Chapter 3 -- The Simple Keynesian Model zFundamental inflexibility assumptions: W -- inflexible P -- inflexible i -- inflexible zOverriding theme -- Production Responds to Economic Activity (focus on goods and services expenditure)

Simplifying Assumptions zBusiness Saving = 0 (All private saving is personal saving) zTaxes don’t depend upon income. zT = G (Balanced Budget) zNX = 0 zAssumptions imply that the “Magic Equation” is now S = I.

Causes of Consumption (C) zDisposable Income (YD = Y - T) YD   C  yReal GDP, or Total Income (Y) Y   YD   C  yNet Taxes (T) T   YD   C  zConsumer Confidence (CC) CC   C 

More Causes of Consumption (C) zReal Interest Rate (r = i -  e ) r   C  yNominal Interest Rate (i) i   r   C  yExpected Inflation Rate (  e )  e   r   C  zReal Wealth (A) A   C 

Measures -- YD  C Relationship zAverage Propensity to Consume (APC) APC = C/YD zMarginal Propensity to Consume (MPC) MPC =  C/  YD

Handling Multiple Causes of Consumption zCauses of Consumption -- Y, T, CC, i,  e, A. zAutonomous Consumption (C 0 ) -- changes in C due to causes other than Y.

Causes of Investment (I) zBusiness Confidence (BC) BC   I  zBusiness Taxes (BT) BT   I 

More Causes of Investment zReal Interest Rate (r = i -  e ) r   I  yNominal Interest Rate (i) i   r   I  yExpected Inflation Rate (  e )  e   r   I  zNote: Investment does not depend upon current income (Y)

Government Purchases of Good and Services (G) zGovernment purchases of goods and services is a policy variable, controlled by the government  no causing variables. zThe previous properties imply that I and G are completely autonomous.

A Numerical Example Y T YD C S I G

The Saving-Investment Relationship zRecall -- macro identity S + (T - G) + -NX = I zWith simplifying assumptions: S = I zWhy doesn’t S = I in numerical example?

Intentions Versus Actual Occurrences zMust distinguish between intended, desired, planned S and I versus actual or realized S and I. zIntended S and I -- strategies, described by schedules and graphs. zActual S and I -- the numbers after the period is over.

Planned Expenditure (E P ) zPlanned Expenditure (E P ) -- The total intended spending for various levels of income. zIn equation form, E P = C + I + G.

Planned Expenditure in the Numerical Example Y T YD C S I G E P

An Equilibrium Level of Real GDP: E P = Y Y T YD C S I G E P

Why is Y* = 85 an Equilibrium? Example 1: Suppose Y = 105. Intended Actual C = 85 C = 85 S = 15 S = 15 I = 10 I = = 15 G = 5 G = 5 E P = 100 Note -- Actual S = Actual I

Why is Y* = 85 an Equilibrium? (Continued) Example 2: Suppose Y = 65. Intended Actual C = 55 C = 55 S = 5 S = 5 I = 10 I = = 5 G = 5 G = 5 E P = 70 Note -- Actual S = Actual I

Why is Y* = 85 an Equilibrium? (Finally) Example 3: Suppose Y = 85. Intended Actual C = 70 C = 70 S = 10 S = 10 I = 10 I = 10 G = 5 G = 5 E P = 85 Note -- Actual S = Actual I

Properties of Equilibrium zNo unintended inventory accumulation or depletion. zAll intentions are realized. zIntended Saving = Intended Investment (only at equilibrium). zE P = Y

Equilibrium and the Natural Level of Real GDP zFundamental Prediction of Keynesian models -- Y* is not necessarily equal to Y N. zClassical Prediction: Self- correcting economy  Y* = Y N. (Business cycle represents deviations from equilibrium)

Keynesian Prediction -- State of the Economy zY* < Y N (sluggish economy) zY* > Y N (accelerating inflation) zY* = Y N (desired state of economy) zIf Y*  Y N, then one needs economic policy to achieve a new equilibrium closer to Y N.

The Keynesian Prescription zAchieve a new equilibrium by shifting the E p curve. zIf Y* < Y N, seek to increase expenditure, described by shifting the E P curve upward. zIf Y* > Y N, seek to decrease expenditure, described by shifting the E P curve downward.

Shifting the E P Curve zKey -- Change Autonomous Consumption, Autonomous Investment, or Government Purchases (or, later, Autonomous Net Exports). zChange C 0 -- change T, CC, i,  e, A zChange I 0 -- change BC, BT, i,  e zChange G 0.

Economic Policy zPurpose -- to move Y* closer to Y N. zMethod -- change autonomous expenditure (C 0, I 0, G 0 ). zIf economy is sluggish (Y* < Y N ), increase autonomous expenditure. zIf economy has accelerating inflation (Y* > Y N ), decrease autonomous expenditure.

Strategies for Policy zExpansionary Policy -- Policy designed to address a sluggish economy (Y* < Y N ). zContractionary Policy -- Policy designed to address an overstimulated, or accelerated inflation economy (Y* > Y N ).

Quantitative Effects -- Changes in C 0, I 0, or G 0 Y T YD C S I G E P

zNote: MPC =  C = = 0.75  YD zExample -- If autonomous government purchases are changed by 5, how much will Y* change as a result?

Solution -- Numerical Example Y E P E P ’ (  G 0 = 5)

The Multiplier Effect zThe Multiplier Effect -- Given an initial change in autonomous consumption, autonomous investment, or government purchases of goods and services, the resulting change in equilibrium output will be a multiple of the initial change.

The Multiplier Effect in Equation Form  Y* = m (  C 0,  I 0,  G 0, or  NX 0 ), where m = the multiplier. m = 1/(1 - MPC) Our Example: (  G 0 = 5   Y* = 20) (20) = (4)(5) MPC = 0.75  m = 1/( ) = 4

Tracing the Effect on  Y*:  G 0 = 5, with MPC = 0.75 Added Added Round Spending Income (0.75) 5(0.75) 3 5(0.75) 2 5(0.75)  Y* 20 20

Properties: Multiplier Effect zThe multiplier varies positively with the MPC, i.e. MPC   m . zApplies for either increases or decreases in C 0, I 0, G 0, or NX 0. zApplies to changes both policy- induced and otherwise. zChanges in autonomous net taxes (T 0 ) have a multiplier effect, but not the same multiplier.

Changing G 0 Versus Changing T 0, MPC = 0.75 Added Spending Round  G 0 = 5  T 0 = (0.75) 2 5(0.75) 5(0.75) 2 3 5(0.75) 2 5(0.75) ______________________________  Y* 20 15

The Net Taxes Multiplier  Y* = -MPC  T MPC zThe Net Taxes Multiplier is smaller than the regular multiplier (less of an impact on Y* for the same initial change). zTax or transfer policy is not as powerful as G policy, but less likely to overshoot Y N.

Application: The Obama Stimulus Plan zThe Obama Stimulus Plan – A $787 B stimulus package passed in February 2009, to address sluggish US economy. -- Tax Cuts = $288 B -- Extended unemployment benefits, education and health care = $224 B -- Federal contracts, grants, and loans = $275 B (Infrastructure improvements = $83 B)

The Simple Keynesian Model -- The Algebra zThe model in equation form. (1) E P = C + I + G, (2) C = C 0 + b(Y - T), (3) I = I 0, (4) G = G 0, (5) T = T 0, (6) At equilibrium, E P = Y*.

Solving for Y* Substitute equations (2), (3), (4), (5), and (6) into (1)  Y* = C 0 + b(Y* - T 0 ) + I 0 + G 0. Solve for Y*  Y* = 1 {C 0 + I 0 + G 0 } + -b T 0. (1 - b) (1 - b)

Removing the Simplifying Assumptions zInvestment depends upon current output or income (Y). I = I 0 + dY, d = marginal propensity to invest zIncome Tax T = T 0 + tY, t = marginal tax rate

Causes of Net Exports (NX = Exports - Imports) zForeign output or income (Y f ) Y f   Exports   NX  zUS output or income (Y) Y   Imports   NX  zBarriers to Trade zReal exchange rate (e) e   NX 

A Model for Net Exports in Equation Form NX = NX 0 - fY NX 0 = Autonomous Net Exports (made up of causes other than Y) f = marginal propensity to import

The Model Without the Simplifying Assumptions: What Results Are The Same? zAnswer -- All the qualitative results are the same!!

Same Results zEquilibrium occurs where E p = Y. zTrue equilibrium, guided by unintended inventory changes. zY* may be, or = Y N. zNeed for policy if Y* is different from Y N. zPolicy – change autonomous expenditure (expansionary or contractionary).

More of the Same Results  Same options as before (C 0, I 0, G 0 ). zMultiplier effect exists. zTax multiplier is smaller than the autonomous spending multiplier.

The Model Without the Simplifying Assumptions: What Results Are Different? zMore possibilities for policy. -- autonomous net taxes (T 0 ) -- marginal tax rate (t) -- trade policy (NX 0 ) zDifferent multipliers for autonomous spending and net taxes.

The Expanded Simple Keynesian Model (1) E P = C + I + G + NX, (2) C = C 0 + b(Y - T), (3) I = I 0 + dY, (4) G = G 0, (5) NX = NX 0 – fY, (6) T = T 0 + tY, (7) At equilibrium, E P = Y*.

More Realistic Multipliers Substitute equations (2)-(7) into (1), solve for Y*. Y* = 1 [C 0 + I 0 + G 0 + NX 0 ] (1 – b(1–t) – d + f) - b [T 0 ]. (1 – b(1–t) – d + f)

The Economy and the Federal Budget zRecall that the Federal Budget is given by Budget = T - G. zSubstitute income tax function for T (with Y = Y*): Budget = (T 0 + tY*) - G. zNote that Y*   Budget 

The Economy and the Balance of Trade zRecall that the Balance of Trade (BOT) is approximated by Net Exports (NX). zAlso recall that the Net Exports equation is (Y = Y*): NX = NX 0 - fY*. zNote that Y*   BOT 