ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

The Keynesian Model

1. The Short-run: Explaining Business Cycle (A Preview) In the second part of the course, we will consider the short-run behavior of the economy and explain the business cycle. In order to fully understand how the macroeconomy works, we have to explore the following three markets: o Goods Market (Ch. 23 & 24) o Money Market (Ch. 25 & 26) o Labor Market (Ch. 27) Understanding these markets allow us to construct the AD-AS Model (Ch. 27) o to contrast how the economy behaves in the short run and how it adjusts to the long run. o to analyze the effects of fiscal policy and monetary policy. To enhance our understanding of the open economy, we supplement our analysis of AD by including the international goods market & foreign exchange market (Ch. 29).

International Goods and Foreign Exchange Market (Ch. 29)

Goods Market Keynesian Model (Ch. 23 & 24) Money Market (Ch. 25 26)

AD Curve

AD-AS Model (Ch. 27)

AS Curve Labor Market (Ch. 27)

2. The Goods Market: Keynesian Model It was proposed that an economys total income was, in the short run, determined largely by the aggregate expenditure (planned expenditure) of the economy. (John Maynard Keynes, The General Theory of Employment, Interest, and Money, 1936.) o By assuming that price level is fixed in the short run, the Keynesian model is developed to capture this insight. Recall that the classical model suggests that changes in the planned expenditure (demand) have no impact on the goods market equilibrium and output level when the Says law holds. What happens now?

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

o o

The critical assumption of the classical model is that the real interest rate adjusts until the loanable funds market clear. This assumption makes sense in the long run, but it may not hold in the short run. Not all saving is supplied to the loanable funds market. Financial intermediaries may not lend out all the loanable funds. Most importantly, in the short run, interest rates can be influenced by other factors.

As the major cause of business cycles is spending, we have to examine the aggregate expenditure (planned expenditure) in details. o Recall that the actual expenditure may not always equal to the planned expenditure, which is the total amount that the economy would like to spend because firms may engage in unplanned change in inventory when their sales do not meet their expectations. On the other hand, C, G and NX are always intentional.

In the Keynesian model, total planned expenditure is called the aggregate expenditure (AE):
AE C I p G NX

3. The Consumption Function

C C a c(Y Ta )

There are two parts of the consumption spending: o Autonomous Consumption (Ca): the portion of consumption expenditure that is independent of disposable income. (How can a person consume a positive amount with zero disposable income?) o Induced Consumption [c(Y Ta)]: the portion of consumption expenditure that responds to changes in income. Disposable income (Y Ta): The income that households that can use at their discretion. Net taxes (Ta) = total taxes transfer payments; it is assumed to be autonomous (independent to income) for simplicity. Marginal propensity to consume (c): the change in consumption induced by a $1 change in income, i.e. C Y .

Example 1: Consider an economy with autonomous consumption Ca = $1400, autonomous taxes T = $1750, and the marginal propensity to consume c = 0.6. Derive the consumption function. What is the consumption when the income (Y) equals $10,000? The consumption function is:
C C a c(Y T )

C 1400 0.6(Y 1750 )

Ca = $1400 (How can a person consume a positive amount with zero disposable income?) If Y = $10,000, C = 1400 + 0.6(10000 1750) = $6350.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Saving occurs when disposable income is larger than consumption expenditure. Saving function:
S Y T C

S Y T [Ca c(Y T )] S C a (1 c)(Y T ) S C a s(Y T )

Marginal propensity to save (1 c) or (s): the change in saving induced by a $1 change in income, i.e. S Y .

Example 2: Given the consumption function in Example 1 is C $1400 0.6(Y 1750 . Derive ) the saving function. What is the level of saving when Y = $10,000? The saving function is:
S Y T C S Y 1750 [1400 0.6(Y 1750 )]
S 1400 0.4(Y 1750 )

If Y = $10,000, S = 1400 + 0.4(10000 1750) = $1900. Factors affecting autonomous consumption (Ca): o Household wealth o Expected future income (optimism or pessimism about future) o Interest rate (r)

4. The Aggregate Expenditure Function Other components of the aggregate expenditure function (besides consumption function): o Planned investment (Ip): includes the planned fixed investment, which is assumed to be exogenous. What are the factors affecting planned investment? For simplicity, government expenditure (G) and net exports (NX) are assumed to be exogenous.

Combining all these components allow us to derive the aggregate expenditure (AE) function:
AE C a c(Y T ) I p G NX AE C a cT I p G NX cY

or
AE A cY

Autonomous expenditure (A): consists of all components of planned expenditure that do not depend on income.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Example 3: Consider an economy with autonomous consumption Ca = $1400, autonomous taxes T = $1750, and the marginal propensity to consume c = 0.6. Given the planned investment Ip = $1800, autonomous government spending G = $1950, net exports NX = $200 and interest rate r = 5. Derive the planned expenditure function. What is the planned expenditure when income (Y) equals $10,000?
AE C a c(Y T ) I p G NX

AE 1400 0.6(Y 1750 1800 1950 200 )

AE 4300 0.6Y

If Y = $10,000, AE = 4300+0.6(10000) = $10300. The planned expenditure (Ep) function is depicted in the following diagram:

Expenditure (AE)

AE 4300 0.6Y

Slope = c = 0.6

A = 4300

Income (Y)

5. The Equilibrium Real GDP When the economy (goods market) is in equilibrium, income equals planned expenditure
Y AE

Graphically, the equilibrium point can be determined by the crossing point of the planned expenditure function and the 45-degree line (Keynesian Cross)

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Expenditure (AE) Y=E Iu

AE A cY

Y2

Y*

Y1

Income (Y)

Why is the economy in equilibrium when Y = AE? o At Y1: Y AE Unplanned increase in inventory (Iu) It induces firms to reduce production until Y falls to the equilibrium level. o At Y2: Y AE Unplanned decrease in inventory It induces firms to increase production until Y rises to the equilibrium level. At Y*: Y AE Unplanned inventory investment = 0 (planned investment = actual investment) There is no tendency for firms to change their production.

Algebraically, the equilibrium income can be solved easily: In equilibrium, Y = AE:

Y A cY A A Y 1 c s

Example 4: Consider the economy in our previous example with the planned expenditure function AE $4300 0.6Y . Is the economy in equilibrium when income (Y) = $10000? If not, what is the equilibrium level of income for the economy? At Y = $10,000, AE = 4300+0.6(10000) = $10300. The planned expenditure is higher than the total output, the economy is not in equilibrium and there is an unplanned decrease of inventory by $300. In equilibrium, Y = AE:

Y 4300 0.6Y

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Y
6. The Multiplier Effect

4300 10750 0.4

Any change in autonomous planned expenditure (A) will cause a change in equilibrium income. To illustrate, suppose there is an increase in A by A : o It shifts the planned expenditure function upward by A o It increases the equilibrium income by Y

Expenditure (AE) Y = AE

AE2 A2 cY

AE1 A1 cY

A2 A1 Y1 Y2 Y = A / (1 c) Income (Y)

The multiplier effect o Notice that the increase in equilibrium income is bigger than the increase in autonomous spending, i.e. Y A . o Why is there multiplier effect? The existence of the induced consumption component in planned expenditure. According to the consumption function, C C a c(Y T ) , higher income causes higher consumption. When an increase in planned investment raises income by $100, it also induces an increase in consumption by $60 if c = 0.6. This increase in consumption by $60 will increase income by $60, further induces an increase in consumption by $36 Therefore, an increase in planned investment causes a greater increase in income.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

1st round 2nd round 3rd round . . . Total

Increase in investment of $100 Increase in consumption of $60 Increase in consumption of $36 . . .

Change in Income (Y) $100 $100 x 0.6 = $60 $100 x 0.62 = $36 . . . $250 = $100 (1 + 0.6 + 0.62 + 0.63 + )

induced change in Consumption (c = 0.6) $100 x 0.6 = $60 $60 x 0.6 = $36 $36 x 0.6 = $21.6 . . . $150

Expenditure multiplier (k): the ratio of the change in output to the change in autonomous planned expenditure. A As Y in equilibrium, 1 c A A Y 1 c s Y 1 1 k A 1 c s

Based on this theory, Keynes suggested demand shocks create business cycle.

Example 5: Consider the economy in our previous example with the planned expenditure function AE $4300 0.6Y . Suppose the businesses are more pessimistic about the future return on investment and reduce their planned investment spending by 500. What is the new equilibrium level of income? What is the multiplier? When Ip decreases by $500, the new planned expenditure is: AE 3800 0.6Y In equilibrium, Y = AE: Y 3800 0.6Y 3800 Y 9500 0.4 The multiplier is: Y 1250 k 2.5 A 500 7. Explaining Business Cycles The Keynesian model shows how output is determined in the short run when price level is fixed. o Is it guaranteed that short-run output level equals the potential (full-employment or natural rate of unemployment) GDP? Based on this theory, Keynes suggested demand shocks create business cycle. o GDP Gap = Actual GDP Potential GDP

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

According to the Keynesian model, the cause for a negative GDP gap is not enough expenditure. Recessionary expenditure gap is the amount by which AE must increase to increase the real GDP to its full-employment level (potential GDP). Inflationary expenditure gap is the amount by which AE must decrease to decrease the real GDP to its full-employment level (potential GDP). Why it is called inflationary expenditure gap?

Example 6: Consider the economy in our previous example after the reduction in planned investment spending by $500. Suppose the potential GDP is $10,000, what are the GDP gap and recessionary (or inflationary) expenditure gap? When Ip decreases by $500, the real GDP is $9500. The GDP Gap = 9500 10000 = 500. As the GDP gap is negative, there is a recessionary expenditure gap. To restore the output back to the full-employment level, it requires Yf = AE:

Y f A 0.6Y

10000 A 0.6(10000 )
A 4000
Therefore, the recessionary expenditure gap is 4000 3800 200

Expenditure (AE) Potential GDP Y=E

AE2 = A2 + mpcY AE1 = A1 + mpcY

Recessionary expenditure gap A2 A1 Y1 Yf GDP Gap = Y1 Yf (Negative) Income (Y)

8. Fiscal Policy: Government Spending and Taxes The government can create an offsetting movement in autonomous spending (in the opposite direction) to any undesirable shift through its control over government spending and autonomous taxes.

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Budget Surplus/Deficit = G T Budget surplus: G T < 0 Budget deficit: G T > 0 If the government desires a higher level of real GDP (fiscal expansion), it can be achieved by: Increasing G What is A when G changes by G? Reducing T What is A when T changes by T?

Example 7: Consider the economy in our previous example after the reduction in planned investment spending by $500. How much government spending must be increased to restore the full employment output or potential GDP? How much taxes must be cut to restore the full employment? Given the recessionary expenditure gap of $200, to restore the economy back to full employment, it requires A to increase by $200. It can be achieved by: G = $200 or c(T) = $200 T = $200/0.6 = -$333.33 The government spending multiplier: the ratio of the change in output to the change in government spending. o As A G , in equilibrium, G G Y 1 c s Y 1 1 Government spendingmultiplier G 1 c s The tax multiplier: the ratio of the change in output to the change in autonomous taxes. o As A cT , in equilibrium, cT cT Y 1 c s Y c c T ax multiplier T 1 c s

Example 8: In the above example, what are the government spending multiplier and tax multiplier? The government spending multiplier is:
Y 1250 2.5 G 500

The tax multiplier is:

Y 1250 1.5 T 833.33

ECON 1220 Principles of Macroeconomics

Semester 2, 2011/12

Either method above would create a large increase in government deficit, which may be undesirable. What if the government increases G and Ta by the same amount (i.e. G = Ta), maintaining a balanced budget? o In this case, as A G cT , in equilibrium, G cT (1 c)G Y G 1 c 1 c Y Balanced- budget multiplier 1 G

Example 9: Consider the economy in our previous example after the reduction in planned investment spending by $500. How much government spending and taxes must be increased to restore the full employment output or potential GDP? If the government maintains a balanced budget, given the output gap of -$500,to restore the economy back to full employment, it requires: G = T = $500

Readings: Chapter 22 23 (p. 685 712)

10

The economy: Turning the corner | The Economist

Page 1 of 2

Share via on email Twitter Facebook

The economy

Turning the corner

A surge of good omens, apart from jobs
Feb 3rd 2011 | WASHINGTON, DC | from PRINT EDITION

RECOVERY has long seemed a transient guest in America. As recently as last summer, a return to falling output seemed a real possibility. On the surface, the latest GDP figures hardly suggest a decisive turn for the better. According to preliminary estimates of fourth-quarter output, the economy expanded at a 3.2% annualised pace, up a bit from a 2.6% rise in the third quarter, though below economists forecasts. But a closer look suggests that Americas economy may at last be approaching something like strong growth. At 3.2%, the rise in GDP is disappointing for this stage in a recovery. At a similar point in the early 1980s business cycle, annual growth was roaring ahead at 7.1%, and employment was growing rapidly. Now the American economy is running a full $800 billion (5.7%) short of its potential output, and only in the fourth quarter did GDP finally pass its pre-recession peak. But the headline figures are misleading. As demand grew late in 2010, consumers purchased more than the economy produced. This meant that inventories shrank. On the national accounts this inventory decline shows up as a 3.7 percentage-point drag on total growth, but is also evidence of strong demand. Real final sales GDP minus inventory changessurged ahead at a 7.1% annual rate in the last three months of the year. That was the best quarterly performance since 1984, and up substantially from the meagre 0.9% annualised growth in the third quarter. Economists are cautious. Inventory declines often go with a drop in imports, and the fourth quarter was no exception. The drop in inventory may presage surging imports as firms restock, meaning that growing demand will simply flow abroad, as has often happened. But there are signs that Americas persistent trade imbalances are eroding. Americas trade deficit shrank for a third consecutive month in November, as exports grew faster than imports. In late December, the dollar resumed a decline that has been interrupted only by periodic European crises. A weakening dollar reduces the cost of American goods abroad, supporting export growth. A yawning trade deficit with China persists, and the dollars fall against Chinas currency, the yuan, proceeds at a glacial pace. But Chinas soaring wages and prices are undermining its international cost advantage. Early signs indicate even better conditions in 2011. Americas first manufacturing report of the year showed activity accelerating to the fastest level since 2004. Markets have shrugged off international crises to attain highs last seen in June 2008, before the Lehman crisis. For the first time in this recovery, the underlying economy looks independently strong, unaided by government stimulus or cyclical factors. It is too soon to declare victory, though. After two years of stimulus, federal government spending has now joined state and local budgets as a drag on growth. This trend will continue; future growth will come despite government cuts rather than because of government support. Financial shocks may yet rattle the world in 2011. And rising commodity prices could pose the

http://www.economist.com/node/18070567/print

2/14/2011

The economy: Turning the corner | The Economist

Page 2 of 2

Share via on email Twitter Facebook

biggest threat of all. Costly commodities will deter the resurgent American consumer, and may also spook the Federal Reserve into withdrawing monetary support at a faster pace.

Enter topic to look up

Meanwhile, the weakness in labour markets continues. Private-sector firms added 187,000 workers in January, according to a private employment report, following a gain of 247,000 in December. These figures, up from an average increase of only 52,000 over the previous six months, may signal a thaw in hiring conditions. But employment is still scarcely 1% above its post-recession lows. Until Americans can count on a reviving economy to produce new jobs they will be sceptical about recovery, and growth will remain vulnerable.
from PRINT EDITION | United States

About The Economist online

About The Economist

Media directory

Staff books

Career opportunities

Contact us

Subscribe Privacy policy Terms of use

[+] Site feedback Help

Copyright The Economist Newspaper Limited 2011. All rights reserved.

Advertising info

Legal disclaimer

Accessibility

http://www.economist.com/node/18070567/print

2/14/2011