Macroeconomics

Chapter 2: Goods Market - Economic Cycle,

Keynesian Cross and IS Curve

Prof. Habermacher
EHL
A glimpse back and forward
• Last chapter’s protagonist: GDP

• GDP as ‘expenditure’: Y=C+I+G+X–M

• ‘All the things we demand from our economy’
• GDP is also: Firm’s VA and hh’s earnings

• This chapter: Use the above formula to understand short-run GDP

movements, especially during a crisis

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Chapter objectives/highlights
• Overarching topic: Short-term evolution of the goods market
+ Z
Y
• Demand’s central role for the economic cycle G
K. M.

T +
• “Stimulus” effect of spending (Keynesian Multiplier) I
C
i
• Effects Fiscal policy
Output
Interest rate

• Judgement: will an economic stimulus work?

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Content

1. Economic cycle & overview

2. Goods market equilibrium
3. Keynesian cross & multiplier
4. IS curve
5. Additional comments & plausibility

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Economic cycle
1. Peak: temporary maximum of business
activity; low unemployment

2. Recession = total output declines;

unemployment rises

3. Trough = bottom of the recession period;

highest unemployment

4. Expansion (recovery): output is

increasing; unemployment begins to fall

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Economic cycle
• Potential GDP ≡ GDP with economic resources sustainably well used
• GDP gap ≡ GDPpotential – GDP (or: Ypotential – Y)
• Recession: positive GDP gap (possibly large) Recession

GDP
gap
Potential GDP

GDP

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Economic cycle: Recession
Graph prev. sl.: output fell by a few percent (e.g., 5%) in recessions

Compared to long-term economic growth, this reduction is not huge!

Question 1: Why are we so worried about recessions then?

• ______________
Unemployment ⇨ Possibly the main worry!
• Equality
• Gvmt finances affected (T ↓, social security spending ↑)
•…
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Economic cycle: Recession - Causes

From one year to the next, output falls, by, e.g., ≥5%

Productive factors are still in place, often: machines, workers…

Question 2: Why, then, is output reduced so suddenly?

Answer 1: Answer 2:
It tends to be demand!
Recall: Production=Demand
⇨ Consumer behavior
 STORYLINE

In many recessions: Not the productive

capacities that are lost

However: Consumers/investors cautious;

reluctant to buy things
⇨ ↓ Consumption
⇨ ↓ Production

Remainder of this chapter:

• Link demand/spending ⇔ production?
• Useful interventions in recessions?

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 MIND

We present you this material as simple, clear models

Reality: Macro is hard!

Not all processes are understood in perfect detail!

Basics: Probably perfectly correct

– and most macroeconomists agree with them –

But, some would surely say: “This or that factor is crucial; you’re
mistaken to ignore it!”

Think independently!

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This chapter is about recessions
Short-term economic development
• Fixed Prices
• Fixed stock of productive capacities
FOCUS

Recession No Recession
We may have: We may have:

• Hesitant consumers & investors; • Reasonable confidence* about the

uncertainty about the future economic development

• Underutilized productive factors • Well utilized productive capacities

(Demand ≈ avail. productive capacities)
⇨ Keynesian/IS-LM model view
*Boom: overconfidence?
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Towards the IS-LM model (this and next chapters)
Model of the economic cycle ⇨ Causes, remedies?
• Both, goods & money market in equilibrium ➔ Macroeconomic equil.
• Demand ⇄ Production ⇄ Revenue
IS-LM Diagram

Interest
THIS CHAPTER

IS curve: Goods market eq. LM curve: Money market eq.

i LM
A
IS

Y Output
• Leading interpretation of Keynes’ Theory
• Born of the 1930s depression
• The “Classical model” would not explain the dramatic production drop while productive
resources remained available

Annex: More detailed overview on the IS-LM model we’ll construct in the next chapters
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IS-LM model: Uses
• Simplest model (?) of how macroeconomic variables relate, in the short
run
• When and why will unemployment ↑ or ↓ ? Will our shop likely have many customers in
the next months and years? Will prices ↑?

• Study impact of policy & behavior on the economy

• Changes in taxes, gvmt spending, interest rate, consumer confidence, willingness to spend, …
⇨ Impact on the goods & monetary markets/output

• Dealing with recessions

• Departure point for you to reflect: how do real-world complications change

the effects analyzed here?

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Assumptions (now and until IS-LM)

• Short-run ⇨ Prices are fixed
• Underutilized productive factors (spare capacities) ⇨ Production is
flexible; can readily meet variations in demand

• Single region

• Central bank fixes the interest rate1

Remember: We analyze output (GDP) but might especially care about

unemployment
1 We ignore the common assumption of a fixed money supply (deviation, e.g., from Blanchard’s main text)
Content

1. Economic cycle & Overview

2. Goods market equilibrium
3. Keynesian cross & multiplier
4. IS curve
5. Additional comments & plausibility

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 Final demand and GDP
Final demand for goods from our economy: Z
Z=C+I+G+X–M
‘All things we demand (buy) from our economy’
Chapter 1

GDP Y
= Final demand (Z)
= Value added, i.e., what firms produce (without interm. goods)
= Revenues of hh

Final demand in the closed economy

Here

Z=C+I+G
Next, we look at C in detail. Later at I.
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Final demand: Consumption

1 2 3
n𝑍 =𝐶+𝐼+𝐺 Your spending function
1 How to relate consumer spending C and Consumption c
income? c0+𝛽y
How much would you spend this year, if, this c(30k)
year, you had a personal revenue y of: =c0+𝛽⋅30k
A) y = 0 CHF ? ⇨ c(0) 𝛽 = Slope
1
B) y = 30 kCHF ? ⇨ c(30k) c0= c(0)
⇨ You spend some, but not all your extra y Income Y
Call the share of your marginal revenue spent 0 30k
𝛽:
c(y) = c0 + 𝛽⋅y
Names
𝑐0 Minimal consumption level
Note: 0 < 𝛽 < 1 Why?
𝛽 Marginal propensity to consume
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Final demand: Consumption

For agg. consumption we add one nuance:

Taxes take away some of the revenue

Consumption C
C(Yd) = c0+ 𝛽Yd
Disposable revenue 𝑌𝑑 :
revenue net of taxes +
If c0
T: Slope = 𝛽
decreases
𝑌𝑑 ≡ 𝑌 − 𝑇 < 45°

c0
Agg. consumption as fct. of agg. revenue:

0
C(Yd) = c0+ 𝛽Yd Disposable income Yd
+
 Final demand: I, G, and T
2 Investment I: What (mainly) firms invest

Investments are very volatile and depend on many factors

For a simple start: Fixed investment

𝐼 = 𝐼ҧ
A few slides later we will consider that I can change

3 Government spending G and taxes T:

We consider we (policy maker) are in control
⇨ Values do not themselves change; they’re ‘fixed’ as far as the model’s
internal changes are concerned:
𝐺 = 𝐺;ҧ 𝑇 = 𝑇ത
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Final demand
Final demand, from 𝑍 = 𝐶 + 𝐼 + 𝐺, Question: What happens if c0, 𝐼,ҧ 𝐺,ҧ or
becomes: 𝑇ത changes?
𝑍 = 𝑐0 + 𝛽 𝑌 − 𝑇ത + 𝐼 ҧ + 𝐺ҧ

= “C” curve, lifted by 𝐼 ҧ + 𝐺ҧ

Demand Z

Final Demand Z
Final

+𝐼 ҧ + 𝐺ҧ

c0 Disposable revenue Yd Disposable revenue Yd

0 0
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Final demand, production, revenue

Recall: Revenue = Final demand!

𝑍 = 𝑐0 + 𝛽 𝑌 − 𝑇ത + 𝐼 ҧ + 𝐺ҧ

Final Demand Z
ത 𝐼 ҧ + 𝐺ҧ
Z = c0+ 𝛽(Y-𝑇)+
𝑌=𝑍 .
𝑌 = 𝑐0 + 𝛽 𝑌 − 𝑇ത + 𝐼 ҧ + 𝐺ҧ
⇨ Revenue depends on… revenue! ↺ Slope = 𝛽 < 45°
+ Z
Y
G
T +
I
C

Three ways to look at this ‘spiral’: 0

Revenue, Production Y
1 Flow diagram for tracking the economic
mechanism
2 Geometrically plot it: Keynesian cross
3 Mathematically solve the equation
1 Flow diagram: Spiraling effect of demand
Consumption becomes revenue and thus consumption again:

+
∆ Goods demand ∆ Firms’ production

+ +
CRUCIAL ∆ Revenues of the
ROLE! + economic agents
Saving

Q: Does this “explode”: ever-increasing demand?

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2 Keynesian Cross: Geometric representation
Recall that we have arrived at
Keynesian cross
𝑌 = 𝑐0 + 𝛽 𝑌 − 𝑇ത + 𝐼 ҧ + 𝐺ҧ
from two equations (see above):

Demand Z
ത 𝐼 ҧ + 𝐺ҧ
Z = c0+ 𝛽(Y-𝑇)+

𝑍 = 𝑐0 + 𝛽 𝑌 − 𝑇ത + 𝐼 ҧ + 𝐺ҧ
Consumption curve + 𝐼 ҧ + 𝐺.ҧ Recall: Slope < 45°
Z*=Y*
𝑍=𝑌
45° line

Both can graphically be drawn in the

Keynesian cross: diagram Y vs. Z 45°
Both equations must hold 0 Y* Revenue,
⇨ Intersection = equilibrium output Y*! Production Y

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3 Algebraic solution
Algebraic solution : Keynesian cross
𝑌 = 𝑐0 + 𝛽 𝑌 − 𝑇ത + 𝐼 ҧ + 𝐺ҧ

Demand Z
[… algebra : isolate Y…] ത 𝐼 ҧ + 𝐺ҧ
Z = c0+ 𝛽(Y-𝑇)+
1
∗
𝑌 = (𝑐0 − 𝛽𝑇ത + 𝐼 ҧ + 𝐺)ҧ
1−𝛽

Z*=Y*
⇨ Equilibrium GDP Y* as a result of
consumer preferences c0 & 𝛽, investments
I, and fiscal policy G & T

45°
Next, we’ll focus on the crucial factor
1 0 Y* Revenue,
> 1, aka “Keynesian multiplier” Production Y
1−𝛽
Content

1. Economic cycle & Overview

2. Goods market equilibrium
3. Keynesian cross & multiplier
4. IS curve
5. Additional comments & plausibility

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Keynesian Cross: Multiplier effect

Consider
1
= 𝑌∗ (𝑐0 − 𝛽𝑇ത + 𝐼 ҧ + 𝐺)ҧ
1−𝛽

Demand Z
ത 𝐼 ҧ + 𝐺1ҧ
Z = c0+ 𝛽(Y-𝑇)+
Impact of changing c0, I, or G on production :
𝜕𝑌 𝜕𝑌 𝜕𝑌 1
= = = >1 Extra gvmt
𝜕𝑐0 𝜕𝐼 𝜕𝐺 1−𝛽 G spending
Keyn. Multiplier
ത 𝐼 ҧ + 𝐺ҧ0
Z = c0+ 𝛽(Y-𝑇)+
Q: Can you show this “>1” graphically?

For taxes, the effect is negative1 1

G
1−𝛽
𝜕𝑌 −𝛽 45° Revenue,
= <0 0 Production Y
𝜕𝑇 1−𝛽 Y0* Y1*
Multiplier for taxes
𝜕𝑌 −𝛽
1 Depending on the slope 𝛽 the absolute tax ‘multiplier’ effect | 𝜕𝑇 | = | 1−𝛽 | can be larger or smaller than 1
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Keynesian Cross: Convergence

• Imagine an initial production below the
Demand Z

equilibrium, 𝑌1 < 𝑌 ∗ .
ത 𝐼 ҧ + 𝐺ҧ
Z = c0+ 𝛽(Y-𝑇)+ • Demand Z1 is given by the Z(Y) curve
• There is a shortage on the goods market:
Z3 𝑌1 < 𝑍1
Z2
Here: Y = Z • Since producers meet the demand on the
Z1 market, production gradually increases…
• First it increases to meet Z1: Y2=Z1
Z1 > Y1

• But this increases also sales & revenues, in

Y1
turn boosting demand to Z2 > Z1, and thus Y,
…
45°
Revenue, • … until the equilibrium level is reached:
0 Y1 Y2 Y3 Y Production Y
*
𝑌1 < 𝑌2 < 𝑌3 < 𝑌4 … = 𝑌 ∗
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Keynesian Cross: Convergence

• This is the same as the effect we’ve shown in
Demand Z

the flow diagram:

ത 𝐼 ҧ + 𝐺ҧ
Z = c0+ 𝛽(Y-𝑇)+

Z3 + Z
Z2
Here: Y = Z
Z1 K. M.
Y

G
T +
I
C
45°
Revenue,
0 Y1 Y2 Y3 Y* Production Y
Endogenizing investment
Investment I
One major factor influencing investments:
To invest, actors must borrow money

“Cost” of borrowing?
Interest, paid to the lender Investment will play a crucial
role!
⇨ If the interest rate i increases, - Significant part of demand
investment decreases (and vice- - Highly volatile
versa):
- Lack of confidence ⇨
𝐼 = 𝐼( 𝑖 ) investments are withheld
−

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Final demand with endogenous investment
Final demand, from 𝑍 = 𝐶 + 𝐼 + 𝐺,
becomes:
𝑍 = 𝑐0 + 𝛽 𝑌 − 𝑇ത + 𝐼( 𝑖 ) + 𝐺ҧ
− If interest i
⇨ Z is decreasing in the interest rate decreases

Final Demand Z
Reason:
If interest i
1. Higher interest reduces
______ investment increases
2. Investment is one of the components
of total final demand

0
Revenue, Production Y

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Keynesian Cross with endogenous investment
1
𝑌∗ = (𝑐0 − 𝛽𝑇ത + 𝐼( 𝑖 ) + 𝐺)ҧ
1−𝛽 −
Example calculation:

Demand Z
ത
Z = c0+ 𝛽(Y-𝑇)+I(ilow)+𝐺
ҧ
Interest i is reduced from 4% to 2%.
Assumed impact: I = +3 bn CHF
⇨ Lifting the demand curve Z by that amount Extra
I investment
Find: !.

a) Increase of Y* if 𝛽 = 0.75? ത
Z = c0+ 𝛽(Y-𝑇)+I(i ҧ
0)+𝐺
b) Impact on Y* if c0 (instead of I) had
increased by 3 bn CHF?
c) And if we had increased T by 3 bn CHF? 1
I
1−𝛽
45°
Hint: Recall equil. GDP Y* increases by even more than I: 0 Y0* Y*i low Revenue,
1
Y∗ = 1−𝛽 I Production Y

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Keynesian Cross: Causes of recessions

When does low demand lead to a recession, 1
∗
𝑌 = (𝑐0 − 𝛽𝑇ത + 𝐼( 𝑖 ) + 𝐺)ҧ
with output below the economy’s potential? 1−𝛽 −

General answer:
Slope = 𝛽
• If something strongly reduces final demand Z

Demand Z
Specifically:
• Consumers spend little: low c0 and/or low 𝛽
Low
• Lack of confidence? demand …
• Low investment I (for a given interest i):
• Lack of confidence? 45°
• Fiscal policy: high
___ T and/or ___
low G 0 Y* Revenue,
Production Y
… depressing
production
Keynesian Cross: What to do in recessions?
What can the state do, to help in a (demand- 1
∗
𝑌 = (𝑐0 − 𝛽𝑇ത + 𝐼( 𝑖 ) + 𝐺)ҧ
induced) recession? 1−𝛽 −

• ± Anything that lifts the final demand

curve!
• Specifically: Slope = 𝛽

Demand Z
a) Fiscal policy
• Increase spending G
• Lower taxes T Y*
b) Monetary policy
• Lower interest i
45°
0 Y* Revenue,
• Annex: Example - Greek crisis & austerity Production Y

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Keynesian Cross: Two FAQ

Q1: Are all recessions due to reduced demand? 1
∗
𝑌 = (𝑐0 − 𝛽𝑇ത + 𝐼( 𝑖 ) + 𝐺)ҧ
1−𝛽 −
• No. Sometimes it’s from a supply
_____ shock. E.g.,
1970’s: oil scarcity/price rises ⇨ recession
Q2: Why not perpetually increase G, or lower T, i?
Slope = 𝛽

Demand Z
• Our model: short-run; when spare capacity
• Higher G or lower T increase gvmt debt; must be
paid back some time
• Low interest rates may help only so much, Y*
reduce future room for maneuver
• Low interest rates ⇨ firms & hh may make risky 45°
investments (interest rate-sensitive)
0 Y* Revenue,
I’d be keener for Keynesian stimuli, if I Production Y
trusted gvmt to fade them out on time!
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Applications (solution in class)

Consider a closed economy characterized by:
𝐶 = 𝐶 𝑌 𝑑 = 40 + 0.8𝑌 𝑑
𝑇 = 50
𝐼 = 100
𝐺 = 50
i. Compute the equilibrium product / income (𝑌0∗ )
ii. Assume that investments increase by 50. Compute the new equilibrium product /
income (𝑌1∗ )
iii. In ii., you should have found a larger change in Y (Δ𝑌 = 𝑌1∗ − 𝑌0∗ ) than the initial change
in I (Δ𝐼 = 50). How is that even possible?
iv. Using your answers to i. and ii., compute the value of the (Keynesian) multiplier of
investments
iv. Determine algebraically the (Keynesian) multiplier of investments
Content

1. Economic cycle & Overview

2. Goods market equilibrium
3. Keynesian cross & multiplier
4. IS curve
5. Additional comments & plausibility

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What is the IS curve?

• The IS curve indicates the Background: + Z
relationship between the Y
interest rate and GDP K. M.

+
𝑌𝐼𝑆 = 𝑌(ณ𝑖) I
- C
− i

IS
IS-Curve: i➔Y
Y
We’ll use the K. Cross to construct
the IS-curve
 K. Cross
Building the IS curve Demand,
Supply

We have seen
1
𝐼 = 𝐼(𝑖) & 𝑌 = ∗
𝐼 ⇨ 𝑌 ∗ = 𝑌 ∗ (𝑖)
− 1−𝛽 −
1
𝑌 ∗ (𝑖)
= (𝑐0 − 𝛽 𝑇ത + 𝐼( 𝑖 ) + 𝐺)ҧ Production Y
1−𝛽 −
𝑌3 𝑌2 𝑌1
We call this negative relationship between i
i and Y the IS curve IS Curve

𝑖3 = 6%
Geometric construction: Simple with K. 𝑖2 =4%
Cross!
𝑖1 = 2%
⇨ See graph (example) Production Y

… 𝑌3 𝑌2 𝑌1
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Shifts in the IS curve: E.g. Pandemic
Example:
• Assume a pandemic means Interest
consumers cook at home rate
instead of going to
restaurants… ?
?
• … so that the minimum level
of consumption, c0, drops

• Q: What happens to the IS

curve? Let’s construct it
(next slides) 0
Production
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Shifts in the IS curve: Pandemic Demand

• If the minimum level of

consumption c0 drops Old c0-𝛽𝑇ത
• … consumer demand drops:
𝐶 = c0 + 𝛽(𝑌 − 𝑇)ത New c0-𝛽𝑇ത
Production

Demand
• … total demand also drops:
𝑍 = 𝐶 + 𝐼 + 𝐺ҧ
where 𝐼 = 𝐼( 𝑖 )
−
• The drop is the same for all
interest rates Production

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Demand If c0
Shifts in the IS curve: Pandemic decreases

• As all demand curves shift down…

• … production equilibriums in the goods
market move left …
• For any given interest rate Production
• … so the IS curve shifts to the left (parallel) 𝑌3 𝑌1
Intuition: Interest
• ↓C ⇨↓Z⇨↓Y rate

• Same for any i ⇨ || shift of IS to left 𝑖3

Discuss: Any multiplier effect & why?

𝑖1
Annex: Exercise with 𝛽 changing Production

𝑌3 𝑌1
As its name suggests, the IS curve will later be one
of the two curves in the graph of the IS-LM model

Annex: Why the name IS, aka “Investment-Savings”

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Content

1. Economic cycle & Overview

2. Goods market equilibrium
3. Keynesian cross & multiplier
4. IS curve
5. Additional comments & plausibility

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Additional comments & plausibility
1. Not all gvmt spending is made equal!

2. The savings paradox

3. Is the “stimulus” effect plausible?

4. “Automatic stabilizers”

5. What does “underutilized factors” require?

6. Current example: The pandemic and inflation

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1. Not all gvmt spending is made equal I/II
• The gvmt can be creative when it wants to boost its own spending
• Difficult to ‘objectively’ estimate the utility of stimulus spending ex-ante
• “Bridges to nowhere”: Money spent (hastily) on (infrastructure) projects
with little ‘intrinsic’ value, beyond the direct spending and employment
associated with the execution of the project itself
• Stimulus example 1: “Scrapping premiums”
Cash for buying a new car while scrapping an old one
• Boosting car makers’ revenue
• Environmental benefit (?): cleaner new cars replace old ones
• Some might worry why others buy cars with their tax money
• Risk: Once a subsidy exists: difficult to remove it

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1. Not all gvmt spending is made equal II/II
• Stimulus example 2: “Stimulus Checks” – Gvmt
sends cash to households
• E.g., US 2020/21 pandemic relief: few kUSD for hh
(incomes < $80k-160k)
• Hope: they spend it quickly to boost the economy
• Studies: share of checks money spent ≈ 25-40%.1
• Thus: Even with a significant K. multiplier of, say,
2-3 for hh spending, extra economic activity
maybe only ≈ 1:1
• Even so, the Keynesian might hope consumers
spend a bit more of that extra money in the years
to come

1 https://libertystreeteconomics.newyorkfed.org/2021/04/an-update-on-how-households-are-using-stimulus-checks/. Large parts were saved or used to pay debt.

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2. The savings paradox
It is said that saving is good, but
this model tells us a different story!
• Imagine that hh aim to save more, i.e., spend less: lower c0
1
∗
⇨ Y* is reduced: 𝑌 = (𝑐0 − 𝛽 𝑇ത + 𝐼( 𝑖 ) + 𝐺)ҧ
1−𝛽 −

Why these two seemingly contradicting views? Is saving still good?

Recall, here we consider the ____

short-run
___
Saving, instead, helps the long-run development of the economy

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3. Is the “stimulus” effect plausible?
• Let’s track (in class): Your decision to buy a coffee in the break!

Don’t dismiss the “small impact”! It may have a small probability, but of a large impact
(when it occurs)

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3. Is the “stimulus” effect plausible?
• You may think yourself about whether this changes the broken
window conclusion

• Few inputs:
• Recall: baker would have spent the money on other things; maybe now he mainly
spends it a bit earlier?
• Immediate boost needed only in recession?
• Other periods: rather focus on using our resources for desirable goods & services!

• Note: If breaking windows is good, surely digging holes and refilling them is too.
Intuitively, devoting a large part of our labour to digging holes and re-filling them,
does not seem to be a recipe for sustainable growth in the long run. The same way,
breaking glass windows…
• See also slide on Bastiat in Chapter 1

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4. “Automatic Stabilizers”
In reality, T is a function of Y: Taxes are typically some %age of
income/profits/sales. ⇨ T increases with Y
In a recession, Y decreases ⇨ decreases T ⇨ cushions the recession
⇨ “Automatic stabilizer”: Without adjusting policy, absolute taxes are
lowered during a recession, which is what the Keynesian model would
suggest to do
And vice versa (economic expansion ⇨ … ⇨ … ⇨ holds back the expansion)
Similar for G and imports M
• Downturns: more households may become eligible for various state
benefits (monetary or in-kind)
• Along with general consumption, also imports can fall during downturns
© EHL Prof. Habermacher 50
© EHL Prof. Habermacher 51

5. What does “underutilized factors” require? I/III

First a glimpse at the AS-AD model
Important: We will learn the "AS-AD" later; no need to know it in detail yet!
• AS = aggregate supply (SRAS = short-run AS)
• AD = aggregate demand

Q: What does the small slope of AS imply? Price

level
a) Prices increase only little if demand AS
and therefore the quantity produced (SRAS)
increases?
b) Prices increase strongly if demand
and therefore the quantity produced
increases? AD
Real GDP
 © EHL Prof. Habermacher 52

5. What does “underutilized factors” require? II/III

• Recall our assumption:
Underutilized factors ⇨ Production flexible; readily meets increased demand
Q1: Which one of the two graphs is more characteristic for such a situation?

Price Price AS = Stimulus

Level Level (SRAS)
AS
(SRAS)

AD1 AD2 AD1 AD2

Real GDP Real GDP
Q2: What happens otherwise (i.e. w/o underutilized factors)?
 © EHL Prof. Habermacher 53

5. What does “underutilized factors” require? III/III

1. Here it might be ‘easy’ for the 2. Here, not quite as easy, but one might
Keynesian to define how much demand identify roughly which level to aim for…
stimulus to provide…
Price SRAS
Level

AD0=AD2
AD1
Real GDP
3. In reality: it’s complex – none really knows precisely how the curves look! Even worse,
one could doubt there are such simple “curves”; instead, a complex structure of supply &
demand; stimulus effect depends on which exact sectors it is implemented in etc.
© EHL Prof. Habermacher 54

6. Current example: The pandemic & inflation I/II

You may have heard the news: Inflation (US & EU) is rampant at the moment (winter
2021/22), while the economies are still suffering from the pandemic
Think it through: Would the following provide a plausible, easy explanation for the
price increases?
1. The pandemic had hit the economies hard, reducing output strongly
2. Various stimuli had been used by gvmts (and CBs) to stabilize demand & incomes
3. Many productive facilities are directly affected by the pandemic: The aggregate
supply curve is impacted significantly by the pandemic and the measures to combat it:
• Restaurants: Not only don’t people not go to restaurants; it’s also restaurants who are
not allowed to provide their service ⇨ Reduction also of the production capacity!
• Benefits to ensure the livelihood of those severely affected by the pandemic, have
reportedly reduced the willingness of staff to return to work in various sectors,
further reducing the supply potential
• Illness/lock-downs of staff meant in many facilities, production may simply have been
difficult to maintain
⇨ Suggesting an (SR)AS curve1 that is rather quickly bending upwards (prices rising if
demand increases) [… continues next slide] 1 See preceding slides
© EHL Prof. Habermacher 55

6. Current example: The pandemic & inflation II/II

4. In consequence, we find ourselves with a limited capacity for extra production; but we try to
stimulate the economy as much as possible; many activities (e.g., dining out) still being
difficult, successful demand stimuli necessarily mean people buy significantly more than usual
of some other goods & services. All in all, inflation therefore had to hit us hard, sooner or
later!

Without studying the case in more detail, it may be difficult to be certain about such a story.
Reading reports and statistics about individual elements of it, could be revealing. In either case,
the (alleged) ‘stylized facts’ mentioned above fit our model rather well!
End

© EHL Prof. Habermacher 56

Annex

© EHL Prof. Habermacher 57

“Classical model”
Classic view, quick & stylized
Output depends mostly on
productive capacity; fixed in
short run; gvmt stay out of
the way so we’ll get
efficient/max production;
increasing demand mainly
increases prices rather than
boosting output (inelastic
goods supply curve)
Return:

© EHL Prof. Habermacher 58

Towards the IS-LM model: detailed overview
• Simple model about the economic cycle analytically ⇨ Causes, remedies?

• Goods market: Keynesian cross & IS curve THIS CHAPTER

• Demand multiplier effect on output
• Construct (Y, i) for which goods demand & production equilibrate,
as function of savings preferences & other economic variables
• Monetary market: LM curve
• Traditional: Construct (Y, i) for which money demand & supply
equilibrate depending on liquidity preferences and prices
• Here: More trivial; when CB fixes the interest rate, the qty of
money is no direct constraint to the economy
• IS-LM model (also next slide)
• Link between output and interest rates in a given economy
Short run with underutilized capacities ⇔
• Intersection of the IS & LM curves: both, goods and monetary
market, to be equilibrated
© EHL Prof. Habermacher 59
 This and next chapter: Towards the IS-LM model
Output & interest rate
Goods market combinations for which
goods market equilibrates
Construct output level for
which goods demand &
production equilibrate, in Keynesian
IS curve
a given economy Cross

Equilibrium
point: interest
IS-LM & output of a
diagram given economy
Money market

Money
Construct interest rates Market LM curve
for which money demand Output & interest rate
& supply equilibrate, in a Diagram
combinations for which
given economy1 money-market
equilibrates1

1 Mind, here: LM collapses to a more trivial line, as we suppose: the CB fixes the interest, not the quantity of money
© EHL Prof. Habermacher 60
Interpretation in terms of Savings vs. Investment
• We have drawn the Keynesian cross in a Z vs. Y 𝑌 = 𝑐0 + 𝛽 𝑌 − 𝑇ത + 𝐼( 𝑖 ) + 𝐺ҧ
plane −
• Alternative interpretation of the equilibrium where
1
final demand equals production (Z=Y):
∗
𝑌 = (𝑐0 − 𝛽𝑇ത + 𝐼( 𝑖 ) + 𝐺)ҧ
1−𝛽 −
• At Y=Z, savings correspond to (planned)

Production Y
investments Slope = 𝛽

Demand Z
• I.e., the money households decide to bring to the
bank, equals firms’ (planned) investment

• To the left of the equilibrium Y* in the K. c., savings

are lower than (planned) investments: Firms Y*
deplete their inventories, to meet the extra
demand

• To the right of the equilibrium Y* in the K. c., 45°

savings exceed (planned) investments: Excess
production (products) accumulate as inventory 0 Y* Revenue,
increases (aka unpanned investment) Production Y

© EHL Prof. Habermacher 61

© EHL Prof. Habermacher 62

Example: Greek debt crisis and imposed austerity

In the aftermath of the fin. crisis 2007-08, Greece’s economy faced difficulties
Expansionary policy?
• The country felt a need for “expansionary” fiscal (and/or monetary) policy: stimulate its
economy
• What would an “expansionary” fiscal policy have been?
EU/Euro dependence
• Part of the EU & Eurozone, Greece could not choose its policies independently
• Some EU/Euro c’tries (e.g., Germany), did not want Greece to receive/spend a lot
• Greece was accused of having provided inaccurate fiscal data in the past (higher deficit than indicated)
Austerity
• Instead, these c’tries wanted to impose a more “austere” fiscal(/monetary) regime:
reduce debt
• What would an “austere” fiscal policy have been?
Outcome
“Greek […] longest recession of any advanced mixed economy to date. […] Greek political
system has been upended, social exclusion increased, and hundreds of thousands of well-
educated Greeks have left the country.” https://en.wikipedia.org/wiki/Greek_government-debt_crisis Return
© EHL Prof. Habermacher 63

Example: Greek debt crisis and imposed austerity

Per-capita GDP Athens: Scene during the Crisis

DE & GR
What is the IS curve?
• For interest rates:
𝑖𝑛 > ⋯ > 𝑖3 > 𝑖2 > 𝑖1 Demand Z

equilibrium productions are:

𝑌𝑛 < ⋯ < 𝑌3 < 𝑌2 < 𝑌1

⇨ Negative relationship between i

and equil. Y (GDP)

• We can plot this negative

relationship as a curve: Y vs. i…
(the IS curve; next slide) 𝑌𝑛 … 𝑌3 𝑌2 𝑌1 Production
Y
EHL Prof. Habermacher 64
Shifts in the IS curve Demand Z

• Assume now that the marginal

propensity to consume 𝛽 increases
• Remember that final demand is:
Production
𝑍 = 𝑐0 + 𝛽 𝑌 − 𝑇ത + 𝐼( 𝑖 ) + 𝐺ҧ
− 𝑌3 𝑌1
• Problem (solution in class): what Interest
happens to the IS curve ? rate i

• If you prefer to simplify the exercise:

𝑖3
consider here that T is being reduced
simultaneously, such as for 𝛽 ⋅ 𝑇 to remain
the same
𝑖1
Production
Return 𝑌3 𝑌1
EHL Prof. Habermacher 65
 Demand Z,
Supply
The IS curve's meaning Y1

The IS curve represents all combinations of interest A‘

rates and production where the goods market is in
equilibrium Y3
Consider hypothetically point A: low production &
low interest
Production
⇨ Overall, demand Z is intermediate:
• Low consumer demand C 𝑌3 𝑌2 𝑌1
(low Y3 ⇨ consumers have low revenue) Interest
• High investment I (as i is low) rate
⇨ Final demand Z = A’
𝑖3
⇨ Shortage of production: A’ is demanded but only
Y3 produced 𝑖2
⇨ Producers start to produce more,1 in turn A
increasing demand … 𝑖1
Production
⇨ Spiral until Z=Y=Y1
1 recall: they always produce what’s demanded
𝑌3 𝑌2 𝑌1
EHL Prof. Habermacher 66
© EHL Prof. Habermacher 67

In a nutshell
– We’ll cover the following in great detail –

Macroeconomics
In the following chapters, a Diagram Revenue vs. Demand
(right) will be of great use
Demand Z

Iterative behavior of the economy

• Demand reacts to revenue
Addon
• Revenue reactsto Chapter 2:⇦Simplified
to demand
INTUITIVE !?
Goods
Market and Keynesian Cross Intro
Each reaction is represented by a corresponding curve
• Blue curve = value of demand,
Prof. for a given revenue
Habermacher
• Red curve = value of revenue, for a given demand
EHL
⇨ Iterating: Demand→Revenue→Demand→… in the
diagram, we find the equilibrium output Y* of the economy
(intersection of the curves) Revenue Y
Iterating = jumping from one axis to axis; the curves
show how
EHL Prof. Habermacher 68

Assumptions: 3 Hypotheses
H1: Simplistic economy
• No investment
• No government
• No trade
• Fixed prices

H2: ‘Money in the pocket’

• Consumers choose qty they consume, somewhat freely, as a fct. of
current revenue.

H3: ‘Producers follow’

• Producers produce as much as consumers buy.
EHL Prof. Habermacher 69

Demand specification
Z = final demand = 𝐶 + 𝐼 + 𝐺 + 𝑋– 𝑀
'what we ask our economy to produce' (Chap. 1)
⇩
𝑍 = 𝐶
⇨ Synonyms here:
Final demand = Household consumption

With H2 ‘Money in the pocket’:

𝑍 = 𝑍(𝑌) RELATION 1
In the short run, hh consume a qty that depends on revenue, but ≠
revenue
EHL Prof. Habermacher 70

Revenue specification: triviality!

• H3 ‘Producers follow’ (in line with Chap. 1):

GDP (Y) = Revenue = Production = Demand Z

⇩
Given a demand Z of $30,000 → Revenues become $30,000

• Interpret GDP as Revenue: Y = Revenue (synonyms)

Calling Y a function of Z, we write

Y(Z) = Z RELATION 2
Revenue reacts to demand, taking on the same value as demand
Simplified Keynesian Cross
Specify Relation 1: How do consumers choose the amount of consumption
as function of their revenue:
Shape of curve 𝑍(𝑌) ?

Example Mr. Paul Typical

• If Paul has no revenue in a year, he consumes …
0$ 20'000 $ ?
• If Paul earns revenue $100,000 in a year, he consumes …
20'000 $ 70'000 $ 100'000 $ 120'000 $ ?

We pretend Paul T. is the only consumer

EHL Prof. Habermacher 71
 Simplified Keynesian Cross
Paul's expenses as fct. of revenue:
Demand Z
1 Z(if Y $0) = $20,000
2 Z(if Y $100,000) = $70,000
100'000 $

Let's draw
• Horizontal = Revenue
• Vertical = Demand

Point 1 ? 0$
Point 2 ?
0$ 100'000 $ Revenue Y

EHL Prof. Habermacher 72

 Simplified Keynesian Cross
Paul's expenses as fct. of revenue:
1 Z(if Y $0) = $20,000

Demand Z
2 Z(if Y $100,000) = $70,000

Finding:
If revenue increases by +$100,000, Paul
spends +$50,000 more
Assumption: For intermediate revenues 70'000 $ 2
(0k < Y < 100k) ⇨ Paul spends
intermediate amounts (20k < Z < 70k)
⇨ Z(Y) = Line 1 2
20'000 $ 1
How to parameterize this line?
𝑍 𝑌 = ________ + ___ ⋅ 𝑌
0$ 100'000 $ Revenue Y

EHL Prof. Habermacher 73

Simplified Keynesian Cross
The blue line, Z(Y), indicates:

Demand Z
For each given revenue
⇩
The corresponding demand

I.e., shows the vertical position 2

70'000 $

Horiz. position Y given

⇩ 20'000 $ 1
Use Line Z(Y)
⇩
Vertical position (value) Z found 0$ Revenue Y

EHL Prof. Habermacher 74

 Simplified Keynesian Cross
Paul's expenses in relation to revenue:
1 Z(if Y $0) = $20,000

Demand Z
2 Z(if Y $100,000) = $70,000
⇨ Z(Y) = Line 1 2

𝑍 𝑌 = 20′000 + 0.5 𝑌

Check your understanding: 70'000 $ 2

If Paul earns $50,000?
𝑍 50′000 = ______ + ___ ⋅ ______
𝑍 50′000 = ______ 20'000 $ 1
How to draw this point? 3
Paul’s demand if he earns $80,000?
0$ 50'000 $ 100'000 $ Revenue Y

EHL Prof. Habermacher 75

Simplified Keynesian Cross
So far: We can draw the value that

Demand Z
demand takes for a given revenue
Z(Y)

Next: How to draw the value that

revenue takes, for a given demand?
70'000 $
Y(Z)= Z
45'000 $

20'000 $

Reminder:
GDP aka Y = Revenue = Production = Demand Z
𝑌(𝑍) = 𝑍
⇨ Demand of $30,000 → Revenues become
0$ 50'000 $ 100'000 $ Revenue Y
$30,000

EHL Prof. Habermacher 76

 EHL Prof. Habermacher 77

Simplified Keynesian Cross

Reminder:
GDP aka Y = Revenue = Production = Demand Z

Demand Z
𝑌(𝑍) = 𝑍
⇨ Demand of $30,000 → $30,000 Revenues
become $30,000
If Z=$30,000, then we know:
A Y(Z=30'000) = ______
Draw A in the graph 70'000 $ 2
What about the following values of
Z? 45'000 $ 3

Y(Z=0) = ______ 20'000 $ 1

Y(Z=60'000) = ______
Y(Z=120'000) = ______
0$ 50'000 $ 100'000 $ Revenue Y
Draw the corresponding line Y(Z)
EHL Prof. Habermacher 78

Simplified Keynesian Cross

The red line, Y(Z)=Z, indicates:

Demand Z
For a given demand
⇩
The revenue that matches.
⇨”How far to the right should we
go?” 70'000 $

Given a vertical position (value) Z, 45'000 $

Y(Z)=Z indicates the horizontal value
Y 20'000 $
45°
The line is trivial: It is the identity!
45° slope 0$ 50'000 $ 100'000 $ Revenue Y
⇨Each revenue simply has the same value
as the demand that corresponds
 EHL Prof. Habermacher 79

Simplified Keynesian Cross

𝑍 𝑌 = 20′000 + 0.5 𝑌
𝑌(𝑍) = 𝑍

Demand Z
Demand responds to revenue, and revenue
↻ responds to demand, ..., ...
We can assume any point in the diagram, ...
... then trace this iterative movement:

𝑌(𝑍) 𝑍(𝑌) 𝑌(𝑍) 𝑍(𝑌)

𝑍 𝑌 𝑍 𝑌 𝑍… 70'000 $

Example of a given demand, of 70’000: 45'000 $

Step 1: leads us to Y(Z)=Y(70'000) = 20'000 $
_______ 45°
Step 2: leads us to Z(Y)=Z(_______) =
_______
Step 3, leads us to Y(Z)=Y(______)= 0$ 50'000 $ 100'000 $ Revenue Y
_______
... ⇨ Let's draw the path
EHL Prof. Habermacher 80

Simplified Keynesian Cross

Does it stop?

Demand Z
When you reach the intersection of
the two lines!

This point is Y*, the equilibrium

revenue.
70'000 $
The point seems to be a little below 45'000 $
$45,000.
20'000 $
45°
Y*
This is the GDP that we expect if
the demand (the behavior!) of
consumers is 0$ 50'000 $ 100'000 $ Revenue Y
𝑍 𝑌 = 20′000 + 0.5 𝑌
EHL Prof. Habermacher 81

Simplified Keynesian Cross

Algebraically, if we take the two
equations together:

Demand Z
𝑍 = 20′000 + 0.5 𝑌
𝑌=𝑍
we receive:
70'000 $
𝑌 = 20′000 + 0.5 𝑌 45'000 $

20'000 $
Isolating 𝑌 yields 45°

𝑌 ∗ = __________ 0$ 50'000 $ 100'000 $ Revenue Y

EHL Prof. Habermacher 82

Simplified Keynesian Cross

A complete exercise:
Demand Z
The consumers consume
• at least 100bn $ (when no revenue),
• but 200bn $ if they earn 300bn $. 500 bn $

Q1: Parameterize our function

𝑍 = ______ + ___ 𝑌

Q2: Draw the situation and construct,

roughly, the economy’s equilibrium output
∗
𝑌𝑑𝑟𝑎𝑤 ≈ __________ 0 bn $

Q3: Calculate the equil. output precisely 0$ 500bn Revenue Y

𝑌 ∗ = __________
EHL Prof. Habermacher 83

Congratulations!
We have covered the core process
underlying (also the non-simplified

Demand Z
version of) the Keynesian cross that
we are studying!

70'000 $

45'000 $

Return 20'000 $
45°

0$ 50'000 $ 100'000 $ Revenue Y