Introduction to Macroeconomics Chapter 22 Keynesian Macroeconomics Chapter

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Introduction to Macroeconomics Chapter 22. Keynesian Macroeconomics

Introduction to Macroeconomics Chapter 22. Keynesian Macroeconomics

Chapter 22. Keynesian Macroeconomics 1. 2. 3. 4. 5. 6. 7. 8. John Maynard

Chapter 22. Keynesian Macroeconomics 1. 2. 3. 4. 5. 6. 7. 8. John Maynard Keynes Consumption Simple Equilibrium Model Add Investment to the Model Add Government Spending to the Model Autonomous Spending Multiplier Recessionary, Inflationary, and Output Gaps Government Fiscal Policy

1. John Maynard Keynes • General Theory… (1936) • Objections to Classical Model •

1. John Maynard Keynes • General Theory… (1936) • Objections to Classical Model • Equilibrium with Unemployment because of inadequate demand • Advocated Activist Government Fiscal Policy • Short-run model of aggregate demand only

1. John Maynard Keynes Objections to Classical Model • Interest rates, prices, and wages

1. John Maynard Keynes Objections to Classical Model • Interest rates, prices, and wages are rigid (“sticky”) • Savings (consumption) is a function of income, not interest rate. • Supply doesn’t create its own demand, it responds to changes in demand

1. John Maynard Keynes Equilibrium with Unemployment Full-employment output • Horizontal Aggregate Supply Curve

1. John Maynard Keynes Equilibrium with Unemployment Full-employment output • Horizontal Aggregate Supply Curve Equilibrium – Sticky prices – Interest rates have only a long run effect – Long-run growth factors can be ignored in shortrun model AS AD

1. John Maynard Keynesian Activist Fiscal Policy – increase government spending – reduce taxes

1. John Maynard Keynesian Activist Fiscal Policy – increase government spending – reduce taxes – Aggregate Demand (AD) shifts to right Full-employment output • Equilibrium Output less than fullemployment output AS AD

1. John Maynard Keynes Short-Run Model of Aggregate Demand Only • Changes in Aggregate

1. John Maynard Keynes Short-Run Model of Aggregate Demand Only • Changes in Aggregate Supply have no effect on spending (contrary to Say’s Law) • Aggregate Supply responds to changes in demand • Economy can be modeled by looking at Aggregate Demand only

2. Consumption • • Consumption Function Graph Consumption Function Autonomous Consumption Marginal Propensity to

2. Consumption • • Consumption Function Graph Consumption Function Autonomous Consumption Marginal Propensity to Consume • Savings • Marginal Propensity to Save • Average Propensity to Consume Average Propensity to Save

2. Consumption Function C = C 0 + b • Y C = desired

2. Consumption Function C = C 0 + b • Y C = desired consumption C 0 = autonomous consumption b = marginal propensity to consume 0<b<1 Y = income

2. Consumption Graph Consumption Function C = C 0 + b • Y Slope

2. Consumption Graph Consumption Function C = C 0 + b • Y Slope = b Intercept = C 0

2. Consumptioon Autonomous Consumption • Autonomous consumption = C 0 • Level of consumption

2. Consumptioon Autonomous Consumption • Autonomous consumption = C 0 • Level of consumption at zero income • Consumption independent of the level of income • “Subsistence” level of income

2. Consumption Marginal Propensity to Consume (MPC) • The change in consumption that results

2. Consumption Marginal Propensity to Consume (MPC) • The change in consumption that results from a $1 change in income • MPC = d. C / d. Y • Slope of the consumption function (b)

2. Consumption Marginal Propensity to Consume (MPC) MPC = d. C / d. Y

2. Consumption Marginal Propensity to Consume (MPC) MPC = d. C / d. Y = 10 / 15 = 0. 667 d. C = 10 d. Y = 15

3. Simple Equilibrium Model Aggregate Expenditures: AE = C + I + G +

3. Simple Equilibrium Model Aggregate Expenditures: AE = C + I + G + NX Assume: – No government, G = 0 – No investment, I = 0 – No international trade, NX = 0 AE = C

3. Simple Equilibrium Model Aggregate Expenditures AE = C 0 + MPC • Y

3. Simple Equilibrium Model Aggregate Expenditures AE = C 0 + MPC • Y Slope = MPC Intercept = C 0

3. Simple Equilibrium Model Equilibrium - the 45 o Line • The 45 o

3. Simple Equilibrium Model Equilibrium - the 45 o Line • The 45 o line: all points that represent potential equilibrium (aggregate expenditures = income) 45 o

3. Simple Equilibrium Model Aggregate Expenditures and the 45 o Line AE Equilibrium

3. Simple Equilibrium Model Aggregate Expenditures and the 45 o Line AE Equilibrium

3. Simple Equilibrium Model Disequilibrium Income > Spending Undesired Inventory Build 45 o Line

3. Simple Equilibrium Model Disequilibrium Income > Spending Undesired Inventory Build 45 o Line AE Income < Spending Undesired Inventory Decline

3. Simple Equilibrium Model Autonomous Consumption Multiplier • Shift in AE - if autonomous

3. Simple Equilibrium Model Autonomous Consumption Multiplier • Shift in AE - if autonomous consumption increases by $1, how much does national income increase by? • National income increases by the Multiplier times the change in autonomous consumption

3. Simple Equilibrium Model Shift in Autonomous Consumption Slope = MPC = 0. 67

3. Simple Equilibrium Model Shift in Autonomous Consumption Slope = MPC = 0. 67 d. C 0 = ± 5 d. Y = ± 15

3. Simple Equilibrium Model Autonomous Consumption Multiplier Spending = Income x Marginal Propensity to

3. Simple Equilibrium Model Autonomous Consumption Multiplier Spending = Income x Marginal Propensity to Consume

4. Add Investment to Model • I = I 0 = Autonomous Investment independent

4. Add Investment to Model • I = I 0 = Autonomous Investment independent of the level of income • AE = Consumption + Investment =C+I = C 0 + MPC • Y + I 0

4. Add Investment to Model Aggregate Expenditures AE = C + I = C

4. Add Investment to Model Aggregate Expenditures AE = C + I = C 0 + MPC • Y + I 0 AE = C + I C Slope = MPC I 0 = 10 C 0 = 10

4. Add Investment to Model Aggregate Expenditures and Equilibrium 45 o Line Equilibrium I

4. Add Investment to Model Aggregate Expenditures and Equilibrium 45 o Line Equilibrium I 0 = 10 C 0 = 10 AE = C + I C

5. Add Government Spending to Model • G = G 0 = Autonomous Government

5. Add Government Spending to Model • G = G 0 = Autonomous Government Spending independent of the level of income • AE = C + I + G = C 0 + MPC • Y + I 0 + G 0

5. Add Government Spending Aggregate Expenditures with Equilibrium G 0 = 10 I 0

5. Add Government Spending Aggregate Expenditures with Equilibrium G 0 = 10 I 0 = 10 C 0 = 10 45 o Line AE = C + I + G C+I C

6. Autonomous Spending Multiplier Autonomous Spending: Spending that is independent of any other variable

6. Autonomous Spending Multiplier Autonomous Spending: Spending that is independent of any other variable (e. g. , income, prices, interest rate) • C 0 = Autonomous Consumption • I 0 = Autonomous Investment • G 0 = Autonomous Government Spending Autonomous (adj. ) - self-governing

6. Autonomous Spending Multiplier The Multiplier = ___1___ 1 - MPC If MPC =

6. Autonomous Spending Multiplier The Multiplier = ___1___ 1 - MPC If MPC = 0. 9, Multiplier = 10 A $1 increase in autonomous spending leads to a $10 increase in national income If MPC = 0. 8, Multiplier = 5 A $1 increase in autonomous spending leads to a $5 increase in national income

6. Autonomous Spending Multiplier Change in Autonomous Spending 45 o Line AE 1 C

6. Autonomous Spending Multiplier Change in Autonomous Spending 45 o Line AE 1 C AE 0 D A B Change in Automous Spending = CD Change in National Income = AB Marginal Propensity to Consume = Slope = BD / AB

6. Autonomous Spending Multiplier Graphical Derivation of Spending Multiplier = Change in National Income___

6. Autonomous Spending Multiplier Graphical Derivation of Spending Multiplier = Change in National Income___ Change in Autonomous Spending = AB / CD = AB / (BC - BD) = AB / (AB - BD) where BC = AB for 45 o triangle = (AB / AB)______ (AB / AB) - (BD / AB) = 1_____ 1 - (BD / AB) where MPC = BD / AB Multiplier = 1_ __ 1 - MPC

6. Autonomous Spending Multiplier Algebraic Derivation of Spending Multiplier AE = C + I

6. Autonomous Spending Multiplier Algebraic Derivation of Spending Multiplier AE = C + I + G = C 0 + MPC • Y + I 0 + G 0 In equilibrium: Y = AE Y = C 0 + MPC • Y + I 0 + G 0 Y - MPC • Y = C 0 + I 0 + G 0 (1 - MPC) • Y = C 0 + I 0 + G 0 Y = ___1___ • (C 0 + I 0 + G 0) 1 - MPC

7. Gaps • Recessionary Gap – output in equilibrium less than full-employment output •

7. Gaps • Recessionary Gap – output in equilibrium less than full-employment output • Inflationary Gap – output in equilibrium greater than fullemployment output • Output Gap – difference between actual output and fullemployment output

7. Gaps and the Keynsian Cross 45 o Line Inflationary Gap Full-employment Output Gap

7. Gaps and the Keynsian Cross 45 o Line Inflationary Gap Full-employment Output Gap Output Recessionary Gap Output Gap AE

8. Government Fiscal Policy • Lump Sum Tax Multiplier • Balanced Budget Multiplier

8. Government Fiscal Policy • Lump Sum Tax Multiplier • Balanced Budget Multiplier

8. Government Fiscal Policy Lump Sum Tax • Consumption = C 0 + MPC

8. Government Fiscal Policy Lump Sum Tax • Consumption = C 0 + MPC • Yd Yd = disposable income = total income (Y) - lump sum tax (T 0) • Consumption = C 0 + MPC • (Y - T 0) = C 0 + MPC • Y - MPC • T 0 • Multiplier = - MPC_ 1 - MPC

8. Government Fiscal Policy Derivation of Lump Sum Tax Multiplier AE = C +

8. Government Fiscal Policy Derivation of Lump Sum Tax Multiplier AE = C + I + G + NX AE = C 0 + MPC • Y - MPC • T 0 + I 0 + G 0 In equilibrium: Y = AE Therefore: Y = C 0 + MPC • Y - MPC • T 0 + I 0 + G 0 Y - MPC • Y = C 0 - MPC • T 0 + I 0 + G 0 (1 - MPC) • Y = (C 0+ I 0 + G 0) - MPC • T 0 Y= 1___ • (C 0+ I 0 + G 0) - MPC_ • T 0 1 - MPC

8. Government Fiscal Policy Balanced Budget Multiplier

8. Government Fiscal Policy Balanced Budget Multiplier