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KEYNESIAN ECONOMICS

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Title: KEYNESIAN ECONOMICS


1
Lecture 6
  • KEYNESIAN ECONOMICS FISCAL POLICY

2
AGGREGATE OUTPUT AND INCOME - 1
  • Each period (weeks, months, years, etc), firms
    produce some aggregate quantity of goods and
    services.
  • We call this aggregate output (Y).
  • We have seen that GDP (Y) can be calculated in
    terms of either income or expenditures.

3
AGGREGATE OUTPUT AND INCOME - 2
  • We will use the variable Y to refer to both
    aggregate output and aggregate income, because
    they are the same seen from different points of
    view.

4
AGGREGATE OUTPUT AND INCOME - 3
  • What happens when output increases?
  • What happens when output is cut?
  • In any given period there is an exact quality
    between aggregate output (production) and
    aggregate income.

5
AGGREGATE OUTPUT AND INCOME - 4
  • Aggregate output can also be looked on as the
    aggregate quantity supplied, because that is the
    amount firms are supplying (producing) during the
    period.

6
AGGREGATE OUTPUT AND INCOME - 5
  • In the lectures which follow, we use the phrase
    aggregate output (income), rather than aggregate
    quantity supplied, but keep in mind that the two
    are equivalent.

7
INCOME, CONSUMPTION AND SAVING - 1
  • In the analysis which follows, we are initially
    going to assume a simple world with no government
    and a closed economy - i.e. no imports and no
    exports.
  • With their income, households can either consume
    or save.

8
INCOME, CONSUMPTION AND SAVING - 2
  • Total household saving in the economy (S) is by
    definition equal to income (Y) minus consumption
    (C)
  • Saving Income Consumption
  • S Y C

9
INCOME, CONSUMPTION AND SAVING - 3
  • The triple equal sign means this is an identity -
    something that is always true.
  • In our simple economy, in which there is no
    government, there are two types of spending
    behavior - spending by households or consumption
    (C) and spending by firms, or investment (I)

10
THE 450 LINE
  • Divides the angle between the two axes of a graph
    in half
  • Has the important property that from any point on
    it, the vertical and horizontal distances
    measured along the axes are equal

11
THE 450 LINE
450
Demand
A
0
a
Output, y
Any point on the 450 line corresponds to the same
vertical and horizontal distances. The distance
0a equals the distance Aa.
12
THE SIMPLEST KEYNESIAN CROSS
  • Uses the 450 line
  • A graph with the demand for goods and services on
    the vertical axis and output ( y ) on the
    horizontal axis
  • The government and foreign sector are omitted
    from this model
  • Only consumers and firms can demand output
  • Consumers demand consumption goods and firms
    demand investment goods
  • Assume initially that consumers and firms demand
    a fixed amount of goods

13
CONSUMPTION AND INVESTMENT DEMAND
  • Consumption demand is C
  • Investment demand is I
  • Total demand is C I
  • In the short run, demand determines output
  • Output demand
  • Output demand C I

14
THE KEYNESIAN CROSS
450
Demand
E
C I Demand
C I
Output , y
0
y
At equilibrium output y, total demand Ey equals
output 0y .
15
THE SIMPLE KEYNESIAN CROSS
  • Superimpose the horizontal line C I (demand)
    on the 450 diagram
  • Total demand is fixed at C I and is independent
    of the level of GDP
  • Equilibrium output is at y, the level of output
    at which the demand line crosses the 450 line at
    point E
  • Output measured on the horizontal axis equals
    demand by consumers and firms
  • Since E is on the 450 line, the vertical distance
    Ey equals the horizontal distance 0y

16
THE KEYNESIAN CROSS
450
Demand
E
C I Demand
C I
Output , y
0
y
At equilibrium output y, total demand Ey equals
output 0y .
17
IF ECONOMY PRODUCES AT A HIGHER LEVEL OF OUTPUT
THAN EQUILIBRIUM
  • More goods and services are being produced than
    are desired by consumers and firms
  • Extra goods will pile up as demand fell short of
    production
  • Firms will react by cutting back on production
  • The economy rapidly adjusts to reach the
    equilibrium level of output

18
EQUILIBRIUM OUTPUT
450
Demand
E
C I Demand
C I
Output, y
0
y
Given total demand equilibrium output (y) is
determined at E, where demand intersects the 450
line.
19
EQUILIBRIUM OUTPUT
450
Demand
E
C I Demand
C I
Output, y
0
y
y1
Given total demand equilibrium output (y) is
determined at E, where demand intersects the 450
line. If output were higher (y1),
20
EQUILIBRIUM OUTPUT
450
E1
Demand

excess production
E
C I Demand
C I
Output, y
0
y
y1
Given total demand equilibrium output (y) is
determined at E, where demand intersects the 450
line. If output were higher (y1), it would
exceed demand and production would fall.
21
IF ECONOMY PRODUCES AT A LOWER LEVEL OF OUTPUT
THAN EQUILIBRIUM
  • Demand would exceed total output
  • Firms find that demand for consumption and
    investment goods is greater that their current
    production
  • Inventories disappear and firms face increasing
    backlogs
  • Firms respond by stepping up production
  • The economy rapidly adjusts to reach the
    equilibrium level of output

22
EQUILIBRIUM OUTPUT
450
E1
Demand

excess production
E
C I Demand
C I
Output, y
0
y
y1
y2
Given total demand equilibrium output (y) is
determined at E, where demand intersects the 450
line. If output were higher (y1), it would
exceed demand and production would fall. If
output were lower (y2),
23
EQUILIBRIUM OUTPUT
450
E1
Demand

excess production
E
C I Demand

C I
insufficient production
E2
Output, y
0
y
y1
y2
Given total demand equilibrium output (y) is
determined at E, where demand intersects the 450
line. If output were higher (y1), it would
exceed demand and production would fall. If
output were lower (y2), it would fall short of
demand and production would rise.
24
THE CONSUMPTION FUNCTION
  • Describes the relationship between consumer
    spending and income
  • C Ca by
  • Consumption spending, C, has two parts
  • Ca autonomous consumption is the part of total
    consumption which is unaffected by the level of
    income, i.e. it is constant at all levels of
    income.
  • by the product of a fraction, b, called the
    marginal propensity to consume (MPC) and the
    level of income, y
  • The consumption function is a line that
    intersects the vertical axis at Ca. It has a
    slope equal to b.

25
THE CONSUMPTION FUNCTION
Consumption function (Ca by)
Demand
Output, y
0
The consumption function relates consumer
spending to the level of income.
26
THE CONSUMPTION FUNCTION
Consumption function (Ca by)
Demand
Ca
Output, y
0
The consumption function relates consumer
spending to the level of income.
27
THE CONSUMPTION FUNCTION
Consumption function (Ca by)
Demand
Ca

autonomous consumption
Output, y
0
The consumption function relates consumer
spending to the level of income.
28
THE CONSUMPTION FUNCTION
Consumption function (Ca by)
Demand
slope b
Ca

autonomous consumption
Output, y
0
The consumption function relates consumer
spending to the level of income.
29
THE CONSUMPTION FUNCTION
  • Although output is on the horizontal axis, output
    and income in this simple economy are identical
  • Output generates income that is all received by
    households
  • As output rises by 1, consumption increases by
    the marginal propensity to consume (b) times 1

30
MARGINAL PROPENSITY TO CONSUME (MPC)
  • Is always less than 1
  • If a consumer receives a dollar of income,
    consumer will spend some of it and save the rest
  • The fraction that the consumer spends is
    determined by the MPC
  • The fraction of income that the consumer saves is
    determined by the marginal propensity to save
    (MPS)
  • The sum of the MPC and MPS is always 1



31
CHANGES IN THE CONSUMPTION FUNCTION
  • The level of autonomous consumption and the MPC
    can change causing movements in the consumption
    function
  • If the level of autonomous consumption is higher,
    it will shift the entire consumption function.
  • Changes in the marginal propensity to consume
    will change the slope of the consumption function.

32
AUTONOMOUS CONSUMPTION CHANGES
  • Increases in consumer wealth will cause an
    increase in autonomous consumption
  • Consumer wealth consists of the value of
    stocks, bonds and consumer durables
  • Increases in consumer confidence will increase
    autonomous consumption

33
MOVEMENTS OF THE CONSUMPTION FUNCTION
Demand
Ca0
Output, y
34
MOVEMENTS OF THE CONSUMPTION FUNCTION
Demand
Ca1
Ca0
Output, y
An increase in autonomous consumption from Ca0
to Ca1 shifts the entire consumption function.
35
MARGINAL PROPENSITY TO CONSUME CHANGES
  • Consumers perceptions of changes in their income
    affect their MPC
  • If consumers believe that an increase in their
    income is permanent, they will consume a higher
    fraction of the increased income than if the
    increase were believed to be temporary


36
MOVEMENTS OF THE CONSUMPTION FUNCTION
Demand
Slope b
Output, y
37
MOVEMENTS OF THE CONSUMPTION FUNCTION
Slope b1
Demand
Slope b
Output, y
An increase in MPC from b to b1 increases the
slope of the consumption function.
38
DETERMINING GDP
  • Plot the consumption function
  • Investment is constant at all levels of income
  • Add the level of desired investment vertically to
    the consumption function
  • The C I line is the total spending in the
    economy
  • At any level of income, total spending is C I
  • The level of equilibrium income, y, occurs where
    the total spending ( C I ) line crosses the 450
    line
  • At this level of output, total spending equals
    output

39
DETERMINING GDP
Demand
Consumption Function C
Ca
Output, y
40
DETERMINING GDP
C I
Demand
Consumption Function C
Ca I
Ca
Output, y
41
DETERMINING GDP
450
C I
Demand
Consumption Function C
Ca I
Ca
Output, y
42
DETERMINING GDP
450
C I
Demand
Consumption Function C
Ca I
Ca
Output, y
y
GDP is determined where the C I line intersects
the 450 line. At that level of output, y ,
desired spending equals output.
43
EQUILIBRIUM INCOME
  • autonomous consumption / (1 - MPC)
  • Y (Ca I) / (1 - b)
  • Suppose C 100 0.6
  • Ca 100
  • b 0.6
  • I 40
  • Using the formula for equilibrium income
  • Y (100 40) / (1 - 0.6)
  • Y 140 / 0.4
  • y 350
  • In equilibrium, saving investment

44
THE MULTIPLIER
  • The increase in output divided by an increase
    investment
  • An increase in investment spending shifts up the
    C I curve by I
  • The intersection with the 450 line shifts from E0
    to E1
  • GDP increases by y from y0 to y1
  • The increase in GDP (y) is greater than the
    increase in investment (I)
  • Since output increases more than the initial
    increase in investment, the multiplier is greater
    than 1

45
THE MULTIPLIER
450
C I 0
Demand
y0
Consumption Function C
E0
Ca I 0

I 0
Ca
Output, y
y0
46
THE MULTIPLIER
450
C I 1
C I 0
I
Demand

y0
Consumption Function C
E0
I 1
Ca I 0

I 0
Ca
Output, y
y0
47
THE MULTIPLIER
450
C I 1
y1
y
C I 0
I
Demand
y0
Consumption Function C
E0
Ca I 0

I 0
Ca
y
Output, y
y0
y1
When investment increases by I from I0 to I1,
equilibrium output increases by y. The change in
output (y) is greater than the change in
investment (I).
48
KEYNESIAN FISCAL POLICY
  • Using taxes and spending to influence the level
    of GDP in the short run

GDP
Taxes Spending
49
GOVERNMENT SPENDING
  • Government purchases of goods and services ( G )
    is a component of spending
  • Total spending is C I G
  • Increases of government purchases ( G ) shift up
    the C I G line just as increases of
    investment spending or autonomous consumption
    spending do
  • The multiplier for government spending is also
    the same as for changes in investment or
    autonomous consumption

50
GOVERNMENT SPENDING
  • Changes in government purchases have exactly the
    same effects as changes in investment spending or
    autonomous consumption spending
  • The multiplier for government spending is also
    the same as for changes in investment or
    autonomous consumption
  • Multiplier for government spending 1 /
    (1-MPC)

51
DISPOSABLE PERSONAL INCOME
  • The income that ultimately flows back to
    households and consumers, after subtracting any
    taxes that are paid and after adding any transfer
    payments received by households (such as social
    security, unemployment insurance and welfare)
  • disposable Personal income
    (y-T)
  • where T is net taxes -- taxes minus transfer
    payments

52
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
450
C I G0
Output, y
y0
53
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
After Spending Increase
450
C I G1
C I G0
Output, y
y0
54
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
After Spending Increase
450
C I G1
C I G0
Output, y
y0
y1
55
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
After Spending Increase
450
C I G1
C I G0
Output, y
y0
y1
An increase in government spending leads to an
increase in output.
56
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
Demand
After Spending Increase
After Tax Increase
450
450
C I G1
C I G
C I G
C I G0
Output, y
y0
Output, y
y1
y0
y1
An increase in government spending leads to an
increase in output.
57
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
Demand
After Spending Increase
After Tax Increase
450
450
C I G1
C I G
C I G0
C I G
Output, y
y0
Output, y
y1
y0
y1
An increase in government spending leads to an
increase in output.
An increase in taxes leads to an decrease in
output.
58
TAX MULTIPLIER
  • Is negative because increases in taxes decrease
    disposable income and lead to reduction in
    consumption spending
  • Is smaller (in absolute value) than the
    government spending multiplier, because an
    increase in taxes first reduces the disposable
    income of households by the amount of the tax
  • tax multiplier - b / (1 - b)
  • - MPC / ( 1 - MPC )

59
BALANCED-BUDGET MULTIPLIER
  • The multiplier for equal increases in government
    spending and taxes
  • Equal increases in spending and taxes will not
    unbalance the budget
  • Is always equal to 1

60
EXPANSIONARY POLICIES
  • Government policies that increase total demand
    and GDP.
  • Tax cuts and spending increases are examples of
    expansionary policies

61
CONTRACTIONARY POLICIES
  • Government policies that decrease total demand
    and GDP.
  • Tax increases and spending cuts are examples of
    contractionary policies.

62
BUDGET DEFICIT
  • Increases when government increases spending
    or cuts taxes to stimulate the economy.

63
PERMANENT INCOME
  • Consumers often base their spending on an
    estimate of their long-run average income.

64
AUTOMATIC STABILIZERS
  • Taxes and transfers which act as economic
    institutions that automatically reduce economic
    fluctuations.

65
HOW AUTOMATIC STABILIZERS WORK
  • When income is high
  • -- government collects more taxes and pays
    out less transfer payments
  • -- since government is taking funds from
    consumers, this tends to reduce consumer
    spending
  • When income is low (i.e., during recessions)
  • -- government collects less taxes and pays
    out more transfer payments
  • -- tends to increase consumer spending, since
    the government is putting funds into the hands
    of consumers

66
AFTER A TAX INCREASE
  • Consumption function depends on after-tax income
  • C Ca b ( 1 - t ) y
  • Marginal propensity to consume is now adjusted
    for taxes and becomes
  • b ( 1 - t )
  • Raising the tax rate therefore lowers the MPC
    adjusted for taxes

67
AN INCREASE IN TAX RATES
450
C I G
Demand
Output, y
y0
68
AN INCREASE IN TAX RATES
450
C I G
Demand
C I G after tax- rate increase
Output, y
y0
69
AN INCREASE IN TAX RATES
450
C I G
Demand
C I G after tax- rate increase
Output, y
y0
y1
70
AN INCREASE IN TAX RATES
450
C I G
Demand
C I G after tax- rate increase
Output, y
y0
y1
An increase in tax rates decreases the slope of
the C I G line. This lowers output and
reduces the multiplier.
71
OTHER FACTORS CONTRIBUTING TO STABILITY OF ECONOMY
  • If households base their consumption decisions
    partly on their permanent or long-run income,
    they will not be very sensitive to changes in
    current income.
  • If consumption doesnt change much with current
    income, the marginal propensity to consume out of
    current income will be small, which will make the
    multiplier small.
  • When consumers base their decisions on long-run
    factors, not just on their current level of
    income, the economy tends to be stabilized.

72
MODIFYING THE MODEL FOR EXPORTS AND IMPORTS
  • Add exports, X, as another source of demand for
    US goods and services
  • Subtract imports, M, from the total spending by
    US residents
  • Consumers will import more goods as income rises
  • imports M my
  • m is the fraction known as the marginal
    propensity to import
  • Subtract this fraction from the overall marginal
    propensity to consume ( b ) to obtain the MPC for
    spending on domestic goods

73
DETERMINING OUTPUT IN AN OPEN ECONOMY
450
Demand
Demand
slope ( b - m )
C a I X
Output, y
y0
Output is determined where demand for domestic
goods equals output.
74
INCREASE IN EXPORTS AND IMPORTS
Demand
Demand
450
450
Ca I X
Ca I X
Output, y
Output, y
y0
y0
75
INCREASE IN EXPORTS AND IMPORTS
Demand
Demand
450
450
X
Ca I X
Ca I X
Output, y
Output, y
y0
y0
76
INCREASE IN EXPORTS AND IMPORTS
Demand
Demand
450
450
After the increase in exports
Increase in the Marginal Propensity to Import
X
Ca I X
Ca I X
Output, y
Output, y
y0
y1
y0
y1
77
INCREASE IN EXPORTS AND IMPORTS
Demand
Demand
450
450
After the increase in exports
Increase in the Marginal Propensity to Import
X
Ca I X
Ca I X
Output, y
Output, y
y0
y1
y0
y1
An increase in exports will increase the level of
GDP
An increase in taxes leads to an decrease in
output.
78
ACTUAL VERSUS PLANNED - 1
  • A firm may not always invest the exact amount
    that it planned to.
  • Why?
  • Firms do not have complete control over their
    investment decisions.
  • This is not true of consumption, as households
    have complete control over their consumption.
    Planned consumption is always equal to actual
    consumption.

79
ACTUAL VERSUS PLANNED - 2
  • Firms can generally chose how much new plant and
    equipment they wish to purchase in any given
    period (e.g. McDonalds buys an extra french-fry
    machines, etc).
  • However, firms have less control over inventory
    investment.
  • Remember, inventories are part of the capital
    stock. Manufacturing firms have two kind of
    inventories
  • Inputs (e.g. tyres, rolled steel, engine blocks,
    etc)
  • Final production (finished automobiles awaiting
    shipment)

80
ACTUAL VERSUS PLANNED - 3
  • Consequently, one component of investment -
    inventory change - is partly determined by how
    much households decide to buy, which is not under
    complete control of firms.
  • If households do not buy as much as firms expect
    them to, inventories will be higher than
    expected, and firms will have made an inventory
    investment that they did not plan to make.

81
ACTUAL VERSUS PLANNED - 4
  • Because involuntary inventory adjustments are
    neither desired nor planned, we need to
    distinguish between actual investment and desired
    , or planned investment.
  • When we have been discussing I in this lecture,
    we have used I to refer to desired or planned
    investment only.
  • So, we could have written
  • Planned aggregate expenditure Consumption
    Planned investment
  • AE C I

82
EQUILBIRUM AGGREGATE OUTPUT (INCOME) - 1
  • In microeconomics we said that equilibrium is
    said to exist in a particular market (e.g. the
    market for bananas) at the price for which the
    quantity demanded is equal to the quantity
    supplied.
  • In macroeconomics, we define equilibrium in the
    goods market as that point at which planned
    aggregate expenditure is equal to aggregate
    output.

83
EQUILBIRUM AGGREGATE OUTPUT (INCOME) - 2
  • Aggregate output Y
  • Planned aggregate expenditure AE C I
  • Equilibrium Y AE, or Y C I
  • This definition of equilibrium can hold if, and
    only if, planned investment and actual investment
    are equal. To understand why, consider Y no equal
    to AE. First let us suppose aggregate output is
    greater than planned aggregate expenditure
  • YgtC I
  • Aggregate outputgt Planned aggregate expenditure

84
EQUILBIRUM AGGREGATE OUTPUT (INCOME) - 3
  • When output is greater than planned spending,
    there is unplanned inventory investment. Firms
    planned to sell more of their goods than they
    sold, and the difference shows up as unplanned
    increase in inventories.
  • Suppose now that planned aggregate expenditure is
    greater than aggregate output
  • C I gt Y
  • Planned aggregate expenditure gt Aggregate output

85
EQUILBIRUM AGGREGATE OUTPUT (INCOME) - 4
  • When planned spending exceeds output, firms have
    sold more than they planned to. Inventory
    investment is smaller than planned.
  • Planned and actual investment are not equal. Only
    when output is exactly matched by planned
    spending will there be no unplanned inventory
    investment.
  • Equilibrium in the goods market is achieved only
    when aggregate output (Y) and planned aggregate
    expenditure (CI) are equal, or when actual and
    planned investment are equal.

86
SAVINGS AND INVESMENT APPROACH - 1
  • Because aggregate income must either be saved or
    spent, by definition
  • Y C S
  • THIS IS AN IDENTITY
  • The equilibrium condition is
  • Y C I
  • BUT THIS IS NOT AN IDENTITY, BECAUSE IT DOES NOT
    HOLD WHEN WE ARE OUT OF EQUILIBRIUM. IT WOULD BE
    AN IDENTITY IF I WERE ACTUAL INVESTMENT RATHER
    THAN PLANNED INVESTMENT

87
SAVINGS AND INVESMENT APPROACH - 2
  • Substituting C S for Y in the equilibrium
    condition, we can write
  • Saving/investment approach to equilibrium C S
    C I
  • Because we can subtract C from both sides of this
    equation, we are left with S I.
  • Thus, only when planned investment equals saving
    will there be equilibrium.
  • Remember, saving is income that is not spent.
    Because it is not spent, saving is like a leakage
    out of the spending stream.

88
SAVINGS AND INVESMENT APPROACH - 3
  • Only if that leakage is counterbalanced by some
    other component of planned spending can the
    resulting planned aggregate expenditure equal
    aggregate output. This other component is planned
    investment (I).
  • The leakage out of the spending stream - saving -
    is matched by an equal injection of planned
    investment spending into the spending stream.
  • For this reason, the saving/investment approach
    to equilibrium is also called the leakages/
    injections approach to equilibrium.
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