Keynesian Macroeconomics: Aggregate Demand and the Multiplier Effect

1
Keynesian Macroeconomics Aggregate Demand and
the Multiplier Effect

• John Maynard Keynes, The General Theory of
  Employment, Interest and Money (1936)
• Great Depression (1929-1938) shows possibility of
  underemployment equilibrium -- actual GDP
  had not been equal to potential for years.
• The Keynesian model distinguishes
• Actual GDP -- what GDP happens to be right now
• Potential GDP -- full employment GDP
• Equilibrium GDP -- a level of GDP at which there
  are no forces tending to change the level of GDP.

2
John Maynard Keynes, 1919 and 1945
3

• The Keynesian system Planned and actual
  investment
• Investment has three components
• Plant and equipment -- drill presses, factory
  buildings, etc.
• Residential investment -- new housing
  construction
• Inventory investment -- Change in Business
  Inventories
• The first two are consciously planned (although
  plans can change, and typically do during a
  recession)
• inventory investment can be unplanned -- if a
  store fails to sell what it had expected to, it
  winds up with more inventory than it had
  expected.
• Stores with unplanned inventory investment will
  cut back on orders -- resulting in reduced
  production at the factory, layoffs and recession.

4
The Consumption Function the key to
Keynes Consumption depends on the level of
DISPOSABLE INCOME (disposable personal income
income - taxes Y - T) Some consumption is
autonomous ( independent of DPI) it may
depend on other factors such as wealth or stock
values. (even at zero income, Bill Gates would
consume something) The consumption function
proposed by Keynes is C C0 Cy ( Y -
T) C0 Autonomous consumption Cy
Marginal propensity to consume The marginal
propensity to consume plays a central role in the
Keynesian system. Keep your eye on the MPC in the
following slides.
5
Income (DPI Disposable Personal Income) and
Consumption (PCE Personal Consumption
Expenditures) (U.S., 1960.Q1 to 2001.Q3, data
from FRED Federal Reserve Economic Data
6
Regression line PCE - 71.23 0.93 DPI
7
The Keynesian model National income identity and
equilibrium The National income identity is Y
C I G NX The Keynesian equilibrium
equation is Y C0 Cy ( Y - T) Ip
G NX Notice that C has been replaced by the
consumption function, and investment by planned
investment. Given values for autonomous
consumption 300 for the marginal
propensity to consume 0.8 for planned
investment 1500 and finally for G 1200, T
1000, and NX 500 the equation can be solved for
Y.
8
Keynesian equilbrium Solution procedure Start
with the equation in general form Y C0 Cy
( Y - T) Ip G NX Substitute in the
given numbers Y 300 0.8 ( Y - 1000)
1500 1200 500 Collect all the constant
terms Y 3500 0.8Y - 800 Y 2700
0.8Y Subtract 0.8 Y from both sides of the
equation 0.2 Y 2700 Finally, multiply both
sides by 1 / 0.2 5 Y 5 (2700) 13,
500
9
The Multiplier Rerun the previous exercise,
raising planned investment by 500. Y 300
0.8 ( Y - 1000) 2000 1200
500 Collect all the constant terms Y 4000
0.8Y - 800 Y 3200 0.8Y Subtract 0.8 Y
from both sides of the equation 0.2 Y
3200 Finally, multiply both sides by 1 / 0.2
5 Y 5 (3200) 16, 000 GDP is UP BY
2,500, NOT up by only 500. Investment spending
has a MULTIPLIER EFFECT of 5
10

• The Multiplier Government Spending and Net
  Exports
• Instead of raising planned investment by 500, as
  on the last slide
• Raise Government Spending by 500
• Raise Net Exports by 500
• Cut taxes by 500
• What happens in each case?
• You should find that the increases in government
  spending and in investment raise income by 2,000
  -- that the multiplier for investment, government
  spending and net exports is exactly the same.
• Hence the major policy proposals made by Keynes
• -- raise government spending to expand the
  economy.
• -- ensure stability in the world trading system
  (IMF, WTO)

11
The Tax Multiplier Tax cuts have a multiplier
effect, but not the same effect as direct
government spending. Reason part of any tax cut
is saved, not spent.Consider the tax cut of
500 Y 300 0.8 ( Y - 500) 1500
1200 500 Collect all the constant terms Y
3500 0.8Y - 400 or Y 3100 0.8Y
Subtract 0.8 Y from both sides of the
equation 0.2 Y 3100 Finally, multiply both
sides by 1 / 0.2 5 Y 5 (3100) 15,
500 GDP is UP BY 2,000, NOT up by 2,500 as
with investment. Tax cut has a MULTIPLIER
EFFECT of 4.0 ( not 5.0 )