Introductory Macroeconomics Lecture 7 PDF

Introductory Macroeconomics Lecture 7: Keynesian Macroeconomics, Part Two Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  Assignment Due date is 4 PM August 30 (Fri) – must upload the file on the...

Introductory Macroeconomics Lecture 7: Keynesian Macroeconomics, Part Two Jonathan Thong Daniel Minutillo 2nd Semester 2024 1  Assignment Due date is 4 PM August 30 (Fri) – must upload the file on the Canvas LMS site under the Assignments tab (upload a few minutes before the deadline!) Work alone or in groups (up to 3) – groups must be formed via the Canvas LMS site (one person should submit the assignment) – details on group formation will be announced on the Canvas LMS this week Covers the first 3 week lectures 2  This Lecture Keynesian Macroeconomics, Part Two – savings and investment – paradox of thrift – more on taxes and spending BOFAH chapter 7 3 Savings and Investment 4  Savings and Investment We assume a closed economy (i.e., no international trade) Private savings is defined as disposable income less consumption S = (Y − T ) − C Substitute in the national income accounting identity Y = C +I +G ⇒ S = (C + I + G − T ) − C Cancelling common terms, private savings may be expressed as S = I + (G − T ) 5  Savings and Investment Key point: In a closed economy, investment equal to I = S + (T − G) – private savings S plus – public savings T − G, i.e. excess tax revenue over gov spending When public savings is – positive, government has fiscal surplus (T > G) – negative, government has fiscal deficit (T < G) 6  Aside on Open Economy In an open economy, domestic investment is equal to I = S + (T − G) + (M − X) – domestic private savings S plus – domestic public savings T − G plus – borrowing from abroad M − X Example: Suppose government budget balanced, G = T , then I = S + (M − X) This tells us that I>S ⇔ M >X We explore this later. For now, back to closed economy. 7  Keynesian Model Revisited Recall the planned consumption function C = C̄ + c(Y − T ) Planned private savings are then given by S = (Y − T ) − C = (1 − c)(Y − T ) − C̄ where 1 − c is the marginal propensity to save An exogenous increase in planned consumption C̄ is equivalent to an exogenous decrease in planned private savings. 8 Planned Private Savings 9  Savings and Investment in Equilibrium From above, planned private savings is S = (1 − c)(Y − T ) − C̄ Equilibrium output can also be defined as when planned investment and planned savings are the same I = S + (T − G) ¯ T̄ , and Ḡ are given. Look for value of Y that solves Suppose I, I¯ = (1 − c)(Y − T̄ ) − C̄ + T̄ − Ḡ The equilibrium output is then 1 C̄ − cT̄ + I¯ + Ḡ
Y = 1−c 10 Paradox of Thrift 11  Paradox of Thrift Is saving more (i.e., being ‘thrifty ’ or frugal) a good thing? Consider a decrease in autonomous consumption C̄ This shifts up the planned private savings function S = (1 − c)(Y − T ) − C̄ So there is now more saving at any level of Y But equilibrium level of output is lower! 12  Why does saving more reduce output? In the Keynesian model, short-run output is demand-determined. More saving means less consumption demand, hence less output. Key point: if output is demand determined, individual households being thrifty may paradoxically be harmful to the economy overall. In this situation, public dissaving (deficit spending) can usefully offset an increase in private savings. 13  What Does this Leave Out? Omits all the long-run supply-side benefits of savings. More savings funds more investment, which builds up the economy’s productive capacity (i.e. the natural level of output). Much more on this in Part II of the subject when we consider the economy over the longer run. 14  Example: A Simple Keynesian Economy Suppose there is no government spending or taxation (Ḡ = T̄ = 0). – Planned private savings S = (1 − c)Y − C̄ – Planned investment I = I¯ Equilibrium output is then determined by 1 I¯ = (1 − c)Y − C̄ ⇒ Y = ¯ (C̄ + I) 1−c Example: if c = 0.5, C̄ = 200, and I¯ = 100, Equilibrium output is 1 Y = (200 + 100) = 600 1 − 0.5 Private savings is S = I¯ = 100. 15 Example: Keynesian Equilibrium 16  Example: Increase in planned savings Suppose increase in planned private savings, C̄ decreases to 150 Short-run equilibrium output falls to Y = 1 1−0.5 (150 + 100) = 500 But actual private savings does not change, S = I¯ Key points: – more savings does not induce more investment (’Animal Spirits’ dominate interest rate incentives) – rather, it is output Y that adjusts to make S = I¯ – all households trying to increase savings can result in a recession! 17 Example: Paradox of Thrift 18 More on Taxes and Spending 19  Example (continued): Fiscal Stimulus Offset fall in consumer spending with rise in government spending Let Ḡ = 50 with T̄ = 0. Public dissaving T̄ − Ḡ = −50 Public dissaving offsets the paradox of thrift. 1 1 C̄ − cT̄ + I¯ + Ḡ =
Y = (150 + 100 + 50) = 600 1−c 1 − 0.5 This recovers the equilibrium Y = 600 Note that public savings decrease while private savings increase. 20 Example (continued): Fiscal Stimulus  Fiscal Stimulus: Increase Ḡ or Decrease T̄ ? Recall generally, short-run output is given by 1 C̄ − cT̄ + I¯ + Ḡ
Y = 1−c We can stimulate output by increase in Ḡ or decrease in T̄ Which gives bigger effect on SR output when deficit increases $1? dY 1 c Change in Ḡ gives dḠ = 1−c = 1+ 1−c dY c Change in T̄ gives dT̄ = − 1−c An increase in Ḡ has a bigger impact than a decrease in T̄. 22  Learning Outcomes 1 Derive an alternative equilibrium condition in the Keynesian model that focuses on the relationship between savings and investment. 2 Understand and explain the ’paradox of thrift’. 3 Be aware of the trade-off between short-run demand management policies and long-run focused policies. 4 Understand the relationship between private and public savings. 5 Understand basic concepts in relation to the fiscal policy, including budget surplus/deficit and the asymmetry between government spending and taxation. 23  New Formula(s) and Notation Alternative Keynesian Equilibrium Condition I = S + (T − G) S household savings (= (Y − T ) − C) 24  Next Lecture Fiscal policy in ordinary times – basic fiscal policy concepts – more on fiscal policy and demand management – government budget constraint, debts and deficits Fiscal policy in extraordinary times – response to the global financial crisis – response to the covid pandemic BOFAH chapter 8 25