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Diploma Macro Paper 2

Monetary Macroeconomics

Lecture 2

Aggregate demand:

Consumption and the Keynesian Cross

Mark Hayes

slide 2

Outline

Introduction

Map of the AD-AS model

Goods marketKX and IS

(Y, C, I)

Moneymarket (LM)

(i, Y)

IS-LM(i, Y, C, I)

AD

Labour market(P, Y)

ASAD-AS

(i, P, Y, C, I)

Foreign exchange market(NX, e)

AD*-AS(i, P, e, Y, C, I, NX)

Phillips Curve(,u)

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Short-run effects of an increase in demand

Y

P

AD1

In the short run when prices are sticky,…

…causes output to rise.

PSRAS

Y2Y1

AD2

…an increase in aggregate demand…

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Outline

Introduction

Map of the AD-AS model

This lecture, we begin explaining the AD curve

Step 1: Equilibrium with variable income and consumption - the Keynesian Cross

Various Multipliers

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The Circular Flow I

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The Circular Flow II

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Income in Classical model

Profit and Rent

Wages

Consumption

Consumption

Saving

Investment

Consumption

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First step to AD - the Keynesian Cross

A simple ‘closed economy’ model (NX exogenous) in which private consumption (C ) is the only element of demand which varies

Notation: I = expected investmentE = C + I + G = expected expenditureY = real GDP = value of output

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Elements of the Keynesian Cross

I I

,G G T T

Consumption function:

for now, investment is exogenous:

Expected expenditure:

equilibrium condition:

Government consumption and tax:

Value of output = expected expenditure

 

 

 

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Plotting the equilibrium condition

income, output, Y

E

expected

expenditure

E =Y

45º

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Plotting planned expenditure

income, output, Y

E

expected

expenditure

E =C +I +G

 

 

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The equilibrium value of income

income, output, Y

E

expected

expenditure

E =Y

E =C +I +G

Equilibrium income

c11

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An increase in autonomous consumption

Y

E

E =Y

E =C +I +G1

E1 = Y1

E =C +I +G2

E2 = Y2Y

G

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The spending multiplier

Definition: the change in income resulting from a (small) change in autonomous expenditure such as G or I.

(In the following slides MPC = c1 )

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The multiplier as a partial derivative

Y C I G

Y C I G

MPC Y G

C G

(1 MPC) Y G

1

1 MPC

Y G

equilibrium condition

in changes

because I exogenous

because C = MPC Y

Collect terms with Y on the left side of the equals sign:

Solve for Y :

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The spending multiplier

 In this model, the spendingmultiplier equals

If MPC = 0.8

15

1 0.8

YG

An increase in G causes income to increase 5 times

as much!

An increase in G causes income to increase 5 times

as much!

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Why the multiplier is greater than 1

An increase in G represents an equal increase in Y: Y = G.

But Y C

further Y

further C

further Y So the final impact on income is much bigger

than the initial G. But not infinite, it converges.

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Conventional explanation of convergence

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The Phillips Machine, 1949

Invented by Bill Phillips at the LSE. A water-driven analogue computer used to demonstrate Keynesian economics

The flaw is that he used water, taking us back to a Classical corn model

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The Phillips Machine, 1949

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The Phillips Machine, 1949

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The Phillips Machine, 1949

www.sms.cam.ac.uk/media/1094078

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An increase in taxes

Y

E

E =C2 +I +G

E2 = Y2

E =C1 +I +G

E1 = Y1Y

C = MPC T

The tax increase reduces consumption, and therefore E:

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The tax multiplier

Definition: the change in income resulting from

a (small) change in T

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The tax multiplier as a partial derivative

Y C I G

MPC Y T

C

(1 MPC) MPC Y T

equilibrium condition in changes

I and G exogenous

Solving for Y :

MPC

1 MPC

Y TFinal result:

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The tax multiplier

MPC

1 MPC

YT

0.8 0.84

1 0.8 0.2

YT

If MPC = 0.8, then the tax multiplier equals

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The tax multiplier

…is negative: A tax increase reduces C, which reduces income.

…is greater than one (in absolute value):

A change in taxes has a multiplier effect on income.

…is smaller than the spending multiplier: Consumers save the fraction (1 – MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.

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The balanced budget multiplier

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YtTG

GTYtcY ])1[(1GYtGcYctY )()1( 11

GctctccY )1()1( 1111

11

1

1

1

c

c

G

Y

BB

By definition:

EquilibriumCondition:

The balanced budget multiplier

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Summary

Keynesian cross: equilibrium income determined with income and consumption variable

Shows how the direction of causation between saving and investment is reversed from the Classical model

The multiplier as comparative statics

– Spending, tax and balanced budget multipliers

– Comparing two equilibrium positions does not explain the dynamic process linking them

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Next time

Step 2 of building the AD curve

Finding equilibrium when income, consumption and investment can all move

the IS-LM model