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MacroeconomicsinShortRun

TheKeynesianTheory

Theory of Income (Y) or Output(Q), and


Employment Determination
QE Y

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.

Classical and Keynesian Economics


KeynesianEconomics:
ClassicalEconomics

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.

1. Product (Goods & Service) Market: reacts somewhat more slowly to


information, but assume able to change production so it clears.
AD=AS determines Output and Price

2. Factor(Labor) Market: reacts most slowly to information. When


economy out of general equilibrium, assume labor supply not equal to labor
demand. Rigid nominal wage W = wP. Employment determined by labor
demand. May have excess supply of labor, hence unemployment.
Nd= Ns determines Wage rate

3. Financial (Money) Market: reacts quickly to information. Assume it


always clears.
Md=Ms determines interest rates

A.
The Product Market Equilibrium

The Product Market Equilibrium


J M Keynes says, the equilibrium level of national income
and Prices is determined at the level where aggregate
demand (AD) for goods and services equals their aggregate
supply (AS).
Equilibrium: AD=AS

Model Can be explained through


Aggregate Supply(AS) Function
Aggregate Demand (AD) Function
Aggregate Consumption Function
Aggregate Saving Function
Investment Function

a. Aggregate Supply Functions/Curve


Aggregate Supply is the total supply of goods and services in an economy which
the economy produces by utilizing all its resources. It depends on productivity.

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)

b. Aggregate Demand Curve


Aggregate Demand Curve is the total demand curve ( aggregate expenditure) of all
economic agent. It is negatively related with the price level and hence slope down
ward from left to right.
Aggregate demand is the total spending on
goods and services in the economy.
AD=C+I+G+(X-M)
Thus Keynes tried to explain the
economic equilibrium with
Two, Three & Four sector model

P1

P2

Y1

Y2

The Product Market Equilibrium: AD=AS


Price Level

LRASC

SRASC

The Product Market Equilibrium: AD=AS


withFixedvs.FlexiblePrices

FixedPrices

FlexiblePrices

Determination of Equilibrium Level of


Income and Output: The AD Curve

Equilibrium level of Income and Output:


The Circular Flow
Let
Y =AD= Aggregate (National)
Income
Z=AE = Aggregate Expenditures
Q=AS= Aggregate Output
(Money Value)
AS=AD=AE always
Or

Z=Y=Q

For Keynes P is fixed

Two Sector Model

Income and Output Determination:


Two Sector Model
Assumption:
1. Only2sectorintheeconomy:HouseholdsandFirms/Industry
1. Households: owneroffactorsofproduction,L,L,K,E
2. Firms/Industry: Hirefactorofproductionandsaleoutputto
households
2. AbsenceofGovernment:NoTax,NoGovt.Exp.
3.

BusinessSector:
a. Nocorporatesaving
b. Noretainearning

4.

AllPricesareFixedinShortrun:StickyPrice,Wage,andinterest
rate.

5.

SupplyofCapitalandTechnologygiven(constant).

Aggregate Supply Functions


Aggregate Supply means total supply of goods and services in an
economy which depends on productivity.
Production Function:
Y f (K, N)
Where K is capital fixed in short run
Keynes Says AD=AS of output
N is labor variable in short run
always
Y=E

AD=AE

E2
E1

450
Y1

Y2

AS=AY

(c) Aggregate demand ( or Expenditure)


= Aggregate supply ( Income)

Aggregate Demand Functions


AggregateDemand:AD=C+I
C=Consumption
I=PrivateDomesticInvestment
1.AggregateDemandforConsumergoods(C)byHouseholds
2.AggregatedemandforInvestmentgoods(I)byFirms
C+I

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

Aggregate Demand Functions/Curve


1. Consumptions Function: C = C0 + c * Y

1. MPC=c slope of consumption function


= dC/dY
= 0.75
2. APC:C/Y

2. Savings Functions: S = -Co+s*Y

1. MPS=s slope of Saving function


= dS/dY
= 0.25
2. APS:S/Y

APC, MPC, APS, MPS


Since Y = C + S
(1)
dividing both sides of equation (1) by
Y, we get the following :
Y = C + S
Y
Y
Y
=> 1 = APC + APS
Since Y = C + S
(1)
Y = C + S (2)
Dividing both sides of equation (2) by
Y ,we get :
Y = C + S
Y
Y
Y
1 = MPC + MPS
=> 1= c +s

1. There is a break even level


of income at which
APC = 1

when C = Y

Below the break-even level of


income
APC > 1 because C > Y
Above the break-even level of
income
APC < 1 because C < Y
2. 0 < MPC < 1 for all level
of income

10

Aggregate Demand Functions/Curve


Aggregate Demand : AD= C +I0
so AD= C0 + c * Y + I0
C= Consumption, I0 is Autonomous Investment

Equilibrium: Income and Output Determination


Equilibrium: AE=AD
=>Y= C + I0
i.e. AE=Y

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

How to determine C???


C=C0+c*Y
Or C=C0+(c/1-c)*{C0+I0}

11

Income and Output Determination :


Savings and Investment Approach
Agg Demand: Y= C + I
=> Y-C= I
Agg Supply: Y=C+S. Savings function
=> Y-C= S
=> S=I
Thus Agg Demand= Agg Supply implies Equilibrium
C+I=C+S
Since I= I0 i.e. Investment is fixed
Substituting S, we get
S=-C0+(1-c)*Y
=> I0 =-C0+(1-c)*Y
=> Y=(1/1-c)*C0+I0
S=I0 exposed or realized Only
SI0 exante or planned

Consumption and Saving Schedules: A


Hypothetical Case
Time
(Year)

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

Change/Shift in Aggregate Demand:


The Multiplier

13

Change in Aggregate Demand: The Multiplier


The shift in aggregate spending shift the aggregate demand
curve and so also aggregate national income.
Multiplier explains the relationship between change in
aggregate spending ( aggregate demand) and change in
national income
1. Investment Multiplier
2. Govt Exp Multiplier
3. Tax Multiplier
4. Balanced Budget Multiplier
5. Export Multiplier
6. Import Multiplier

Change in Aggregate Demand: The Multiplier


Shift in aggregate demand curve
1. Due to shift in C
2. Due to Shift in I
Let c=0.80 i.e. MPC, the multiplier
would be 5. Let initial
investment is 100.
Round of
Income
Generation

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

Change in Aggregate Demand: The Multiplier


Model: Y=

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

Uses and Limits of the Multiplier


Uses
The Multiplier process by indicating different phases of
trade cycles helps the business community to plan its
transactions accordingly.
Multiplier analysis acts as an important tool for the
modern governments in formulating economic policies.
A government, through multiplier analysis, can know the
quantity of investment that has to be made to reach full
employment level.
The Multiplier principle shows the importance of deficit
budgeting
30

15

Uses and Limits of the Multiplier


Limitations
a. Multiplier process works only when there is adequate availability of consumer goods.
b. Full value of multiplier is achieved only when various increments in investments are
repeated at regular intervals.
c. The full value of the multiplier can be achieved only when there is no change in the MPC
during the process of income propagation.
d. Multiplier does not work well in case of leakages from MPC
a. Payments of the past debts
b. Purchase of exiting wealth
c. Import of goods and services
e. Does not work well in case of full employment of resources.
Applications

Less application in case of Less developed countries due to high MPC.

Vast agricultural sector

Disguised unemployment

Low level of capital equipment, technology

Vast non-monetised sector

Producing for self consumption

31

Paradox of Thrift and Multiplier


Savings is a virtue
A Penny saved is a penny earned.
Those who save become reach and
prosperous.
Keynes
criticized,
the
above
sentence may be true for an
Individual but not for the society
When all or most households
become thrifty, they consume less
and save more, the level of Income
and savings declines.

16

Three Sector Model

Income and Out Determination:


Three Sector Model
Three Sector Economy:
1. Households
2. Firms/Industry
3. Govt.
Government can affect aggregate economic activities
through
Fiscal Policy
Monetary policy and credit Policy
Industrial Policy
Labor Policy, Employment Policy, Wage Policy
Control and Regulation of Monopoly
Export and Import Policy
Environment Policy

17

Income and Out Determination:


Three Sector Model

GovernmentActivities:
1. ImposesonlyDirectTaxes(T)onHouseholds
2. Spendmoneytobuygoodsandservicesfromfirms
andfactorservicesfromhouseholds (G)
3. Maketransferpayment(Tr)tohouseholds.
eg.Pensions,subsidiesetc.

Aggregate Demand Functions/Curve


Given:
AE=C+I+G
C=C0 +c*Y
I=I0
G=G0

Step3.SubstituteAEfromStep1intostep
2:
Y=C0 +c*Y+I0 +G0
or

Y=(C0 +I0 +G0)+c*Y


Step1.Substituteintoequation
foraggregateexpenditures: Step4. SolveforNationalIncome(Y)
AE=C0 +c*Y+I0 +G0
Y =(C0 +I0 +G0)+c*Y
Step2.StatetheEquilibrium
Condition:
Y=AE

Y c*Y =C0 +I0 +G0

Y = 1 *(C0 +I0 +G0)


1 c
TheGovtExpenditureMultiplier:
Y/G=1/1c

18

Equilibrium: Income and Output Determination


AE =AD

AS

C+I+G
C+I

1600
Expenditure
C, I,G

1200

45
1200

Output

1600

(Real GDP -trillions of


Rs.)

Aggregate Demand Functions/Curve


A.ImposingTax(T)
Given: AE=C+I+G
C=C0 +c* Y
I=I0
G=G0
IfGovt ImposesIncomeTax,
ThenYd=YT,
Where,Yd =Disposable
Income
T=tax
Now,C=C0 +c*Yd
C=C0 +c*(YT)
Step1.Substituteintoequation
foraggregateexpenditures:
AE=C0 +c*(YT)+I0 +G0
Step2.StatetheEquilibrium
Condition:
Y=AE

Step3.SubstituteAEfromStep1into
Step2:

Or

Y =C0 +c*(YT)+I0 +G0


Y =(C0 +I0 +G0)+c*Y c*T

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

Equilibrium Income and Output:


A. Imposing Tax (T)

Aggregate Demand Functions/Curve


B.IncludingTransfer
Payment(GTr)

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

Aggregate Demand Functions/Curve:


C.TaxationAsaFunctionofIncome
Given:AE=C+I+G
C=C0 +c*Y
I=I0
G=G0
a.IfGovt ImposesIncomeTax,thenYd=YT,
Y=NationalIncome
Yd =disposableIncome
T=tax
C=C0 +c*Yd OrC=C0 +c*(YT)

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.

Govt Expenditure Multiplier: Y/ G=

3.

Govt Tax Multiplier

4.

Govt Transfer Payment Multiplier: Y/ GTr=

5.

Govt Income Tax Multiplier: Y/ T=

: Y/ T=

c
1 c
c
1 c ct

6. The Complete Fiscal policy Multiplier: Y/ G=

1
1 c ct

If Y/ G- Y/ GTr=1, then So Y/ G> Y/ GTr

Government Fiscal Policy: Balanced Budget Multiplier


FromStep4(assumet=0):
Y= 1*[C0+I0 +G0 +c*(GTr T0)]
1 c

Ex. Rs.1 increase in government spending


exactly matched by Rs.1 increase in lump sum
taxes

Spending multiplier (assume no income tax)


1
1c

Lump Sum tax multiplier


- c
1-c

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

Balanced budget multiplier: G= T

Spending multiplier + lump sum tax


multiplier
1 + -c
1c 1c

=1c =1
1-c

Multiplier=1

22

Government Fiscal Policy: Multipliers


Assume c (marginal propensity to consume) = 0.80

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

Tr - Social Security Benefits

n/c

n/c

Tr Unemployment Comp.

Increase

Decrease

n/c

n/c

Decrease

Increase

Taxes
Actual Outcomes

TA Lump Sum Tax


tY) - Income Tax Receipts

Automatic stabilizers describes/refers on how modern government budget policies,


particularly income taxes and welfare spending, act to dampen fluctuations in real GDP

23

Four Sector Model

Income and Out Determination:


Four Sector Model
Four Sector Economy:
1.Households
2.Firms/Industry
3.Govt.
4.Foreign Sector: Export and Import
Foreign Transaction in two things
1. Commodity Flow
2. Financial Flow

24

Export, Import and Aggregate Demand


a. Export Function: determinant

Prices of export in relation to those in importing


countries
Income of importing countries
Income elasticity of import
Tariff and trade policies: both the country
Exchange rate policies
Export policy
Export duties and subsidies
Availability of export surplus
Etc.

Export, Import and Aggregate Demand


b. Aggregate Demand (Expenditures) with Exports:
Given:
AE = C + I + G+X
C = C0 + c * Y
Yd=Y-T
I = I0,, T=T0, GTr=0 ,G = G0 ,,
X=X0

Step 3. Substitute AE from Step 1 into


Step 2:
or

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

Export, Import and Aggregate Demand


c. Import Function: determinant
Prices of foreign goods in relation to domestic
prices.
Income of domestic countries
Income elasticity of import
Tariff and trade policies: both the country
Exchange rate policies
Import duties and subsidies
Etc.

Export, Import and Aggregate Demand


d. Aggregate Demand (Expenditures) with Exports:
Given:
AE = C + I + G+X-M
C = C0 + c * Y
Yd=Y-T
I = I0,, T=T0, GTr=0, G = G0 ,

X=X0, M =M0+ m*Y

Step 1. Substitute into equation for aggregate expenditures:


AE = C0 + c * (Y T)+ I0 + G0+X0- M0- m*Y
Step 2. State the Equilibrium Condition:
Y = AE

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Export, Import and Aggregate Demand


Step 3. Substitute AE from Step 1 into Step 2:
or

Y = C0 + c * (Y-T) + I0 + G0+X0- M0- m*Y


Y = (C0 + I0 + G0+X0) + c * Y - c * T - M0- m*Y

Step 4. Solve for National Income (Y)


=>Y = (C0 + I0 + G0+X0) + c * Y- c * T- M0- m*Y
=> Y - c * Y + m*Y = C0 + I0 + G0+X0- c * T- M0

=> Y =
1
1 c+m

* (C0 + I0 + G0+X0-M0) - c * T

Foreign Trade Multiplier:

Y/ X= ___1__
1 c+m

Equilibrium Income and Output


with Export and Import

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The Complete Four Sector Model:


Aggregate Demand

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 = C0 + c * (Y-T0-t*Y+GT0) + I0 + G0+X0- M0- m*Y


Y = C0 + I0 + G0+X0 + c * Y - c * T0 - c *tY+c * GT0- M0- m*Y

Step 4. Solve for National Income (Y)


=> Y = C0 + I0 + G0+X0 + c * Y- c * T0 - c *tY+ c * GT0- M0- m*Y
=> Y - c * Y + m*Y + c *tY = C0 + I0 + G0+X0- c * T0 + c * GT0- M0
=>(1 c+ct+m) * Y = C0 + I0 + G0+X0-M0- c * T0+ c * GT0
=> Y =
1
* (C0 + I0 + G0+X0-M0 - c * T0+ c * GT0)
1 c+ct+m
Foreign Trade Multiplier:

Y/ X=

___1__
1 c+ct+m

B.
The Factor (Labour) Market Equilibrium

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Labor Market Equilibrium


Labor Market in the Keynesian Sticky Wage Model

Nd= f( real wage rate)


They are negatively related
Nd is MRPL=w

Ns= f( real wage rate)


They are positively related

Nd= Ns determines real wage rate,w

C.
The Financial (Money) Market Equilibrium

Money Or Cash
Keynesian Financial Market
Bond

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Financial(Money) Market Equilibrium:


Md=Ms
Demand for Money: Md= L(P,Y,i) or Md= P L(Y,i)
Supply of Money : Ms is fixed ( by RBI)
i

Md positively related with income


Md negatively related with interest rate

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.

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Thank You All

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