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Deviation of actual from potential GDP (Income), that is the GDP Gap. ( ex-The Great Depression) The determination of GDP in the short run depends on the behavior of key categories of aggregate spending: Consumption (APC and MPC), Investment (autonomous and induced, interest rates), Government Spending (Fiscal measures) and Net Exports. Consumption spending depends on real interest rates and business confidence. A necessary condition for GDP to be in equilibrium is that desired domestic spending equals actual output.
Equilibrium GDP
Desired Aggregate Expenditure
AE=Y AE (C+I)
AE=Y
E
45
Real NI (GDP)
Equilibrium GDP
S>I
I>S
Changes In GDP
Shifts in Aggregate Spending Function
In E AE1
Desired Aggregate Expenditure Desired Aggregate Expenditure
AE E1 E0 In E
AE0
In Y
In Y o Yo Real NI (GDP) Y1
Yo Real NI (GDP)
Y1
-20 -10 0 10 20 30
B
Dissaving
Income
(i) (ii) (iii) (iv) 2. (i) (ii) (iii) (iv) (v) (vi)
Institutional Arrangements: with respect to the behavior of business corporations and governments, Keynes listed the following four motives for accumulation: Enterprise- the desire to expand or to do big things. Liquidity- the desire to face emergencies successfully. Rising Income the desire to demonstrate successful management. Financial Prudence the desire to ensure adequate financial provisions against depreciation. Objective Factors: Objective factors that cause shift in consumption function are. Changes in Wage Level Distribution of Income Windfall Gains and Losses Fiscal Policy Changes in Expectations Rate of Interest
Investment Function
In Keynesian economics, investment means real investment and not financial investment. Real investment implies the creation of new machines, new factory buildings, roads, bridges, and other forms of productive capital, which directly generates new jobs and increases production. Real investment does not include the purchase of existing stocks, shares and securities, which is merely an exchange of money from one hand to another. Such an investment is simply financial investment and has no direct impact on the employment and output of the economy. Types of Investment 1. Induced or Private Investment Income 2. Autonomous or Public Investment 3. Planned Investment and Unplanned Investment 4. Gross and Net Investment: Gross Investment includes a) net investment and b) depreciation and Net Investment includes Gross Investment minus Depreciation
Investment
I I
Propensity to Invest 1. Average Propensity to Invest ( API): The ratio between aggregate investment and aggregate income. API= I/Y. 2. Marginal Propensity to Invest ( MPI): The ratio of change in investment to change in income.
I L I2 K I1 T Investment Investment I
I1
Y1 Income
Y1
Y2
Income
PROBLEMS
Recession Aggregate Spending < GDP Recessionary Gap = shortfall Inflation Aggregate Spending > GDP Inflationary Gap = excess
The Multiplier
The concept of Multiplier is an integral part of Keynes Theory of Employment. Keynes believed that an initial increment in investment increases the final income by many times. Keynes gave the name Investment Multiplier which is also known as Income Multiplier or simply Multiplier. Multiplier is expressed as K= Change in Income (Y)/ Change in Investment (I) According to Kurihara, The Multiplier is the ratio of change in income to the change in Investment. According to D.Dillard, Investment Multiplier is the ration of an increase in income to given increase in Investment In short the Multiplier tells us how many times the income increases as a result of an initial increase in investment.
The multiplier tells us how many times the income increases as a result of increased investment. It applies to autonomous investment. There is closed economy. There is no change in the prices of commodities. There is no time lags. The MPC remains constant. The situation is less than full employment. The factors and resources of production are easily available. The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate income. An increase in spending by one party increases the income of others. Thus, growth in spending can expand output by a multiple of the original increase. The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income. The size of the multiplier increases with the marginal propensity to consume (MPC).
Additional consumption
(Rs)
Marginal propensity to consume 3/4 3/4 3/4 3/4 3/4 3/4 3/4
Round 4
Round 5 All others
421,875
316,406 949,219
316,406
237,305 711,914
Total
4,000,000
3,000,000
For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.
Relation between MPC and Multiplier Total Income = Total Consumption + Total Investment Or Y=C+I Or Change in Income = Change in Consumption + Change in Investment Or Change in Investment = Change in Income -- Change in Consumption By definition, Multiplier is K = Change in Income / Change in Investment Substituting the value of Change in Investment in K equation we get K = Change in Income / Change in Income -- Change in Consumption Dividing both the numerator and denominator by Change in Income, we have 1 Change in Income -- Change in Consumption K= Change in Income 1 K = 1-- Change in Consumption / Change in Income
K = 1/ 1MPC, K = 1/ MPS
Y= C + I
C+I+G
E1 I CONSUMPTION INVESTMENT
C+I
E0
0
INCOME
The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% = 3/4). Here, a Rs 1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent etc. until
Leakages of Multiplier
Saving Debt Cancellation Imports Price Inflation Hoarding Purchase of old shares and securities Taxation Undistributed Profits
Size of multiplier
10.0 5.0 4.0 3. 0 2.0 1.5
As the MPC increases, more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.). The effect is that for higher MPCs, higher multipliers result. Specifically the relationship follows this equation:
M = 1 - MPC
1.
Desired Expenditure E1
AE=Y AE1
2. E1
AE=Y
AE1 AE0
Desired Expenditure
E0
AE0
E0
Y1
Y0 Y1 Real NI (GDP)
AE=Y
1. 2.
3.
E1
AE1 AE0
E0
Y0
Y1 Real NI (GDP)
(BUSINESS CYCLES)
Peak
Peak
Peak
Peak
Peak
Peak
Level of GNP
Through
Depression
Through
Through
Through
Through Through
Depression
TIME
Price Stability
Types of price rise1. Creeping-2 percent annually 2. Walking-5 percent annually 3. Running-10 percent annually 4. Galloping or Hyper Inflation-more than 10 percent annually On the basis of time1. Peace time 2. War time 3. Post war time Main causes 1. Demand Pull 2. Cost-push-wage push, profit push, material push
P2
Price Level P1
P2 D2 D1 D M Output P1 s d4 d3
d1
d2
m m1 m3 m4
Output
E1 P1 P S1
Price Level
S
M1 M
Output
INFLATIONARY GAP
According to Keynes, inflationary gap exists when, at full employment income level, aggregate demand exceeds supply. This means that due to increase in investment and government expenditure, the money income increases, but production does not increase because of the limitations of productive capacity. As a result, an inflationary gap comes to exist, causing the prices to rise. The prices continue to rise so long as the inflationary gap exists.
Inflationary gap E
AS or Y=C+I+G
AD or C+I+G
EXPENDITURE (C+I+G)
O
A B
AS or Y=C+I+G
EXPENDITURE (C+I+G)
Deflationary gap prevails when AD is less than AS at full employment level of output. Income equilibrium occurs while resources are unemployed.
O YO Yf
Income (Y)
Equilibrium GDP
Equilibrium GDP: At the Equilibrium level of GDP, purchasers wish to buy exactly the amount of national output that is being produced. At GDP above equilibrium, desired spending falls short of national output, and output will sooner or later be curtailed. At GDP below equilibrium, desired spending exceeds national output, and output will sooner or later be increased. In a closed economy with no government, desired saving equals desired investment at equilibrium GDP. Changes in GDP: With constant price level, equilibrium GDP is increased by a rise in the desired consumption or investment spending that is associated with each level of NI. Equilibrium GDP is decreased by a fall in desired spending. Changes in equilibrium is also because of Multiplier effect.