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The circular flow of income and the Keynesian

multiplier

- Equilibrium in the goods market

Equilibrium in the goods market

- The analysis of the goods market equilibrium is

the starting point of Macroeconomic analysis

(particularly from the Keynesian point of view) - All the goods and services are aggregated into a

single market ? 1 equation - The purpose is to find the equilibrium level of

output Y on this market ? 1 unknown - A second issue is to describe how Y varies as a

function of other macroeconomic variables

Equilibrium in the goods market

The circular flow of income

Aggregate demand and output

The multiplier and role of savings

The circular flow of income

Households

Firms

The circular flow of income

Real flows

Households

Firms

The circular flow of income

Monetary flows

Households

Firms

The circular flow of income

- The circular flow of income is what guarantees

the existence of the central accounting

identities - Remember Three definitions of GDP (output)
- Sum of the expenditures Z
- Sum of the value added produced Q
- Sum of the incomes distributed Y
- Accounting identities
- Production Aggregate expenditure (Q Z )
- Production Incomes of factors of production (Q

Y )

Equilibrium in the goods market

The circular flow of income

Aggregate demand and output

The multiplier and role of savings

Aggregate demand and output

- In the Keynesian model, the aggregate demand

(also called planned expenditure) in a closed

economy with no government is - Z C I
- with Z Aggregate Demand
- C Consumption of households
- I Investment of firms

Aggregate demand and output

- Consumption C is not fixed. Its level depends on

the level of income Y, and is given by the

consumption function. - C C0 cY
- Where
- C0 is the autonomous level of consumption, i.e.

the level of consumption that does not depend on

income - c is the marginal propensity to consume (mpc)

the amount spent out of an extra unit of income. - The converse is the marginal propensity to save

(mps) s, such that - c s 1

Aggregate demand and output

- For the moment, investment I is considered to be

exogenous. - Its level is pre-determined and does not depend

on output - This is a simplifying assumption that will be

relaxed later on (when interest rates are

introduced) - Aggregate demand Z is therefore a function of

output Y, of the marginal propensity to consume c

and of the exogenous level of investment I. - Z C0 cY I

Aggregate demand and output

Aggregate demand as a function of income

Aggregate Demand Z

Aggregate Demand (planned expenditure) Z C0

cY I

mpc 0ltclt1

Autonomous demand (not a function of Y) C0 I

Income, output Y

Aggregate demand and output

- Effective demand and equilibrium
- For any level of planned expenditure Z (with a

slope lt 1), There is only a single point for

which the planned expenditure is equal to the

level of income Y - This gives the equilibrium condition on the goods

market Y Z - Warning There is no guarantee that this point is

a full employment equilibrium !! - This will be examined later.

Aggregate demand and output

Equilibrium on the goods market

Aggregate Demand Z

Effective expenditure Y Z

Aggregate Demand (planned expenditure) Z C0

cY I

Income, output Y

Y

Aggregate demand and output

- For each aggregate demand curve Z there is only a

single point for which the planned expenditure is

equal to the level of income Y - But Z is determined by the plans of agents!
- What happens if the level of planned expenditure

Z is not equal to Y ? - The goods market is not in equilibrium !!
- Output will adjust so that the equilibrium is

reached

Aggregate demand and output

Disequilibrium with Z gt Y

Aggregate Demand Z

Effective expenditure

Aggregate Demand (planned expenditure)

Income, output Y

Y

Y

Aggregate demand and output

Disequilibrium with Z lt Y

Aggregate Demand Z

Effective expenditure

Aggregate Demand (planned expenditure)

Income, output Y

Y

Y

Equilibrium in the goods market

The circular flow of income

Aggregate demand and output

The multiplier and role of savings

The multiplier and the role of savings

- So aggregate demand is given by
- Z C I
- And the equilibrium condition is
- Y Z
- So what happens to output Y if investment I

increases by an amount ?I ? - In fact, ?Y gt ?I !!
- Why is that?

The multiplier and the role of savings

Multiplier effect on the goods market

Aggregate Demand Z

Y Z

Z2 C0 cY I2

Z1 C0 cY I1

1. An increase in planned investment

?I

2. leads to a more than proportional increase in

income

?Y

Income, output Y

Y1

Y2

The multiplier and the role of savings

- So aggregate demand is given by Z C0 cY I
- And Y Z
- Solving for the equilibrium level of output gives

us - There are 2 equivalent interpretations to this

result

Multiplier

Autonomous demand (exogenous)

The multiplier and the role of savings

Why do we observe ?Y gt ?I ?

- First interpretation a multiplier effect due to

the circular flow of income

Increase in savings ?Y mps

Increase in planned investment ?I

Increase in income ?Y

Increase in consumption ?Y mpc

The multiplier and the role of savings

Why do we observe ?Y gt ?I ?

- Step 1 output increases by ?I
- Step 2 output increases by c ?I
- Step 3 output increases by c2 ?I
- Step 4 output increases by c3 ?I
- ..... This continues forever ! The closer c is to

1, i.e. the less people save, the larger the

effect. (why ?) - The aggregate size of the increase is equal to

The multiplier and the role of savings

Why do we observe ?Y gt ?I ?

- Second interpretation The economy is increasing

output in order to balance investments and

savings - This is because the equilibrium condition Y Z is

equivalent to I S (planned investment

savings) - These two equilibrium conditions are equivalent !

The multiplier and the role of savings

- Aggregate demand can be decomposed into

consumption and investment - Z C I
- Income can be decomposed into consumption and

savings - Y Y (cs) C S
- So one can see that setting Y Z is equivalent to

setting I S !

The multiplier and the role of savings

Why do we observe ?Y gt ?I ?

- Starting from equilibrium, if investment

increases by ?I, then we are no longer in

equilibrium - I ?I gt S
- To get back to equilibrium, we need savings to

increase by the same amount (?S ?I ). - Given the savings function,
- So we have

?

?

The multiplier and the role of savings

Why do we observe ?Y gt ?I ?

- Both explanations (spending multiplier or

savings/investment balancing) are equally valid. - The spending multiplier is usually easier to

understand, and is found in most manuals - The savings/investment balance, however, often

brings more interesting explanations of the

real-life economic phenomena.

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