EC4004 LECTURE 18Keynesian Model gets a workout

LAST TIMEFull Keynesian Model:

AE = C + I + G + X-M

TODAY.Aggregate Expenditure & Aggregate Demand.

NEWS.

UE Increases to 13.5%, growth reduction to -7.5% of Real GDP. Sees further tax hikes and spending cuts for next 3 years.

22 Ernst & Young Economic Eye Winter forecast Ernst & Young Economic Eye Winter forecast 23

5.1 Migration outlook

One of the ways in which the both economies, and more noticeably ROI, have been transformed in recent years has been through

Attracted by employment opportunities (and the chance to improve

provided a supply of labour, a boost directly to demand, and was

displacement of native workers or downward pressures on wages).

Now that the Island economy has taken a turn for the worse, the migration pattern will have shifted, but to what extent is hard to

the latest data supports this with Q2 QNHS data showing a decrease of 35,200 in the number of non-ROI nationals in the labour force (many of whom will have returned home rather than becoming inactive).

migrants in ROI with NI remaining very moderately positive, though

2014 that the ROI forecast returns to a positive net migration

net balance.

Fig 5.1: All-Island net migration trend and forecast

modest than expected by many, with the ROI live register recording a continued increase in non-ROI residents on the register, up from 41,000 to 78,000 between September 2008 and September 2009. This suggests a proportion of recent arrivals have decided to stay through more challenging times (though as reported by the labour force data above, which includes the employed and unemployed, many have returned). The number of migrants staying despite not being in work is not surprising given the high level of integration

opportunities in many of their countries of origin. The pattern of

condition as is likely for many of those previously employed in the construction sector, or if social security becomes less generous.

No comparable data exists for NI, which does not record country of

likely given the pattern in Worker Registrations which shows a fall over the last 12 months.

5.2 Wider implications of demographic change

Lower population as result of reduced in-migration / increased out-migration will reduce unemployment (below what it otherwise could have risen to) and consequently the associated costs of

However lower population will also reduce demand for a range of services and crucially for housing, which will add further downward pressure to the already fragile construction sector. While it is not only population which determines the demand for housing (the

available amongst other things all have an impact), population is a key factor as evident by recent housing completion trends

Who will be here for recovery?

Fig 5.2: ROI relationship between net migration and total housing

completions

Making basic assumptions about the average number of persons per dwelling (which is a critical assumption and depends on range of actors including the type of new build), and using the Economic Eye population forecast, suggests a very modest demand for housing going forward in the short-run (Table 5.1). This is especially in ROI. Note this analysis takes no account of potentially

demand to replace demolished housing.

Data from the Department for the Environment, Heritage and Local Government shows 2009 Q1 housing completions of 7,600. Pro rata over the year would give an annual projection of some 20,000-25,000 new homes in 2009 (this appears to be the current consensus forecast for completions in ROI in 2009).

indicative projection estimates produced by the basic Economic Eye housing model. Mismatches in the spatial distribution of demand and supply, plus replacement of stock (which may be greater in

demand projections are striking relative to recent history.

Less than 10,000 new housing completions are projected to be demanded annually in ROI in 2009, 2010 and 2011 (i.e. close to the actual number of new completions in Q1 2009 – Table 5.1).

This even includes a replacement demand element for demolished stock using recent rates of demolition and an assumption that the average number of persons per dwelling will continue to fall slightly in the coming years which may not be the case (school leavers, graduates etc may live with parents for longer or in higher density rented accommodation). Though if a high proportion of new build is say 1-bed apartments then the projected excess supply may be lower (as this type of housing would have a lower occupancy rate / average number of persons ratio).

It is though worth saying that we suspect actual number of completions will not drop as low as 10,000 pa and could turn out close to 20,000 in 2009 and 10,000-15,000 in 2010 and 2011 (note our indicative projections exclude public sector new build but are still a useful indicator of demand).

Nevertheless indicative housing demand in ROI drops to no higher the projected level required in NI, a major turnaround from recent years, due to overall stronger population growth in NI (where migration is forecast to contract much more modestly as it did not reach the same peak).

forecast (as many other demand factors are not considered), it does demonstrate the potential impact of migration on the wider economy and particularly the construction industry and supply-chain sectors (and tax revenue from stamp duty etc).

Table 5.1: All-Island housing completion trends and indicative

demand projections

Ernst & Young Report on Ireland, 2009.

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MULTIPLIER IN ECONOMICS MULTIPLIERAny initial change in spending causes a chain reaction of more

spending

Initial increase in government

spending

Operates through a multiplier

Larger increase in real GDP

Spending Multiplier EffectRound

12

Δ Spending

!500!250!125!63

!62

!1,000

34

All other rounds

Total spending

Formula: 1 / (1 – MPC)

(or)

1 / MPS

DEBATE CURRENTLY RAGING ON WWW.VOXEU.ORG: IS MULTIPLIER >1 OR NOT

AGGREGATE EXPENDITURE MODEL

• GDP Gap: The amount by which aggregate expenditures fall short of the amount required to achieve full employment equilibrium

• Keynes Solution: Increase autonomous spending by the amount of the recessionary GDP gap.

• Govt. Should manage AD to maintain full employment

ROUTES TO KEYNESIAN SOLUTIONS

When ∆Y/Y <0,

1.Increase government spending

2.Lower taxes

3.Raise transfer payments

NOW.Aggregate Supply

& Aggregate Demand.

REMEMBERThe sum of all expenditure in the economy over a period of time

AD = C+I+G+(X-M) = AE (in equilibrium)

C= Consumption Spending

I = Investment Spending

G = Government Spending

(X-M) = difference between spending on imports and receipts from exports (Balance of Payments)

WHEN AE ISN’T EQUAL TO AD

Aggregate Expenditure is a relationship showing, for a given price level, planned spending at each level of income, i.e. total C + I (Planned) + G + X - M at each level of aggregate income.

The aggregate demand curve (AD) tells us, at each price level, how much aggregate output will be demanded

If planned spending > output, inventories fall, firms increase output, households get more $$, buy more, (but less and less) each time.

MARKET VS AGGREGATE MODELS

The market model measures physical units whereas the aggregate model measures value

AGGREGATE DEMAND(WRITE THIS DOWN)

AD curve shows the level of real GDP purchased by everyone at different price levels during a time period, ceteris paribus

AGGREGATE DEMAND CURVE(WRITE THIS DOWN)

Inflation

Real National Income

AD

2.0%

Y1

At an inflation level of 2%, the AD curve

gives a level of output of Y1

This level of output will be associated

with a particular level of unemployment

which we will call U = 5%

U = 5%

3.0%

Y2

At a higher rate of inflation (3.0%)

rising interest rates mean that C, I and

(X-M) all have negative effects on AD – NY falls to Y2

U = 7%

The lower level of National Income

requires fewer units of labour –

unemployment rises to 7% shown by U = 7%

Increase in C,I, G, (X-M)

Increase in the aggregate demand curve

SHIFTS IN THE AGGREGATE DEMAND CURVE

Inflation

Real National Income

AD

2.0%

Y1U = 5%

Shifts in AD will be caused by changes in

factors affecting C, I, G and (X-M) (exogenous

factors) e.g. increasing income

tax rates affect consumption

AD2

Y2U = 2%

Any exogenous factor causing C,

I or G to rise, or a trade surplus

causes a shift to the right in AD

This would cause a rise in national

income (economic growth) and lead to

a fall in unemployment (U = 2%) (and vice versa)

CHANGES IN AD: CONSUMPTION

Exogenous factors affecting consumption:Tax rates

Incomes – short term and expected income over lifetimeWage increasesCreditInterest ratesWealth

PropertySharesSavingsBonds

CHANGES IN AD: INVESTMENT

Spending on:

Machinery

Equipment

Buildings

Infrastructure

Influenced by:

Expected rates of return

Interest rates

Expectations of future sales

Expectations of future inflation rates

CHANGES IN AD: GOVERNMENT

Defence

Health

Social Welfare

Education

Foreign Aid

Regions

Industry

Law and Order

KEY VARIABLES

(Write these down)

Inflation

Growth

Unemployment

Balance of Payments (X-M)

KEY POLICIES

Monetary Policy

Don’t have one. (ECB)

Fiscal Policy

Government spending & government income (taxes & borrowing)

Supply-Side Policy

Aggregate supply. Next lecture!

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WRITE DOWN2 THINGS YOU

REMEMBER FROM TODAY.

EC4004 LECTURE 18Keynesian Model gets a workout