John Maynard Keynes The General Theory A workout with the basic macroeconomic magnitudes in a mixed economy

A MACROECONOMIC IDENTITY Y = C + S + T INCOME IS THE SUM OF: THE PART YOU SPEND, THE PART YOU DON’T SPEND, THE PART YOU NEVER SAW (because the government took it as taxes).

MACROECONOMIC EQUILIBRIUM INCOME = EXPENDITURES Y = E Y = C + I + G C + S + T = C + I + G S + T = I + G Note that I is “given”; G and T are policy variables; and C (and therefore S) depend directly on Y.

E Y Y C+I+G C+I C I+G S+T I S S, I

E Y Y C+I+G C+I C I+G S+T I S S, I

E Y Y C+I+G I+G S+T S, I

IS NORWAY IN EQUILIBRIUM? Y = 180 C = 120 S = 60 T = 0 I = 36 G = 24

IS NORWAY IN EQUILIBRIUM? Y = 180 C = 120 S = 60 T = 0 I = 36 G = 24

IS NORWAY IN EQUILIBRIUM? Y = 180 C = 120 S = 60 T = 0 I = 36 G = 24

IS NORWAY IN EQUILIBRIUM? Y = 180 = ? C = 120 S = 60 T = 0 I = 36 G = 24

NORWAY IS IN EQUILIBRIUM. Y = 180 = 180 = E C = 120 S = 60 T = 0 I = 36 G = 24 People are producing and consuming 120. They’re producing but not consuming another 60. They save the 60, which is borrowed partly by the private sector (36) and partly by the government (24). These borrowers then take command over the unconsumed 60.

E Y Y C+I+G I+G S+T S, I

IS NORWAY IN EQUILIBRIUM? Y = 180 C = 120 S = 60 T = 0 I = 36 G = 24

IS NORWAY IN EQUILIBRIUM? Y = 180 C = 120 S = 60 T = 0 I = 36 G = 24

IS NORWAY IN EQUILIBRIUM? Y = 180 C = 120 S = 60 S + T = 60 T = 0 I = 36 G = 24

IS NORWAY IN EQUILIBRIUM? Y = 180 C = 120 S = 60 S + T = 60 T = 0 I = 36 G = 24

IS NORWAY IN EQUILIBRIUM? Y = 180 C = 120 S = 60 S + T = 60 T = 0 I = 36 I + G = 60 G = 24

NORWAY IS IN EQUILIBRIUM Y = 180 C = 120 S = 60 S + T = 60 T = 0 I = 36 I + G = 60 G = 24

E Y Y C+I+G I+G S+T S, I

IS EASWAY IN EQUILIBRIUM? Y = 120 C = 84 S = 30 T = 6 I = 17 G =10

IS EASWAY IN EQUILIBRIUM? Y = 120 C = 84 S = 30 T = 6 I = 17 G =10

IS EASWAY IN EQUILIBRIUM? Y = 120 C = 84 S = 30 T = 6 I = 17 G =10

IS EASWAY IN EQUILIBRIUM? Y = 120 = ? C = 84 S = 30 T = 6 I = 17 G =10

EASWAY ISN’T IN EQUILIBRIUM. Y = 120 > 111 = E C = 84 S = 30 T = 6 I = 17 G =10

E Y Y C+I+G I+G S+T S, I EXCESS INVENTORIES

IS SOUWAY IN EQUILIBRIUM? Y = C = 150 S = 45 T = 3 I = 24 G =30

IS SOUWAY IN EQUILIBRIUM? Y = C = 150 S = 45 T = 3 I = 24 G =30

IS SOUWAY IN EQUILIBRIUM? Y = 198 C = 150 S = 45 T = 3 I = 24 G =30

IS SOUWAY IN EQUILIBRIUM? Y = 198 C = 150 S = 45 T = 3 I = 24 G =30

IS SOUWAY IN EQUILIBRIUM? Y = 198 = ? C = 150 S = 45 T = 3 I = 24 G =30

SOUWAY ISN’T IN EQUILIBRIUM. Y = 198 < 204 = E C = 150 S = 45 T = 3 I = 24 G =30

E Y Y C+I+G I+G S+T S, I DEFICIENCY OF INVENTORIES

IS WESWAY IN EQUILIBRIUM? Y = C = S = 46 T = 20 I = 38 G =28

IS WESWAY IN EQUILIBRIUM? Y = C = S = 46 T = 20 I = 38 G =28

IS WESWAY IN EQUILIBRIUM? Y = C C = S = 46 T = 20 I = 38 G =28

IS WESWAY IN EQUILIBRIUM? Y = C C = S = 46 T = 20 I = 38 G =28

IS WESWAY IN EQUILIBRIUM? Y = C+46+20=C+38+28? C = S = 46 T = 20 I = 38 G =28

WESWAY IS IN EQUILIBRIUM Y = C + 66 = C + 66 = E C = S = 46 T = 20 I = 38 G =28

IS WESWAY IN EQUILIBRIUM? Y = C = S = 46 T = 20 I = 38 G =28

IS WESWAY IN EQUILIBRIUM? Y = C = S = 46 T = 20 I = 38 G =28

IS WESWAY IN EQUILIBRIUM? Y = C = S = 46 S + T = 66 T = 20 I = 38 G =28

IS WESWAY IN EQUILIBRIUM? Y = C = S = 46 S + T = 66 T = 20 I = 38 G =28

IS WESWAY IN EQUILIBRIUM? Y = C = S = 46 S + T = 66 T = 20 I = 38 I + G = 66 G =28

WESWAY IS IN EQUILIBRIUM. Y = C = S = 46 S + T = 66 T = 20 I = 38 I + G = 66 G =28

E Y Y C+I+G I+G S+T S, I

MACROECONOMIC EQUILIBRIUM INCOME = EXPENDITURES INCOME = EXPENDITURES Y = E Y = E Y = C + I + G Y = C + I + G C + S + T = C + I + G C + S + T = C + I + G S + T = I + G S + T = I + G

John Maynard Keynes The General Theory Can you write the equation describing consumption behavior if you know two point on that equation?

In 2000 Prophetess Mary earned a fairly good income, partly by making predictions about the outcome of the Bush-Gore race for the presidency. She earned about $15,000 that year, out of which she spent about $12,500. She knew that in 2001, with no election to stimulate her business, her income might fall to $10,000, out of which she would spend $9,500. On the basis of these data (and assuming no taxes), calculate Prophetess Mary’s marginal propensity to consume. Unfortunately, Prophetess Mary’s Bush-Gore predictions turned out to be exactly wrong (Poor Mary; Poor Gore!), and her business dried up completely. Her income dropped (temporarily) to zero in How much do you think she spent on consumption goods while making no income at all?

9. During this election year, Prophetess Mary is earning a fairly good income, partly by making predictions about the outcome of the Bush-Gore race for the presidency. She will earn about $15,000 this year, out of which she’ll spend about $12,500. Next year, with no election to stimulate her business, her income may fall to $10,000, out of which she may spend $9,500. On the basis of these data (and assuming no taxes), we can calculate that Prophetess Mary’s marginal propensity to consume (MPC) is A B C D

C Y C = a+bY 15,000 12,500 10,000 9,500 5,000 3,000 MPC = b = slope = 3,000 / 5,000 = 0.60

9. During this election year, Prophetess Mary is earning a fairly good income, partly by making predictions about the outcome of the Bush-Gore race for the presidency. She will earn about $15,000 this year, out of which she’ll spend about $12,500. Next year, with no election to stimulate her business, her income may fall to $10,000, out of which she may spend $9,500. On the basis of these data (and assuming no taxes), we can calculate that Prophetess Mary’s marginal propensity to consume (MPC) is A B C D

10. But suppose Prophetess Mary’s Bush-Gore predictions turn out to be exactly wrong, and her business dries up completely. Even with her income dropping (temporarily, she hopes) to zero in 2001, she will engage in consumption spending (symbolized by “a”) in the amount of A. $2,500. B. $3,000. C. $3,500. D. $4,000.

C Y C = a+bY 15,000 12,500 10,000 9,500 5,000 3,000 MPC = b = slope = 0.60 C = a + bY 10,000 9,500 9,500 = a (10,000) a = 9,500 – 6,000 a = 3,500 C = a + bY a = 3,500

10. But suppose Prophetess Mary’s Bush-Gore predictions turn out to be exactly wrong, and her business dries up completely. Even with her income dropping (temporarily, she hopes) to zero in 2001, she will engage in consumption spending (symbolized by “a”) in the amount of A. $2,500. B. $3,000. C. $3,500. D. $4,000.

John Maynard Keynes The General Theory Can you work through the Study Problem in Keynesian Economics posted as a handout?

ECON 2030 STUDY PROBLEM: KEYNESIAN MACROECONOMICS Y=C+I+G The equality between Y (which represents income and measures output) and C+I+G (which represents total expenditures, or aggregate demand), is the (Keynesian) equilibrium condition.

C=a+bY This simple linear equation shows the general form of the relationship between income and consumer spending. It describes consumer behavior. Note that a>0; 0<b< 1. ECON 2030 STUDY PROBLEM: KEYNESIAN MACROECONOMICS

Y=C+S In the absence of taxation, this equation is an identity which defines savings. That is, saving (S) is defined as that part of income not spent on consumption goods (Y-C). With taxation, we would write Y=C+S+T. ECON 2030 STUDY PROBLEM: KEYNESIAN MACROECONOMICS

Here’s a particular Macroeconomy: C= Y This is a specific consumption equation that describes the consumer behavior in some particular economy during some particular period of time.

Here’s a particular Macroeconomy: C= Y This magnitude represents the current level of investment, which is based on the prevailing state of business confidence. (Keynes would mention something about “animal spirits” here.) I=50

Here’s a particular Macroeconomy: C= Y These magnitudes represent the current levels of government spending and taxation. Query: How is the government financing G if T is 0? I=50 G=60; T=0

Here’s a particular Macroeconomy: C= Y This is the full- employment level of income--the level of income that reflects an absence of (cyclical) unemployment and corresponds to a wage rate that clears the labor market. I=50 G=60; T=0 Y fe =1,300

Here’s a particular Macroeconomy: C= Y Answer the following questions based on these data and your understanding of the Keynesian framework. I=50 G=60; T=0 Y fe =1,300

What are these data telling us? What is the MPC? MPC stands for Marginal Propensity to Consume and is symbolized by “b” in the equation C=a+bY. In this economy, then, MPC=b=0.8. When people get a raise, they increase their spending on consumption goods by 80% of the raise.

What are these data telling us? What is the MPS? MPS stands for Marginal Propensity to Save and is symbolized by “1-b” in the equation S=-a+(1-b)Y. In this economy, then, MPS=1-b=0.2. When people get a raise, they increase their saving by 20% of the raise.

What are these data telling us? What is the significance of the "100" in the equation C= Y? The 100 is the level of consumption spending that corresponds to an income of zero. With no income, this spending would also represent "dissaving."

And now for some calculations: What is the investment multiplier and the government-spending multiplier? The spending multiplier (whether it’s investors or the government doing the spending) is the 1/(1-b) in the equations:  Y = 1/(1-b)  I and  Y = 1/(1-b)  G

And now for some calculations: What is the investment multiplier and the government-spending multiplier? 1/(1-b) = 1/(1-0.8) = 1/0.2 = 5. So, when investors or the government increase their spending by, say, 10, there will be a spiraling up of both income and expenditures in the amount of 50.

And now for some calculations: What saving equation corresponds to this particular consumption equation? Consumption is given by C= Y. Savings is given by S= Y. Just change the sign of the intercept term and use the MPS instead of the MPC as the coefficient of Y. Note that MPC+MPS=1.

And now for some calculations: At what level of income does savings equal zero? Savings is given by S= Y. Just write S= Y=0 and solve for Y. 0.2Y = 100 Y = 500

Y S= Y S At Y=500, S=0

And now for some calculations: How much is aggregate demand when income is 1,100? Consumption is the only component of aggregate demand that depends on income: C= Y = (1100) = 980. C+I+G = =1,090. So, when Y=1,100, C+I+G is 1,090.

And now for some calculations: Is the economy in equilibrium at this level of income? No. Y = 1,100; C+I+G is 1,090. The equilibrium condition is not met. Further, with spending less than output (as measured by income), inventories are piling up, and the economy will be spiraling down.

And now for some graphics: Sketch the aggregate demand curve and the 45 o line and locate Y=1100 and Y=1300 (relative to equilibrium income). What is the equilibrium level of income?

E Y C+I+G C+I C 1,100 1,300 Y = E = C + I + G Y = Y Y – 0.8Y = Y = 210 Y = 1,050 1,050

And now for some stimulant packages and policy prescription. Suppose that government spending is increased by 30. What does this do to the equilibrium level of income?  Y = 1/(1-b)  G  Y = 1/(1-0.8) 30 = 5(30) = 150

E Y C+I+G’ C+I C 1,200 1,300 An increase in G of 30 will increase the equilibrium level of Y by 150. The new Y eq will be 1, = 1,200. 1,050

And now for some stimulant packages and policy prescription. How much more government spending is required to drive the economy to full employment? After the increase of 30, income settles in at 1,200. Full employment is 1,300, so we need another  Y of 100.

And now for some stimulant packages and policy prescription. How much more government spending is required to drive the economy to full employment?  Y = 1/(1-b)  G 100 = 1/(1-0.8)  G 100 = 5  G;  G = 100/5 = 20

E Y C+I+G’ C+I C 1,200 1,300 To increase Y by another 100, the government can increase G by another 20. 1,050

A Postscript. What assumptions about wage rates and prices do all your calculations and graphics presuppose? We assume that wage rates and prices are "sticky downwards"--and for simplicity, we assume that they do not change at all. If they did actually change quickly enough to clear the markets for goods and for labor, then there would be no lapses from full employment to theorize about.

John Maynard Keynes The General Theory A workout with the basic macroeconomic magnitudes