Title: KEYNESIAN ECONOMICS
1Lecture 6
- KEYNESIAN ECONOMICS FISCAL POLICY
2AGGREGATE OUTPUT AND INCOME - 1
- Each period (weeks, months, years, etc), firms
produce some aggregate quantity of goods and
services. - We call this aggregate output (Y).
- We have seen that GDP (Y) can be calculated in
terms of either income or expenditures.
3AGGREGATE OUTPUT AND INCOME - 2
- We will use the variable Y to refer to both
aggregate output and aggregate income, because
they are the same seen from different points of
view.
4AGGREGATE OUTPUT AND INCOME - 3
- What happens when output increases?
- What happens when output is cut?
- In any given period there is an exact quality
between aggregate output (production) and
aggregate income.
5AGGREGATE OUTPUT AND INCOME - 4
- Aggregate output can also be looked on as the
aggregate quantity supplied, because that is the
amount firms are supplying (producing) during the
period.
6AGGREGATE OUTPUT AND INCOME - 5
- In the lectures which follow, we use the phrase
aggregate output (income), rather than aggregate
quantity supplied, but keep in mind that the two
are equivalent.
7INCOME, CONSUMPTION AND SAVING - 1
- In the analysis which follows, we are initially
going to assume a simple world with no government
and a closed economy - i.e. no imports and no
exports. - With their income, households can either consume
or save.
8INCOME, CONSUMPTION AND SAVING - 2
- Total household saving in the economy (S) is by
definition equal to income (Y) minus consumption
(C) - Saving Income Consumption
- S Y C
-
9INCOME, CONSUMPTION AND SAVING - 3
- The triple equal sign means this is an identity -
something that is always true. - In our simple economy, in which there is no
government, there are two types of spending
behavior - spending by households or consumption
(C) and spending by firms, or investment (I)
10THE 450 LINE
- Divides the angle between the two axes of a graph
in half - Has the important property that from any point on
it, the vertical and horizontal distances
measured along the axes are equal
11THE 450 LINE
450
Demand
A
0
a
Output, y
Any point on the 450 line corresponds to the same
vertical and horizontal distances. The distance
0a equals the distance Aa.
12THE SIMPLEST KEYNESIAN CROSS
- Uses the 450 line
- A graph with the demand for goods and services on
the vertical axis and output ( y ) on the
horizontal axis - The government and foreign sector are omitted
from this model - Only consumers and firms can demand output
- Consumers demand consumption goods and firms
demand investment goods - Assume initially that consumers and firms demand
a fixed amount of goods
13CONSUMPTION AND INVESTMENT DEMAND
- Consumption demand is C
- Investment demand is I
- Total demand is C I
- In the short run, demand determines output
- Output demand
- Output demand C I
14THE KEYNESIAN CROSS
450
Demand
E
C I Demand
C I
Output , y
0
y
At equilibrium output y, total demand Ey equals
output 0y .
15THE SIMPLE KEYNESIAN CROSS
- Superimpose the horizontal line C I (demand)
on the 450 diagram - Total demand is fixed at C I and is independent
of the level of GDP - Equilibrium output is at y, the level of output
at which the demand line crosses the 450 line at
point E - Output measured on the horizontal axis equals
demand by consumers and firms - Since E is on the 450 line, the vertical distance
Ey equals the horizontal distance 0y
16THE KEYNESIAN CROSS
450
Demand
E
C I Demand
C I
Output , y
0
y
At equilibrium output y, total demand Ey equals
output 0y .
17IF ECONOMY PRODUCES AT A HIGHER LEVEL OF OUTPUT
THAN EQUILIBRIUM
- More goods and services are being produced than
are desired by consumers and firms - Extra goods will pile up as demand fell short of
production - Firms will react by cutting back on production
- The economy rapidly adjusts to reach the
equilibrium level of output
18EQUILIBRIUM OUTPUT
450
Demand
E
C I Demand
C I
Output, y
0
y
Given total demand equilibrium output (y) is
determined at E, where demand intersects the 450
line.
19EQUILIBRIUM OUTPUT
450
Demand
E
C I Demand
C I
Output, y
0
y
y1
Given total demand equilibrium output (y) is
determined at E, where demand intersects the 450
line. If output were higher (y1),
20EQUILIBRIUM OUTPUT
450
E1
Demand
excess production
E
C I Demand
C I
Output, y
0
y
y1
Given total demand equilibrium output (y) is
determined at E, where demand intersects the 450
line. If output were higher (y1), it would
exceed demand and production would fall.
21IF ECONOMY PRODUCES AT A LOWER LEVEL OF OUTPUT
THAN EQUILIBRIUM
- Demand would exceed total output
- Firms find that demand for consumption and
investment goods is greater that their current
production - Inventories disappear and firms face increasing
backlogs - Firms respond by stepping up production
- The economy rapidly adjusts to reach the
equilibrium level of output
22EQUILIBRIUM OUTPUT
450
E1
Demand
excess production
E
C I Demand
C I
Output, y
0
y
y1
y2
Given total demand equilibrium output (y) is
determined at E, where demand intersects the 450
line. If output were higher (y1), it would
exceed demand and production would fall. If
output were lower (y2),
23EQUILIBRIUM OUTPUT
450
E1
Demand
excess production
E
C I Demand
C I
insufficient production
E2
Output, y
0
y
y1
y2
Given total demand equilibrium output (y) is
determined at E, where demand intersects the 450
line. If output were higher (y1), it would
exceed demand and production would fall. If
output were lower (y2), it would fall short of
demand and production would rise.
24THE CONSUMPTION FUNCTION
- Describes the relationship between consumer
spending and income - C Ca by
- Consumption spending, C, has two parts
- Ca autonomous consumption is the part of total
consumption which is unaffected by the level of
income, i.e. it is constant at all levels of
income. - by the product of a fraction, b, called the
marginal propensity to consume (MPC) and the
level of income, y - The consumption function is a line that
intersects the vertical axis at Ca. It has a
slope equal to b.
25THE CONSUMPTION FUNCTION
Consumption function (Ca by)
Demand
Output, y
0
The consumption function relates consumer
spending to the level of income.
26THE CONSUMPTION FUNCTION
Consumption function (Ca by)
Demand
Ca
Output, y
0
The consumption function relates consumer
spending to the level of income.
27THE CONSUMPTION FUNCTION
Consumption function (Ca by)
Demand
Ca
autonomous consumption
Output, y
0
The consumption function relates consumer
spending to the level of income.
28THE CONSUMPTION FUNCTION
Consumption function (Ca by)
Demand
slope b
Ca
autonomous consumption
Output, y
0
The consumption function relates consumer
spending to the level of income.
29THE CONSUMPTION FUNCTION
- Although output is on the horizontal axis, output
and income in this simple economy are identical - Output generates income that is all received by
households - As output rises by 1, consumption increases by
the marginal propensity to consume (b) times 1
30MARGINAL PROPENSITY TO CONSUME (MPC)
- Is always less than 1
- If a consumer receives a dollar of income,
consumer will spend some of it and save the rest - The fraction that the consumer spends is
determined by the MPC - The fraction of income that the consumer saves is
determined by the marginal propensity to save
(MPS) - The sum of the MPC and MPS is always 1
31CHANGES IN THE CONSUMPTION FUNCTION
- The level of autonomous consumption and the MPC
can change causing movements in the consumption
function - If the level of autonomous consumption is higher,
it will shift the entire consumption function. - Changes in the marginal propensity to consume
will change the slope of the consumption function.
32AUTONOMOUS CONSUMPTION CHANGES
- Increases in consumer wealth will cause an
increase in autonomous consumption - Consumer wealth consists of the value of
stocks, bonds and consumer durables - Increases in consumer confidence will increase
autonomous consumption
33MOVEMENTS OF THE CONSUMPTION FUNCTION
Demand
Ca0
Output, y
34MOVEMENTS OF THE CONSUMPTION FUNCTION
Demand
Ca1
Ca0
Output, y
An increase in autonomous consumption from Ca0
to Ca1 shifts the entire consumption function.
35MARGINAL PROPENSITY TO CONSUME CHANGES
- Consumers perceptions of changes in their income
affect their MPC - If consumers believe that an increase in their
income is permanent, they will consume a higher
fraction of the increased income than if the
increase were believed to be temporary
36MOVEMENTS OF THE CONSUMPTION FUNCTION
Demand
Slope b
Output, y
37MOVEMENTS OF THE CONSUMPTION FUNCTION
Slope b1
Demand
Slope b
Output, y
An increase in MPC from b to b1 increases the
slope of the consumption function.
38DETERMINING GDP
- Plot the consumption function
- Investment is constant at all levels of income
- Add the level of desired investment vertically to
the consumption function - The C I line is the total spending in the
economy - At any level of income, total spending is C I
- The level of equilibrium income, y, occurs where
the total spending ( C I ) line crosses the 450
line - At this level of output, total spending equals
output
39DETERMINING GDP
Demand
Consumption Function C
Ca
Output, y
40DETERMINING GDP
C I
Demand
Consumption Function C
Ca I
Ca
Output, y
41DETERMINING GDP
450
C I
Demand
Consumption Function C
Ca I
Ca
Output, y
42DETERMINING GDP
450
C I
Demand
Consumption Function C
Ca I
Ca
Output, y
y
GDP is determined where the C I line intersects
the 450 line. At that level of output, y ,
desired spending equals output.
43EQUILIBRIUM INCOME
- autonomous consumption / (1 - MPC)
- Y (Ca I) / (1 - b)
- Suppose C 100 0.6
- Ca 100
- b 0.6
- I 40
- Using the formula for equilibrium income
- Y (100 40) / (1 - 0.6)
- Y 140 / 0.4
- y 350
- In equilibrium, saving investment
44THE MULTIPLIER
- The increase in output divided by an increase
investment - An increase in investment spending shifts up the
C I curve by I - The intersection with the 450 line shifts from E0
to E1 - GDP increases by y from y0 to y1
- The increase in GDP (y) is greater than the
increase in investment (I) - Since output increases more than the initial
increase in investment, the multiplier is greater
than 1
45THE MULTIPLIER
450
C I 0
Demand
y0
Consumption Function C
E0
Ca I 0
I 0
Ca
Output, y
y0
46THE MULTIPLIER
450
C I 1
C I 0
I
Demand
y0
Consumption Function C
E0
I 1
Ca I 0
I 0
Ca
Output, y
y0
47THE MULTIPLIER
450
C I 1
y1
y
C I 0
I
Demand
y0
Consumption Function C
E0
Ca I 0
I 0
Ca
y
Output, y
y0
y1
When investment increases by I from I0 to I1,
equilibrium output increases by y. The change in
output (y) is greater than the change in
investment (I).
48KEYNESIAN FISCAL POLICY
- Using taxes and spending to influence the level
of GDP in the short run
GDP
Taxes Spending
49GOVERNMENT SPENDING
- Government purchases of goods and services ( G )
is a component of spending - Total spending is C I G
- Increases of government purchases ( G ) shift up
the C I G line just as increases of
investment spending or autonomous consumption
spending do - The multiplier for government spending is also
the same as for changes in investment or
autonomous consumption
50GOVERNMENT SPENDING
- Changes in government purchases have exactly the
same effects as changes in investment spending or
autonomous consumption spending - The multiplier for government spending is also
the same as for changes in investment or
autonomous consumption - Multiplier for government spending 1 /
(1-MPC)
51DISPOSABLE PERSONAL INCOME
- The income that ultimately flows back to
households and consumers, after subtracting any
taxes that are paid and after adding any transfer
payments received by households (such as social
security, unemployment insurance and welfare) - disposable Personal income
(y-T) - where T is net taxes -- taxes minus transfer
payments
52CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
450
C I G0
Output, y
y0
53CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
After Spending Increase
450
C I G1
C I G0
Output, y
y0
54CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
After Spending Increase
450
C I G1
C I G0
Output, y
y0
y1
55CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
After Spending Increase
450
C I G1
C I G0
Output, y
y0
y1
An increase in government spending leads to an
increase in output.
56CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
Demand
After Spending Increase
After Tax Increase
450
450
C I G1
C I G
C I G
C I G0
Output, y
y0
Output, y
y1
y0
y1
An increase in government spending leads to an
increase in output.
57CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
Demand
After Spending Increase
After Tax Increase
450
450
C I G1
C I G
C I G0
C I G
Output, y
y0
Output, y
y1
y0
y1
An increase in government spending leads to an
increase in output.
An increase in taxes leads to an decrease in
output.
58TAX MULTIPLIER
- Is negative because increases in taxes decrease
disposable income and lead to reduction in
consumption spending - Is smaller (in absolute value) than the
government spending multiplier, because an
increase in taxes first reduces the disposable
income of households by the amount of the tax - tax multiplier - b / (1 - b)
- - MPC / ( 1 - MPC )
59BALANCED-BUDGET MULTIPLIER
- The multiplier for equal increases in government
spending and taxes - Equal increases in spending and taxes will not
unbalance the budget - Is always equal to 1
60EXPANSIONARY POLICIES
- Government policies that increase total demand
and GDP. - Tax cuts and spending increases are examples of
expansionary policies
61CONTRACTIONARY POLICIES
- Government policies that decrease total demand
and GDP. - Tax increases and spending cuts are examples of
contractionary policies.
62BUDGET DEFICIT
- Increases when government increases spending
or cuts taxes to stimulate the economy.
63PERMANENT INCOME
- Consumers often base their spending on an
estimate of their long-run average income.
64AUTOMATIC STABILIZERS
- Taxes and transfers which act as economic
institutions that automatically reduce economic
fluctuations.
65HOW AUTOMATIC STABILIZERS WORK
- When income is high
- -- government collects more taxes and pays
out less transfer payments - -- since government is taking funds from
consumers, this tends to reduce consumer
spending - When income is low (i.e., during recessions)
- -- government collects less taxes and pays
out more transfer payments - -- tends to increase consumer spending, since
the government is putting funds into the hands
of consumers
66AFTER A TAX INCREASE
- Consumption function depends on after-tax income
- C Ca b ( 1 - t ) y
- Marginal propensity to consume is now adjusted
for taxes and becomes - b ( 1 - t )
- Raising the tax rate therefore lowers the MPC
adjusted for taxes
67AN INCREASE IN TAX RATES
450
C I G
Demand
Output, y
y0
68AN INCREASE IN TAX RATES
450
C I G
Demand
C I G after tax- rate increase
Output, y
y0
69AN INCREASE IN TAX RATES
450
C I G
Demand
C I G after tax- rate increase
Output, y
y0
y1
70AN INCREASE IN TAX RATES
450
C I G
Demand
C I G after tax- rate increase
Output, y
y0
y1
An increase in tax rates decreases the slope of
the C I G line. This lowers output and
reduces the multiplier.
71OTHER FACTORS CONTRIBUTING TO STABILITY OF ECONOMY
- If households base their consumption decisions
partly on their permanent or long-run income,
they will not be very sensitive to changes in
current income. - If consumption doesnt change much with current
income, the marginal propensity to consume out of
current income will be small, which will make the
multiplier small. - When consumers base their decisions on long-run
factors, not just on their current level of
income, the economy tends to be stabilized.
72MODIFYING THE MODEL FOR EXPORTS AND IMPORTS
- Add exports, X, as another source of demand for
US goods and services - Subtract imports, M, from the total spending by
US residents - Consumers will import more goods as income rises
- imports M my
- m is the fraction known as the marginal
propensity to import - Subtract this fraction from the overall marginal
propensity to consume ( b ) to obtain the MPC for
spending on domestic goods
73DETERMINING OUTPUT IN AN OPEN ECONOMY
450
Demand
Demand
slope ( b - m )
C a I X
Output, y
y0
Output is determined where demand for domestic
goods equals output.
74INCREASE IN EXPORTS AND IMPORTS
Demand
Demand
450
450
Ca I X
Ca I X
Output, y
Output, y
y0
y0
75INCREASE IN EXPORTS AND IMPORTS
Demand
Demand
450
450
X
Ca I X
Ca I X
Output, y
Output, y
y0
y0
76INCREASE IN EXPORTS AND IMPORTS
Demand
Demand
450
450
After the increase in exports
Increase in the Marginal Propensity to Import
X
Ca I X
Ca I X
Output, y
Output, y
y0
y1
y0
y1
77INCREASE IN EXPORTS AND IMPORTS
Demand
Demand
450
450
After the increase in exports
Increase in the Marginal Propensity to Import
X
Ca I X
Ca I X
Output, y
Output, y
y0
y1
y0
y1
An increase in exports will increase the level of
GDP
An increase in taxes leads to an decrease in
output.
78ACTUAL VERSUS PLANNED - 1
- A firm may not always invest the exact amount
that it planned to. - Why?
- Firms do not have complete control over their
investment decisions. - This is not true of consumption, as households
have complete control over their consumption.
Planned consumption is always equal to actual
consumption.
79ACTUAL VERSUS PLANNED - 2
- Firms can generally chose how much new plant and
equipment they wish to purchase in any given
period (e.g. McDonalds buys an extra french-fry
machines, etc). - However, firms have less control over inventory
investment. - Remember, inventories are part of the capital
stock. Manufacturing firms have two kind of
inventories - Inputs (e.g. tyres, rolled steel, engine blocks,
etc) - Final production (finished automobiles awaiting
shipment)
80ACTUAL VERSUS PLANNED - 3
- Consequently, one component of investment -
inventory change - is partly determined by how
much households decide to buy, which is not under
complete control of firms. - If households do not buy as much as firms expect
them to, inventories will be higher than
expected, and firms will have made an inventory
investment that they did not plan to make.
81ACTUAL VERSUS PLANNED - 4
- Because involuntary inventory adjustments are
neither desired nor planned, we need to
distinguish between actual investment and desired
, or planned investment. - When we have been discussing I in this lecture,
we have used I to refer to desired or planned
investment only. - So, we could have written
- Planned aggregate expenditure Consumption
Planned investment - AE C I
82EQUILBIRUM AGGREGATE OUTPUT (INCOME) - 1
- In microeconomics we said that equilibrium is
said to exist in a particular market (e.g. the
market for bananas) at the price for which the
quantity demanded is equal to the quantity
supplied. - In macroeconomics, we define equilibrium in the
goods market as that point at which planned
aggregate expenditure is equal to aggregate
output.
83EQUILBIRUM AGGREGATE OUTPUT (INCOME) - 2
- Aggregate output Y
- Planned aggregate expenditure AE C I
- Equilibrium Y AE, or Y C I
- This definition of equilibrium can hold if, and
only if, planned investment and actual investment
are equal. To understand why, consider Y no equal
to AE. First let us suppose aggregate output is
greater than planned aggregate expenditure - YgtC I
- Aggregate outputgt Planned aggregate expenditure
84EQUILBIRUM AGGREGATE OUTPUT (INCOME) - 3
- When output is greater than planned spending,
there is unplanned inventory investment. Firms
planned to sell more of their goods than they
sold, and the difference shows up as unplanned
increase in inventories. - Suppose now that planned aggregate expenditure is
greater than aggregate output - C I gt Y
- Planned aggregate expenditure gt Aggregate output
85EQUILBIRUM AGGREGATE OUTPUT (INCOME) - 4
- When planned spending exceeds output, firms have
sold more than they planned to. Inventory
investment is smaller than planned. - Planned and actual investment are not equal. Only
when output is exactly matched by planned
spending will there be no unplanned inventory
investment. - Equilibrium in the goods market is achieved only
when aggregate output (Y) and planned aggregate
expenditure (CI) are equal, or when actual and
planned investment are equal.
86SAVINGS AND INVESMENT APPROACH - 1
- Because aggregate income must either be saved or
spent, by definition - Y C S
- THIS IS AN IDENTITY
- The equilibrium condition is
- Y C I
- BUT THIS IS NOT AN IDENTITY, BECAUSE IT DOES NOT
HOLD WHEN WE ARE OUT OF EQUILIBRIUM. IT WOULD BE
AN IDENTITY IF I WERE ACTUAL INVESTMENT RATHER
THAN PLANNED INVESTMENT
87SAVINGS AND INVESMENT APPROACH - 2
- Substituting C S for Y in the equilibrium
condition, we can write - Saving/investment approach to equilibrium C S
C I - Because we can subtract C from both sides of this
equation, we are left with S I. - Thus, only when planned investment equals saving
will there be equilibrium. - Remember, saving is income that is not spent.
Because it is not spent, saving is like a leakage
out of the spending stream.
88SAVINGS AND INVESMENT APPROACH - 3
- Only if that leakage is counterbalanced by some
other component of planned spending can the
resulting planned aggregate expenditure equal
aggregate output. This other component is planned
investment (I). - The leakage out of the spending stream - saving -
is matched by an equal injection of planned
investment spending into the spending stream. - For this reason, the saving/investment approach
to equilibrium is also called the leakages/
injections approach to equilibrium.