The Power Of Macroeconomics

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The Power Of Macroeconomics
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The Keynesian Multiplier Model And Fiscal Policy
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The Purpose Of This Lesson

• Is to illustrate the basic Keynesian
  model--arguably one of the most important models
  in macroeconomic history.
• We will also introduce you to one of the most
  important tools in macroeconomics, that of fiscal
  policy.

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Lesson 3 Colander McConnell Samuelson
Schiller Brue Nordhaus 3rd Edition 14th
Edition 16th Edition 8th Edition
Complete Textbook (includes both Micro-and
Macroeconomics) Macroeconomics Text Only
11, 12 9, 10, 12 22, 24 9, 10, 11
11, 12 9, 10, 12 6, 8 9, 10, 11
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A Model With Many Names

• Some economists refer to the Keynesian model as
  the multiplier model while other call it the
  aggregate production-aggregate expenditures
  model.
• We will use these names interchangeably as we
  show you how the development and application of
  the basic Keynesian model gave birth to fiscal
  policy.

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Fiscal Policy
Government Expenditures
Stimulate
Contract
Tax Changes
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The Basic Keynesian Model

• Provides a straightforward approach to using
  fiscal policy to close a recessionary gap.
• In theory, the model may be used to calculate
  very precisely how much government spending must
  be increased, or taxes must be cut, to stimulate
  an economy back to full employment.

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A Warning

• Note, however, macroeconomics is hardly this
  simple a harsh reality that economists learned
  in the 1970s with the emergence of a virulent
  stagflation.

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In Future Lessons

• Well talk more about stagflation and the
  complexities of macroeconomics later.
• For now, lets master the simple Keynesian model
  and fiscal policy.

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Some Important History I

• The General Theory of Employment, Interest and
  Money contains little resembling todays basic
  textbook Keynesian model.
• How Keynes arcane prose was transformed into an
  easily understood algebraic and graphical model
  is a story in and of itself involving two key
  figures, Professors Alvin Hansen and Paul
  Samuelson.

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Some Important History II

• Alvin Hansen was a Classical economist who left
  the University of Wisconsin to take a post at
  Harvard and converted to Keynesianism.
• At Harvard, Hansen led a seminar that became an
  important cauldron of ideas for the Keynesian
  doctrine.
• Hansen also took regular trips to Washington,
  D.C. to spread the Keynesian gospel to the
  nations policymakers.

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Some Important History III

• Most importantly, Hansen wrote A Guide to Keynes
  which became the bible for economic students in
  the 1950s.
• Hansens star pupil Paul Samuelson wrote what
  would become the definitive macroeconomic
  textbook.
• Out of these writings has emerged the basic
  Keynesian model.

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The Assumption Of Fixed Prices
Price Level
Classical Range
Intermediate Range
Keynesian Range
Potential Output

• The most important assumption underlying this
  model is that prices are fixed.
• Keynes didnt believe this but did believe that
  when the economy is in the recessionary range,
  prices and wages were sufficiently inflexible so
  that income would adjust much faster than prices.

Aggregate Output
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The Implication

• The fixed price assumption allowed Hansen and
  Samuelson to develop a Keynesian model readily
  distinguishable from the aggregate
  supply-aggregate demand model.

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The Keynesian Model
Aggregate Expenditures
AECIGX
Real GDP, Output
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The Keynesian Model
Aggregate Expenditures
Qr
Real GDP, Output
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The Keynesian Model
Aggregate Expenditures
Qi
Real GDP, Output
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Says Law and the Circular Flow Diagram
Aggregate Supply(AS) Employee compensation,
rents, interest, and profit
Aggregate Demand (AD) Consumption Investment

• A leakage is income not directly spent on
  domestic output but is diverted from the circular
  flow.
• An injection is an addition of income to the
  circular flow.
• Savings is a leakage while investment is an
  injection.

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LEAKAGES Consumer saving Business
saving Taxes Imports
INJECTIONS Investment Government spending Exports

• In an economy with a government sector, taxes and
  government spending represent important leakages
  and injections, respectively.
• In an open economy where trading occurs, import
  leakages and export injections are likewise
  important in determining actual output.

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LEAKAGES
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Aggregate Production

• Is defined as the total amount of goods and
  services produced in the economy.
• By definition, production creates an equal amount
  of income so that the aggregate production curve
  is a 45 line.

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Aggregate Production
A
E
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Aggregate Expenditures

• Total spending or aggregate expenditures may be
  represented algebraically by the equation
• AEConsumptionInvestmentGovernment
  ExpendituresNet Exports
• The aggregate expenditures curve is simply the
  vertical summation of these four components.

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Aggregate Expenditures
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Aggregate Expenditures
Autonomous consumption happens independently of
income
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The Keynesian Expenditure Function

• To fully understand how the Keynesian model
  works, we have to understand
• Autonomous consumption
• Why the AE curve is flatter than the AP curve
• To do this, we will examine the major components
  of the Keynesian Expenditure Function
  consumption, investment, government expenditures,
  and net exports.

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Consumption

• The largest component of aggregate expenditures.
• Accounts for almost 70 of total aggregate
  expenditures in the U.S.

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Value of Category Category of
1996 Percent consumption (, billion) of
total
Durable goods 538 12 Motor vehicles 222 Househo
ld equipment 212 Other 104 Nondurable goods
1,350 31 Food 658 Clothing
and apparel 237 Energy 119 Other 336 Services
2,504 57 Housing 628 Househo
ld operation 251 Transportation 170 Medical
care 681 Other 773 _____
___ Total, personal
consumption expenditures
4,392 100
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Consumption
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Autonomous Consumption

• First, there is a level of consumption that
  occurs even if a person loses his or her job.
• This person will still be able to consume by
  dipping into savings.
• The level of consumption that occurs regardless
  of changes in ones income is called autonomous
  consumption.

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Induced Consumption

• Second, there is a level of induced consumption
  that will depend on the individuals disposable
  income.
• Disposable income is the amount of money you have
  left after paying taxes to the government.

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Marginal Propensity To Consume

• Keynes described this behavior in terms of a
  persons marginal propensity to consume or
  marginal propensity to expend.
• This MPC or MPW is simply the extra amount
  that people consume when they receive an extra
  dollar of disposable income.

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Marginal Propensity To Save

• The marginal propensity to save or the marginal
  propensity to withdraw is simply the reciprocal
  of the MPC and it measures the extra amount
  people save when they receive an extra dollar of
  disposable income.

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An Example

• Some people may spend seventy five cents of every
  dollar of their disposable income and save 25
  cents.
• What will be the MPC and what would be the MPS?

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An Example

• In this case the marginal propensity to consume
  or MPC is .75 and the MPS is .25
• In another situation, people may spend as much as
  90 cents and save only ten cents of every dollar.
  
• In this case the MPC is .90 and the MPS .10

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MPC15/200.75
The aggregate expenditures curve is flatter than
the 45 degree line in the Keynesian model
precisely because the MPC is less than one.
MPS5/200.25
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(1) (2) (3)
(4) (5) Disposable
income Consumption Marginal propensity Net
saving Marginal propensity (after taxes)
expenditures to consume ()
to save () ()
(MPC) (4)(1)-(2) (MPS)
A 24,000 24,110 -110 890/1,0000.89 110/1,000
0.11 B 25,000 25,000 0 850/1,0000.85
150/10000.15 C 26,000 150 750/1,0000.75 2
50/1,0000.25 D 27,000 400 640/1,0000.64 3
60/1,0000.36 E 27,240 760 590/1,0000.59
F 27,830 1,170 G 30,000 28,360 1,640
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(1) (2) (3)
(4) (5) Disposable
income Consumption Marginal propensity Net
saving Marginal propensity (after taxes)
expenditures to consume ()
to save () ()
(MPC) (4)(1)-(2) (MPS)
A 24,000 24,110 -110 890/1,0000.89 110/1,000
0.11 B 25,000 25,000 0 850/1,0000.85
150/10000.15 C 26,000 25,850 150 750/1,0000
.75 250/1,0000.25 D 27,000 26,600 400 640/1
,0000.64 360/1,0000.36 E 28,000 27,240 760
590/1,0000.59 410/1,0000.41 F 29,000 27,830
1,170 530/1,0000.53 470/1,0000.47 G 30,000 2
8,360 1,640
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What It Looks Like

• It can be expressed in an equation, a table or a
  graph.
• Algebraically, then, we can represent the
  Keynesian consumption function simply as follows
• CC0 MPCYd
• Total consumption, C, equals autonomous
  consumption, C0, plus induced consumption where
  induced consumption equals the MPC times Yd .

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The Consumption Function
slopeMPC
The slope of the consumption function is the MPC,
or 0.75.
A
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Malthus Point Redux

• You can see how this consumption function relates
  back to the problem that Thomas Malthus
  originally identified with Says Law and the
  Classical model.
• People wont necessarily spend everything they
  earn and aggregate expenditures therefore need
  not equal aggregate production.

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A Simplifying Assumption

• In the Keynesian model, whether the economy is in
  full employment equilibrium will depend on the
  levels of the three other components of the
  aggregate expenditures curve I, G, and net
  exports.

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Investment

• Investment expenditures include
• purchases of residential structures,
• investment in business plant and equipment,
• and additions to a companys inventory.
• Investment in plant and equipment is by far the
  biggest category, averaging a full 70 percent of
  total investment annually while total investment
  expenditures account for roughly 15 percent of
  total aggregate expenditures.

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Investment

• Assumed to occur independently of the level of
  income.
• Algebraically, this means I is equal to
  autonomous investment, Io.
• Therefore, the investment function may be
  represented as a horizontal line.

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The Investment Function
Investment (billions)
AP
Income
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Determinants of Investment I

• Keynes believed investment was sensitive to
  changes in the interest rate.
• When the interest rate falls, investment rises.
• When the interest rate rises, investment falls.

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Determinants of Investment I

• Keynes did not believe that falling interest
  rates and increased investment would necessarily
  lead to a full employment equilibrium like the
  Classical economists did.

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Animal Spirits

• Keynes believed investment was driven by animal
  spirits or the expectations businesses had
  regarding potential sales and profits.
• If businesses believed the economy was about to
  go bad, it could become a self-fulfilling
  prophecy because they would cut back on
  investment and production and help trigger a
  recessionary spiral.

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End of Part 1
Lecturer Peter Navarro Multimedia Designer Ron
Kahr Female Voice Ashley West Leonard