Transcript Lecture 10: Macro: Simple Keynesian Model of Aggregate Demand

Economics for CED
Noémi Giszpenc
Spring 2004
Lecture 10: Macro: Keynesian
Model of Aggregate Demand
June 9, 2004
Neoclassical economists assumed
• That the employment of labor would be
determined by the supply and demand for
labor, along with the wage in purchasing
power terms.
• The employment of labor, together with the
productivity of labor, would determine
production as measured by RGDP.
• Then the Great Crash/Depression of 1929
happened.
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1883-1946
Enter John Maynard Keynes
• A theory of “equilibrium” unemployment
• Right or wrong, now used to make economic
policy and to forecast economic events
• Key question: How are national income and
expenditure determined?
– Recall: components of expenditure are
•
•
•
•
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C (Consumption)
I (Investment)
G (Government purchases)
NX (Net Exports)
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A picture of the economy
Human Economy
goods & services
wages & dividends
goods & services--Exports
payment for purchases
Energy
payment for purchases
labor & ingenuity
Natural World
Matter
Households
Business
services & transfers
taxes
goods & services(labor & ingenuity)
taxes
goods & services--Imports
services & transfers
(wages)
payment for purchases
Government
Heat
Rest of
World
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Waste
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Picture showing money flow
Human Economy
Output = Y
Energy
Net Taxes = T
Exports = X
Natural World
Matter
Disposable
Income = Yd
Households
Business
Private
Savings = S
Imports = M
G = Public
Consumption Government
Rest of World
Loan to RoW
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Net Public
Savings
Private Consumption = C
Investment = I
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Heat
Waste
Banks
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Income and Consumption
• Keynes theorized a “psychological law”:
One more dollar of income would lead to more
consumption, but only of part of the dollar:
– Fraction spent = marginal propensity to consume (MPC)
• A Simple Consumption Function:
C = C0 + bY
–
–
–
–
Where C is Consumption
b is MPC
Y is income
so what’s C0?…Autonomous consumption: the portion of
consumption expenditure that does not depend on income.
• What you would want to spend even if you had no money.
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A simple model
– And assuming C0 positive,
I constant and G, NX 0
expenditure
• Given C = C0 + bY and
Y = C + I + G +NX
• Equilibrium is where
expenditure = income
(the 45o line)
I
• Or, algebraically:
Ye=(C0+I) / (1-MPC)
C0
• 1/(1-MPC) is the “autonomous
consumption multiplier”
Since MPC < 1, multiplier is > 1
• each person's spending is
someone else’s income
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45o
C+I
C
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Ye
income/
production
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How to move toward equilibrium?
• Inventories: a kind of capital good.
– An increase in inventories is an investment.
– A decrease in inventories is a negative
investment.
• If businessmen do not sell as much as they expected,
find themselves with more inventories than planned
– These increases in inventories are "unintended
investment.”
– Realized investment is sum of planned investment and
unintended inventory increases
– In model, I (of C+I) is planned investment.
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What happens in disequilibrium?
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expenditure
• If production is greater than Ye,
it exceeds planned expenditure.
• So, inventories build up.
• So, businesses cut back on
orders, factories cut back on
production, until production falls
back to equilibrium level.
• If production less, inventories
drawn down further than
expected, so businesses make
extra orders, factories increase
production… back to Ye.
• A plan-fulfillment equilibrium.
45o
C+I
C
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Ye
income/
production
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Lots of scope for unemployment
• Equilibrium level of production in model depends on
planned level of production.
• What if producer fears that others will cut back on
production?
– Assumes spending will be less
– Therefore plans to produce less to meet smaller demand
– If everyone reasons this way, expectations are fulfilled:
aggregate production is less, people have less income, and
aggregate demand is smaller
– If this happens, there is a recession, and it is a result of a
coordination failure
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What happens if spending drops?
expenditure
45o
C+I
C’+I
• Say autonomous
spending drops by a
certain amount, X.
• Equilibrium output
drops by the amount X
times the multiplier:
– X/(1-MPC)
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Ye’
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Ye
income/
production
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Saving and Investment
• Saving = Income – Consumption
S = Y – C (or Y = C + S)
– This is an identity (it’s how it’s defined)
– For households, it’s disposable income (net of taxes):
• Yd = Y – T; where T is taxes (minus transfers)
• Substituting into equilibrium model:
Y = C + I + G + NX = S + C + T; so by identity:
S = C + I + G + NX – C – T = I + G + NX – T
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Where does saving go?
• S = I + G + NX – T (by identity)
– If trade is balanced, NX = 0.
– If the government budget is balanced, G = T.
– This would lead to S = I:
all household saving going into investment.
– If NX > 0 (we export more than we import),
some saving goes as a loan to the Rest of the World.
• If NX < 0 (trade deficit) RoW loans to us.
– If G < T (a government budget surplus), more saving is available to
go to investment or as loan to RoW.
• If G > T (budget deficit) some saving has to go as loan to government
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How to increase saving?
• Saving is defined as identity: income minus
consumption, S = Y – C
• Can reducing consumption lead to more
saving?
• Reduce autonomous consumption C0
– Ye = (C0+I0)/(1 – MPC). Change to C0-x.
– Ye’= Ye – x/(1 – MPC) = (C0-x)/(1 – MPC)+S’
– (after some algebra) S’ = Ye – C = S (no change)
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There must be some way!
• Let’s try this: decrease the marginal
propensity to consume, MPC.
– Once again Ye’ < Ye (equilibrium output
down) and S’ = S (no change). No dice.
• “The paradox of thrift”
– In our simple model, saving (S) can’t be
different from intended investment, I (in
equilibrium).
– Illustrates the “fallacy of composition.”
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Don’t save: spend and boom!
• Increase in autonomous consumption has a
multiplier effect (even keeping I constant).
• Increase in MPC increases multiplier.
• Woohoo! Party! Y is in the house!
– Is there a downside? Yes:
– Although I does not decrease, proportionally to
RGDP, it does decrease.
It doesn’t keep up with growth of economy.
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Investment isn’t constant anyway
• Imagine a business with a steady level of investment,
I. (basically replacement)
• Demand picks up: in order to meet expanded
demand, increase to I*. (expansion)
– Increase in I increases total demand by multiplier
• Boom!
• Say demand eventually steadies. I* falls back down a
bit to I*’. (replacement of a bigger stock)
– Decrease in I decreases total demand by multiplier
• Bust!
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Paul Samuelson b. 1915
1970 Nobel laureate, wrote most successful principles textbook ever
Accelerator principle
• Amount of investment depends on the rate of
increase of production (not just amount)
• When demand is increasing, investment has to
increase a lot to keep up.
– Growth leads to growth, for a while…
• When production levels off, investment drops a lot (to
replacement levels)
– Slowdown leads to more slowing down…
• This is where term “business cycles” comes from.
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International Trade / “Contagion”
• If NX rises, then ceteris paribus, Ye rises (by
the multiplier).
– So exports more politically popular than imports
• But recall: if NX>0, some S has to go as loan to RoW
• If a country’s Y increases, buys more of all
goods--including imports
• Its imports are other countries’ exports
• This leads to greater Y in other countries
– Busts can also spread from country to country
• Especially important for small countries dependent on
trade
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How to keep track of trade?
•
•
Current account measures trade in goods
and services (credits increase balance)
Capital account measures trade in
investments (debits increase balance)
–
•
Credits = LHS; Debits = RHS of accounts
4 Transactions (see next slide):
1.
2.
3.
4.
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U.S. exports a Ford truck for $10K
U.S. purchases Japanese stocks of $5K
U.S. imports French wine for $2K
U.S. imports Brazilian beef for $12K
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Current Acct (CA) & Capital Acct (KA)
Credit (Cr.) & Debit (Dr.)
1. U.S. exports a Ford truck for $10K
1. Cr. CA $10K (inc. NX)
2. Dr. KA $10K (inc. in FX holdings)
2. U.S. purchases Japanese stocks of $5K
1. Dr. KA $5K (inc. in foreign assets)
2. Cr. KA $5K (dec. in FX holdings) (stock cost us
Yen)
3. U.S. imports French wine for $2K
1. Dr. CA $2K (dec. NX)
2. Cr. KA $2K (dec. in FX holdings)
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Another accounting detour
Current Account (NX)
(goods & services)
Cr.
Capital Account (FX)
(foreign assets)
Dr.
Cr.
1) $10K
$10K (1b
2b) $5K
($4K)
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Dr.
$2K (3
3b) $2K
$12K (4
4b) $12K
Trade deficit (NX<0)
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$5K (2
At this point,
NX=$8K,FX=$8K
Loan from RoW
(net liability)
($4K)
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Government Fiscal Policy
– Can increase G to combat
unemployment
– Can decrease G to combat
inflation
expenditure
• “Fiscal policy” is when
national government makes
decisions on taxation and
spending to influence the
level of production and
employment.
• Increasing the autonomous
spending, G, increases Ye by
multiplier.
G
I
C0
• What about taxes?
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45o
C+I+G
C+I
C
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Ye
income/
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Don’t forget taxes!
• Consumption depends on disposable income
Yd = Y - T
– T is net taxes: sum of income taxes Yt and
non-income taxes TX, minus transfers TR
•  T   Yd   C   Ye
– by a “tax multiplier”: MPC/(1-MPC)
– Cut in taxes and increase of transfers have same
effect on equilibrium aggregate demand
• But they have different effects in many other ways, and
are likely to affect different people.
• And have smaller (indirect) effect than changes in G.
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Trygve Haavelmo
(b. 1911), 1989
Nobel laureate
Bonus: Balanced Budget multiplier
• Suppose government increases
G and T by same amount, B.
–  G   Ye by B/(1-MPC)
–  T   Ye by B*MPC/(1-MPC)
– Net increase in Ye is
B*(1-MPC)/(1-MPC) = B*1 = B
• “balanced budget multiplier” is 1
• Probably the only realistic kind of balanced
budget: “cyclically balanced budget”
– government deficits in recession periods
offset by government surpluses in boom periods.
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