KEYNESIAN ECONOMICS

1
Lecture 6

• KEYNESIAN ECONOMICS FISCAL POLICY

2
AGGREGATE 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.

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AGGREGATE 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.

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AGGREGATE 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.

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AGGREGATE 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.

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AGGREGATE 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.

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INCOME, 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.

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INCOME, 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

9
INCOME, 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)

10
THE 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

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THE 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.
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THE 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

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CONSUMPTION 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

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THE KEYNESIAN CROSS
450
Demand
E
C I Demand
C I
Output , y
0
y
At equilibrium output y, total demand Ey equals
output 0y .
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THE 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

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THE KEYNESIAN CROSS
450
Demand
E
C I Demand
C I
Output , y
0
y
At equilibrium output y, total demand Ey equals
output 0y .
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IF 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

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EQUILIBRIUM 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.
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EQUILIBRIUM 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),
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EQUILIBRIUM 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.
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IF 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

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EQUILIBRIUM 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),
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EQUILIBRIUM 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.
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THE 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.

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THE CONSUMPTION FUNCTION
Consumption function (Ca by)
Demand
Output, y
0
The consumption function relates consumer
spending to the level of income.
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THE CONSUMPTION FUNCTION
Consumption function (Ca by)
Demand
Ca
Output, y
0
The consumption function relates consumer
spending to the level of income.
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THE CONSUMPTION FUNCTION
Consumption function (Ca by)
Demand
Ca

autonomous consumption
Output, y
0
The consumption function relates consumer
spending to the level of income.
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THE 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.
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THE 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

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MARGINAL 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

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CHANGES 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.

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AUTONOMOUS 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

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MOVEMENTS OF THE CONSUMPTION FUNCTION
Demand
Ca0
Output, y
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MOVEMENTS OF THE CONSUMPTION FUNCTION
Demand
Ca1
Ca0
Output, y
An increase in autonomous consumption from Ca0
to Ca1 shifts the entire consumption function.
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MARGINAL 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

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MOVEMENTS OF THE CONSUMPTION FUNCTION
Demand
Slope b
Output, y
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MOVEMENTS 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.
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DETERMINING 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

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DETERMINING GDP
Demand
Consumption Function C
Ca
Output, y
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DETERMINING GDP
C I
Demand
Consumption Function C
Ca I
Ca
Output, y
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DETERMINING GDP
450
C I
Demand
Consumption Function C
Ca I
Ca
Output, y
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DETERMINING 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.
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EQUILIBRIUM 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

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THE 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

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THE MULTIPLIER
450
C I 0
Demand
y0
Consumption Function C
E0
Ca I 0

I 0
Ca
Output, y
y0
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THE 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
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THE 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).
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KEYNESIAN FISCAL POLICY

• Using taxes and spending to influence the level
  of GDP in the short run

GDP
Taxes Spending
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GOVERNMENT 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

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GOVERNMENT 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)

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DISPOSABLE 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

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CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
450
C I G0
Output, y
y0
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CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
After Spending Increase
450
C I G1
C I G0
Output, y
y0
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CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING AND
TAXES
Demand
After Spending Increase
450
C I G1
C I G0
Output, y
y0
y1
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CONSUMPTION 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.
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CONSUMPTION 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.
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CONSUMPTION 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.
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TAX 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 )

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BALANCED-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

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EXPANSIONARY POLICIES

• Government policies that increase total demand
  and GDP.
• Tax cuts and spending increases are examples of
  expansionary policies

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CONTRACTIONARY POLICIES

• Government policies that decrease total demand
  and GDP.
• Tax increases and spending cuts are examples of
  contractionary policies.

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BUDGET DEFICIT

• Increases when government increases spending
  or cuts taxes to stimulate the economy.

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PERMANENT INCOME

• Consumers often base their spending on an
  estimate of their long-run average income.

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AUTOMATIC STABILIZERS

• Taxes and transfers which act as economic
  institutions that automatically reduce economic
  fluctuations.

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HOW 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

66
AFTER 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

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AN INCREASE IN TAX RATES
450
C I G
Demand
Output, y
y0
68
AN INCREASE IN TAX RATES
450
C I G
Demand
C I G after tax- rate increase
Output, y
y0
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AN INCREASE IN TAX RATES
450
C I G
Demand
C I G after tax- rate increase
Output, y
y0
y1
70
AN 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.
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OTHER 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.

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MODIFYING 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

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DETERMINING 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.
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INCREASE IN EXPORTS AND IMPORTS
Demand
Demand
450
450
Ca I X
Ca I X
Output, y
Output, y
y0
y0
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INCREASE IN EXPORTS AND IMPORTS
Demand
Demand
450
450
X
Ca I X
Ca I X
Output, y
Output, y
y0
y0
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INCREASE 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
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INCREASE 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.
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ACTUAL 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.

79
ACTUAL 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)

80
ACTUAL 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.

81
ACTUAL 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

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EQUILBIRUM 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.

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EQUILBIRUM 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

84
EQUILBIRUM 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

85
EQUILBIRUM 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.

86
SAVINGS 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

87
SAVINGS 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.

88
SAVINGS 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.