Professional Documents
Culture Documents
TheKeynesianTheory
MacroeconomicsintheShortRun
FordRidesTheBusinessCycleRollercoaster
SalesofFordcarsandtruckshave
fluctuatedupanddownwiththephasesof
thebusinesscycle.
Salesriseinboomsandfallin
recessions.
Carsaredurablegoods.
Salesfellbymorethan40%ineachofthe
19811982and20072009recessions.
Inthefirst2yearsoftheGreatDepression
(19291931),
Fordssalesfellbyalmost2/3rd,
GMsalesfellby1/2,and
U.S.Steelsalesfellby3/4.
MacroeconomicsintheShortRun
FordRidesTheBusinessCycleRollercoaster
RealGDPdeclinedby27%betweenbusinesscyclepeakin1929andtroughin
1933.
Investmentspendingfellby81%,andtheS&P500stockindexfell85%.
Unemploymentrosefromunder3%in1929toover20%in1933.
Unemploymentwasabove11%in1939,sixyearsaftertrough.
BusinesscycleswerenotemphasizedinmacroeconomicsbeforetheGreat
Depression.
U.S.economyexperiencedbusinesscyclesasfarbackastheearly19th
century.
Thesefirmswerecuttingproductionandemploymentasaresultofthesluggish
growthoftotalspending,oraggregateexpenditure.
Thissectiondiscusseshowaggregateexpenditureaffectseconomyintheshortrun.
JohnMaynardKeynesdevelopedaninfluentialbusinesscyclemodelin1936.
Theperfectcompetitioninbothlabor
Classicaleconomistassumesthat
andoutputmarketsisunrealistic.
thereisperfectcompetitionin
bothlaborandoutputmarkets. ThePostulatesofSayslawfailed
duringgreatdepression.ASnotequal
Sayslawi.e.supplycreatesits
toADalways.InfactfallinADleadto
owndemand,Nofluctuationsis
Businesscycle(fluctuationinOutput)
output.AS=AD.
ProblemofAS
Laboristheonlyfactorof
production
ProblemofAD
ApartfromLaborotherfactorof
productionsarealsoimportant.
Prices,wagesandInterestRate
areflexible.
ClassicallongrunAnalysis.
LRASisVertical
NoRoleofGovt.
NoRoleofMoney
Prices,Wages&InterestRatesare
Sticky.
Everythingisinshortrun.
SRASisUpwardsloping
ActiveRoleofGovt.
ActiveRoleofMoney.
KeynesianPremises
J.M Keynes assumes that some Prices, Wages and Interest rates are fixed in the
shortrun. It implies that some markets need not clear.
A.
The Product Market Equilibrium
Y f (K, N)
Production Function:
Where K is capital, fixed in short run
N is labor, variable in short run
PriceLevel
LRASC
SRASC
Output(RealGDP)
P1
P2
Y1
Y2
LRASC
SRASC
FixedPrices
FlexiblePrices
Z=Y=Q
BusinessSector:
a. Nocorporatesaving
b. Noretainearning
4.
AllPricesareFixedinShortrun:StickyPrice,Wage,andinterest
rate.
5.
SupplyofCapitalandTechnologygiven(constant).
AD=AE
E2
E1
450
Y1
Y2
AS=AY
AD=C+I
I
AggregateDemandFunctions/Curve
1.ConsumptionFunction(C):C=C0 +c*Y
Co =Autonomousconsumption
c=Marginalpropensitytoconsume
outofincome(MPC)
Y=Income
Keynesian
Psychological
law
of
consumption,' men or women are
disposed , as a rule and on average , to
increase their consumption as their
income increases, but not as much as the
increase in their income
2.SavingsFunctions:S=YC
=YC0c*Y
=C0+s*Y
S= C0+s*Y
wheres=1c
Co =AutonomousSaving
s=Marginalpropensitytosave
outofincome(MPS)
S=Saving
Y=Income
C=Consumption
0<MPC<1
when C = Y
10
Keynesian cross
Substituting C,
Y= C0+c*Y+I0
Or
Y- c*Y= C0+I0
Or
(1-c)*Y= C0+I0
1
Or
Y (
) * (C0 I0 )
1 c
11
LevelsofGDP
orY
C=200+cY
S=YC
APC=
C/Y
APS=
S/Y
MPC=
dC/dY
MPS=
1MPC
1990
100
275
175
2.75
1.75
0.75
0.25
1991
200
350
150
1.75
0.75
0.75
0.25
1992
300
425
125
1.42
0.42
0.75
0.25
1993
400
500
100
1.25
0.25
0.75
0.25
1994
500
575
75
1.15
0.15
0.75
0.25
1995
600
650
50
1.08
0.08
0.75
0.25
1996
700
725
25
1.04
0.04
0.75
0.25
1997
800
800
1.00
0.00
0.75
0.25
1998
900
875
25
0.97
0.03
0.75
0.25
1999
1000
950
50
0.95
0.05
0.75
0.25
2000
1100
1025
75
0.93
0.07
0.75
0.25
2001
1200
1100
100
0.92
0.08
0.75
0.25
2002
1300
1175
125
0.90
0.10
0.75
0.25
2003
1400
1250
150
0.89
0.11
0.75
0.25
12
S=I
Levelsof
GDP
(i.e.(Y)
Planned
Consumption
(C)
Planned
Saving:
YC=S
Planned
Investment
(I)
Levelof
GDP(Y)
AD=Planned
Consumption(C)+
Investment(I)
(TotalExp)
100
275
175
100
100
<
375
Expansion
200
350
150
100
200
<
450
Expansion
300
425
125
100
300
<
525
Expansion
400
500
100
100
400
<
600
Expansion
500
575
75
100
500
<
675
Expansion
600
650
50
100
600
<
750
Expansion
700
725
25
100
700
<
825
Expansion
800
800
100
800
<
900
Expansion
900
875
25
100
900
<
975
Expansion
1000
950
50
100
1000
<
1050
Expansion
1100
1025
75
100
1100
<
1125
Expansion
1200
1100
100
100
1200
1200
Equilibrium
1300
1175
125
100
1300
>
1275
Contraction
1400
1250
150
100
1400
>
1350
Contraction
Resulting
Tendencyof
Output
S=I0 exposedorrealizedOnly
SI0 exanteorplannedalways.Itsequalonlyattheequilibriumlevel
13
Consumption
(C )
Income
Generation
100.00
1st
2nd
80.00
80.00
3rd
64.00
64.00
4th
51.20
51.20
5th
40.96
.
..
40.96
.
0.00
Total
500.00
..
last
Total
Income
14
C + I0
Let Investment Increase ( I0), then this increases Y, which induces to increase
Consumption ( C0).
So,
Y+Y=C + C+ I0+ I0
=>Y=C+ I0
We know C= C0+c*Y
=> C= C0+c* Y
Substituting C
=> Y= C0+c* Y + I0
=>Y= C0*(1/1-c)+(1/1-c)* I0
=>Y= C0*(1/1-c)+(1/1-c)* I0
=> Y
1
1 c
1
1 c
is called as investment multiplier
15
Disguised unemployment
31
16
17
GovernmentActivities:
1. ImposesonlyDirectTaxes(T)onHouseholds
2. Spendmoneytobuygoodsandservicesfromfirms
andfactorservicesfromhouseholds (G)
3. Maketransferpayment(Tr)tohouseholds.
eg.Pensions,subsidiesetc.
Step3.SubstituteAEfromStep1intostep
2:
Y=C0 +c*Y+I0 +G0
or
18
AS
C+I+G
C+I
1600
Expenditure
C, I,G
1200
45
1200
Output
1600
Step3.SubstituteAEfromStep1into
Step2:
Or
Step4. SolveforNationalIncome(Y)
Y =(C0 +I0 +G0)+c*Y c*T
Y = 1 *(C0 +I0 +G0c*T)
1 c
TheTaxMultiplier:Y/T=c/1c
19
Step1.Substituteintoequationforaggregate
expenditures:
AE=C0 +c*(YT+GTr )+I0 +G0
Given:AE=C+I+G
C=C0 +c*Y
Step2.StatetheEquilibriumCondition:
I=I0
Y=AE
G=G0
a.IfGovt ImposesIncome
Step3.SubstituteAEfromStep1intoStep2:
Tax,ThenYd=YT,
Y =C0 +c*(YT+GTr ) +I0 +G0+GTr
Y=NationalIncome
Yd =disposableIncome OrY =(C0 +I0 +G0)+c*Y c*T+c*GTr
T=tax
Step4. SolveforNationalIncome(Y)
b.IfGovt IncludingTransfer
Payment,Then
Y =(C0 +I0 +G0)+c*Y c*T+c*GTr
C=C0 +c*(Yd +GTr)
orC=C0 +c*(YT+GTr)
Y = 1 *(C0 +I0 +G0)c*T+c*GTr
1 c
20
Step1.Substituteintoequationforaggregate
expenditures:
AE=C0 +c*(YT0 t*Y )+I0 +G0
Step2.StatetheEquilibriumCondition:
Y=AE
Step3.SubstituteAEfromStep1intoStep2:
Y =C0 +c*(YT0 t*Y ) +I0 +G0
=>Y =(C0 +I0 +G0)+c*Y c*Tct*Y
Step4. SolveforNationalIncome(Y)
Y =(C0 +I0 +G0)+c*Y c*T ct *Y
b.IfGovt IncludingTransferpayment,then
C=C0 +c*(YT+GTr)
=> Y = 1 *(C0 +I0+G0c*T)
1 c+ct
c.IfGovt IncludingTaxationasafunctionof
Income,then
Govt Income Tax Multiplier: Y/ T=
T=T0+t*Y
and C=C0 +c*(YT0tY)
c
(NoTransferpayment)
1 c ct
AggregateDemandFunctions/Curve
Govt.FiscalPolicy : TaxFunction,GovtExpandTransferPayment
GivenEquations:
Step 3. Substitute AE from Step 1 into Step 2:
AE=C+I+G
where, C=C0 +c*Y
Y = C0 + I0 + G0 + c * Y - c * t * Y - c * T0 + c * GTr
I=I0,G=G0,
NowC=C0 +c*Yd withdisposableincome
where,Yd =Y t*Y T0 +GTr
Step 4. Solve for National Income (Y)
So,C=C0 +c*(YT0t*Y+GTr)
=>Y = C0 + I0 + G0 + c * Y - c * t * Y - c * T0 + c * GTr
Yd =disposableincome; t*Y=income
taxrevenues; T0 =lumpsumtax
GTR =govttransferpayments
Y=
1 * [C0 + I0 + G0 + c *(GTr - T0)]
[1 - c * (1 - t )]
Step1:Restateaggregateexpenditures
AE=C+I+G
=C0 +c*Yd +I0 +G0
=C0 +c*(Y t*Y T0 +GTr)+I0 +G0
=C0+I0 +G0+c*Y c *t *Y c*T0+c *GTr
Step2.StatetheEquilibriumCondition:
Y=AE
21
The Multiplier
Change in Y = Multiplier * Change in C0, I0,or G0 or GTr
Equilibrium model solution:
Y = 1 * (C0 + I0 + G0)
1-c
1.
Autonomous Spending Multiplier: Y/ I =
1
1 c
1
1 c
c
1 c
2.
3.
4.
5.
: Y/ T=
c
1 c
c
1 c ct
1
1 c ct
Multiplier(assumeC0 =I0=GTr=0):
Y= 1*( G0 c* T0)
1 c
BalancedBudget( G0 = T0):
Y= 1*( G0 c* G0)
1 c
= 1*(1 c) * G0
1 c
=1 * G0
=1c =1
1-c
Multiplier=1
22
No Income
Tax
Income Tax
(t = 0.3)
(t = 0.0)
Autonomous
Spending
1 =5
1-c
= 2.3
1
1 c (1-t)
Transfer
Payment
c =4
1-c
= 1.8
c
1 c (1-t)
Lump Sum
Tax
- c =-4
1-c
= - 1.8
c
1 c (1-t)
Automatic Stabilizers
Economy Moves Into
Recession
Inflation
Desired Policy
Government Spending
Increase
Decrease
Decrease
Increase
G - Defense Spending
n/c
n/c
n/c
n/c
Tr Unemployment Comp.
Increase
Decrease
n/c
n/c
Decrease
Increase
Taxes
Actual Outcomes
23
24
Y = C0 + c * (Y-T) + I0 + G0+X0
Y = (C0 + I0 + G0+X0) + c * Y - c * T
Step 1. Substitute into equation for Step 4. Solve for National Income (Y)
aggregate expenditures:
AE = C0 + c * (Y T)+ I0 + G0+X0 Y = (C0 + I0 + G0+X0) + c * Y- c * T
Y - c * Y = C0 + I0 + G0+X0- c * T
Step 2. State the Equilibrium
Condition:
Y = AE
Y=
1 * (C0 + I0 + G0+X0) - c * T
1c
Export Multiplier:
Y/ X=
1
1c
25
26
=> Y =
1
1 c+m
* (C0 + I0 + G0+X0-M0) - c * T
Y/ X= ___1__
1 c+m
27
Aggregate Demand :
The Complete Four Sector Model
Aggregate Demand (Expenditures) with Import and Exports:
Given:
AE = C + I + G+X-M
C = C0 + c * Yd
Yd=Y-T
T=T0+t*Y
I = I0, G=G0 , GTr=GT0>0 , X=X0,
M =M0+ m*Y
Now C= C0 + c * (Y-T0-t*Y+GT0)
Step 1. Substitute into equation for aggregate expenditures:
AE = C0 + c * (Y T0-t*Y+GT0)+ I0 + G0+X0- M0- m*Y
Step 2. State the Equilibrium Condition:
Y = AE
28
Aggregate Demand :
The Complete Four Sector Model
Step 3. Substitute AE from Step 1 into Step 2:
Or
Y/ X=
___1__
1 c+ct+m
B.
The Factor (Labour) Market Equilibrium
29
C.
The Financial (Money) Market Equilibrium
Money Or Cash
Keynesian Financial Market
Bond
30
Ms
i2
Md (Y2, i)
i1
Md (Y1, i)
M
Ms, Md
References
1. Ch 6,7, & 8 in Macroeconomic Theory
and Policy by D N Dwivedi, 3ed
2. Ch3 & 4, Macroeconomics by Blanchard
4ed.
31
32