Chapter 8: Keynesian Macroeconomics

Lecture 8

Chapter 8: Keynesian Macroeconomics

The Classical model introduced in chapter 7 focuses on the long run. Full employment is achieved in the long run (which is defined as after all adjustments occur).

Keynes developed his theories in response to the Great Depression, when a number of countries got stuck in situations of high unemployment for extended periods. He tried to explain how a country can get stuck.

Aggregate Expenditures

GDP = AE = C + I + G + NX

Simplifying Assumptions (for now):

1. Ignore government and the foreign sector

2. Assume that all saving is personal saving

3. Assume excess plant capacity and, therefore, no pressure on the aggregate price level

There are two things you can do with your disposable income: save it (S) or spend it (C).

Yd = S + C

Keynes believed that as income increases consumption also increases, but not by as much as the change in income. The marginal propensity to consume is equal to the change in consumption associated with a given change in income: MPC = ΔC/ΔYd.

Similarly, MPS = ΔS/ΔYd

MPC + MPS = 1

Two other important equations: APC = C ÷ Yd, APS = S ÷ Yd

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An important concept: the 45° line

In everyday life, the 45° line is a reference line that shows all the points where the value on the horizontal axis and the value on the vertical axis are equal:

number of treats45° line

number of trick-or-treaters

We want to be on the 45° line, where the number of treats matches the number of trick-or-treaters. Points above the line represent too many treats and points below the line represent not enough treats (too many trick-or-treaters).

In Keynesian economics, the 45° line is a reference line that shows all the points where income and consumption are equal:

Consumption45° line

Income

What do points above the 45° line represent? What about below the 45° line?

______

Consumption

C = a + MPC•Yd

Income

Where the value of a is determined by wealth, expectations, household debt, and taxes.

______

Investment

Investment is determined by interest rates, business expectations about the future, technological change, capital goods on hand, and operating costs. These determinants affect the rate of return on investment and, therefore, the amount of investment.

Notice that income does not affect investment.

Investment

Income

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The Simple Keynesian Model

Equilibrium occurs when Y = AE. Notice that this happens when withdrawals of spending (saving) equals injections of spending (investment).

AE 45° line (all points where Y = AE)

AE = C + I0

Consumption

a + I0

I0Investment

Income (Y)

Saving and

Investment

Saving

I0 Investment

Income (Y)

-a

Using the Simple Keynesian Model:

Show what will happen if investment spending increases from I0 to I1.

AE 45° line (all points where Y = AE)

AE = C + I0

a + I0

Y* Income (Y)

Saving and

Investment

Saving

I0 Investment

Income (Y)

-a

Make sure that you can also show what will happen if investment decreases.

Another important thing about changes in spending: the multiplier effect

“Changes in Spending are Amplified”

Notice from page 198 in your text that a $100 increase in spending causes income/output to increase by more than $100.

Specifically, the spending multiplier, k, is

k = 1/(1 – MPC)

If MPC = .75 then k = 1/(1 - .75) = 1/.25 = 4.

A multiplier of 4 implies that a $1 increase in spending causes a $4 increase in output.

The Full Keynesian Model

We will assume (for simplicity) that government spending, taxes, and net exports are all independent of Y.

This means that their graphs look like the investment spending graph:

Government

Spending

Income (Y)

Net Export

Spending

NX0 (X – M)

Income (Y)

Taxes

Income (Y)

We will also assume (for simplicity) that all taxes are paid in a lump sum. Taxes are subtracted from income, Y, to get disposable income, YD.

Therefore, adding these components to the mix, we get:

AE 45° line (all points where Y = AE)

AE = C + I0 + G + NX

a + I0+ G + NX

Y* Income (Y)

Saving,

I, G, NX

Saving

I0 + G + NXI + G + (X – M)

Income (Y)

-a

The economy will always move to equilibrium

AE 45° line (all points where Y = AE)

AE = C + I0 + G + NX

a + I0

Y* Income (Y)

Y* is where this economy will automatically go.

Scenario #1

What will happen if income in the economy is currently bigger than Y*, let’s say equal to Y1? On this graph, show that at Y1,income > AE. When income > AE the economy will shrink as firms lay off workers and cut production.

AE 45° line (all points where Y = AE)

a + I0

Y* Y1 Income (Y)

Y* is where this economy will automatically go.

Scenario #2

What will happen if income in the economy is currently smaller than Y*, let’s say equal to Y2? On this graph, show that at Y2,income < AE. When income < AE the economy will expand as firms hire more workers and boost production.

AE 45° line (all points where Y = AE)

a + I0

Y2 Y* Income (Y)

Y* is where this economy will automatically go.

Notes about Macroeconomic Equilibrium in the Simple Keynesian Model

Macroeconomic equilibrium occurs at the income level where there are no net pressures pushing the economy to move to a higher or lower level of income and output.

In equilibrium, leakages = injections, that is, S + T + IM = I + G + EX.

In equilibrium, Aggregate Expenditures = Income, that is, C + I + G + NX = Y.

Important Keynesian insight:Y* isn’t necessarily where we want to be. That is

macroeconomic equilibrium doesn’t necessarily occur at the full employment level of output.

We might want to be at Y1, for example. Why won’t we stay there?

Or we might want to be at Y2. Why won’t we stay there?

Scenario #1, Revisited: A recessionary gap

Recessionary gaps occur when there is too little spending to maintain full employment (Yfull)

What will happen if income in the economy is currently bigger than Y*, let’s say equal to Yfull? On this graph, show that at Yfull, income > AE. When income > AE the economy will shrink as firms lay off workers and cut production.

AE 45° line (all points where Y = AE)

a + I0

Y* Yfull Income (Y)

Y* is where this economy will automatically go, even though we don’t want to go there!

Scenario #2, Revisited: An inflationary gap

Inflationary gaps occur when there is too much spending to maintain full employment (Yfull)

What will happen if income in the economy is currently smaller than Y*, let’s say equal to Yfull? On this graph, show that at Yfull, income < AE. When income < AE the economy will expand as firms hire more workers and boost production.

AE 45° line (all points where Y = AE)

a + I0

Yfull Y* Income (Y)

Y* is where this economy will automatically go, even though we don’t want to go there!

The Great Depression, according to Keynes

AE 45° line (all points where Y = AE)

a + I0

Yfull Income (Y)

1. In 1929 the economy was at full employment (income = Yfull). We will start at this equilibrium.

2. Investment spending collapsed by 91% from 1929 to 1933. Show this graphically.

3. Find the new equilibrium.

4. Explain why the economy was not able to stay at full employment, that is, why it got stuck in a recessionary gap.

Keynes’ Prescription for Moving the Economy Back to Full Employment:

Increase government spending or cut taxes.

How does government intervention work?

Remember from above, that “changes in spending are amplified.” Here is the formula for finding how a particular change in spending will affect output:

The change in output = the multiplier x the initial change in AE

Exercise 1:

Assume that k = 4 and that AE increases by $100. How will output change?

Answer: The change in output = 4 x $100 = $400. Output will rise by $400.

Exercise 2:

Assume that MPC = .80 and that government spending increases by $787 billion. How will output change?

Answer: The change in output = (1/(1 – 0.80)) x $787 billion = 5 x $787 billion = $3,935 billion. Output will rise by $3,935 billion.

Exercise 3:

Assume that MPC = .80 and that taxes increase by $787 billion. How will output change?

Answer (this takesthree steps):

Step 1: ΔYD = -ΔT = -($787 billion) = -$787 billion

Step 2: ΔC = MPC x -ΔYD = .80 x -$787 billion = -$629.6 billion. Consumption will fall by $629.6 billion.

Step 3: The change in output = the multiplier x the initial change in AE = (1/(1 – 0.80)) x -$629.6 billion = 5 x -629.6 billion = -$3,148 billion. Output will fall by $3,148 billion

Exercise 4:

Assume the multiplier = 5. What will happen if the government intervenes in the economy to cure a recessionary gap by spending $787 billion and at the same time raises taxes by $787 billion so that the federal budget remains balanced?

Answer: Output will rise by $787 billion. This outcome is known as the balanced budget multiplier effect. “Equal changes in government spending and taxation lead to an equal change in output. That is, the balanced budget multiplier is equal to 1.”

Exercise 5:

Exercise 4 assumed the multiplier = 5, which implies that the MPC is .80. Will the answer to exercise 4 change if the MPC is some number other than .80?

Answer: No. No matter what the values of MPC and MPS are, the balanced budget multiplier is equal to 1.

Real World Intervention:

Robert J. Barro, “The Stimulus Evidence One Year On,” Wall Street Journal, 2/23/2010.

“My research shows an extra $600 billion of public spending at the cost of $900 billion in private expenditure.”