LECTURE NOTES Chapter 5: The Keynesian System (I): The Rle f Aggregate Demand 1. The Prblem f Unemplyment Keynesian ecnmics develped in the cntext f the Great Depressin Sharp fall in GDP High rate f unemplyment (25%) Keynes bk was written fr the particular case f the U.K. (but the title is General Thery ) The prblem f high unemplyment is a deficiency in Aggregate Demand Investment was t lw Remember: MV = Py = NGDP = C + I + G + NX Keynesian ecnmics argues that Aggregate Demand deficiency can be cmpensated with gvernment spending n public wrks (expansinary fiscal plicy.) In Keynes s wrds: scialize investment. Linel Rbbins n the treatment f classical ecnmists (emphasis added): On this plane, nt nly is any real knwledge f the classical writer nn-existent but further their place has been taken by a set f mythlgical figures, passing by the same names, but nt infrequently invested with attitudes almst exactly the reverse f the thse which the riginals adpted. These dummies are very malignant creatures indeed [ ] They can cnceive f n functin f the state than that f the night watchman [ ] Hence, when a ppular writer f the day wishes t present his wn pint f view in a specially favurable setting, he has nly t pint the cntrast with the attitude f these reprehensible peple and the desired effect is prduced. Rbbins, L. (1952). The Thery f Ecnmic Plicy. Lndn: Macmillan. p. 5. Page 1 f 14
2. The Simple Keynesian Mdel: Cnditins fr Equilibrium Output In Keynesian mdels equilibrium requires utput t equal aggregate demand Y C + Ir (realized investment)+ T [utput] Y = E = C + I (desired investment) + G [AD] Y C + S + T [Incme] Equilibrium cnditins Y = E = C + I (desired investment) + G S + T = I + G Ir = I These tw can differ if inventries changed unexpectedly (I r I) There are n retained earnings, therefre All business prfits g t the husehlds as dividends, wage, etc., incme Husehld s incme is distributed thrugh three channels T business by (1) cnsumptin and (2) t investment thrugh savings T (3) gvernment spending thrugh taxes Cnsumptin is a direct link between husehld s incme and the prductive sectr But there are tw likeages (incme nt ging frm the husehld t the business sectr): Savings in the financial markets (what if investment is in financial assets?) (Net) taxes paid t the gvernment (what if sme tax revenue is nt spent?) Als injectins Business demand fr utput (rather than the husehld) Gvernment spending (if G > T) Page 2 f 14
If utput > aggregate demand Y > E C + I r + G > C + I + G I r > I If utput < aggregate demand Y < E C + I r + G < C + I + G I r < I Page 3 f 14
3. The Cmpnents f Aggregate Demand Cnsumptin C = a + b Y D, a > 0, 0 < b < 1 a: effect n cnsumptin ther than dispsable incme b = ΔC ΔY D is the marginal prpensity t cnsume (MPC) Als: Y D Y T C + S. Then: S Y D C D sme math S = a + (1 b) Y D 1 b = ΔS ΔY D is the marginal prpensity t save (MPS) MPC + MPS = 1 Thugh ther variables (i.e. wealth) als affect cnsumptin, in this mdel dispsable incme is the main driver f cnsumptin which is the mayr cmpnent f GDP Page 4 f 14
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Investment Cnsumptin is a stable functin f dispsable incme Investment is nt Autnmus cmpnents f AD: determined independently f the level f incme Investment (mre vlatile) Gvernment spending (less vlatile and manageable by plicy makers) AD = cnsumptin + autnmus cnsumptin Investment decisins Similar thery abut interest rates Entrepreneurs linearly extraplate the past int the future Entrepreneurs rely n the beliefs f ther entrepreneurs Then: Investment is subject t big changes due t animal spirits (fears, hpes, etc.) Gvernment spending and taxes Defined by the plicy makers -> unrelated t the level f incme Taxes are als defined by the plicy makers, nt by incme Page 6 f 14
4. Determining Equilibrium Incme Equilibrium cnditin Y = Y = E = C + I + G Y = E = a + by D + I + G Y = E = a + by bt + I + G 1 (a bt + I + G) 1 b autnmus autnmus expenditures expenditure multiplier Page 7 f 14
Assume Y < AD Inventries fall Then business increase investment Therefre Y increases until equilibrium is reached Assume Y > AD Inventries rise Then business decrease investment Therefre Y decreases until equilibrium is reached Page 8 f 14
5. Changes in Equilibrium Incme ΔY = ΔY = 1 = 1 = 1 ΔI ΔG (1 b) 1 MPC MPS Keynesian multiplier: 1 MPS Because 0 < b < 1, Keynesian multiplier > 1 Then: ΔY > ΔI and ΔY > ΔG Equilibrium cnditin after a shck ΔY = ΔC + ΔI ΔY ΔC = ΔI ΔS = ΔI And because S + T = I + G ΔS ΔI = ΔG ΔT ΔS ΔI = ΔG (if net Taxes are cnstant) G needs t cmpensate fr net savings nt invested Change in taxes ΔY = b ΔT 1 b Incme is shifted by b dllars because dispsable incme decreases by ΔT but dispsable incme that ges t cnsumptin is b per dllar Implicatin: If yu have/want t increase incme, better t increase G than reduce T. An increase in gvernment spending financed with taxes ΔY + ΔY = 1 + b = 1 ΔG ΔT 1 b 1 b Fr gvernment spending t have an effect n incme it shuld nt be financed by taxes Page 9 f 14
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6. Fiscal Stabilizatin Plicy Use G s stabilize ther vlatile and irratinal (animal spirits) autnmus cnsumptin cmpnents (investment) Ideally: ΔG = ΔI Be careful: The simple Keynesian mdel is designed t restre equilibrium, NOT t increase ptential utput Side nte (be careful hw yu read equatins): Des ΔG ΔY r des ΔY ΔG What is the causal relatin? A mathematical frmulatin takes the causal relatin as given. If yur thery has the wrng causal relatinship yu can have a cnsistent mathematical mdel with the wrng causal relatinship and n sign f the theretical mistake Page 12 f 14
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7. Exprts and Imprts in the Simple Keynesian Mdel Assume nw an pen ecnmy with exprts (X) and imprts (Z) Then: Y = E = C + I + G + X Z Assume nt taxes (fr simplicity) and that: C = a + b Y, a > 0, 0 < b < 1 Z = u + v Y, u > 0, 0 < v < 1 Y = a + b Y + I + G + X u v Y Y = 1 (a + I + G + X u) 1 b+v Keynesian multiplier in pen ecnmies is smaller than Keynesian multiplier in clse ecnmies 1 < 1 1 b+v 1 b Fiscal plicy is less effective in ecnmies with large marginal prpensity t imprt Page 14 f 14