Lecture 7 - Keynesian Income and Expenditure Model - PDF

Lecture 7 The Keynesian Income and Expenditure Model: A Simple economy References : Hubbard and O'Brien Chapter 23 Learning outcomes of today’s lecture Understand the history and logic behind the Keynesian model. Identify and explain the components of the Keynesian model and the co...

Lecture 7 The Keynesian Income and Expenditure Model: A Simple economy References : Hubbard and O'Brien Chapter 23 Learning outcomes of today’s lecture Understand the history and logic behind the Keynesian model. Identify and explain the components of the Keynesian model and the connection to aggregate demand. Analyze and interpret Keynesian equilibrium both numerically and graphically. Comprehend the multiplier effect and use it to explain the impact of autonomous spending on the economy. D R. D E B O S H R E E GHOSH 2 Remember solutions to a recessionary gap? Recessionary gap solution Non- Discretionary expansionary fiscal policy Discretionary (can be demand side or policy supply side) Demand side AD = C + I + G + (X-M) D R. D E B O S H R E E GHOSH 3 History of government intervention John Maynard Keynes developed a framework to explain the high levels of unemployment experienced in the 1920s and 1930s in Great Britain. Keynes later suggested to correct the recession situation, government must intervene [KNOWN AS FISCAL POLICY]. His proposition was based on his proposed model – The Keynesian model This lecture is about the developing the Keynesian model D R. D E B O S H R E E GHOSH 4 The Keynesian model The model examines the effects of consumption, savings, and investment on equilibrium real GDP, in the short run under a fixed price assumption The effects are analysed based on the aggregate demand equation AD = C + I + G + (X-M) Remember in short run equilibrium Aggregate demand (AD) = Aggregate supply (AS) D R. D E B O S H R E E GHOSH 5 The Keynesian model Aggregate demand is the total quantity of Aggregate expenditure is the total goods and services demanded across all amount of spending on an economy's levels of an economy at a particular price goods and services at a given level of level and in a given period. income. Aggregate demand (AD) and Aggregate expenditure (AE) can be considered two sides of the same coin because they both describe the total amount of spending in an economy. However, they are viewed from slightly different perspectives. D R. D E B O S H R E E GHOSH 6  The Keynesian model Aggregate demand It is represented by the AD Aggregate expenditure The AE model focuses on curve, which shows the relationship between the the relationship between total spending and the overall price level and the quantity of output economy's income or output. (focus on the axis demanded. (focus on axis labels) labels) D R. D E B O S H R E E GHOSH 7 The Keynesian model - focus consumption AD = AE = C + I + G + (X-M) = Y Consumption in an economy is determined by the consumption function C = a + bY The intercept a in this The slope b of this equation measures is the equation measures fraction of a change in disposable income consumption even when the that is spent on consumption. income is 0. It is known as as marginal propensity to It is known as autonomous consume (MPC) consumption D R. D E B O S H R E E GHOSH 8  The Keynesian model - focus consumption- MPC Consumption function Consumption expenditure in C = a + bY trillion dollars C = 1.8 + 0.75Y = 1.8 + 0.75Y Here 1.8 is the autonomous consumption and 0.75 is the MPC = 0.75 MPC. Interpreted as C = $1.5 trillion With every 1 dollar increase in income, the Y = $2 trillion consumption increases by 75 cents. Represented by the slope = 0.75 1.8 Cℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 ΔC 1.5 𝑏 = 𝑀𝑃𝐶 = = = = 0.75 Change in income ΔY 2 Even if there is no income i.e Y=0, the consumption is still Real GDP in trillion dollars $1.8 trillion D R. D E B O S H R E E GHOSH 9  The Keynesian model - focus savings AE = C + I + G + (X-M) = Y C=Y–S (Remember Income is either consumed or saved in a closed model) S=Y–C S = Y – (a + bY) (Remember C = a + bY) Rearranging S = –a + (1 – b)Y The slope 1-b in this equation is the marginal propensity to save The intercept -a in this equation is “autonomous” (MPS). It measures the fraction of a change in disposable savings income that is saved. One will have negative savings when the income is 0 D R. D E B O S H R E E GHOSH 10  The Keynesian model - focus savings- MPS Savings function Savings trillion dollars S = –a + (1 – b)Y S = -1.5 + 0.25Y = -1.8 + 0.25Y Here -1.8 is the autonomous savings and 0.25 is the MPS. MPS = 0.25 Interpreted as S = $0.5 trillion With every 1 dollar increase in income, the saving Y = $2 trillion increases by 25 cents. Real GDP in trillion dollars Represented by the slope = 0.25 -1.8 Cℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 Δ𝑆 0.5 𝑏 = 𝑀𝑃𝑆 = = = = 0.25 Change in income ΔY 2 Even if there is no income i.e Y=0, the saving is still -$1.8 trillion D R. D E B O S H R E E GHOSH 11 The Keynesian model – linking MPS and MPC Now we know that Y (income) = C (consumed)+ S (saved) Then, ΔY = ΔC + ΔS ΔY ΔC ΔS Then, = + ΔY ΔY ΔY 1= 𝑀𝑃𝐶+ 𝑀𝑃𝑆 D R. D E B O S H R E E GHOSH 12 Putting everything together AE = C + I + G + (X-M) Assume for now that G and (X-M) components do not exist Assume investment (I) is fixed (autonomous i.e. does not depend on other factors) Then, AE = C + I AE = (a + bY) + I (remember both a and I are autonomous) AE = A + bY where A = a + I D R. D E B O S H R E E GHOSH 13 Keynesian Equilibrium graphically speaking Equilibrium is achieved when Aggregate expenditure in trillion dollars AE = A + bY = Y (where A = a + I) The 45-degree line shows all points AE0 where aggregate expenditures and output are equal. Therefore, an intersection of the AE line with the 45- E0 degree line shows point of equilibrium A quick video on the importance of the 45-degree can be found here (link) 450 Y0 Real GDP in trillion dollars D R. D E B O S H R E E GHOSH 14  Keynesian Equilibrium solving numerically Assume Investment (autonomous) (I) = $ 0.5 trillion dollars Aggregate expenditure in trillion dollars Autonomous consumption (a) = $ 1.5 trillion dollars Marginal propensity to consume = 0.75 AE0 = 2 + 0.75Y Then, Consumption function = a + bY = 1.5 + 0.75Y AE expenditure function = (a + bY) + I = 1.5 + 0.75Y + 0.5 E0 = 2 + 0.75Y Equilibrium real GDP by solving for AE = Y 2 + 0.75Y = Y 450 Y=8 8 Real GDP in trillion dollars D R. D E B O S H R E E GHOSH 15  Keynesian Equilibrium graphically speaking - Auto component changes Suppose any component of autonomous AE1 = 5 + 0.75Y Aggregate expenditure in trillion dollars component increases. For example, investment or autonomous consumption increases then E1 AE line shifts up. AE0 = 2 + 0.75Y Slope DOES NOT change since MPC has not changed but intercept on the y axis shifts up as autonomous component (i.e. the component E0 when income is 0) has increased. Assume A = 3, if after the change the economy remains at the same real output level A Y0 even when AE has increased, then at this point AE > Y leading to a fall in inventory and 450 Y0 Y1 indicating to the firms to produce more Real GDP in trillion dollars D R. D E B O S H R E E GHOSH 16  Keynesian Equilibrium solving numerically - MPC changes Suppose instead of autonomous component, AE1 = 2 + 0.80Y Aggregate expenditure in trillion dollars only the MPC increases from 0.75 to 0.80 and E1 autonomous component remains at 2 AE0 = 2 + 0.75Y ONLY the slope changes since MPC has changed but intercept on the y axis remains same as autonomous component (i.e. the E0 component when income is 0) has not changed Intersection of the AE line with the 45-degree line shows point of equilibrium 450 Y0 Y1 Real GDP in trillion dollars D R. D E B O S H R E E GHOSH 17  Keynesian Equilibrium solving numerically - MPC changes Then, AE1 = 2 + 0.80Y Aggregate expenditure in trillion dollars Consumption function = a + bY = 1.5 + 0.80Y E1 AE expenditure function = (a + bY) + I = 1.5 + 0.80Y AE0 = 2 + 0.75Y + 0.5 = 2 + 0.80Y Equilibrium real GDP by solving for AE = Y E0 2 + 0.80Y = Y Y = 10 450 Y0 Y1 Real GDP in trillion dollars D R. D E B O S H R E E GHOSH 18  The multiplier effect We observe that a change in autonomous component or a change in MPC leads to a change in real GDP The change in any autonomous component does not lead to the exact same change in real GDP. A ≠ Y When the autonomous component increases or decreases, it leads to a change in real GDP that can be a multiple of the initial change in magnitude. Picture credit :Investopedia / Mira Norian D R. D E B O S H R E E GHOSH 19 Example of the mechanism of the multiplier effect D R. D E B O S H R E E GHOSH 20 The multiplier In equilibrium Y = AE = A + bY (where A autonomous component and b is MPC) So, we know if A increases then Y (real GDP) would increase but by HOW MUCH? Solving for equilibrium for change ΔY = ΔA + bΔY 1 ΔY = ΔA 1−b The is the multiplier denoted by . The ΔY 1 ratio of the increase in equilibrium real = GDP to the increase in autonomous ΔA 1−b expenditure D R. D E B O S H R E E GHOSH 21 The multiplier – an example AE0 = 2 + 0.75Y Calculate the multiplier 1 1 Multiplier =  = = =4 1−b 1−0.75 Using the multiplier, calculate the change in real GDP due to a change in autonomous consumption by 10 1 Therefor an initial increase of ΔY = Δ𝐴 10 in the autonomous 1−b expenditure leads to a change ΔY= 10 * 4 = 40 of 40 in real GDP D R. D E B O S H R E E GHOSH 22 The multiplier – an example AE0 = 2 + 0.75Y Calculate the multiplier when the MPC changes to 0.80 1 1 Multiplier =  = = =5 1−b 1−0.80 Using the multiplier, calculate the change in real GDP due to a change in autonomous consumption by 10 1 An increase in MPC magnifies ΔY = Δ𝐴 the effect of autonomous 1−b expenditure on real GDP. ΔY= 10 * 5 = 50 D R. D E B O S H R E E GHOSH 23 Summary Keynesian model is reason and argument behind fiscal policy i.e. discretionary government policy The success of Keynesian model depends on the magnitude of the MPC since it directly effects the multiplier Higher the multiplier, higher is the effect on GDP for a change in autonomous consumption. Consumption expenditure is the biggest component of aggregate expenditure D R. D E B O S H R E E GHOSH 24 Next Week Understanding the Keynesian model using the three sector and four sector model Determining the equilibrium and change in GDP when autonomous component changes in a three and four sector model Calculate the multipliers under the three sector and four sector model and compare it with a two-sector model D R. D E B O S H R E E GHOSH 25