Transcript The Keynesian Framework

Chapter 23
The Keynesian
Framework
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Learning Objectives
• See the differences among saving, investment, desired
saving, and desired investment and explain how these
differences can generate short run fluctuations in real
GDP
• Understand the Keynesian cross and determination of
an equilibrium level of income
• Analyze autonomous changes in macroeconomic
variables and their potential to cause economic
fluctuations
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Learning Objectives (Cont.)
• Define the liquidity preference theory and its
role in determining interest rates
• Comprehend the Keynesian theory of monetary
policy and its role in impacting the economy
• Understand the Keynesian version of aggregate
demand/aggregate supply analysis
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Introduction
• In 1936, John Maynard Keynes published The General
Theory of Employment, Interest and Money
• Concerned with short-run as compared to the Classical
Economists who focused on long-run
• Argued that free market forces could take considerable
time to adjust
• In the short run there could be lengthy periods of
underemployment
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Introduction (Cont.)
• Preoccupied with what determined the level of real
economic activity during long periods of recession or
depression
• If economy were sufficiently depressed, could
experience increases in real output without any increase
in the price level
• Assumed that the price level is fixed
• Focused on aggregate demand and supply since full
employment was irrelevant
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When Saving Doesn’t Equal
Investment
• Classical economists stated that equilibrium
existed when total saving desired by households
equals total investment desired by firms
• However, Keynes asked what happens when
desired savings exceeds desired investment and
prices were not free to adjust
– Prices are sticky and will not decline as inventories
build up
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When Saving Doesn’t Equal
Investment (Cont.)
– Wages are resistant to decreases
– Since interest rates are determined in the money
market, fluctuations will not necessarily equilibrate
desired saving and desired investment
– Therefore, since prices will not fall, both real
output and income will decline until desired
savings equaled desired investment at a lower
equilibrium GDP
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Consumption
and Simple GDP Determination
• Figure 23.1 represents the Keynesian cross
diagram
• Real income and real output are measured in the
horizontal axis (Income: Y)
• Different types of expenditures are measured on
the vertical (Expenditure: E)
• A 45 degree line from origin traces the
equilibrium condition where E = Y
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FIGURE 23.1 Spending determines income.
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Consumption and Simple GDP
Determination (Cont.)
• Expenditure takes two forms—consumption and
investment
– Consumption Function (C)
• Consumption is a linear function of income (Y)
• C = a + bY
• “b” is equal to the slope of the consumption line
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Consumption and Simple GDP
Determination (Cont.)
– Consumption Function (C) (Cont.)
• Marginal propensity to consume (MPC)
– The slope of the consumption functions (b)
– how much additional consumption would result from a $1
increase in income and is always less than 1
• “a” of the consumption function represents consumption
level if income were equal to zero
• The consumption function will shift up or down if the
value lf “a” changes due to increased/decreased personal
wealth
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Consumption and Simple GDP
Determination (Cont.)
– Investment (I)
• A relationship between the rate of interest on bonds and
the level of investment spending by business firms
• A negative relationship—when interest rates fall,
investment spending will increase
• Entrepreneurs invest as long as the rate of return on
investment exceeds the rate of interest
• If the rate of interest is given, the level of investment
will be constant and not a function of income
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Consumption and Simple GDP
Determination (Cont.)
• Total expenditure is equal to the sum of consumption
which varies with income and investment which is
constant (E = C + I)
• At points along the 45 degree line, total expenditure (E)
is equal to total income (Y)
• Since desired savings is equal to Y – C and E = Y, it
follows that along the 45 degree line desired savings is
equal to desired investment (S = I)
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Consumption and Simple GDP
Determination (Cont.)
• Savings Function (Figure 23.2)
– The marginal propensity to save (MPS) is equal to
1 – MPC and less than 1
– This represents the slope of the savings function
which graphs a linear relationship between savings
and income
S = -a + (1 - b)Y
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FIGURE 23.2 Saving and
investment determine income.
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Consumption and Simple GDP
Determination (Cont.)
• Savings Function (Figure 23.2) (Cont.)
– The economy is in equilibrium at an income level
where the savings function is equal to a fixed
investment
– This level of income is identical to the level where
the total expenditure function crosses the 45
degree line
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Changes in GDP
• The equilibrium level of income will not change
unless there is a change in the consumption or
investment functions
• This equilibrium would be a desirable outcome
if level of income (output) was at full
employment level
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Changes in GDP (Cont.)
• Keynes argued that since the level of investment is
highly unstable, it is likely that the equilibrium output
level will not equal the full employment level of output
• If entrepreneurs became uncertain about the future,
investment spending would decline (total expenditure
function would shift down) and equilibrium would be
established at a lower level of GDP
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Changes in GDP (Cont.)
• Multiplier—actual decline in GDP will be a
multiple of the reduction in investment spending
– When investment declines, income begins to decline
– This induces a reduction in consumer spending,
further lowering the level of income
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Changes in GDP (Cont.)
• Multiplier (Cont.)
– The total change in income is related to the initial
decline in investment through the multiplier, which
takes the following form
Multiplier 
1
(1  b)
Where: b = marginal propensity to spend
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Changes in GDP (Cont.)
• Multiplier (Cont.)
– Therefore, the total change in income resulting from a
change in investment is:
Y  I
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1
1b
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Autonomous versus Induced
Changes in GDP
• Figures 23.3 and 23.4 suggest that anything that shifts
the position of the total desired spending function will
alter GDP
• Such shifts are produced by autonomous spending
changes which are independent of GDP
• However, the multiplier was based on the idea that
autonomous spending changes will induce further
changes in spending
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FIGURE 23.3 A decline in investment spending
reduces Y by a multiple of the change in investment.
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FIGURE 23.4 A decline in investment
spending reduces Y by a multiple of the
change in investment.
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Autonomous versus Induced
Changes in GDP (Cont.)
• The larger the marginal propensity to spend (b),
the greater the induced change in spending
• Keynes argued that consumption spending is
largely induced, while investment spending is
largely autonomous—dependent on expected
rate of return on capital and rate of interest
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Autonomous versus Induced
Changes in GDP (Cont.)
• Exports and Imports
– The multiplier expression can be modified to take
account of changes in other components of spending
– Exports add to aggregate demand and imports
reduce aggregate demand and these changes are
impacted by the multiplier
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Government to the Rescue
• Keynes was concerned that changes in autonomous
spending would cause wide fluctuations in economic
activity
• Government spending was necessary to offset the
changes in autonomous spending and restore the
economy to full employment
• Therefore, total spending is the sum of consumer,
investment, and government expenditures
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Government to the Rescue (Cont.)
• Figure 23.5 demonstrated the effect of additional
government spending to raise the income level of the
economy, ideally to the full employment level
– Government spending (G) is added to C + I
– This increases spending in the economy to
C+ I+G
– Total impact of additional government spending is enhanced
through the multiplier
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FIGURE 23.5 Adding government
spending raises income.
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Government to the Rescue (Cont.)
• Figure 23.6 shows the effect of increasing taxes
which lowers income
– Government usually finances spending by taxation
– Taxation will reduce disposable income which
further reduces income through the multiplier
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FIGURE 23.6 Introducing taxes lowers
income.
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Government to the Rescue (Cont.)
– Government spending and taxes can be changed by
government policy to buffer the effects of changes in
autonomous spending
– Fiscal policy—deliberate manipulation of taxes or
government spending to achieve a desired level of
income consistent with full employment
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Money and Rate of Interest
• Keynes stated that interest rates were determined by the
supply of and demand for money rather than by savings
and investment
• Money might affect the level of real economic activity,
only to the extent that it influenced the rate of interest
• Changes in the interest would alter desired investment
spending and thereby the change the level of GDP
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Money and Rate of Interest (Cont.)
• The Keynesian system of income determination deals
only with flows in the economy—consumption, saving,
investment and income over a period of time
• These flows deal in real goods and services and not
financial transactions
• Keynes introduced the idea that money is a financial
asset, held in an individual’s portfolio and is part of an
individual’s wealth
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Money and Rate of Interest (Cont.)
• Demand for Money (Figure 23.7)
– Public’s portfolio consists of two types of assets—
money and all other assets (represented by bonds)
– Money is liquid—risk free, but does not earn interest
– However, the price of bonds can vary in terms of
money, so the owner can suffer capital losses or reap
capital gains, depending on changes in interest rates
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FIGURE 23.7 Keynesian interest theory.
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Money and Rate of Interest (Cont.)
• Demand for Money (Figure 23.7) (Cont.)
– Money is a riskless asset, and bonds are risky assets
– Therefore, more bonds in a portfolio means more risk
– The decision regarding the composition of a portfolio
between money and bonds will be determined by the overall
expected return, the “average” interest rate, on bonds
– The demand for money, liquidity preference, is a function of
the rate of interest
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Money and Rate of Interest (Cont.)
• Demand for Money (Figure 23.7) (Cont.)
– The demand for money is negatively sloped with respect to
interest
– Speculative demand for money—individuals hold more
money (fewer bonds) at low interest rates since they expect
interest rates to rise in the future which will cause a capital
loss on bond holdings
– At low rates of interest, individuals have a small opportunity
cost of forgoing interest by holding money and prefer
liquidity
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Money and Rate of Interest (Cont.)
• Demand for Money (Figure 23.7) (Cont.)
– Individuals are risk averse— hold bonds only if rate
of interest is high enough to compensate for the risk
of holding bonds
– The supply of money is assumed to be constant and
does not vary with interest rates
– The equilibrium level of interest is the
intersection of the supply and demand curves
(Figure 23.7)
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Monetary Policy
• Changes in the demand for or supply of money
will cause a change in equilibrium rate of
interest and impact investment spending
• Cost of Capital Effect (Figure 23.8)
– Demonstrates the effect of increasing the money
supply relative to equilibrium interest rates
– Demand for money does not change, only the supply
of money increases
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FIGURE 23.8 Effect on the interest
rate of changing the money supply.
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Monetary Policy (Cont.)
• Cost of Capital Effect (Figure 23.8) (Cont.)
– Increased money supply indicates cash balances are
too high so individuals purchase stocks which
increases the price and lowers the interest rate
– A lower interest rate will stimulate investment
spending and higher GDP via the multiplier
– Decrease in the money supply would have the
opposite effect
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Monetary Policy (Cont.)
• Negative relationship between the demand for
money and the rate of interest provides a link
between changes in the supply of money and level of
economic activity
• Liquidity Trap (Figure 23.9)
– However, under certain economic conditions, increased
supply of money will not lower the rate of interest
– At low rates of interest the demand for money becomes
perfectly horizontal
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FIGURE 23.9 Keynesian liquidity trap.
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Monetary Policy (Cont.)
• Liquidity Trap (Figure 23.9) (Cont.)
– At these low rates, individuals expect interest rates
to increase and consider holding bonds too risky
– Liquidity trap—any increase in money supply will
simply be held by the public (hoarding) and none of
the increased liquidity would spill over to the bond
market
– In this range of money demand, monetary policy is
completely ineffective
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Monetary Policy (Cont.)
• Wealth Effect
– It is possible that consumers may change their
spending in response to variations in the interest rate
– Lowering of interest results in higher prices of bonds
and consumers feel wealthier
– Based on this wealth effect, consumers will spend
more, thereby causing the consumption function to
shift upward
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Monetary Policy (Cont.)
• Monetary Policy and International Trade (Exchange
Rate Effect)
– Although exports and imports are small segments of U.S.
economy, there is a large impact of monetary policy on GDP
through net exports
– Effect of a change in money supply
• Decrease in money supply causes interest rates to rise
• This increase relative to interest rates in other countries will encourage
foreigners to buy U.S. bonds to enjoy a higher return
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Monetary Policy (Cont.)
• Monetary Policy and International Trade (Exchange
Rate Effect) (Cont.)
– Effect of a change in money supply (Cont.)
• Purchase U.S. dollars with foreign exchange which drives up value of
the dollar under a flexible exchange rate system
• A stronger dollar will discourage exports and encourage imports
• Net exports decline when domestic interest rates rise, driving down
GDP
• This international exchange rate effect strengthens the efforts of the
government to slow down economic activity
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Monetary Policy (Cont.)
• Summary of the three effects
– Transmission mechanism of monetary policy—
Three components of monetary policy
• Cost of capital effect—influences investment through the
cost to businesses of raising capital
• Wealth effect—operates through interest rates on
consumer wealth which effects consumer spending
• Exchange rate effect—operates through interest rates and
foreign exchange rate to effect net exports
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Monetary Policy (Cont.)
• Transactions Demand and Monetary Policy (Figure
23.10)
– Keynes raised the idea of a speculative demand for money
that is related to the rate of interest
– Increase in GDP leads to an increase in amount of money
demanded--people need additional cash to carry out a higher
level of transactions
– Changes in the liquidity preference will cause equilibrium
rate of interest to change—increased liquidity would increase
interest rates
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FIGURE 23.10 A shift in the demand for
money changes the interest rate.
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Monetary Policy (Cont.)
• Transactions Demand and Monetary Policy
(Figure 23.10) (Cont.)
– An increase in income
• This will cause a rightward shift of the demand curve
• Shift of money demand curve will increase interest rates
• However, actions by central bank to increase the supply of
money might prevent an increase in interest rates
• A growing economy will need a balanced growth of
money to prevent interest rates from rising
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Monetary Policy (Cont.)
• Transactions Demand and Monetary Policy
(Figure 23.10) (Cont.)
– The transaction demand for money is probably
affected by the interest rate as well as by income—
higher interest rates will reduce the demand for
transaction balances
– Greater use of credit cards reduces the demand for
money, thereby lowering interest rates, permitting
investment and GDP to increase
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Monetary Policy (Cont.)
• Expectations and Monetary Policy
– It is generally assumed that expectations are
exogenous—determined outside the system
– Assuming the central bank makes changes in the
money supply and these changes are totally
unanticipated, monetary policy alters the interest
rate according on the conditions just described
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Monetary Policy (Cont.)
• Expectations and Monetary Policy (Cont.)
– However, if the actions of the Federal Reserve are
completely anticipated, individuals will make
portfolio adjustments before the Fed enacts the
policy change
– The result is that the anticipated monetary policy
change will alter interest rates before it is
implemented
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Aggregate Demand and Supply
• The Keynesian assumption of fixed prices
changes the shape of the aggregate supply curve.
• Figure 23.11 displays the Keynesian aggregate
supply curve which is different than that
envisioned by the classical economists
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FIGURE 23.11 Increase in aggregate demand
raises real income or prices, depending on the
shape of aggregate supply.
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Aggregate Demand and Supply
(Cont.)
• This aggregate supply curve is in two parts
– A horizontal segment which reflects the fact that prices do not
increase when the economy is at less than full employment
– A vertical segment, which is the classical school’s supply
schedule, showing only prices increase after full employment
output is reached
• If aggregate demand increases in the horizontal portion
the result will be higher real output and lower
unemployment at a constant price level
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Aggregate Demand and Supply
(Cont.)
• This was the range of the curve that Keynes was
concerned with—levels of employment well below the
full employment level
• In this range, actions by the government to stimulate
output will result in real changes to the economy
• If the economy is operating at or near full employment,
actions by the government will result in upward
pressure on prices—inflation
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Aggregate Demand and Supply
(Cont.)
• Supply-side policies
– This is relevant in the full employment range of
aggregate supply
– Since the productive capacity is determined by
supply of labor, capital and technology, policies that
increase these factors will increase potential real
output
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Aggregate Demand and Supply
(Cont.)
• Supply-side policies (Cont.)
– The government does not directly control any of these, but
tax policies can influence the willingness of households and
business firms to supply labor and invest in capital
– According to supply-siders, the main consequence of
reducing tax rates is increased production incentives which
shifts the vertical portion of the aggregate supply curve to the
right
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