Introduction to Macroeconomics

Chapter 22. Keynesian Macroeconomics

Chapter 22. Keynesian Macroeconomics

1. John Maynard Keynes

2. Consumption

3. Simple Equilibrium Model

4. Add Investment to the Model

5. Add Government Spending to the Model

6. Autonomous Spending Multiplier

7. Recessionary, Inflationary, and Output Gaps

8. Government Fiscal Policy

1. John Maynard Keynes

• General Theory… (1936)

• Objections to Classical Model

• Equilibrium with Unemployment because of inadequate demand

• Advocated Activist Government Fiscal Policy

• Short-run model of aggregate demand only

1. John Maynard Keynes Objections to Classical Model

• Interest rates, prices, and wages are rigid (“sticky”)

• Savings (consumption) is a function of income, not interest rate.

• Supply doesn’t create its own demand, it responds to changes in demand

1. John Maynard Keynes Equilibrium with Unemployment

• Horizontal Aggregate Supply Curve– Sticky prices– Interest rates

have only a long run effect

– Long-run growth factors can be ignored in short-run model Output

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1. John Maynard Keynes Keynesian Activist Fiscal Policy

• Equilibrium Output less than full-employment output– increase

government spending

– reduce taxes

– Aggregate Demand (AD) shifts to right

Output

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1. John Maynard Keynes Short-Run Model of Aggregate Demand Only

• Changes in Aggregate Supply have no effect on spending (contrary to Say’s Law)

• Aggregate Supply responds to changes in demand

• Economy can be modeled by looking at Aggregate Demand only

2. Consumption

• Consumption Function

• Graph Consumption Function

• Autonomous Consumption

• Marginal Propensity to Consume• Savings• Marginal Propensity to Save• Average Propensity to Consume

Average Propensity to Save

2. Consumption Consumption Function

C = C0 + b • Y

C = desired consumption

C0 = autonomous consumption

b = marginal propensity to consume

0 < b < 1

Y = income

2. Consumption Graph Consumption Function

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Intercept = C0

Slope = b

C = C0 + b • Y

2. Consumptioon Autonomous Consumption

• Autonomous consumption = C0

• Level of consumption at zero income

• Consumption independent of the level of income

• “Subsistence” level of income

2. Consumption Marginal Propensity to Consume (MPC)

• The change in consumption that results from a $1 change in income

• MPC = dC / dY

• Slope of the consumption function (b)

2. Consumption Marginal Propensity to Consume (MPC)

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dY = 15

dY = 15

dY = 15

dY = 15

dC = 10

dC = 10

dC = 10

dC = 10

MPC = dC / dY = 10 / 15 = 0.667

3. Simple Equilibrium Model

Aggregate Expenditures:

AE = C + I + G + NX

Assume:– No government, G = 0– No investment, I = 0– No international trade, NX = 0

AE = C

3. Simple Equilibrium Model Aggregate Expenditures

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Intercept = C0

Slope = MPC

AE = C = C0 + MPC • Y

3. Simple Equilibrium Model Equilibrium - the 45o Line

• The 45o line: all points that represent potential equilibrium (aggregate expenditures = income)

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3. Simple Equilibrium Model Aggregate Expenditures and the 45o Line

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Equilibrium

3. Simple Equilibrium Model Disequilibrium

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Income > SpendingUndesired Inventory Build

Income < SpendingUndesired Inventory Decline

3. Simple Equilibrium Model Autonomous Consumption Multiplier

• Shift in AE - if autonomous consumption increases by $1, how much does national income increase by?

• National income increases by the Multiplier times the change in autonomous consumption

3. Simple Equilibrium Model Shift in Autonomous Consumption

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dC0 = ± 5

dY = ± 15

Slope = MPC = 0.67

3. Simple Equilibrium Model Autonomous Consumption Multiplier

Person Income Spending 1 - + $5.00

2 $5.00 $5 x 0.67 = $3.33

3 $3.33 $3.33 x 0.67 = $2.22

4 $2.22 $2.22 x 0.67 = $1.48

5 $1.48 $1.48 x 0.67 = $0.99

… … … Totals $15.00 $15.00

Spending = Income x Marginal Propensity to Consume

4. Add Investment to Model

• I = I0

= Autonomous InvestmentInvestment independent of the level of income

• AE = Consumption + Investment = C + I

= C0 + MPC • Y + I0

4. Add Investment to Model Aggregate Expenditures

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Slope = MPC

AE = C + I = C0 + MPC • Y + I0

C0 = 10

I0 = 10

C

AE = C + I

4. Add Investment to Model Aggregate Expenditures and Equilibrium

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AE = C + IEquilibrium

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C0 = 10

5. Add Government Spending to Model

• G = G0

= Autonomous Government SpendingSpending independent of the level of income

• AE = C + I + G

= C0 + MPC • Y + I0 + G0

5. Add Government Spending Aggregate Expenditures with Equilibrium

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C + IEquilibrium

C

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C0 = 10

AE = C + I + G

G0 = 10

6. Autonomous Spending Multiplier

Autonomous Spending: Spending that is independent of any other variable (e.g., income, prices, interest rate)

• C0 = Autonomous Consumption

• I0 = Autonomous Investment

• G0 = Autonomous Government Spending

Autonomous (adj.) - self-governing

6. Autonomous Spending Multiplier The Multiplier

Multiplier = ___1___

1 - MPC

If MPC = 0.9, Multiplier = 10A $1 increase in autonomous spending leads to a

$10 increase in national income

If MPC = 0.8, Multiplier = 5A $1 increase in autonomous spending leads to a

$5 increase in national income

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45o Line

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Change in Automous Spending = CDChange in National Income = AB

Marginal Propensity to Consume = Slope = BD / AB

6. Autonomous Spending Multiplier Change in Autonomous Spending

6. Autonomous Spending Multiplier Graphical Derivation of Spending Multiplier

Multiplier = Change in National Income___

Change in Autonomous Spending

= AB / CD

= AB / (BC - BD)

= AB / (AB - BD) where BC = AB for 45o triangle

= (AB / AB)______

(AB / AB) - (BD / AB)

= 1_____

1 - (BD / AB)

where MPC = BD / AB

Multiplier = 1_ __

1 - MPC

6. Autonomous Spending Multiplier Algebraic Derivation of Spending Multiplier

AE = C + I + G

= C0 + MPC • Y + I0 + G0

In equilibrium:

Y = AE

Y = C0 + MPC • Y + I0 + G0

Y - MPC • Y = C0 + I0 + G0

(1 - MPC) • Y = C0 + I0 + G0

Y = ___1___ • (C0 + I0 + G0)

1 - MPC

7. Gaps

• Recessionary Gap– output in equilibrium less than full-employment

output

• Inflationary Gap– output in equilibrium greater than full-

employment output

• Output Gap– difference between actual output and full-

employment output

7. Gaps Gaps and the Keynsian Cross

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InflationaryGap

Output Gap Output Gap

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8. Government Fiscal Policy

• Lump Sum Tax

• Lump Sum Tax Multiplier

• Balanced Budget Multiplier

8. Government Fiscal Policy Lump Sum Tax

• Consumption = C0 + MPC • Yd

Yd = disposable income

= total income (Y) - lump sum tax (T0)

• Consumption = C0 + MPC • (Y - T0)

= C0 + MPC • Y - MPC • T0

• Multiplier = - MPC_

1 - MPC

8. Government Fiscal Policy Derivation of Lump Sum Tax Multiplier

AE = C + I + G + NX

AE = C0 + MPC • Y - MPC • T0 + I0 + G0

In equilibrium:

Y = AE

Therefore:

Y = C0 + MPC • Y - MPC • T0 + I0 + G0

Y - MPC • Y = C0 - MPC • T0 + I0 + G0

(1 - MPC) • Y = (C0+ I0 + G0) - MPC • T0

Y = 1___ • (C0+ I0 + G0) - MPC_ • T0

1 - MPC 1 - MPC

8. Government Fiscal Policy Balanced Budget Multiplier

Multiplier

Autonomous Government Spending

___1___ 1 - MPC

Lump Sum Tax - _MPC_ 1 - MPC

$1 Spending - $1 Tax 1