Keynesian 01
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Keynesian System I : Role of Aggregate Demand
• The Problem of Unemployment: The Keynesian Economics
was developed against the background of the great
depression of 1930s.• The effect of depression on the US economy: unemployment
increases from 3.2% in 1929 to 25.2% in 1933.
• Real GNP decreased by 30%
• According to JM Keynes, high unemployment in GB and USand other economies was due to deficiency in aggregate
demand.
• Aggregate demand was low due to low investment demand.
• Keynes says, to remove unemployment, aggregate demandhas to increase, which need fiscal policy and govt. in the
form of spending on public work project.
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Keynesian System I : Role of Aggregate Demand
• Central notion in keynesian model in achieving an
equilibrium level of output requires, Output = Aggregate
demand.
• Aggregate demand = E = C + I + G
• C = HH consumption
• I = Desired business investment
• G = govt. sector demand for goods and services.
• GDP = GNP (closed economy)
• GDP = NDP (depreciation ignored)
• Aggregate price level is fixed
• Y = national income = C + S + T
• Income is either consumed, saved or paid out as taxes.
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• Y = national product = C + Ir + G
• Ir = realised investment
• G = govt spending
• C = consumption
•Income = Expenditure
• C + S + T = Y = C + I + G
• S + T = I + G
• Product = Expenditure
• C + Ir + G = C + I + G• So, Ir = I
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• So, the condtion for equilibrium in the model is• Y = C + I + G (1)
• S + T = I + G (2)
• Ir = I (3)
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The Components of Aggregate Demand
• Consumption(C):
• Kenes Psychological law of consumption statesthat Consumer expenditure was a stable
function of disposable income.
• C = bYd
----- (4)
• Where, a>0 and 0< b <1
• b is the slope of the consumption function,
measures the increase in consumption due to
per unit increase in the disposable income;
• b = MPC = C/ Yd
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The Components of Aggregate Demand
• Investment(I): Changes in the desired business
investment expenditure is one of the majorfactor that keynes thought responsible for
changes in income.
• Investment primarily responsible for instability
of income.
• Investment is determined by (i) interest rate
and (ii) business expectations.
• Govt. expenditures(G):are controlled by the
policy makers.
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Determining the Equilibrium Level of Income
• E = Y = C + I + G
• Where, C = a + bYd = a + by – bT• (as Yd = Y – T)
• Y = a + bY – bT + I + G
• Or, Y – bY = a – bT + I + G
• Y (1 – b) = a – bT + I + G
• Or Y = 1 / (1 – b) [a – bT + I + G] ----------(5)
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Determining the Equilibrium Level of Income
• Horizontal axis represents – Income
• Vertical axis represents – aggregate expenditure• 45 0 line indicates the all the points along this line,
aggregate income = aggregate expenditure
• E = Y = C + I + G
• We derive the aggregate expenditure (E) by adding I +G to C = a + bYd at each level of income.
• Because autonomous expenditure component does not
depend on the income and C + I + G curve lies above
the consumption function by a constant amount.
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Y = C + I + G
TABLE 1 Finding Equilibrium
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Output
(Income)
Y
Net
Taxes
T
Disposable
Income
Y d ≡Y T
Consumption
Spending
C = 100 + .75 Y d
Saving
S
Y d – C
Planned
Investment
Spending
I
Government
Purchases
G
Planned
Aggregate
Expenditure
C + I + G
Unplanned
Inventory
Change
Y (C + I + G )
Adjustment
to Disequi-
librium
300 100 200 250 - 50 100 100 450 - 150 Output ↑
500 100 400 400 0 100 100 600 - 100 Output ↑
700 100 600 550 50 100 100 750 - 50 Output ↑
900 100 800 700 100 100 100 900 0 Equilibrium
1,100 100 1,000 850 150 100 100 1,050 + 50 Output ↓
1,300 100 1,200 1,000 200 100 100 1,200 + 100 Output ↓
1,500 100 1,400 1,150 250 100 100 1,350 + 150 Output ↓
The Determination of Equilibrium Income
C = 100 + .75 Y d
I = 100,
G = 100,
T = 100
D t i i th E ilib i L l f I
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Determining the Equilibrium Level of Inco
• From the equation of determining the equilibrium
level of income, we have derived the E = a + bY – bT+ I + G
• In the above equation, the component a – bT + I + G
represents the autonomous components of
expenditure.
• The expenditure function shift every time these
expenditure components change.
• The slope of the expenditure function is thecoefficient of Y i.e. b (MPC)
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Determining the Equilibrium Level ofIncome
• So, when the MPC decreases, theexpenditure function is flatter and when
MPC increases, the expenditure function is
steeper.• YE = (autonomous exp. Multiplier) x
(autonomous expenditure)
• YE = 1 / (1-b) [a – bT + G + I)
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Determining the Equilibrium Level ofIncome
• The expenditure multiplier = k• The marginal propensity to consume = b
• So, when b = 0.5 k = 2
b = 0.8 k = 5b = 0.9 k = 10
The autonomous expenditure multiplier gives the
changes in the equilibrium level of output perunit change in the autonomous expenditure
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Determining the Equilibrium Level ofIncome
•The autonomous expenditure are the expenditure that arelargely determined by factors other than current income.
• a = autonomous component of consumption expenditure
• bT = autonomous affect of tax collection on aggregate
demand and determined through marginal propensityto consume.
• (a – bT) determines the height of the consumption
function.
• I = autonomous investment• G = autonomous govt. expenditure
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MPS S
Y
MPS I
Y
Because S must be equal to I for equilibrium to be restored, wecan substitute I for S and solve:
Therefore, Y I MPS
1
, or
Recall that the marginal propensity to save (MPS)is the fraction of a change in income that is
saved. It is defined as the change in S (∆S) overthe change in income (∆Y ):
The Investment Multiplier
MPS 1multiplier
MPC - 11multiplier It followsthat
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TABLE 2 Finding Equilibrium after a Investment Increase of 50 (I Has Increased from 100 in Table 1
to 150 Here)
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Output
(Income)
Y
Net
Taxes
T
Disposable
Income
Y d ≡Y T
Consumption
Spending
C = 100 + .75 Y d
Saving
S
Y d – C
Planned
Investment
Spending
I
Government
Purchases
G
Planned
Aggregate
Expenditure
C + I + G
Unplanned
Inventory
Change
Y (C + I + G )
Adjustment
to
Disequilibrium
300 100 200 250 - 50 150 100 500 - 200 Output ↑
500 100 400 400 0 150 100 650 - 150 Output ↑
700 100 600 550 50 150 100 800 - 100 Output ↑
900 100 800 700 100 150 100 950 - 50 Output ↑
1,100 100 1,000 850 150 150 100 1,100 0 Equilibrium
1,300 100 1,200 1,000 200 150 100 1,250 + 50 Output ↓
Fiscal Policy at Work: Multiplier Effects
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TABLE 24.2 Finding Equilibrium after a Government Spending Increase of 50 (G Has Increased from
100 in Table 9.1 to 150 Here)
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10)
Output
(Income)
Y
Net
Taxes
T
Disposable
Income
Y d ≡Y T
Consumption
Spending
C = 100 + .75 Y d
Saving
S
Y d – C
Planned
Investment
Spending
I
Government
Purchases
G
Planned
Aggregate
Expenditure
C + I + G
Unplanned
Inventory
Change
Y (C + I + G )
Adjustment
to
Disequilibrium
300 100 200 250 - 50 100 150 500 - 200 Output ↑
500 100 400 400 0 100 150 650 - 150 Output ↑
700 100 600 550 50 100 150 800 - 100 Output ↑
900 100 800 700 100 100 150 950 - 50 Output ↑
1,100 100 1,000 850 150 100 150 1,100 0 Equilibrium
1,300 100 1,200 1,000 200 100 150 1,250 + 50 Output ↓
Fiscal Policy at Work: Multiplier Effects
The Government Spending Multiplier
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Increasing governmentspending by 50 shifts the
AE function up by 50.As Y rises in response,additional consumption is
generated.Overall, the equilibriumlevel of Y increases by200, from 900 to 1,100.
The Government Spending Multiplier
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tax multiplier The ratio of change in the equilibrium level ofoutput to a change in taxes.
tax multiplier MPC
MPS
-
Y MPS
(initial increase in aggregate expenditure) 1
1( ) MPC Y T MPC T
MPS MPS - -
The Tax Multiplier
Because the initial change in aggregate expenditure caused by atax change of ∆T is (−∆T × MPC ), we can solve for the taxmultiplier by substitution:
Because a tax cut will cause an increase in consumptionexpenditures and output and a tax increase will cause a reduction in consumption expenditures and output, the tax multiplier is a
negative multiplier:
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•It is easy to show formally that the balanced-budget multiplier = 1.
Gincrease in spending:( )C T MPC − decrease in spending:
( )G T MPC - = net increase in spending
In a balanced-budget increase, G = T; so we can substitute:
net initial increase in spending:
G −
G (MPC ) =
G (1 − MPC )
Deriving the Fiscal Policy Multipliers
The Balanced-Budget Multiplier
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1( )Y G MPS G
MPS
Because MPS = (1 − MPC ), the net initial increase in spending is:
G (MPS)
We can now apply the expenditure multiplier to this net initialincrease in spending:
MPS
1
Deriving the Fiscal Policy Multipliers
The Balanced-Budget Multiplier
Thus, the final total increase in the equilibrium level of Y is just equalto the initial balanced increase in G and T .
Fiscal Policy at Work: Multiplier Effects
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TABLE 3 Finding Equilibrium after a Balanced-Budget Increase in G and T of 200 Each (Both G and
T Have Increased from 100 in Table 1 to 300 Here)
(1) (2) (3) (4) (5) (6) (7) (8) (9)
Output
(Income)
Y
Net
Taxes
T
Disposable
Income
Y d ≡Y T
Consumption
Spending
C = 100 + .75 Y d
Planned
Investment
Spending
I
Government
Purchases
G
Planned
Aggregate
Expenditure
C + I + G
Unplanned
Inventory
Change
Y (C + I + G )
Adjustment
to
Disequilibrium
500 300 200 250 100 300 650- 150 Output ↑
700 300 400 400 100 300 800 - 100 Output ↑
900 300 600 550 100 300 950 - 50 Output ↑
1,100 300 800 700 100 300 1,100 0 Equilibrium
1,300 300 1,000 850 100 300 1,250 + 50 Output ↓
1,500 300 1,200 1,000 100 300 1,400 + 100 Output ↓
Fiscal Policy at Work: Multiplier Effects
The Balanced-Budget Multiplier
Fiscal Policy at Work: Multiplier Effects
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TABLE 4 Summary of Fiscal Policy Multipliers
Policy Stimulus Multiplier
Final Impact on
Equilibrium Y
Government
spending
multiplier
Increase or decrease in the
level of government
purchases: ∆G
Tax multiplier Increase or decrease in the
level of net taxes: ∆T
Balanced-budget
multiplier
Simultaneous balanced-budget
increase or decrease in thelevel of government purchases
and net taxes: ∆G = ∆T
1
1
MPS
- MPC
MPS
1 G
MPS
MPC
T MPS
-
G
Fiscal Policy at Work: Multiplier Effects
The Balanced-Budget Multiplier
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federal budget The budget of the federalgovernment.
The “budget” is really three different budgets:
It is a political document that dispenses favors to certain groups or regionsand places burdens on others.
It is a reflection of goals the government wants to achieve.
The budget may be an embodiment of some beliefs about how (if at all)the government should manage the macroeconomy.
The Federal Budget
The Federal Budget
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TABLE 24.5 Federal Government Receipts and Expenditures, 2009 (Billions of Dollars)
Amount Percentage of Total
Current receipts
Personal income taxes 828.7 37.2
Excise taxes and customs duties 92.3 4.1
Corporate income taxes 231.0 10.4
Taxes from the rest of the world 12.3 0.6
Contributions for social insurance 949.1 42.7
Interest receipts and rents and royalties 48.2 2.2Current transfer receipts from business and persons 68.1 3.1
Current surplus of government enterprises − 4.9 − 0.2
Total 2,224.9 100.0
Current Expenditures
Consumption expenditures 986.4 28.6
Transfer payments to persons 1596.1 46.2
Transfer payments to the rest of the world 61.7 1.8
Grants-in-aid to state and local governments 476.6 13.8
Interest payments 272.3 7.9
Subsidies 58.2 1.7
Total 3,451.3 100.0
Net federal government saving—surplus (+) or deficit (−)
(Total current receipts − Total current expenditures) − 1,226.4
The Federal Budget
The Budget in 2009
The Federal Budget
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federal surplus (+) or deficit (−) Federal government receiptsminus expenditures.
The Federal Budget
The Budget in 2009
CHAPTER 24 APPENDIX A
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Y C I G
C a b Y T -( )
Y a b Y T I G - ( )
Y a bY bT I G -
Y bY a I G bT - -
Y b a I G bT ( )1- -
)(
1
1bT G I a
b Y -
-
Deriving the Fiscal Policy Multipliers
The Government Spending and Tax Multipliers
We can derive the multiplier algebraically using our hypotheticalconsumption function:
The equilibrium condition is
By substituting for C , we get
This equation can be rearranged to yield
Now solve for Y by dividing through by (1 − b):
CHAPTER 24 APPENDIX A
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•It is easy to show formally that the balanced-budget multiplier = 1.
Gincrease in spending:( )C T MPC − decrease in spending:
( )G T MPC - = net increase in spending
In a balanced-budget increase, G = T; so we can substitute:
net initial increase in spending:
G − G (MPC ) = G (1 − MPC )
Deriving the Fiscal Policy Multipliers
The Balanced-Budget Multiplier
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T Y Y d
-
)3/1200( Y Y Y d --
Y Y Y d
3/1200 -
d Y C 75.100
)3/1200(75.100 Y Y C -
FIGURE 24B.1 The Tax Function
The Case in Which Tax Revenues Depend on Income
This graph shows net taxes
(taxes minus transfer payments)as a function of aggregateincome.
CHAPTER 24 APPENDIX B
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When taxes are strictly lump-sum (T =100) and do not depend on income, the
aggregate expenditure function is
steeper than when taxes depend on
income.
FIGURE 24B.2 Different Tax Systems
G I C Y
100 .75( 200 1/3 ) 100 100Y Y Y I GC
-
4505.
5.450
1001002515075.100
-
Y
Y Y
Y Y Y
The Case in Which Tax Revenues Depend on Income
CHAPTER 24 APPENDIX B
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C a b Y T -( )
0C a bY bT btY - -
0( )C a b Y T tY - -
0Y a bY bT btY I G
C
- -
Y b bt
a I G bT -
-1
1 0( )
The Government Spending and Tax Multipliers Algebraically
The Case in Which Tax Revenues Depend on Incomes
Through substitution we get
Solving for Y :
CHAPTER 24 APPENDIX B
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1
1 b bt -
The Government Spending and Tax Multipliers Algebraically
The Case in Which Tax Revenues Depend on Incomes
This means that a $1 increase in G or I (holding a and T 0 constant) willincrease the equilibrium level of Y by
Holding a, I , and G constant, a fixed or lump-sum tax cut (a cut in T 0)will increase the equilibrium level of income by
bt b
b
-1