c 0 +c 1 ( y−T )
Where T is total taxes net of transfers

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 To get to the consumption function we use as the core of the model of the demand side, we make the additional
consumption that taxes are a fixed proportion of income i.e. T = ty, where 0 < t < 1 – the consumption function
then becomes:

C=c 0 +c 1 ( 1−t ) y

 This is referred to as a Keynesian consumption function – it consists of a constant term, c 0, which is often
referred to as autonomous consumption, and c 1 (1−t ) y , which shows households spending a fixed proportion of
their disposable income
 c 1 is referred to as the marginal propensity to consume (0< c1 <1)
 The MPC shows the change in consumption as a result of a change in post-tax or disposable income:

∆C
MPC= Disposable
=c 1 , where y Disposable=( 1−t ) y
∆y
The multiplier
 If we substitute the consumption into the equation for aggregate demand:
y D=c0 + c1 ( 1−t ) y + I +G

y−c1 ( 1−t ) y =c 0 + I +G

1
( c0 + I +G )
1−c1 ( 1−t ) ⏟
y=
⏟ autonomous demand
multipler

The IS curve
Deriving the IS equation
 We assume the interest rate has an impact on
investment spending, and incorporate this into
the investment function:
I =a 0−a1 r
 We can then use k to denote the multiplier and
simplify to achieve a simple equation for the IS
curve:
1
y= [ c + ( a0−a 1 r ) +G ]
1−c1 ( 1−t ) 0
¿ k [ c 0 + ( a0−a1 r ) + G ]¿ k ( c 0 +a0+G )−k a1 r ¿ A−ar
Where A ≡ k ( c 0+ a0 +G ) and a=k a1 Figure 1.6 – Deriving the IS curve

 Using the IS curve, we can summarise its properties:

1. The IS curve is downward sloping because a low interest rate generates high investment, which will be
associated with high output; vice versa
2. The slope of the IS:
(a) Any change in the size of the multiplier will change the slope of the IS curve
 For example, a rise in the marginal propensity to consume, c 1, or a fall in the tax rate, t, will
increase the multiplier, making the IS flatter
(b) Any change in the interest sensitivity of investment (a 1) will lead to a consequential change in the slope of
the IS curve
 For example, a more interest-sensitive investment function (higher ( a 1) will result in a flatter
curve
3. Shifts in the IS curve: any change in autonomous consumption, investment or government expenditure will
cause the IS curve to shift by the change in autonomous spending times the multiplier

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Forward-looking behaviour
 The spending decisions of agents in the present are influenced by their expectations of the future – this means
that there is an intertemporal component to both consumption and investment

 Households adjust their current spending based on their expected income in the future i.e. if someone knew
they were going to earn a lot more money at a fixed point in the near future, they may borrow in the present,
consume more and pay back the money when they begin to earn more – this behaviour is referred to as
consumption smoothing
 Firms make decisions (e.g. purchasing machinery, equipment and premises) based on a business plan that
includes forecast about future demand for their products and input cost- investment is intrinsically forward
looking, as it incurs a cost today, but the stream of benefits occurs in the future
o For example, a firm selling cars to China might choose to build a new factory (i.e. undertake investment)
based on forecasts that Chinese incomes (and their demand for cars) will continue to rise rapidly over
the next 20 years

Present value calculation

 We assume that firms aim to maximise profits, so they undertake investment projects if these offer a return that
is higher than costs
o The spending on investment typically precedes the returns, which may be lumpy and spread over a
number of years
 We deal with this by calculating the ‘Present Value’(V) of the expected flow of profits Π , where Π t , Π t +1,… is
the flow of profits in period t, t +1, etc.
o Suppose the interest rate is 10% - then if I say £100 today, I will have £110 in a year’s time (100(1+10%));
expressed the other way around, we could say that £110 in a year’s time has the same value as £100 –
its present value is £100
X
 If interest rates are constant at r, the value of X in n years’ time is the same as that of today
(1+r )n
 We can calculate the present value of our stream of expected profits, Π E, from an investment project with
profits over T years by:
Π Et +1 Π Et +2 T
Π Et +i
E
V =Π +
t
E
t + + …=∑
(1+r ) (1+r)2 i =0 (1+r)
i

(expected present value calculation)

 If the cost of the machine is greater than the present value of the flow of profits from the machine, then it would
be more profitable not to buy the machine, but instead put the money in the bank or in bonds (which earn
interest r
 Similarly, if the money to purchase the machine is being borrowed, then if the cost of the machine is greater
than the present value, buying the machine will be unprofitable
 On the other hand, if the present value is greater than the cost, then this investment is profitable

 This can be applied to modelling consumption decisions

 If we assume that individuals live forever, we can use the formula for calculating present value to calculate the
expected present value of lifetime wealth, which is defined at time t:
∞
1
Ψ tE= (⏟
1+r ) A t−1 + ∑ (1+r yE
i t +i
Assets the individual held at the end of the previous period ⏟
i=0 )
present value of expected post−tax lifetime labour income

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Consumption
The permanent income hypothesis (PIH)

 This states that individuals optimally choose how much to consume by allocating their resources across their
lifetimes – this includes their assets, and their current and future income
 It’s a forward-looking decision, and it will depend on interest rates, asset values, expectations of future income
and expectation of future taxes

 When individuals start work, their income is low

and they will borrow to consume more; when
income increases, they keep consumption
constant and use the excess income to pay off
debts and save for retirement; then at retirement
their income falls and they draw down their
savings

Figure 1.7 – PIH

 Whether an individual prefers their smooth

consumption path to be one of constant consumption in each period, or of rising or falling consumption, will
depend on the relationship between the interest rate on saving and borrowing, and the rate at which the
individual trades off consumption in the future for consumption in the present
 Households choose a path of consumption to maximise its lifetime utility subject to its lifetime budget
constraint:
∞
1
Ψ tE=( 1+r ) At −1+ ∑ yE
i t+ i
i=0 (1+r )
 Solving this gives us the Euler equation:
1+ ρ E
C t= C
1+r t +1
 If the interest rate r and the subjective discount rate, ρ , are the same, then households will get the same return
from saving, r, as their willingness to trade off consumption in the present for consumption in the future, ρ
In this case, the agent prefers a constant level of consumption in each period, C t=C tE+1
o If the discount rate is above the interest rate, C t >C Et+ 1, then consumption is falling over time, reflecting
the ‘impatience’ of the household
o If the opposite is true, a patient household will have a path in which consumption rises over time i.e.
C t <C Et+ 1
o These consumption patterns are independent of period by period changes in income
 When ρ=r , consumption is:
r
C t= ΨE
1+r t

 An individual with this consumption function will borrow and save to deliver a perfectly smooth
consumption path (in expectation)
 The amount they consume each period is equal to the annuity value of expected lifetime wealth and is
called ‘permanent income’
 The individual consumes their permanent income and the formula ensures that in expectation, they will be
able to do this forever
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Predictions and empirical evidence on the PIH

1.) Anticipated or foreseen changes in income should have no effect on consumption when they occur
 Anticipated changes will already have been incorporated into consumption through the recalculation of
permanent income
 Hence, when the change in current income is recorded, the marginal propensity to consume is predicted to
be zero (the multiplier is equal to zero)
 A finding of ‘excess sensitivity’ to anticipated income changes would contradict the full smoothing behaviour
predicted by the PIH

2.) News or unanticipated changes in income should affect consumption because they require the recalculation of
future lifetime,Ψ tE
(a) News of a temporary increase in income – if current income y t increases unexpectedly by one unit,
consumption increases by the extent to which this raises permanent income
 Since the increase in one unit will be spread over the entire future, the PIH consumption
r
function tells us that permanent income and hence consumption by very little, by times the
1+ r
increase in lifetime wealth
r
 The marginal propensity to consume out of temporary income is
1+ r
(b) News of a permanent increase in income – if there is news that income y t is higher from now and for every
future period by one unit, then permanent income and hence consumption rise by the full one unit
 This means that the marginal propensity to consume is one
 ‘Excess smoothness’ of consumption in response to news of permanent income changes would
contradict the simple PIH

Excess sensitivity to anticipated changes in income

 The first hypothesis suggests that there should be no change in consumption the time income changes, if the
change in income was known – consumption should have already have been adjusted as soon as the news
arrived of the change in income
o However, studies have shown that some households responded immediately to changes in income – it
was household with low and income that responded the most, underlining the likely role of limits on the
ability of households to borrow – this is referred to as the excess sensitivity of consumption and is
evidence against the PIH
o What has been observed is that when income falls in a predictable way on retirement, consumption falls,
though by not as much
o The fact that there is excess sensitivity to anticipated rises in income and not so much to falls in income
underlines the importance of credit constraints

Excess sensitivity to news about temporary income and excess smoothness to news about permanent income

 Studies have found that consumption over-responds to temporary income shocks – in the case of positive
income shocks, this violates the PIH
o The fact that people respond to a windfall by raising spending suggests that discount rates are higher
than assumed in the simple PIH: people appear to be more impatient than the hypothesis assumes
o It is also likely that uncertainty about whether observed income changes are temporary or permanent
prevents households from acting as PIH would predict – for example, if a household 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 the PIH behaviour

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Credit constraints, impatience and uncertainty

 Three reasons for failure of PIH:
1. Presence of credit constraints
2. Impatience
3. Uncertainty

Credit Constraints

 If people prefer to smooth consumption but cannot do so, they can’t borrow to bring forward consumption
when their current income is below their expected income – they are facing credit constraints
 Because of information problems facing banks in assessing creditworthiness, banks are not always willing to lend
to households without the wealth or collateral to secure a loan that they may need to smooth consumption

Impatience

 The PIH households start saving as soon as the news of the fall in future income is received, which allows them
to smooth consumption over the two periods
 In contrast, the impatient households fail to reduce current consumption upon receipt of the news, meaning
consumption falls dramatically
when income falls

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Investment
Tobin’s q theory of investment
 Firm’s choose the amount of investment to undertake with a view to maximise the expected discounted profits
over the lifetime of the project
o The q theory amounts to comparing the benefits from investment in an increase in the capital stock with
the costs of doing so: if the expected benefits exceed the costs, investment should take place

MB of investment a f k
q= =
MC of investment δ +r
 Optimal investment occurs when q = 1 i.e. where MB = MC
o If q > 1, the firm should invest to increase the capital stock until q = 1, and vice versa if q < 1
 Firms should undertake more investment if there is:
1. An increase in the rate of technology, a
2. An increase in the marginal productivity of capital, f k , which indicates the increase in output the new
capital equipment will produce
3. A reduction in rate of interest, r
4. A reduction in the rate of depreciation, δ . For example, a rise in the expected rate of depreciation (e.g.
as a result of future legislation banning fuel-inefficient cars) would lead to a reduction level of current
investment because would reduce the expected benefits to the firm from additional investment in the
auto industry

 Marginal q implies firms adjust their level of investment in each period to equate the marginal benefits and
marginal costs of investment – this does not fit with the real-world data on investment
 It is difficult to observe marginal product of capital and a measure of technology

 We can use average Q:

Market value of firm
Q=
Replacement cost of capital
 The market value of the firm as reflected in its stock market valuation is compared with the replacement cost of
the capital cost
 If the market value Is higher, then this signals that the firm should increase investment
 If the market value is below the replacement cost, the firm would not want to build a new factory
because it could buy an existing one more cheaply
 Where as q is the ratio of the marginal benefit of a unit of investment to its marginal cost, Q depends on the taol
expected return from the firm’s capital divided by the total cost
 For publicly listed companies, the stock market provides a forward0looking measure of the market value of the
firm, which can be used in the numerator of the Q equation: when the firm’s market value rises relative to the
replacement cost of the firm, as reflected in a rise in the price of its shares, the model suggests that investment
should go up – a higher interest rate and depreciation rate will raise the replacement cost of capital
 The idea is that the market value incorporates information about how well the firm is expected to be able to
implement the investment, whether new competitirs will

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