Intro Macro - Week 4 Keynesian Model Notes PDF

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INTRO MACROWEEK 4 – Keynesian ModelTEXTBOOK NOTESCh7 Spending and output in the shortrun7 Introduction to the Keynesian Model John Maynard Keynes proposed the idea that aggregate spending may cause output to fall below potential output Government policies that affect the level of spending can be u...

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INTRO MACRO WEEK 4 – Keynesian Model TEXTBOOK NOTES Ch7 Spending and output in the short run 7.1 Introduction to the Keynesian Model

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John Maynard Keynes proposed the idea that aggregate spending may cause output to fall below potential output

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Government policies that affect the level of spending can be used to eliminate output gaps (stabilisation policies e.g. fiscal policy)

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Keynesian model only applies in the short-run - where firms don't adjust their prices, but instead meet the demand forthcoming at pre-set prices o As prices are fixed, this model doesn't account for inflation

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This assumption (that firms vary production to meet demand at fixed prices) implies spending will have powerful effects on a nation's GDP

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Firms don’t change their prices frequently because of menu costs

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Decision involves a cost-benefit comparison: does the benefit of changing prices outweigh menu costs? (The benefit being whether sales will be brought more in line with normal production capacity)

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As this model is in the short-run, there is no distinction between real and nominal variables like GDP o Since prices don't change, any changes in real variables will impact nominal variables

7.2 Aggregate expenditure

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Output at each point in time in the economy depends on planned aggregate expenditure - the total planned spending on final goods and services

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Aggregate expenditure = C + I + G + NX

Planned versus actual expenditure 

Planned spending can differ from actual spending - a firm can sell less or more of its products than intended

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Unsold inventory are treated as an investment

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Denote IP as planned investment, and I as actual investment

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A firm that sells less of its output than planned will add more to its inventory than planned have I > IP

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A firm that sells more than expected will add less to its inventory, and have I < IP

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Actual and planned investment may differ for firms - but for households and the government not so much, Therefore, we can define planned aggregate expenditure as:

Consumer spending and the economy 

An important determinant of the amount people plan to consume is there after-tax, or disposable income

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Disposable income (of private sector) = total production of the economy, Y, less net taxes (T), so (Y - T)

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We can assume that consumption spending (C) increases as (Y - T) increases

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CONSUMPTION FUNCTION: Link between consumption and disposable income for private sector:

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Wealth effect = changes in asset prices that affect households' wealth and spending on consumption goods

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Marginal propensity to consume (MPC) = the c parameter in the above equation, the amount by which consumption rises when current disposable income rises by one dollar o c is a proportion between 0 and 1 (0 < c < 1) o Slope of the consumption function

7.3 Planned aggregate expenditure and output

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In the above example, 960 is the exogenous expenditure (doesn't depend on output)

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The induced expenditure is 0.8Y (depends on output)

* 7.4 Short-run equilibrium output How is output determined? 

During the short-run period, firms produce an amount that is equal to planned aggregate expenditure

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Short-run equilibrium output = the level of output where output Y equals planned aggregate expenditure PAE

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Y = PAE

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Injections = the component of PAE that doesn't come from households consumption expenditure (INJP), all sources of exogenous expenditure in the economy

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Consists of investment expenditures, gov. expenditure and expenditure by foreign residents on domestic exports

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Withdrawals = that part of income NOT spend on goods and services produced domestically, NOT used for consumption purposes

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Includes saving, tax payments, expenditure on imports (W = S + T + M)

o

How does the above equation relate to the equilibrium of Y = PAE? 

Recall that PAE = C + IP + G + NX

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In equilibrium, it must be that Y = C + IP + G + NX

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Subtracting C from both sides, we get Y - C = IP + G + NX

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Recall from earlier chapters that private saving S = Y C-T

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Therefore, Y - C = S + T, and S + T = I P + G + NX

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Remembering that net exports NX represents exports (X) less imports (M),

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We can rewrite as S

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Left hand side of the above equation is withdrawals (leakages), right hand side is injections Equilibrium of Y = PAE is the same as the equilibrium of withdrawals and planned injections

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+ T + M = IP + G + X

DISEQUILIBRIUM: suppose PAE > Y 

This means C + IP + G + NX > Y, and IP + G + NX > S + T + M, so planned injections would exceed withdrawals

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We would expect aggregate output to grow to match the level of PAE

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This growth is triggered by an unexpected depletion of firm's inventories

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PAE > Y --> tells us that firms hadn't made their investment plans based on having to meet this high level of PAE

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Firms would have to run down their inventories in order to meet demand, and eventually boost production

DISEQUILIBRIUM: now suppose PAE < Y 

This implies INJP < W

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Leads to contraction in the economy - firms will have an unplanned increase in inventories, and are unable to sell all that is produced

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Firms will cut back on production - aggregate output shrinks

7.5 Consumption and investment in the 2-sector model

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Two-sector model = imagine economy consists of only households and firms

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Household's aggregate income corresponds to economy's total GDP - no taxes to be paid

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Consumption function:

o

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In a two-sector model, S = Y - C, so the saving function is S = Y - (Cbar + cY), or:

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Vertical intercept of the saving function is negative of the exogenous component of consumption (the intercept of consumption function)

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In the event aggregate income were 0, there would only be exogenous consumption Cbar The funds to finance this would come from reducing savings (the negative sign)

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Saving is the only withdrawal in the 2 sector model

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Planned investment is the only source of planned injections

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Treats planned investment as exogenous - it doesn't change when GDP/output changes!!! The rationale is the fact that other factors influence investment plans more, which are real interest rate and entrepreneur's expectations

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Entrepreneur's expectations = expectations held by decision-makers in firms about the future profitability of proposed investment projects

7.6 The 45-degree diagram

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The 45-degree line represents all the possible points where the economy's equilibrium condition is satisfied

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Planned spending by households can be represented with consumption function

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Firms' spending plans are investments - which we have assumed to be exogenous

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PAE is the sum of household's consumption spending and firm's planned investment spending

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The point at which the PAE line crosses the 45-degree line marks the economy's equilibrium given the current spending plans of households and firms

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At that point, the spending plans of households and firms match the economy's actual level of production

7.7 Withdrawals and injections

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Planned injections = withdrawals when the economy's saving function intersects economy's planned investment function

DISEQUILIBRIUM where withdrawals > injections, PAE < Y 

Recall that withdrawals are the part of income NOT spent on consumption

7.8 The Four-Sector Model

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PAE = C + IP + G + NX

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Some more assumptions need to be made:

 Net taxes consist of an exogenous component (Tbar) that is unrelated to income, and another component proportional to income. t = tax rate o  Consumption depends on after-tax income o

 Imports are proportional to income (M = mY)

1. Planned investment, gov expenditure and exports are ALL exogenous - they don't vary when income varies

1. Withdrawals consist of saving, tax and spending on imports  Total withdrawals increase if GDP increases - each component increases in line with aggregate income 1. Planned injections are firms' planned investment, gov. expenditure and exports  All are assumed to be exogenous 

Economy's interpretation of the equilibrium stays the same!!  Planned aggregate spending still = aggregate output  Withdrawals still equal planned injections

7.9 Example: Planned spending and the output gap

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Moral of the story: decline in exogenous expenditure leads to contractionary output gap!!!

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Equilibrium level of GDP is below the economy's potential level

7.10 The Multiplier

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Decline in government spending leads to a much greater fall in output

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Fall in consumer spending not only reduces sales of consumer goods, it also reduces incomes of workers and owners in industries that produce the goods

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As their incomes fall, these workers reduce their spending, which reduces the output and income of other producers ---> MULTIPLIER

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Successive rounds of declines in spending and income leads to an ultimate decrease in PAE

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Income-expenditure multiplier: effect of a one-unit increase in exogenous expenditure on short-run equilibrium output

INTUITION BEHIND THE MULTIPLIER:    

Small change in exogenous expenditure leads to a larger change in output Intuition: exogenous change in expenditure becomes income for others Keynesian consumption function: increase in income is partly saved and partly consumed (disposable income) Increase in consumption further increases national income --> further increases expenditure

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Applies to any number x greater than 0 but less than 1

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E.g. if x = 0.8, the spending on domestically produced goods and services that takes place in each round is 0.8 times the spending from the previous round

Multiplier for basic Keynesian model 

Let k = c(1 - t) - m be the coefficient in front of Y in the 4sector model equation for PAE

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K = marginal propensity of expenditure on domestically produced goods and services

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Multiplier for a four-sector model = 1−k

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Multiplier for a two-sector model = 1−c

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Note that: k is heavily influenced by c

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If marginal propensity to CONSUME is large, then falls in income will reduce people's spending largely, and the multiplier effect will be large  Increase in marginal propensity to SAVE would lead to less consumption for any increase in income (reduced multiplier effect)

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Multiplier will be smaller the higher the tax rate ---> if the tax rate is high, a change in domestic income won't flow through to expenditure as much

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Propensity to import increased ---> multiplier will decrease, because a smaller proportion of disposable income will be spent on domestic goods/services

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