GRIPS Macroeconomics II

Fall II Semester, 2016

Lecture 1: Determination of National Income  Classical and Keynesian
Junichi Fujimoto
December 5, 2016

National income identity

Y = C + I + G + NX

(1)

S =Y C G

(2)

Y : GDP
C : Consumption (= goods and services purchased by the household)
I : Investment (= goods purchased for future use)
G: Government purchases (= goods and services purchased by the central and local government)
N X : Net exports (= exports  imports)
T : Net tax (= tax  transfer payment)
S : National saving
From (1) and (2),

N X = S I.

(3)

N X = (Y T C I) + (T G).

(4)

(1) can also be written as

(3) implies that net exports equal the dierence between national saving and investment, and (4) implies that net
exports equal the sum of private excess saving (Y T C I) and government budget surplus (T G).

1.1 Determination of national income: AD and AS curves

The next couple of lectures will discuss how, in the classical theory and in the Keynesian theory, Y is determined
in a closed economy which does not trade with other economies.
AD and AS curves

The AD (aggregate demand) and AS (AS:aggregate supply) curve, respectively, denotes the relation between the
demand/supply of goods and the general price level. P and Y are determined at the intersection of these two
curves.
The AD and AS curves in the classical theory

In the classical theory, the AS curve is vertical, so a shift in the AD curve only changes P , without aecting Y .
Therefore, Y is determined only from the AS curve; so even if the government can shift the AD curve with policies,
that does not allow the government to control Y .
1

AS

LRAS
SRAS

AD

AD
Y

classical

Keynesian

Figure 1: AD and AS curves

The AD and AS curves in the Keynesian theory

The biggest dierence from the classical theory is that the Keynesian theory distinguishes the short-run and longrun AS curves (SRAS and LRAS, respectively). The Keynesian AS curve is horizontal or upward sloping in the
short run (Figure 1 corresponds to the latter case), so when the AD curve shifts to the right, Y rises in the short
run. But the LRAS is vertical, so in the long run, such shift only causes a rise in P , just like in the classical theory.
Therefore, according to the Keynesian theory, if the government can shift the AD curve, the government can control
Y in the short run.
Note: The terms short/long run pertains to whether they are suciently long for the price adjustment to occur,
and there are no clear denitions such as X years, Z months, etc.
Derivation of AD and AS curves (overview)

The following diagrams give an overview of how AD and AS curves are derived in the classical/Keynesian theory.

Demand Side

Supply Side

quantity equation of money:

M=kPY

Firms
optimization problem
Labor demand LD

Households
optimization problem
Labor supply

equilibrium labor input

AD Curve

LS

L*

M
kP

Downward sloping AD curve

Y * = F ( L* )
vertical AS curve Y = Y *

equilibrium output

Determination of national income (classical)

Figure 2: Derivation of AD and AS curves (Classical theory)

Demand Side

Supply Side

Equilibrium in the
goods market

Equilibrium in the
money market

IS curve

LM curve

The LRAS is vertical, just like

in the classical theory Y =
Y*
The SRAS is either horizontal (= P constant)
or upward sloping, due to insufficient price
adjustment

downward sloping AD curve

Determination of national income (Keynesian)

Figure 3: Derivation of AD and AS curves (Keynesian theory)

Production and the labor market

Let us examine production and the labor market, which compose the supply side of the economy. For simplicity,
the stock of capital in the economy is assumed to be constant, and is not treated explicitly in the analysis. The
basis of the analysis is the optimization problems of the household and the rm.

2.1 The household's optimization problem (= utility maximization)

Let us consider the household's optimization problem below.

max U (C, L)
C,L

s.t. pC wL
The household utility U is an increasing function of consumption C , and a decreasing function of labor supply L. p
is price level, and w is nominal wage. Also, U is assumed to be continuously dierentiable and strictly quasiconcave
(Note: This kind of mathematical details are discussed in the microeconomics course; this course requires only
basic optimization theory, hence I won't go into details.). By solving this optimization problem, we obtain the labor
supply function LS .
There are two approaches for solving this problem: (1) solve for C (or L) from the budget constraint, substitute
into the utility function, and consider a single variable optimization problem, (2) use the Lagrangian method.
Here, let us follow the latter approach. The Lagrangian is

L = U (C, L) + (wL pC).

The rst order conditions (i.e., set the partial derivatives with respect to C , L, to zero) are:

UC

= p,

(5)

UL

= w,

(6)

wL = pC.

(7)

Here, UC and UL are, respectively, the partial derivative of U with respect to C and L, and correspond to the
marginal utility of consumption and the marginal (dis)utility of labor. From (5) and (6),
w
(8)
UL = UC .
p
(8) implies that it is optimal to choose (C, L) such that the magnitude of disutility from an additional one unit of
labor supply (LHS) equals the gain in utility from additional consumption of goods enabled by the increase in labor
supply. Combining this equation (8) and (7), we obtain the labor supply function.
(Example with a specic utility function)

max U (C, L)

C,L

2C 2 L

s.t. pC wL
The Lagrangian is

L = 2C 2 L + (wL pC)
The FOCs are
1

C 2

= p,

(9)

= w,

(10)

wL = pC.

(11)

By eliminating from (9) and (10), we obtain

w
.
p
Substituting this into (11) and solving for L, we obtain the labor supply function
w
LS = .
p
1

C2 =

Note that this is an increasing function of the real wage,

w
p.

(12)

2.2 The rm's optimization problem (= prot maximization)

Next, let us consider the rm's optimization problem below.

max

= pY wL

(13)

s.t. Y

= F (L)

(14)

The production function F is such that F 0 > 0, F 00 < 0 (i.e., decreasing returns to scale). Substituting (14) into
(13),
max = pF (L) wL
L

The FOC is

w
.
(15)
p
This implies that for the rm, it is optimal to choose the level of labor input such that the marginal product of
labor (M P L) equals the real wage wp . From this condition, we obtain the labor demand function LD .
(Example with a specic production function)
M P L = FL =

max

pF (L) wL

s.t. F (L)

2L 2

From (15),
1

L 2 =

w
.
p

Solving this for L, we obtain the labor demand function

w
LD = ( )2 .
p
Note that this is a decreasing function of the real wage,

w
p.

2.3 Equilibrium employment and output

The labor market equilibrium corresponds to the intersection of LS and LD .
w
p

LS

w *
)
p

LD

L*

Figure 4: Labor market equilibrium

In the example above, (12) and (16) imply

w
( ) = L = 1.
p
Substituting this into the production function, we obtain the equilibrium output
1

Y = 2(L ) 2 = 2.

(16)