Introductory Macroeconomics Lecture 6: Keynesian Economics I PDF

Introductory Macroeconomics Lecture 6: Keynesian Macroeconomics, Part One Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Keynesian Macroeconomics, Part One – determinants of aggregate...

Introductory Macroeconomics Lecture 6: Keynesian Macroeconomics, Part One Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  This Lecture Keynesian Macroeconomics, Part One – determinants of aggregate expenditure – Keynesian equilibrium (Keynesian cross) – role of government expenditure BOFAH chapter 7 2  Recall the Big Debate Classical (pre-1930s) business cycle theory – Say’s Law: ‘supply creates its own demand ’ – markets operate well, interventions are counter-productive Keynesian business cycle theory (since 1930s) – Say’s Law need not hold at macro level * can have economy-wide market failure due to lack of demand * business cycles driven by fluctuations in aggregate demand – interventions can stabilise business cycle fluctuations by stabilising aggregate demand 3  Keynesian Theory: Main Elements Key assumptions – prices and wages do not fully adjust in short run (‘sticky prices ’) Key contributions – output can be demand-determined – importance of expectations, confidence, ’animal spirits’ Key implications – recessions can be fought by policies that stimulate demand 4  Keynesian Theory: Controversies Why don’t prices and wages adjust to clear markets? – are prices really more difficult to adjust than quantities What determines expectations? Why are expectations so volatile? What policy settings best manage fluctuations in demand? – fiscal policy? monetary policy? – automatic stabilisers vs. discretionary stimulus? – decision lags vs. implementation lags? 5 Determinants of Aggregate Expenditure 6  Keynesian Model of Aggregate Expenditure We start with a simple closed economy version of the model Let P AE denote planned aggregate expenditure P AE = C + I + G We can think of P AE as the total planned spending on final domestically produced goods and services for a given interval of time (i.e., a quarter or a year) What are the determinants of C, I, and G? 7  Planned Consumption Key building block of Keynesian model Planned consumption is linear function of disposable income C = C̄ + c (Y − T ), 0 AE, surprisingly high demand, unplanned inventory draw down – P AE = AE, planned and actual expenditure consistent 13  Equilibrium Output To find this Keynesian equilibrium level of Y we use the P AE = AE = Y condition to write C̄ + c(Y − T̄ ) + I¯ + Ḡ = Y This is one equation to be solved for one unknown, Y We can visualise this solution using the Keynesian Cross 14 Keynesian Equilibrium (Keynesian Cross) 15  Keynesian Equilibrium Key idea here is that economy can get stuck at an equilibrium level of output below potential output – hence stuck with high unemployment, via Okun’s Law In this equilibrium, planned and actual expenditure consistent – no self-correcting tendency for output to change Keynes viewed this as an explanation for persistently high unemployment during the Great Depression 16 Keynesian Equilibrium 17 Role of Government Expenditure 18  What Can be Done? How can we bring output back to potential? One idea is to use fiscal policy (e.g., increasing Ḡ or decreasing T̄ ) Need to solve for equilibrium Y , see how Y depends on Ḡ and T̄ 19  Solve for Y Write P AE = AE condition in terms of Y Y = C̄ + c(Y − T̄ ) + I¯ + Ḡ Bring cY to LHS and collect terms (1 − c)Y = C̄ − cT̄ + I¯ + Ḡ Divide both sides by 1 − c to get 1 C̄ − cT̄ + I¯ + Ḡ
Y = 1−c We can now see how Y depends on Ḡ, T̄ , C̄, and I¯ 20  How Y depends on Ḡ, T̄ , C̄, and I¯ Fiscal policy effects – increase in autonomous government spending Ḡ increases Y – increase in autonomous taxation T̄ decreases Y Other shifts in demand – increase in autonomous consumption C̄ increases Y – increase in autonomous investment I¯ increases Y – how do these changes relate to “animal spirits”? What are the sizes of these effects? 21  Government Spending Multiplier Take the derivative of Y with respect to Ḡ dY 1 = >1 (since 0 < c < 1) dḠ 1−c An increase in Ḡ increases Y by more than one-for-one This is known as the multiplier effect Example: if c = 0.2 and Ḡ increases by $20b then Y increases by dY 1 × $20b = × $20b = 1.25 × $20b = $25b dḠ 1 − 0.2 Amplifies both increases and decreases in autonomous expenditure 22 Increase in Government Spending 23  Government Spending Multiplier Intuition: – Increase in government expenditure has direct effect on income – Part of this increase in income is itself consumed, which leads to further indirect effect on income – Total effect is greater than direct effect. How much more depends on how much of income is consumed Mathematics: – $1 increase in Ḡ has $1 direct effect on Y – And $1 increase in Y increases consumption C by $c which adds further to the increase in Y – That $c increase in Y further increases consumption C by $c × c which adds further to the increase in Y – Direct effect plus all the indirect effects 1 lim 1 + c + c2 + c3 +... cn
= n→∞ 1−c 24  Balanced-Budget Multiplier Suppose we finance increase in government spending Ḡ with increase in taxes T̄ , keeping the budget deficit/surplus unchanged Total effect on output 1 c dY = dḠ − dT̄ 1−c 1−c If new spending is fully paid for, dḠ = dT̄ 1 c dY = dḠ − dḠ = dḠ 1−c 1−c In this case, this will lead to a simple one-for-one increase in Y. The indirect effects are undone by the increase in taxation to fund increase in spending. 25  Learning Outcomes 1 Understand and explain basic contributions of, and controversies about, the Keynesian view of Macroeconomics. 2 Understand the determinants of planned aggregate expenditure, and the difference between “animal spirits” and the marginal propensity to consume. 3 Understand the Keynesian equilibrium, including how to compute it and why it is different to the classical equilibrium. Explain the consequences when the Keynesian equilibrium is not met. 4 Understand and explain the utility in using fiscal policy to influence the Keynesian equilibrium. 5 Understand and explain the multiplier effect. Critically reflect on the outcome of a balanced budget policy. 26  New Formula(s) and Notation Consumption Function (example) C = C̄ + c(Y − T ) AE actual expenditure c marginal propensity to consume (MPC) P AE planned actual expenditure T taxes (net of transfers) ¯ {·} an exogenous (fixed) variable dy derivative of y with respect to x dx 27  Next Lecture Keynesian Macroeconomics, Part Two – savings and investment – paradox of thrift – more on taxes and spending BOFAH chapter 7 28