Keynesian Macroeconomics Aggregate Demand the Multiplier Effect John

Keynesian Macroeconomics: Aggregate Demand the Multiplier Effect • John Maynard Keynes, The General Theory of Employment, Interest and Money (1936) • Great Depression (1929 -1938) shows possibility of underemployment equilibrium -actual GDP had not been equal to potential for years. • The Keynesian model distinguishes: – Actual GDP -- what GDP happens to be right now – Potential GDP -- full employment GDP – Equilibrium GDP -- a level of GDP at which there are no forces tending to change the level of GDP.

John Maynard Keynes, 1919 and 1945

The Keynesian system: Planned and actual investment Investment has three components: • Plant and equipment -- drill presses, factory buildings, etc. • Residential investment -- new housing construction • Inventory investment -- Change in Business Inventories The first two are consciously planned (although plans can change, and typically do during a recession); inventory investment can be unplanned -- if a store fails to sell what it had expected to, it winds up with more inventory than it had expected. Stores with unplanned inventory investment will cut back on orders -resulting in reduced production at the factory, layoffs and recession.

The Consumption Function: the key to Keynes Consumption depends on the level of DISPOSABLE INCOME (disposable personal income = income - taxes = Y - T) Some consumption is autonomous (= “independent” of DPI): it may depend on other factors such as wealth or stock values. (even at zero income, Bill Gates would consume something) The consumption function proposed by Keynes is: C = C 0 + Cy ( Y - T) C 0 = Autonomous consumption Cy = Marginal propensity to consume The marginal propensity to consume plays a central role in the Keynesian system. Keep your eye on the MPC in the following slides.

Income (DPI = Disposable Personal Income) and Consumption (PCE = Personal Consumption Expenditures) (U. S. , 1960. Q 1 to 2001. Q 3, data from FRED: Federal Reserve Economic Data

Regression line: PCE = - 71. 23 + 0. 93 DPI

The Keynesian model: National income identity and equilibrium The National income identity is: Y = C + I + G + NX The Keynesian equilibrium equation is: Y = C 0 + Cy ( Y - T) + Ip + G + NX Notice that C has been replaced by the consumption function, and investment by planned investment. Given values for autonomous consumption = 300 for the marginal propensity to consume = 0. 8 for planned investment = 1500 and finally for G = 1200, T = 1000, and NX = 500 the equation can be solved for Y.

Keynesian equilbrium: Solution procedure Start with the equation in general form: Y = C 0 + Cy ( Y - T) + Ip + G + NX Substitute in the given numbers: Y = 300 + 0. 8 ( Y - 1000) + 1500 + 1200 + 500 Collect all the constant terms: Y = 3500 + 0. 8 Y - 800 Y = 2700 + 0. 8 Y Subtract 0. 8 Y from both sides of the equation: 0. 2 Y = 2700 Finally, multiply both sides by 1 / 0. 2 = 5 Y = 5 (2700) = 13, 500

The Multiplier Rerun the previous exercise, raising planned investment by 500. Y = 300 + 0. 8 ( Y - 1000) + 2000 + 1200 + 500 Collect all the constant terms: Y = 4000 + 0. 8 Y - 800 Y = 3200 + 0. 8 Y Subtract 0. 8 Y from both sides of the equation: 0. 2 Y = 3200 Finally, multiply both sides by 1 / 0. 2 = 5 Y = 5 (3200) = 16, 000 GDP is UP BY 2, 500, NOT up by only 500. Investment spending has a MULTIPLIER EFFECT of 5

The Multiplier: Government Spending and Net Exports Instead of raising planned investment by 500, as on the last slide: • Raise Government Spending by 500 • Raise Net Exports by 500 • Cut taxes by 500 What happens in each case? You should find that the increases in government spending and in investment raise income by 2, 000 -- that the multiplier for investment, government spending and net exports is exactly the same. Hence the major policy proposals made by Keynes: -- raise government spending to expand the economy. -- ensure stability in the world trading system (IMF, WTO)

The Tax Multiplier Tax cuts have a multiplier effect, but not the same effect as direct government spending. Reason: part of any tax cut is saved, not spent. Consider the tax cut of 500: Y = 300 + 0. 8 ( Y - 500) + 1500 + 1200 + 500 Collect all the constant terms: Y = 3500 + 0. 8 Y - 400 or Y = 3100 + 0. 8 Y Subtract 0. 8 Y from both sides of the equation: 0. 2 Y = 3100 Finally, multiply both sides by 1 / 0. 2 = 5 Y = 5 (3100) = 15, 500 GDP is UP BY 2, 000, NOT up by 2, 500 as with investment. Tax cut has a MULTIPLIER EFFECT of 4. 0 ( not 5. 0 )