EC4006 Intermediate Macroeconomics Lecture

EC4006Effective Demand and IS-LM

Stephen Kinsella | stephen.kinsell@ul.ie | stephenkinsella.net

So Far

Outline of Macroeconomics

History & Development of the Subject

IS-LM

IS-LMDeveloped by Hicks (1937) and others

Simple, BOE calculating Model (or is it?)

Lots of Problems:

Long Run/Short Run

Aggregation Problems

Idea of ‘One’ Interest Rate

‘Dark Forces of Time & Ignorance’

Demo

Today

ISLM & Effective Demand (ED)

Message: Output of Economy Depends on Components of ED

Effective Demand

Assume there are N workers, and a static production technology.

Let’s describe the calculations of the Firm.

Value of Output - (Factor Cost + User Cost) = Profit of Firm

Firm wants to Max(Profit)

Now from Economy’s POV:

Aggregate income is Factor Cost + Profit

Aggregate Supply Function (ASF) is expectation of proceeds from employment of resources in this way.

ASF = f(N), where N = No. of Workers

Aggregate Demand Function (ASD) is expectation of proceeds from employing N workers.

ASD = f(N).

When ADF > ASF, employ more people

When ADF < ASF, fire people

@ ADF = ASF, entrepreneurs' expectation of profits will be maximised

Big Questions

Does Supply create Demand

Or, does Demand create Supply?

Dynamics

If N goes up, Ag. Income goes up, Consumption goes up.

Need increasing investment to absorb this

So eqm. level of employment depends on level of investment

What changes investment? Marginal Efficiency of Capital (MEC)

Summary

Income depends on employment of N workers

income/consumption relationship depends on propensity to consume, call this IC

income/investment relationship depends on MEC

Sum of IC and MEC is effective demand

Even better Summary

The volume of employment in equilibrium depends on

(i) the aggregate supply function, ASF

(ii) the propensity to consume, IC, and

(iii) the volume of investment

Let’s think about Ireland Right Now

Real GDP dropping at 4-6%

Deflation 2-4%

UE running at 11%, so far this year, expectations much higher

Domestic investment in toilet.

Where is effective demand?

Put ISLM and Effective Demand Together

Next TimeEmployment and Money

Read Article on Public Folders

Expect Sample Exam next Friday