Macroeconomics 4. The Keynesian Model and its Policy Implications

Macroeconomics 4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest 4.3. Fiscal and Monetary Policy in the Keynesian Model Monetary Policy Fiscal Policy Lohnpolitik 3.3. The Long-rund Implications of the Keynesian Model Konjunkturelle Erholung ohne Fiskal- oder Monetary Policy Konjunkturelle Überhitzung durch Fiskal- oder Monetary Policy 4.5. Policy Conclusions Practical Problems of Anti-cyclical Policy Case Study: Fiscal Policy in Germany Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 1

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy Monetary Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions Practical Problems of Anti-cyclical Policy Case Study: Fiscal Policy in Germany Limits of Government Debt Case Study: Economic Policy in the Great Recession 4.6. Questions for Review Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 2

Macroeconomics Literature:
◆ Chapter 9, 10, 11, 13, 14 Mankiw, Gregory; Macroeconomics, Worth Publishers. ◆ Kapitel 10, Baßeler, Ulrich et al.; Grundlagen u. Probleme der Volkswirtschaft, Schäfer-Pöschel. Prof. Dr. Rainer Maurer - 3 - Prof. Dr. Rainer Maurer 3

4.1. The Keynesian Theory Prof. Dr. Rainer Maurer - 4 - Prof. Dr. Rainer Maurer 4

4. The Keynesian Model and its Policy Implications 4. 1
4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory The Crisis of Neoclassical Theory Until the world economic crisis of 1929, the neoclassical model was the consensus model of market oriented economists. This appraisal of the neoclassical theory was altered by the world economic crisis. Such a sharp and lasting break of economic development was inconsistent with the neoclassical hypothesis of the immanent stability of market economies. Rising unemployment, bankrupt companies and decreasing incomes caused social problems that called for new solutions. Prof. Dr. Rainer Maurer - 5 - Prof. Dr. Rainer Maurer 5

The Development of the Dow Jones Index
4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory The Development of the Dow Jones Index electrification: connection for power supply, public power grid In summer 1929 the American economy started to cool down, which was in part a result of a more restrictive monetary policy by the Fed, which had caused an increase of interest rates from The stock market became more and more nervous in the course of the summer and finally started to collapse on Thursday the 24th of October. By an intervention of four large commercial banks (J.P. Morgan, National City, Chase National, Guaranty Trust), which bought large volumes of stock, prices recovered. But the following Monday selling began and on Tuesday a real panic started. The Dow Jones lost 13% (Monday) 12 % (Tuesday). Stock prices fell from their max at 381 to a level of 198 in a couple of days. Until April 1930 prices recovered up to a level of nearly 300. However, the deterioration of the real economy caused then a steadily slide of prices until summer 1932, when the Dow Jones index reached the bottom with 41 index points. Prof. Dr. Rainer Maurer - 7 - Quelle: Prof. Dr. Rainer Maurer 7

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory Prof. Dr. Rainer Maurer - 8 - Prof. Dr. Rainer Maurer 8

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory The analysis of demand shocks in the neoclassical model has revealed that a reduction of consumption demand should lead to an increase in savings, which should reduce the interest rate such that demand for investment goods grows and replace the reduction in consumption (and vice versa). This mechanism did not work in the world economic crisis! Prof. Dr. Rainer Maurer - 9 - Prof. Dr. Rainer Maurer 9

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory The Keynesian Theory Under these historical circumstances John Maynard Keynes developed his new macroeconomic theory, which was intended to explain the consequences of the world economic crisis and to deliver economic policy recommendations appropriate to overcome such a crisis. This theory was published in a book with the title “General Theory of Employment, Interest and Money” (1936). In this book, Keynes contested two basic assumptions of the neoclassical theory by assuming that …in the short run, goods prices are fix, so that they cannot de-crease in case of a reduction of goods demand. As a consequen-ce, he assumed that instead of goods prices the supply of goods adjusts to changes in demand = “Keynesian Price Rigidity”. …household consumption is only a positive function of household income C(Y ↑)↑; the negative impact of the interest rate C(i↓)↑ can be neglected = “Keynesian Consumption Function”. Prof. Dr. Rainer Maurer - 13 - Prof. Dr. Rainer Maurer 13

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory The Keynesian consumption function C(Y↑)↑ corresponds at first sight much better to empirical observations as the neoclassical consumption function C(i↑)↓. The empirical correlation between consumption and income is in deed much stronger than the empirical correlation between consumption and interest rates, as the following graphs demonstrate: Prof. Dr. Rainer Maurer - 14 - Prof. Dr. Rainer Maurer 14

= Keynesian Consumption Function
= C(Y↑)↑ = Keynesian Consumption Function old-age pension insurance Prof. Dr. Rainer Maurer - 15 - Quelle: SVG (2003), eigene Berechnungen Prof. Dr. Rainer Maurer 15

= Neoclassical Consumption Function
shotgun = C(i↑)↓ = Neoclassical Consumption Function Quelle: SVG (2003), eigene Berechnungen Prof. Dr. Rainer Maurer - 16 - Prof. Dr. Rainer Maurer 16

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory The second basic difference between Keynesian and neo-classical theory is the so called “Keynesian Price Rigidity”: In neoclassical theory, an increase of production output causes an increase of marginal costs, so that firms increase their prices (and vice versa). Consequently, an increase of the demand for goods causes an increase of the prices of goods (and vice versa). In Keynesian theory, firms do not immediately adjust their prices to production output: An increase (decrease) of the demand for goods causes a corresponding increase (decrease) of the supply of goods. The prices of goods stay however constant. Who is right – Keynes or the Neoclassics? Prof. Dr. Rainer Maurer - 17 - Prof. Dr. Rainer Maurer 17

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory p S(p)1 S(p)1 Production costs higher than market price Price increase with time lag p1 p1 D(p)2 D(p)2 D(p)1 D(p)1 Immediate increase of production Neoclassical Market Keynesian Market Prof. Dr. Rainer Maurer - 18 - Prof. Dr. Rainer Maurer 18

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory An large-scale empirical study of the European Central Bank has led to the following result: Percentage Distribution of Firms According Their Frequency of Price Adjustments per Year Survey Period ; Sample Size Firms; BE = Belgium, DE= Germany; FR=France, IT=Italy LU= Luxembourg, NL=Netherlands, AT=Austria, PT=Portugal Prof. Dr. Rainer Maurer - 19 - Quelle: The Pricing Behavior of Firms in the Euro Area, EZB (2005) Prof. Dr. Rainer Maurer 19

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory From these and similar studies follows: Firms do not immediately adjust their prices to changes in costs. Instead, they keep their prices constant over a longer period of time – just as assumed by Keynes. If firms try to maximize their profits, they should in principle change their prices when their costs change. Why then do firms not change their prices more often? Menükosten-Argument: Preisanpassung bei Nachfragerückgang bei monopolistischem Wettbewerb und konstanten Grenzkosten (=variable Durchschnittskosten) und historischen Fixkosten. Nur dann wenn die Differenz aus Fläche „+“ und Fläche „-“ größer ist als die Kosten der Preisanpassung, lohnt eine Preisanpassung. () P2 Prof. Dr. Rainer Maurer P1 - - 21 - + dK(Y) dY (kg) X2 X1 Prof. Dr. Rainer Maurer 21 D = p(Y) Menge

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory Why do prices not change more often? In reality, changing prices causes costs: Internal organizational costs: Information of staff members, distribution chains, sales agents… External communication costs: Explication and justification of price changes to clients… Technical costs: printing costs of pricelists, mailing expenses… If the costs per price change are higher than the return of a price change, a continuous adjustment of prices is not profit maximizing, as the following diagram shows: Menükosten-Argument: Preisanpassung bei Nachfragerückgang bei monopolistischem Wettbewerb und konstanten Grenzkosten (=variable Durchschnittskosten) und historischen Fixkosten. Nur dann wenn die Differenz aus Fläche „+“ und Fläche „-“ größer ist als die Kosten der Preisanpassung, lohnt eine Preisanpassung. () P2 Prof. Dr. Rainer Maurer P1 - - 22 - + dK(Y) dY (kg) X2 X1 Prof. Dr. Rainer Maurer 22 D = p(Y) Menge

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory € The costs per price change will typically be constant or slightly increasing, if the number of price changes per year grows. Costs per Price Change 3 € 3 € Number of Price Changes per Year 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 23

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory € The costs per price change will typically be constant or slightly increasing, if the number of price changes per year grows. Costs per Price Change 3 € 6 € Number of Price Changes per Year 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 24

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory € The return per price change will typically decrease, if the number of price changes per year grows. The return of 1 price change every 2 years will normally be quite high, since it is very likely that significant changes of production costs and demand strength will occur within a time span of 2 years. The return of 4 price changes per year will normally be lower, since it is not so likely that significant chan-ges of production costs and demand strength will occur every quarter… Return per Price Change Number of Price Changes per Year 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 25

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory € Return of an additional price change higher than costs Costs per Price Change Return per Price Change More often price changes profitable Number of Price Changes per Year 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 26

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory € Return of an additional price change lower than costs Costs per Price Change Return per Price Change Less often price change profitable Number of Price Changes per Year 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 27

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory € => Profit maximizing number of price changes per year = 2 Costs per Price Change Return per Price Change Number of Price Changes per Year 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 28

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory € Profit at 2 adjustments of prices per year => Profit maximizing number of price changes per year = 2 Costs per Price Change Return per Price Change Number of Price Changes per Year 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 29

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory € => The higher the costs per price adjustment, the lower the number of profit maximizing price adjustments per year! Costs per Price Change2 Costs per Price Change1 Return per Price Change Number of Price Changes per Year 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 30

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory As the diagrams show: It is possible to explain, why firms on average do not change their prices more often than one time per year with the standard microeconomic profit-maximization behavior: An optimal adjustment of prices according to the current demand and supply situation causes an additional return. But this return has to be compared to the additional costs caused by the price adjustment. Only if the additional return is larger than the additional costs, a price adjustment is actually profitable. Depending on the relation between the costs and return of a price change it can be profit-maximizing to hold prices on average constant for a time span of a year or even longer. Rigid price setting and profit maximization are compatible! Prof. Dr. Rainer Maurer - 33 - Prof. Dr. Rainer Maurer 33

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory The Keynesian theory assumes therefore that in the “short-run” (= within a time span of one year) firms keep their prices constant: P = constant within one year If the demand for goods changes in the short-run, firms do simply adjust their production instead of prices to the demand for goods. Consequently, in the short-run firms' production of goods Y is always equal to the sum of households consumption demand C plus firms’ demand for investment goods I plus government consumption demand G: Y = C + I + G Consequently, in the short-run demand for goods determines supply of goods! Prof. Dr. Rainer Maurer - 34 - Prof. Dr. Rainer Maurer 34

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory If we add now the Keynesian consumption function C(Y) we receive the following relationship: Y = C(Y) + I + G Obviously, this is a circular relationship: GDP, Y, depends on consumption C(Y) and consumption C(Y) depends on GDP Y and so on… As the following analysis will show, this circular relationship can boost the effects of economic policy (but complicates a bit the graphical analysis…). Blackboard with G=I=5 and c=0,5 Prof. Dr. Rainer Maurer - 35 - Prof. Dr. Rainer Maurer 35

4.1. The Keynesian Theory The "Keynesian Cross" Prof. Dr. Rainer Maurer - 36 - Prof. Dr. Rainer Maurer 36

Graphical exposition of these considerations:
4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods Graphical exposition of these considerations: C(Y)= 0,5 * Y Supply of Goods = Production of Goods = Income = Y Prof. Dr. Rainer Maurer - 43 - Prof. Dr. Rainer Maurer 43

Consumption (C) dependent on GDP (Y)
4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods Consumption (C) dependent on GDP (Y) C(Y)= 0,5 * Y Supply of Goods = Production of Goods = Income = Y Prof. Dr. Rainer Maurer - 44 - Prof. Dr. Rainer Maurer 44

Government Consumption = G = 5
4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods C(Y) + G = 0,5*Y+G C(Y)= 0,5 * Y Government Consumption = G = 5 Supply of Goods = Production of Goods = Income = Y Prof. Dr. Rainer Maurer - 45 - Prof. Dr. Rainer Maurer 45

4. The Keynesian Model and its Policy Implications 4. 1. 1
4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD = 0,5*Y+G+I C(Y) + G = 0,5*Y+G Investment = I = 5 C(Y)= 0,5 * Y Supply of Goods = Production of Goods = Income = Y Prof. Dr. Rainer Maurer - 46 - Prof. Dr. Rainer Maurer 46

= Where does the equation 0,5*Y+G+I = Y hold?
4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods At what level of income (Y) does the total demand for goods equal income? YD = 0,5*Y+G+I C(Y) + G = 0,5*Y+G C(Y) = 0,5 * Y At what level does income generate a demand for goods, which is again equal to the level of income? = Where does the equation 0,5*Y+G+I = Y hold? Supply of Goods = Production of Goods = Income = Y Prof. Dr. Rainer Maurer - 47 - Prof. Dr. Rainer Maurer 47

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods Every point on this 45°-line implies: Demand for Goods = Supply of Goods Supply of Goods = Production of Goods = Income = Y Prof. Dr. Rainer Maurer - 48 - Prof. Dr. Rainer Maurer 48

The 45°-line reveals the solution:
4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods The 45°-line reveals the solution: YD = 0,5*Y+G+I C(Y) + G = 0,5*Y+G C(Y)= 0,5 * Y Supply of Goods = Production of Goods = Income = Y Prof. Dr. Rainer Maurer - 49 - Prof. Dr. Rainer Maurer 49

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD = 0,5*Y+G+I C(Y) + G = 0,5*Y+G C(Y)= 0,5 * Y Investment = 5 Gov. Consumption = 5 Consumption = 0,5 * (20) = 10 Supply of Goods = Production of Goods = Income = Y Prof. Dr. Rainer Maurer - 50 - Prof. Dr. Rainer Maurer 50

3. Das keynesianische Modell der Volkswirtschaft 3. 1
3. Das keynesianische Modell der Volkswirtschaft 3.1. Die Struktur des keynesianischen Modells Digression: What happens, if supply of goods is larger than the equilibrium value = if there is excess supply ? The following digression shows that in this case an adjustment process takes place. Since supply of goods under Keynesian assumptions always adjusts to demand for goods, supply falls until it equals demand: Prof. Dr. Rainer Maurer - 51 - F49-F66 Prof. Dr. Rainer Maurer 51

Digression: What happens, if supply of goods is smaller than the
equilibrium value = if there is excess demand ? The following digression shows that in this case an adjustment process takes place. Since supply of goods under Keynesian assumptions always adjusts to demand for goods, supply grows until it equals demand: 3. Das keynesianische Modell der Volkswirtschaft 3.1. Die Struktur des keynesianischen Modells Prof. Dr. Rainer Maurer - 61 - Prof. Dr. Rainer Maurer 61

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory What happens now, if the equilibrium on the market for goods is disturbed by a sudden increase in investment demand? Prof. Dr. Rainer Maurer - 68 - Prof. Dr. Rainer Maurer 68

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD = 0,5*Y+G+I C(Y) + G = 0,5*Y+G C(Y)= 0,5 * Y How strong is GDP-growth, if investment grows by 5 ? Supply of Goods= Income = Y Prof. Dr. Rainer Maurer - 69 - Prof. Dr. Rainer Maurer 69

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD= 0,5*Y+G+I+ΔI Increase in Invest-ment by 5 YD = 0,5*Y+G+I C(Y) + G = 0,5*Y+G C(Y)= 0,5 * Y How strong is GDP-growth, if investment grows by 5 ? Supply of Goods= Income = Y Prof. Dr. Rainer Maurer - 70 - Prof. Dr. Rainer Maurer 70

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD= 0,5*Y+G+I+ΔI YD = 0,5*Y+G+I C(Y) + G = 0,5*Y+G C(Y)= 0,5 * Y Increase in Invest-ment by 5 Increase in GDP by 10 = 5 * (1/(1-0,5)) Supply of Goods= Income = Y Prof. Dr. Rainer Maurer - 71 - Prof. Dr. Rainer Maurer 71

Increase in invest-ment by 5
4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD= 0,5*Y+G+I+ΔI YD = 0,5*Y+G+I Investment = 10 C(Y) + G = 0,5*Y+G C(Y)= 0,5 * Y Gov. Consumption = 5 Increase in invest-ment by 5 Growth of Consumption = 5 Consumption = 0,5*20 = 10 Consumption = 0,5 * 30 = 15 Supply of Goods= Income = Y Prof. Dr. Rainer Maurer - 72 - Prof. Dr. Rainer Maurer 72

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD= 0,5*Y+G+I+ΔI YD = 0,5*Y+G+I C(Y) + G = 0,5*Y+G As implied by the investment multiplier 1/(1-c), a consumption ratio of c = 50% together with an increase in investment by 5 causes GDP to grow by 10 = 5 * (1/(1-0,5)) = 5 * 2. C(Y)= 0,5 * Y Increase in Invest-ment by 5 Supply of Goods= Income = Y Prof. Dr. Rainer Maurer - 73 - Prof. Dr. Rainer Maurer 73

4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory The following diagram graphically illustrates the multiplier effect: Prof. Dr. Rainer Maurer - 74 - Prof. Dr. Rainer Maurer 74

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD= 0,5*Y+G+I+ΔI YD = 0,5*Y+G+I 1st: Increase in Demand by 5 C(Y) + G = 0,5*Y+G C(Y)= 0,5 * Y Increase in Invest-ment by 5 What causes the multiplier effect? Supply of Goods= Income = Y Prof. Dr. Rainer Maurer - 75 - Prof. Dr. Rainer Maurer 75

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD= 0,5*Y+G+I+ΔI YD = 0,5*Y+G+I C(Y) + G = 0,5*Y+G 2nd: Increase in Income by = ΔY C(Y)= 0,5 * Y Increase in Invest-ment by 5 What causes the multiplier effect? Supply of Goods= Income = Y Prof. Dr. Rainer Maurer - 76 - Prof. Dr. Rainer Maurer 76

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD= 0,5*Y+G+I+ΔI YD = 0,5*Y+G+I 3rd: Increase in Consumption by c*ΔY = 0,5 * 5 = 2,5 C(Y) + G = 0,5*Y+G C(Y)= 0,5 * Y Increase in Invest-ment by 5 What causes the multiplier effect? Supply of Goods= Income = Y Prof. Dr. Rainer Maurer - 77 - Prof. Dr. Rainer Maurer 77

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD= 0,5*Y+G+I+ΔI YD = 0,5*Y+G+I C(Y-T) + G 4th: Increase in Income by ΔY = 2,5 C(Y)= 0,5*Y+G C(Y)= 0,5 * Y Increase in Invest-ment by 5 What causes the multiplier effect? Supply of Goods= Income = Y Prof. Dr. Rainer Maurer - 78 - Prof. Dr. Rainer Maurer 78

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD= 0,5*Y+G+I+ΔI 5th: Increase in Consumption by c*ΔY = 0,5 * 2,5 = 1,25 YD = 0,5*Y+G+I C(Y) + G = 0,5*Y+G C(Y)= 0,5 * Y Increase in Invest-ment by 5 What causes the multiplier effect? Supply of Goods= Income = Y Prof. Dr. Rainer Maurer - 79 - Prof. Dr. Rainer Maurer 79

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Demand for Goods YD= 0,5*Y+G+I+ΔI YD = 0,5*Y+G+I etc... C(Y) + G = 0,5*Y+G C(Y)= 0,5 * Y Increase in Invest-ment by 5 => The primary increase in investment demand by 5 is multi-plied by the additional increase in consum-ption demand by factor 2 = 1/ (1-0,5). Supply of Goods= Income = Y Prof. Dr. Rainer Maurer - 80 - Prof. Dr. Rainer Maurer 80

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Verbal Description of the Multiplier Process: An increase in investment demand by 5 causes an increase in total supply (which does always adjust to total demand) by 5 . This causes an increase in household income by 5 . This increase in income by 5 and a consumption ratio of 50 % causes an increase in consumption by 0,5 * 5 = 2,5 . This increase in consumption demand by 2,5 causes an increase in total supply by 2,5 . This causes an increase in household income by 2,5 . This increase in income by 2,5 and a consumption ratio of 50 % causes an increase in consumption by 0,5 * 2,5 = 1,25 . This increase in consumption demand by 1,25 causes in increase in total supply by 1,25 . This causes an increase in household income by 1,25 . This increase in income by 1,25 and a consumption ratio of 50 % causes an increase in consumption by 0,5 * 1,25 = 0,625 , and so on ... Prof. Dr. Rainer Maurer - 81 - Prof. Dr. Rainer Maurer 81

4. The Keynesian Model and its Policy Implications The "Keynesian Cross" Would this work? How would Keynes argue? Prof. Dr. Rainer Maurer - 83 - Prof. Dr. Rainer Maurer 83

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market Prof. Dr. Rainer Maurer - 85 - Prof. Dr. Rainer Maurer 85

4. The Keynesian Model and its Policy Implications The Keynesian Model with Capital Market The Keynesian Model with Capital Market The "Keynesian Cross" reveals the basic features of the Keynesian Theory. It suffers, however, from the shortcoming of constant investment. Keynes assumed that firms' investment depends on two factors: the capital market interest rate (i), which represents the costs of investment, and the expected return on investment E(r), where the function “E(r)” symbolizes the expectation value of the return on investment “r”. Like the Neoclassics, Keynes assumed that a higher (lower) interest rate reduces (increases) firm investment, since it increases (lowers) investment costs. Following Keynes, an increase (decrease) of the expected return on investment, increases (decreases) firm investment, since more investment projects become profitable at a higher return. Prof. Dr. Rainer Maurer - 86 - Prof. Dr. Rainer Maurer 86

Investment demand I(i) negatively depends on the interest rate i.
4. The Keynesian Model and its Policy Implications The Keynesian Model with Capital Market Interest Rate I(i, E(r1)) Investment Investment demand I(i) negatively depends on the interest rate i. Prof. Dr. Rainer Maurer - 88 - Prof. Dr. Rainer Maurer 88

4. The Keynesian Model and its Policy Implications The Keynesian Model with Capital Market Interest Rate E(r1) < E(r2) I(i, E(r2)) I(i, E(r1)) Investment Investment demand of firms I(i) positively depends on expected return E(r): If the expected return increases, investment demand increases too. Prof. Dr. Rainer Maurer - 89 - Prof. Dr. Rainer Maurer 89

4. The Keynesian Model and its Policy Implications The Keynesian Model with Capital Market Interest Rate E(r1) > E(r2) I(i, E(r1)) I(i, E(r2)) Investment Investment demand of firms I(i) positively depends on expected return E(r): If the expected return decreases, investment demand decreases too. Prof. Dr. Rainer Maurer - 90 - Prof. Dr. Rainer Maurer 90

4. The Keynesian Model and its Policy Implications The Keynesian Model with Capital Market Interest Rate Demand C(Y)+I(i, E(r1)) S(Y) = 0,5*Y C(Y)= 0,5* Y I(i, E(r1)) S= 15 = 0,5*30 Investment Y = 30 Income = Y Since household consumption depends on household income C(Y), household savings, which equal household income minus household consumption, depends on income too: Y – C(Y) = S(Y). If for example household income is Y = 30 and the consumption ratio is c = 50% household savings equal S(Y) = Y – C(Y) = 30 – 0,5*30 = 15 Consequently, savings like consumption do not depend on the interest rate! Prof. Dr. Rainer Maurer - 91 - Prof. Dr. Rainer Maurer 91

4. The Keynesian Model and its Policy Implications The Keynesian Model with Capital Market Interest Rate Demand C(Y)+I(i, E(r1)) S(Y) = 0,5*Y i1 C(Y)= 0,5* Y I(i, E(r1)) I = 15 I1 = 15 Investment Income = Y As the capital market diagram now shows, at the resulting interest rate i1 the demand for investment goods equals I1 = 15 too, so that the resulting equilibrium income is indeed equal to Y=30. This somewhat astonishing result is not due to chance but a consequence of a mathematical law called “Walras’ Law”. Prof. Dr. Rainer Maurer - 92 - Prof. Dr. Rainer Maurer 92

Digression: Walras’ Law
“Walras’ Law” was discovered by the French economist Léon Walras and 1874 published in his book “Éléments d’èconomie politique pure”. Is says: “If the number of all markets in an economy is equal to N and N-1 markets are in equilibrium (i.e. demand equals supply on N-1 markets) and all households keep their budgets (i.e. spend not more and not less money for consumption and savings than equals their income), then the Nth market will automatically be in equilibrium too (i.e. demand equals supply on the Nth market too).” In the above version of a Keynesian model only two markets exist: The goods market and the capital market. Hence N=2. Consequently, if the goods market is in equilibrium such that Y = C(Y) + I(i, E(r)) and the household keeps its budget constraint such that Y = C(Y) + S(Y) then, the capital market must necessarily be in equilibrium too, i.e. savings supply S(Y) must be equal to investment demand I(i, E(r)) such that S(Y)= I(i, E(r)) It is easy to see that this is actually true, if one subtracts the budget constraint from the goods market equilibrium equation: Y – [Y] = C(Y) + I(i, E(r)) – [C(Y) + S(Y)] <=> = I(i, E(r)) – S(Y) <=> S(Y) = I(i, E(r)) 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory Prof. Dr. Rainer Maurer - 93 - Prof. Dr. Rainer Maurer 93

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Consume Prof. Dr. Rainer Maurer - 94 - Prof. Dr. Rainer Maurer 94

4. The Keynesian Model and its Policy Implications Reduction of the Propensity to Consume Since under Keynesian assumptions, the supply of goods does always adjust to the demand for goods, a reduction of demand causes immediately a reduction of GDP: If households expect a deterioration of the economic development, so that they fear unemployment and increase their savings to have a financial “safety cushion” in the case they become unemployed, they reduce their consumption demand. Consequently, what they have expected, a deterioration of the economic development, does actually occur. Such a phenomenon is called “self-fulfilling expectations”: What is expected does actually happen, because it is expected. „precautionary savings“ Prof. Dr. Rainer Maurer - 95 - Prof. Dr. Rainer Maurer 95

4. The Keynesian Model and its Policy Implications Reduction of the Propensity to Consume Interest Rate Demand C(Y) + 15 S(Y) = 0,5*Y i1 C(Y)= 0,5* Y I(i, E(r1)) I1=15 S1= 15 Investment Income = Y Y1 What happens, if households expect a deterioration of economic development and do therefore increase their savings ratio from (1-c) = 50% to (1-c) = 75%? Prof. Dr. Rainer Maurer - 97 - Prof. Dr. Rainer Maurer 97

The consumption ratio decreases from c = 50% to c = 25%
4. The Keynesian Model and its Policy Implications Reduction of the Propensity to Consume Interest Rate Demand C(Y) + 15 S(Y) = 0,5*Y i1 C(Y)= 0,5* Y I(i, E(r1)) I1=15 S1= 15 Investment Income = Y Y1 What happens, if households expect a deterioration of economic development and do therefore increase their savings ratio from (1-c) = 50% to (1-c) = 75%? The consumption ratio decreases from c = 50% to c = 25% Prof. Dr. Rainer Maurer - 98 - Prof. Dr. Rainer Maurer 98

4. The Keynesian Model and its Policy Implications Reduction of the Propensity to Consume Interest Rate Demand 0,5*Y + 15 S(Y) = 0,5*Y i1 0,25*Y + 15 C(Y)= 0,5* Y I(i, E(r1)) C(Y)= 0,25* Y I1=15 S1= 15 Investment Income = Y Y1 What happens, if households expect a deterioration of economic development and do therefore increase their savings ratio from (1-c) = 50% to (1-c) = 75%? The consumption ratio decreases from c = 50% to c = 25% Prof. Dr. Rainer Maurer - 99 - Prof. Dr. Rainer Maurer 99

4. The Keynesian Model and its Policy Implications Reduction of the Propensity to Consume Interest Rate Demand S(Y) = 0,75*Y i1 0,25*Y + 15 I(i, E(r1)) C(Y)= 0,25* Y I1=15 S2= 15 Investment Income = Y Y2 The consumption ratio decreases from c = 50% to c = 25% => GDP decreases from Y1=15 * (1/(1-0,5) = 30 to Y2= 15 * (1/(1-0,25) = 20 Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 100

4. The Keynesian Model and its Policy Implications Reduction of the Propensity to Consume Interest Rate Demand S(Y) = 0,75*Y i1 0,25*Y + 15 I(i, E(r1)) C(Y)= 0,25* Y I1=15 S2= 15 Investment Income = Y Y2 Savings and investment remain unchanged, since the increase in the savings ratio 0,75 = (1-0,25) does exactly compensate for the decrease in GDP to a level of 20:1) S(Y1) = (1-0,5) * 30 = 0,5 * 30 = = S(Y2)= (1 - 0,25) * 20 = 0,75 * 20 1) All variables change simultaneously. Therefore savings must not be calculated based on starting income (=30). The resulting income of a period is not given before the end of a period, which equals 20 in the given example. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 101

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 104

4. The Keynesian Model and its Policy Implications Reduction of the Propensity to Invest Since under Keynesian assumptions, supply of goods does always adjust to demand for goods, a reduction of demand causes immediately a reduction of GDP: If firms expect a deterioration of economic development, so that they fear a decrease in investment return, they reduce their demand for investment goods so that their expectations actually realize. Consequently, what they have expected, a deterioration of the economic development, does actually occur. Consequently, firms too can cause “self-fulfilling expectations”: What is expected does actually happen, because it is expected. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 105

4. The Keynesian Model and its Policy Implications Reduction of the Propensity to Invest Interest Rate Demand C(Y) + 15 S(Y) = 0,5*Y i1 I(i, E(r1)) I1=15 S1= 15 Investment Income = Y Y1 What happens, if firms expect a lower investment return r2 < r1 , because of a deterioration of the economic development and lower their investment from 15 to 5 ? Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 106

4. The Keynesian Model and its Policy Implications Reduction of the Propensity to Invest Interest Rate Demand C(Y) + 15 S(Y) = 0,5*Y i1 C(Y) + 5 I(i, E(r1)) I(i, E(r2)) I2=5 S1= 15 Investment Income = Y Y1 The demand for investment goods and the demand for credits to finance these investment goods decrease.1) 1) All variables change simultaneously. Therefore, both demand curves must be shifted simultaneously. (If only the credit demand curve were shifted, the decreasing interest rate would increase investment demand to its starting level.) Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 107

4. The Keynesian Model and its Policy Implications Reduction of the Propensity to Invest Interest Rate Demand S(Y) = 0,5*Y C(Y) + 15 i1 C(Y) + 5 I(i, E(r1)) I(i, E(r2)) I2=5 S2= 5 Investment Y2 Income = Y If investment equals 5 and the consumption ratio is 50%, the resulting GDP equals Y = 5 * ( 1/(1-0,5) ) = 5 * 2 = 10 For an consumption ratio for c = 50% the savings ratio will equal (1-c) = 50%, so that at a GDP of 10, savings equal S(Y) = 0.5 * 10 = 5. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 108

4. The Keynesian Model and its Policy Implications Reduction of the Propensity to Invest Interest Rate Demand S(Y) = 0,5*Y i1 C(Y) + 5 I(i, E(r2)) I2=5 S2= 5 Investment Y2 Income = Y If investment equals 5 and the consumption ratio is 50%, the resulting GDP equals Y = 5 * ( 1/(1-0,5) ) = 5 * 2 = 10 For a consumption ratio of c = 50% the savings ratio will equal (1-c) = 50%, so that at a GDP of 10 savings equal S(Y) = 0.5 * 10 = 5. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 109

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Invest Reduction of the Propensity to Consume Consequences for the Labor Market Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 114

4. The Keynesian Model and its Policy Implications Consequences for the Labor Market As the preceding chapter has revealed, a deterioration of consumer and/or investor expectations concerning the economic development can actually cause a recession – a reduction of GDP. A reduction of GDP means however that firms also reduce their demand for production factors - notably their demand for labor: If wages are not flexible, but fixed by collective labor agreements, labor supply stays unchanged. If labor demand slumps while labor supply stays constant, unemployment will emerge. This kind of unemployment is ultimately caused by a reduction in the demand for goods. It is called “Keynesian unemployment” Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 115

The Effect of the Demand for Goods on the Labor Market
Y The Effect of the Demand for Goods on the Labor Market "Normal Capacity GDP" or "Full Employment GDP" Under the assumptions of the neoclassical model (s. chapter 2.1.) the supply of goods depends on the equilibrium labor input LD(w1/P1,K1) and the given capital stock K1. The resulting level of GDP is called "Normal Capacity GDP” or (since there is no unemployment) "Full Employment GDP“. Y(LD1,K1) Y(L,K1) Equilibrium Labor Input L Labor Demand of the Neoclassical Model LD1(w1/P1,K1) LS(w/p) P1 w1 _ LD (w/p,K1) L LD1(w1/P1,K1) 116

Y The Effect of the Demand for Goods on the Labor Market "Normal Capacity GDP" or "Full Employment GDP" Under the assumption of the Keynesian model, firms adjust in the short run their production of goods to the demand for goods. Therefore they will also adjust their labor demand to the demand for goods in the short run! Consequently, in the short run, the labor demand of firms is, under Keynesian assumptions, not determined by the real wage w/P and the given capital stock K1, i.e. by LD(w/P,K1), but by the demand for goods YD. The "short-run" demand for labor therefore equals LD(YD) Y(LD1,K1) Y(L,K1) Equilibrium Labor Input L Labor Demand of the Neoclassical Model LD1(w1/P1,K1) LS(w/p) P1 w1 _ LD (w/p,K1) L LD1(w1/P1,K1) 117

Y The Effect of the Demand for Goods on the Labor Market "Normal Capacity GDP" or "Full Employment GDP" If the demand for goods equals the full employment GDP, i.e. YD= Y(LD1,K1), Keynesian labor demand will equal the equilibrium labor input of the neoclassical model: LD(YD) = LD(w1/P1,K1). YD,1 Y(L,K1) Keynesian Labor Demand L LD(YD,1) LS(w/p) P1 w1 _ LD (w/p,K1) L LD1(w1/P1,K1) 118

Y The Effect of the Demand for Goods on the Labor Market Decrease of GDP below its Full Employment Level in a Recession If the demand for goods falls (for one of the reasons discussed in section 3.2.) below the full employment GDP, i.e. YD< Y(LD1,K1), Keynesian labor demand will be lower than the equilibrium labor input of the neoclassical model: LD(YD) < LD(w1/P1,K1). If the real wage is downward fixed by a collective bargaining contract to the long-run market equilibrium level of w1/P1, the resulting unemployment is called “Keynesian unemployment” YD,1 Y(L,K1) YD,2 Decrease of Keynesian Labor Demand in a Recession L1 L LD(YD,2) LD(YD,1) Keynesian Unemployment LS(w/p) P1 w1 _ L LME ECB L1 119

Y The Effect of the Demand for Goods on the Labor Market Increase in GDP above its Full Employment Level in a Boom We know from section 3.2. that also the opposite can happen: The demand for goods can grow above full employment GDP, i.e YD > Y(LD1,K1). Then Keynesian labor demand will be higher than the equilibrium labor input of the neoclassical model: LD(YD) > LD(w1/P1,K1). Since collective bargaining contracts typically allow an increase of wages, wages will grow (also due to overtime premiums). The result is called “Keynesian overemployment” YD,2 YD,1 Y(L,K1) Increase in Short-run Labor Demand in a Boom L1 L LD(YD,1) LD(YD,2) P1 w2 _ LS(w/p) P1 w1 _ Keynesian Overemployment L L1 120

Classification of Business Cycles:
Rezession = Tatsächliches Wachstum kleiner als Trendwachstum. Aufschwung = Tatsächliches Wachstum größer als Trendwachstum. Classification of Business Cycles: Actual GDP Growth > Growth Trend =Upswing Actual GDP Growth < Growth Trend =Downswing Prof. Dr. Rainer Maurer Source: EU-Ameco Database Prof. Dr. Rainer Maurer 121

Classification of Business Cycles:
Rezession = Tatsächliches Wachstum kleiner als Trendwachstum. Aufschwung = Tatsächliches Wachstum größer als Trendwachstum. Classification of Business Cycles: Actual GDP Growth > Growth Trend =Upswing Actual GDP Growth < Growth Trend =Downswing Prof. Dr. Rainer Maurer Source: EU-Ameco Database Prof. Dr. Rainer Maurer 122

- 123 - Source: EU-AMECO Data Base
Rezession = Tatsächliches Wachstum kleiner als Trendwachstum. Aufschwung = Tatsächliches Wachstum größer als Trendwachstum. Die Arbeitslosenquote wird als Quotient aus der Anzahl der Arbeitslosen und des Arbeitskräftepotenzials einer Volkswirtschaft wie folgt berechnet: (Zahl der registrierten Arbeitslosen) / (Zahl der zivilen Erwerbstätigen + Zahl der registrierten Arbeitslosen) Arbeitslosenbestand: Offiziell registrierte Arbeitslosigkeit/Gemeldete Arbeitslosigkeit: Die Berechnung der registrierten Arbeitslosigkeit wird von der Bundesagentur für Arbeit durchgeführt. Die Definition der Zählkriterien (wer gilt als arbeitslos) bestimmt das Bundesministerium für Arbeit und Soziales. Unter registrierter Arbeitslosigkeit wird in Deutschland allgemein die Zahl der Arbeitslosen verstanden, die bei der Bundesagentur für Arbeit nach dem SGB III bzw. einer Arbeitsgemeinschaft oder Optionskommune nach dem SGB II (Sozialgesetzbuch) arbeitslos gemeldet sind. Arbeitslos ist, wer weniger als 15 Stunden in der Woche arbeitet, aber mehr als 15 Stunden arbeiten will und jünger als das jeweilige Rentenalter ist. Darüber hinaus muss die Person dem Arbeitsmarkt zur Verfügung stehen und bereit sein, jede zumutbare Arbeit anzunehmen. Mit Verweis auf die Verfügbarkeit zählt nach § 16 Absatz 2 SGB III nicht als arbeitslos, wer an Maßnahmen der Bundesagentur für Arbeit teilnimmt (z.B. Trainingsmaßnahmen, Arbeitsgelegenheiten). Ebenfalls nicht berücksichtigt werden Personen, die arbeitsunfähig erkrankt sind. Source: EU-AMECO Data Base Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 123

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Invest Reduction of the Propensity to Consume Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 125

4. The Keynesian Model and its Policy Implications Fiscal Policy As we have already seen, there are two types of fiscal policy depending on their way of financing: Debt Financed Fiscal Policy Tax Financed Fiscal Policy If the government finances its consumption (G) by taxes (T) and by debt (DG) the following budget constraint results: G = T + DG To simplify the following analysis we will analyze only debt financed fiscal policy: G = DG | Debt Financed Fiscal Policy Under Keynesian assumptions, tax financed fiscal policy has the same results, yet the strength of the effect is somewhat weaker, since it lacks a multiplier effect (Haavelmo-Theorem). Prof. Dr. Rainer Maurer 126

4. The Keynesian Model and its Policy Implications Fiscal Policy i Y S(Y) = 0,5*Y C(Y) + I° i# C(Y) Full Employ-ment GDP I° I(i, E(r°)) I,S Y I° Y°D Y#D Starting point is a situation, where a demand-side recession has caused GDP to fall to a level of Y°D below its full employment level Y#D, so that Keynesian unemployment has emerged. What happens then, if the government rises its consumption from G=0 to G=5 and finances this expenditure with new debt of DG=G=5 via the credit market? Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 127

4. The Keynesian Model and its Policy Implications Fiscal Policy i Y S(Y) = 0,5*Y C(Y) + I° + G C(Y) + I° i# C(Y) I° I(i, E(r°)) I,S Y I° Y°D Y#D The rise of government consumption from G=0 to G=5 raises total demand for goods by 5. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 128

4. The Keynesian Model and its Policy Implications Fiscal Policy i Y S(Y) = 0,5*Y C(Y) + I° + G C(Y) + I° i# I(i, E(r°)) + DG C(Y) I° I(i, E(r°)) I,S Y I° Y°D Y#D The multiplier effect then causes total demand to grow by additional 5 units, so that total GDP grows by 10. To finance this additional government consumption, the credit demand grows by the government demand for credits equal to G=DG=5. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 129

4. The Keynesian Model and its Policy Implications Fiscal Policy i Y S(Y) = 0,5*Y C(Y) + I° + G C(Y) + I° i# I(i, E(r°)) + DG C(Y) I° I(i, E(r°)) I,S Y I° Y°D Y#D Since the increase in income by 10, increases, for a given savings ratio of 50%, the credit supply of households by 5, credit supply of households grows by the same amount as government consumption. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 130

4. The Keynesian Model and its Policy Implications Fiscal Policy i Y S(Y) = 0,5*Y C(Y) + I° + G C(Y) + I° i# I(i, E(r°)) + DG C(Y) I° I(i, E(r°)) I,S Y I° Y°D Y#D The rise of GDP to its full employment level Y#D, increases the demand for labor to its full employment level LD(Y#D)=LD(w1/P1,K1), so that the Keynesian unemployment disappears. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 131

Keynesian Unemployment
Fiscal Policy The increase of GDP from Y°D to Y#D caused by the increase of government consumption causes an increase of the short-run demand for labor from LD(Y°D) to LD(Y#D). Consequently, the Keynesian Unemployment caused by the recession completely disappears. If the increase of government consumption were lower that G=5, Keynesian unemployment would not completely disappear. If the increase of government consumption were stronger than G=5, GDP would grow stronger than Y#D. This would cause an "overheating" of the economy. Y#D Y(L,K1) Y°D L1 L LD(Y°D) LD(Y#D) LS(w/p) Keynesian Unemployment LS(w/p) P1 w1 _ L L1 132

Disappearance of Keynesian Unemployment
Fiscal Policy The increase of GDP from Y°D to Y#D caused by the increase of government consumption causes an increase of the short-run demand for labor from LD(Y°D) to LD(Y#D). Consequently, the Keynesian Unemployment caused by the recession completely disappears. If the increase of government consumption were lower that G=5, Keynesian unemployment would not completely disappear. If the increase of government consumption were stronger than G=5, GDP would grow stronger than Y#D. This would cause an "overheating" of the economy. Y#D Y(L,K1) Y°D L1 L LD(Y°D) LD(Y#D) LS(w/p) Disappearance of Keynesian Unemployment LS(w/p) P1 w1 _ L L1 133

4. The Keynesian Model and its Policy Implications Fiscal Policy Why is fiscal policy able to cause an economic recovery under Keynesian assumptions, but not under the assumptions of the neoclassical model? Under the assumption of the neoclassical model, the supply of goods is fix. An increase in the demand for goods cannot cause an increase in the supply of goods: The increase in government debt, causes an increase in the demand for credits. Since the supply of credits does, however, not grow, the resulting increase in the interest rate causes a reduction of investment (I(i↑)↓) and a reduction of household consumption (C(i↑)↓). This is the reason for the complete „Crowding-Out“ under neoclassical assumptions. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 136

Tax financed fiscal policy?
4. The Keynesian Model and its Policy Implications Fiscal Policy Why is fiscal policy able to cause an economic recovery under Keynesian assumptions, but not under the assump-tions of the neoclassical model? Under the assumptions of the Keynesian model, the supply of goods adjusts to the demand for goods, so that GDP and hence household income grows. The increase in government debt, causes an increase in the demand for credits. The increase in GDP causes at the same time an increase in household savings, so that credit supply grows. The increase in household credit supply is sufficient to compensate the effect of additional government credit demand on the interest rate. Therefore, an increase in the interest rate does not take place! Therefore, investment demand for firms does not decrease. As a consequence, a debt-financed expansion of government consumption does not result in a „Crowding-Out“ of private demand! Prof. Dr. Rainer Maurer Tax financed fiscal policy? Prof. Dr. Rainer Maurer 137

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy Monetary Policy Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 138

4. The Keynesian Model and its Policy Implications Monetary Policy In the above analysis of fiscal policy the existence of money supply and demand was neglected by assuming implicitly a pure barter economy. Under the existence of money, the effect of fiscal policy would be somewhat dampened, because an increase in GDP increases the demand for money and consequently the interest rate, so that investment demand shrinks somewhat and the net increase in GDP is correspondingly smaller. Nevertheless, the net effect of fiscal policy on GDP is significantly positive, even in a Keynesian model with money. In this sense, the neglect of money is harmless. Of course, in the following analysis of monetary policy, we cannot neglect the existence of money . Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 139

4. The Keynesian Model and its Policy Implications Monetary Policy The Determinants of Money Supply: Just like in the neoclassical model, the central bank determines money supply: MS As the discussion of monetary policy in Chapter 6 will show, most central banks offer in various ways their money as a credit on the capital market. Therefore, we can simply add money supply of the central bank to credit supply of households. Consequently, total real credit supply equals the sum of real savings of households plus the real value of money supply by the central banks ( =nominal money supply (MS) divided by the price level P: Total Real Credit Supply = S(Y) + MS / P Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 140

4. The Keynesian Model and its Policy Implications Monetary Policy The Credit Market without Money Supply and Demand: S(Y) i# I(i, E(r°)) I° Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 141

4. The Keynesian Model and its Policy Implications Monetary Policy The Credit Market with Money Supply: S(Y) S(Y) + MS / P i# MS/P I(i, E(r°)) I° I° + RD° Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 142

4. The Keynesian Model and its Policy Implications Monetary Policy Determinants of Money Demand: Just like in the neoclassical model, firms demand money to pay their production factors labor and capital. Consequently, the real demand for money depends on the sum of real wage and real interest payments, which equal real GDP: Y. Additionally, the original Keynesian model accounts for the fact, that households and firms care for the opportunity costs of holding money (= interest costs = interest rate = i) and do therefore demand less money if the interest rate is high and vice versa. For simplicity we will neglect the dependency of money demand on the interest rate in the following exposition, since it has no significant effects on the results. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 143

4. The Keynesian Model and its Policy Implications Monetary Policy Determinants of Money Demand: Consequently, real money demand depends like in the neoclassical model positively on GDP (Y) : Real Money Demand = RD(Y) Total real credit demand equals then credit demand for the purchase of investment goods I(i, E(r)) plus money demand: Total Real Credit Demand = I(i, E(r)) + RD(Y) Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 144

4. The Keynesian Model and its Policy Implications Monetary Policy The Credit Market with Money Supply: S(Y) S(Y) + MS / P i# MS/P I(i, E(r°)) I° I° + RD° Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 146

4. The Keynesian Model and its Policy Implications Monetary Policy The Credit Market with Money Supply and Money Demand: S(Y) S(Y) + MS / P i# RD(Y) MS/P I(i, E(r°)) + RD(Y) I(i, E(r°)) I° I° + RD° Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 147

4. The Keynesian Model and its Policy Implications Monetary Policy The Credit Market with Money Supply and Money Demand: If money supply (MS/P) equals money demand (RD(Y)), the interest rate equals the natural interest rate, i.e. the interest rate that would result without money. S(Y) S(Y) + MS / P i# RD(Y) MS/P I(i, E(r°))+ RD(Y) I(i, E(r°)) I° I° + RD° Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 148

4. The Keynesian Model and its Policy Implications Monetary Policy The capital market with money supply and demand can now be inserted into the Keynesian model: Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 149

4. The Keynesian Model and its Policy Implications Monetary Policy i Y S(Y°) S(Y°)+M/P C(Y)+I° i° C(Y) I(i)+RD(Y°) Full Employ-ment GDP I° I(i) I,S Y I° I°+RD° Y°D Y#D Starting point is a situation, where a demand-side recession has caused GDP to fall to a level of Y°D below its full employment level Y#D, so that Keynesian unemployment has emerged. Ex. 25, sl. 195 Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 150

4. The Keynesian Model and its Policy Implications Monetary Policy i Y S(Y°)+M/P+5 C(Y)+I° i° C(Y) I(i)+RD(Y°) I° I(i) I,S Y I° I°+RD° Y°D Y#D What happens now, if the central bank rises money supply and hence total credit supply by ΔM /P= 5 ? Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 151

4. The Keynesian Model and its Policy Implications Monetary Policy i Y S(Y°)+M/P+5 C(Y)+I° i° I° i# C(Y) I(i)+RD(Y°) I° I(i) I,S Y I# I#+RD° Y°D Y#D The raise of money supply causes a reduction of the interest rate from i° to i#. This rises investment from I° to I#. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 152

4. The Keynesian Model and its Policy Implications Monetary Policy i Y S(Y°)+M/P+5 C(Y)+I# C(Y)+I° i° i# C(Y) I(i)+RD(Y°) I# I(i) I,S Y I° I° I# I#+RD° Y°D Y#D The rise of investment by 5 increases the demand for goods by 5. The multiplier process causes a final increase in GDP by 10 units. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 153

4. The Keynesian Model and its Policy Implications Monetary Policy i Y S(Y°)+M/P+5 C(Y)+I# C(Y)+I° i° i# C(Y) I(i)+RD(Y°) I# I(i) I,S Y I° I# I#+RD° Y°D Y#D The growth of GDP causes a higher demand for labor, so that labor demand grows and Keynesian unemployment disappears. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 154

4. The Keynesian Model and its Policy Implications Monetary Policy i S(Y°)+M/P+5 Y S(Y#)+M/P+5 C(Y)+I# C(Y)+I° i# C(Y) I(i)+RD(Y°) I# I(i) I,S Y I# I#+RD° Y°D Y#D Since GDP grows by 10, household savings grow by 10 times the savings ratio: 10*(1-c) = 10*0,5 = 5. This causes credit supply to shift to the right by 5 units. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 155

RD(Y)-curve shifts to the right too.
4. The Keynesian Model and its Policy Implications Monetary Policy i Y S(Y#)+M/P C(Y)+I# C(Y)+I° i# I(i)+RD(Y#) C(Y) I# I(i) I,S Y I# I#+RD° Y°D Y#D This would cause a further decrease in the interest rate. However the increase in GDP causes also an increase in money demand, so that the RD(Y)-curve shifts to the right too. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 156

4. The Keynesian Model and its Policy Implications Monetary Policy i Y S(Y#) S(Y#)+M/P C(Y)+I# i# I(i)+RD(Y#) C(Y) I# I(i) I,S Y I# I#+RD# Y°D Y#D To simplify the analysis, we make the assumption that money demand RD(Y) shifts to the right by the same amount as the savings supply, so that the interest rate stays constant at the level caused by monetary policy i#. In this case the adjustment process comes to an end. If the shift of money demand were smaller, a further decrease of the interest rate would cause a further growth of GDP. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 157

Macroeconomics Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 164

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy Monetary Policy 4.4. The Long-run Implications of the Keynesian Model Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 165

4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model As section 3.1 has shown that in reality it takes one year until firms start to adjust their prices. When firms adjust their prices, they will do so according to the current degree of their capacity utilization: When a rise in the demand for goods has caused a boom so that production lies above full employment GDP, firms will notice that an increase in prices will help to increase their profits. When a decline in the demand for goods has caused a recession so that production lies below full employment GDP, firms will notice that a decrease in prices will help to increase their profits. In the following, we will therefore analyze what happens, if the economy is in a recession (production below the full employment level) and firms start to reduce their prices. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 166

4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model A change of the price level will affect the economy in the same way as in the neoclassical model (s. Chapter 2.2.1): Via the capital market: Starting point is an equilibrium in the capital market: S(Y) + M / P° = I(i°, E(r)) + RD(Y) If there is an recession, firms will decrease their prices from P° to P# < P°. This will cause an increase of the real value of money from M / P# > M / P°. As a result their will be excess supply of credits: S(Y) + (M / P# ) Excess supply will decrease the interest rate from i# < i°, so that investment demand will grow from I(i°, E(r)) to I(i#, E(r)) until a new equilibrium is reached: Higher investment in turn will increase the demand for goods. > I(i°, E(r)) + RD(Y) I(i° , E(r)) + RD(Y) = > Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 168

4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model Y P°> P# S(Y°)+M/P° S(Y°)+M/P# C(Y)+I° i° i# C(Y) I(i)+RD(Y°) Full Employ-ment GDP I(i) I° I,S Y I° I°+RD° P Y° Y# The resulting lower interest rate i# triggers the same adjustment process as discussed in section “ Monetary Policy”! When the price level of goods prices decreases from P° to P#, the real value of the money offered by the central bank increases: (MD/P↓)↑ This causes an increase in credit supply from S(Y°)+MD/P° to S(Y°)+MD/P# Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 169

4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model Y S(Y°)+M/P# C(Y)+I° i° i# C(Y) I(i)+RD(Y°) I(i) I° I,S Y I° I# I#+RD° Y° Y# This increase in credit supply causes the interest rate to decrease from i° to i#. The lower interest rate causes a rise of investment from I° to I#. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 170

4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model Y S(Y°)+M/P# C(Y)+I# C(Y)+I° i° i# C(Y) I(i)+RD(Y°) I# I(i) I,S Y I° I# I#+RD° Y° Y# This increase in investment increases the demand for goods from Y°D to Y#D. Since the supply of goods adjusts to the demand for goods, the demand for labor grows to the full-employment level. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 171

4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model Y S(Y°)+M/P# C(Y)+I# S(Y#)+MD/P# i# I(i)+RD(Y#) C(Y) I(i)+RD(Y°) I# I,S Y I# I#+RD# Y° Y# The resulting rise of GDP from Y°D to Y#D increases household savings from S(Y°) to S(Y#) and money demand from RD(Y°) to RD(Y#). Under the assumption that savings supply and money demand grow by the same margin the interest rate i# stays constant. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 172

4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model Y C(Y)+I# S(Y#)+M/P# i° i# I(i)+RD(Y#) C(Y) I# I(i) I,S Y I# I#+RD# Y° Y# Consequently, the decrease in prices by firms causes a decrease in the interest rate, which causes an increase in investment. This increase in investment causes an increase in the demand for goods, which leads ultimately to an increase in the demand for labor. (->Exercise 27) Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 173

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy Monetary Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions Practical Problems of Anti-cyclical Policy Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 179

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy As the above analysis has shown, “in the long run” (=when prices start to adjust) the economy is able to find its way out of recession without any help by the government. In other words, in the long run the “self-healing capacities” of the market work – even under the assumptions of the Keynesian model. This however means, that the Keynesian theory does not imply the necessity of government anti-cyclical policy. The Keynesian theory implies however that government business cycle policy makes sense, if it allows to accelerate the process of economic recovery. Such an acceleration of economic recovery is, however, only possible if the government (or the central bank) is able to react in face of a recession before firms start lowering their prices (and cause a recovery in this way). Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 180

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy Consequently, the time-frame for government business cycle policy corresponds to the span of time until firms start adjusting their prices (about 1 year). Only if the government (and/or the central bank) is able to increase the demand for goods before firms start adjusting their prices, it is possible to shorten the duration of the autonomous adjustment process of the economy. If fiscal and monetary policy come to late, i.e. when firms have already reduced their prices, this may cause an excess demand for goods that can lead to an overheating of the economy: The following graphs illustrate this problem: Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 181

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy Ideal Case: No Implementation Lag => No Danger of Overheating: Implementation Lag of Fiscal Policy = 0 Year No Overheating, since no price adjustment takes place! Fiscal Policy becomes effective: G↑ Increase in Demand for Goods: YD↓↑ Overcoming of Recession before 1 year is over! => => 0,5 Year 1 Year 1,5 Year Start of Re-cession: YD↓ No reason for price adjustment, since the recession is already overcome! Start of Price Adjustment by Firms = 1 Year Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 182

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy Realistic Case: Implementation Lag => Danger of Overheating: Implementation Lag of Fiscal Policy = 1 Year Twofold Demand Effect : YD↑+YD↑ => Over-heating of the Econo-my Fiscal Policy becomes effective: G↑ Increase in Demand for Goods: YD↑ => 0,5 Year 1 Year 1,5 Year Start of Re-cession: YD↓ Firms decrease Prices: P↓ => i↓=>I(i)↑ Increase in Demand for Goods: YD↑ => Start of Price Adjustment by Firms = 1 Year Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 183

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy As a consequence, the resulting excess demand for goods causes in the long run (when firms start to adjust their prices again) an increase in prices, which will finally cause a recession (exercise 27). In this case, fiscal or monetary policy would not dampen but boost business cycle fluctuations. These dangers lead to the question, whether the government (or the central bank) is able to react fast enough to reduce the duration of the recovery process and avoid an overheating of the economy. This question will be discussed in the following. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 185

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy Practical experience with anti-cyclical fiscal policy has shown that there are several reasons for lags in the implementation of such policies. These lags can be classified according to the following scheme: Total Implementation Lag Inside Lag Outside Lag Time between a shock to the economy and the policy action responding to that shock. Time between the policy action and its influence on the economy. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 186

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy The inside lag of fiscal policy has two sources: The government needs time to analyze the causes of a recession (“diagnosis lag”): Only in case of a reduction of the demand for goods caused by a deterioration of the expec-tations of firms and households (= demand side shock) Keynesian government spending policies will work. If the recession is caused e.g. by a shock in the prices of raw materials (= supply side shock), Keynesian spending policies will not work. The government needs time to change its budgeting: On the expenditure side laws must be changed in order to increase government spending for goods and services. On the revenue side laws must be changed in order to finance the additional government spending: Taxes and/or borrowing must be increased. Changing laws takes time (weeks if not months) in a parliamentary system (“reaction lag”) Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 187

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy The outside lag of fiscal policy: Once the fiscal policy measures of the government are implemented, some time is needed until they unfold their full influence on the economy: In our textbook version of the Keynesian model a primary increase in the demand for goods immediately causes an increase in income and the increase in income causes immediately an additional increase in household consumption demand via the multiplier effect. In reality, a couple of time is needed until households realize the increase in their income (and/or lower risk of getting unemployed) and react on this with a rise of their demand for goods. Therefore, in reality the multiplier effect needs much more time to get started than in the simple Keynesian textbook model. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 188

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy Taken together, the implementation lags of fiscal policy may delay its effect on the real economy for a span of time, which is likely between half a year and one year. Hence the implementation lag comes close to the one-year lag with which firms adjust their prices! Total Implementation Lag Inside Lag Outside Lag Time between a shock to the economy and the policy action responding to that shock. Time between the policy action and its influence on the economy. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 189

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy The Forecast Problem: In principle, business cycle forecasts could be one way to circumvent the problem of implementation lags. Such forecasts could help to start the implementation of fiscal policy measures in advance, so that the effects of fiscal policy already start working at the beginning of a recession. However this approach works only, if the forecasts are sufficiently reliable. Experience has however shown, that forecasts of economic developments are exposed to a high degree of uncertainty. Forecasts of economic phenomena are forecasts of a complex system and are as difficult as forecast of meteorological or ecological phenomena. The following graph gives an example how difficult economic forecasting can be. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 190

Red Line: Actual US-unemployment rate.
4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy Blue lines: Forecasts of the US-unemployment rate (average value of 20 US forecast institutes) Red Line: Actual US-unemployment rate. Quelle: Mankiw, Gregory; Macroeconomics, Worth Publishers, S. 384 Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 191

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy The Policy Problem: Critics of the concept of anti-cyclical fiscal policy argue that governments are not altruistic and benevolent agents committed to the public welfare only, but strive – like households or firms – to maximize their individual welfare. If this hypothesis were right, it would be unlikely that governments actually try to reduce business cycle fluctuations. Instead they would use their economic policy instruments to increase the probability of being reelected. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 192

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy Therefore, these critics of fiscal policy argue that if governments were given access to a lot of fiscal policy instruments, they would not stabilize the economy but destabilize it with a “political business cycle” of the following kind: A couple of time before an election, the government increases government consumption, in order to rise the growth of income and reduce unemployment. This resulting improvement of economic conditions induces the electors to vote for the government. Once the government has won the elections, it will immediately reduce government consumption, in order the keep the government deficit in check – and be able to rise again government consumption before the next elections. This reduction of government consumption will cause a recession after the election. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 193

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy To sum up: The practical implementation of fiscal policy is subject to a couple of problems that do not appear in the Keynesian textbook model: The Implementation Lag The Forecast Problem The Policy Problem Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 194

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy Anti-cyclical monetary policy too can be subject to implementation lags: The inside lag of economic policy is, however, typically much shorter than the inside lag of fiscal policy, since the central bank can change its money supply immediately without changes of laws that must be approved by the parliament (see chapter 6 “Monetary Theory and Policy”). Nevertheless the outside lag of monetary policy can be quite important: Even though the effect of a change of monetary policy on interest rates is quite direct and fast in reality (see the next diagram), a decrease in interest rates does not immediately cause an increase in firms’ demand for investment goods. This is the case, because investment plans of firms are made in advance and it takes up to six months until firms actually demand more investment goods and hence increase economic demand. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 195

1) Private Haushalte; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft
2) Unternehmen außerhalb des Finanzsektors; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft Quelle: ECB Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 196

4. The Keynesian Model and its Policy Implications Practical Problems of Anti-cyclical Policy The forecast problem is of course the same for monetary and fiscal policy. However, for an independent central bank, the policy problem of monetary policy is of less importance as for fiscal policy. Since the inside implementation lag and policy problem is of less importance, monetary anti-cyclical policy has much more proponents than fiscal policy. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 198

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Inves Consequences for the Labor Markett 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy Monetary Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions Practical Problems of Anti-cyclical Policy Case Study: Fiscal Policy in Germany Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 199

4. The Keynesian Model and its Policy Implications Case Study: Fiscal Policy in Germany The concept of anti-cyclical fiscal policy implies: Increase of credit financed government consumption in recessions and, consequently, government budget deficits in recessions: T-G < 0 Dampening of economic activity in booms by a reduction of government demand and, consequently, government budget surpluses in booms : T-G > 0 If periods of budget deficits and budget surpluses set off each other, the total amount of accumulated government debt should stay constant. This idea is displayed by the following graph: Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 200

The Theory of Anti-Cyclical Fiscal Policy
GDP with perfect anti-cyclical fiscal policy UPSWING DOWN-SWING UPSWING GDP-Level Actual GDP without anti-cyclical fiscal policy Time + Budget Surplus = T-G > 0 Budget Surplus − figProf. Dr. Rainer Maurer Budget Deficit = T-G < 0 Prof. Dr. Rainer Maurer 201

Acceptance of the Treuhand-Debt by the Government
UMTS-Auction Hans Eichel Peer Steinbrück Acceptance of the Treuhand-Debt by the Government Prof. Dr. Rainer Maurer Source: SVR (2004) Prof. Dr. Rainer Maurer 204

4. The Keynesian Model and its Policy Implications Case Study: Fiscal Policy in Germany As these charts show, there is no strong evidence that German governments since 1970 have followed the theory of anti-cyclical fiscal policy. If we add up the yearly budget deficits of the last chart (= DG,t) over the past, we receive the level of accumulated government debt: LADG,t = DG,t + DG,t-1 + DG,t-2 + DG,t-3 +… If we divide the level of accumulated government debt up to a certain year t by the GDP level of this year, we receive the debt-GDP ratio: LADG,t / GDPt If the growth rate of accumulated government debt is stronger than the growth rate of GDP, the debt-GDP ratio is growing. After the acceptance of the Treuhand-Debt by the government in 1996 the debt-GDP ratio reached for the first time the 60% limit according to the definition of the Maastricht Treaty. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 205

Source: SVR (2004) - 206 - Prof. Dr. Rainer Maurer 206

What will the long-run consequences of the „debt brake“ be?
4. The Keynesian Model and its Policy Implications Case Study: Fiscal Policy in Germany To fight the steadily increase of public debt, the German parliament has implemented a so called “debt brake” in the German constitution (Article 115) by May 2009. According to this debt brake, the federal government must run a balanced government budget, i.e. G = T, starting with the year 2016. the federal states must run a balanced government budget starting with the year 2020. There are however exceptions: In a recession, debt financed government expenditure is allowed, if the debts are reduced again in an upswing = anticyclical fiscal policy is allowed. In case of “natural disasters” or “extraordinary emergencies” debt financed government expenditures are allowed, if it is ensured that the resulting debt is paid back afterwards. What will the long-run consequences of the „debt brake“ be? Prof. Dr. Rainer Maurer Does this make sense? Prof. Dr. Rainer Maurer 209

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Inves Consequences for the Labor Markett 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy Monetary Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions Practical Problems of Anti-cyclical Policy Case Study: Fiscal Policy in Germany Limits of Government Debt Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 210

4. The Keynesian Model and its Policy Implications Limits of Government Debt Is there an economic limit for government debt? Arithmetically the upper limit is the present value of maximal tax payments, which depend on the politically maximal possible tax rate and GDP (τmax * Yt): If the present value of all future interest payments on government debt becomes larger than the present value of the maximal possible future tax payments, the government is not able to serve its debt and has to declare bankruptcy. This equation shows that the “debt-to-GDP ratio” LADt / Yt is a reasonable empirical measure for sustainability of government debt. Present value of future interest payments Present value of future tax payments ≤ Definition: 𝑙𝑎𝑑 = 𝐿𝐴𝐷 / GDP => (δ 𝐿𝐴𝐷)/(δ 𝑡)=𝐺 −𝑇=𝐵+𝑖∗𝐿𝐴𝐷 𝑤ℎ𝑒𝑟𝑒 𝐵=𝑃𝑟𝑖𝑚𝑎𝑟𝑦 𝐷𝑒𝑓𝑖𝑐𝑖𝑡=𝐺 −𝑇−𝑖∗𝐿𝐴𝐷 => (δ 𝑙𝑎𝑑)/(δ 𝑡)=((B+ i∗LAD) ∗GDP) -(δ GDP)/(δ t) ∗LAD)/〖GDP〗^2 (δ 𝑙𝑎𝑑)/(δ 𝑡)= 0 <=> 0 =((B+ i∗LAD) ∗GDP) –((δ GDP)/(δ t)) * LAD)/〖GDP〗^2 -B/GDP =(i∗LAD ) –((δ GDP)/(GDP)) * LAD)/〖GDP〗 -B/GDP =( i -(δ GDP)/(GDP) )*LAD /〖GDP〗 -B/GDP =( interest rate –GDP growth ) * (LAD/GDP) Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 211

4. The Keynesian Model and its Policy Implications Limits of Government Debt Is there an economic limit for government debt? Of course, governments will try to reduce their debt repayments before this upper limit is reached – they will “restructure” their debt: “debt restructuring” = “partial bankruptcy” Since this is a risk for the creditors of government debts, financial markets will typically react long before the upper limit is reached and demand a risk premium (= higher interest rate). In reality, the reputation of governments seems to play an important role for the level of such risk premiums, as the following diagrams show: Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 212

Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 213

4. The Keynesian Model and its Policy Implications Limits of Government Debt Why does the Japanese debt-to-GDP ratio not lead to higher risk premiums? The creditors of Japanese government debt expect that the japanese government is able and willing to serve its debt in the future. The expectations of financial markets play a crucial role in respect to the upper limit of government debt. It is even possible that the phenomenon of self-fulfilling expectations appears, as the following scheme displays: Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 217

4. The Keynesian Model and its Policy Implications Limits of Government Debt Self-fulfilling expectations of government bankruptcy: Sales lead to fall in market prices of government bonds Doubts come up concerning the ability of a government to repay all debt. Fall in market price = Increase of effective interest rate Higher interest rates increase costs of revolving government debt. Ability of government to repay debt falls. Prof. Dr. Rainer Maure 2

4. The Keynesian Model and its Policy Implications Limits of Government Debt Important: There are historical examples showing that governments had been able to reduce a debt burden of more than 200% of GDP, without bankruptcy or „restructuring“ of debt: Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 220

It is possible to reduce the debt-to-GDP ratio without reducing the debt level…

Nominal GDP must grow faster as the debt level!

4. The Keynesian Model and its Policy Implications Limits of Government Debt Is there an economic limit for government debt? However, keeping the total debt growth rate below the GDP growth rate can be politically difficult – if the interest rate is larger than the GDP growth rate: To keep the debt-to-GDP ratio constant the following relationship must hold: This formula is quite intuitive. In means: _____________________________________________ Definition: 𝑙𝑎𝑑 = 𝐿𝐴𝐷 / GDP => (δ 𝐿𝐴𝐷)/(δ 𝑡)=𝐺 −𝑇=𝐵+𝑖∗𝐿𝐴𝐷 𝑤ℎ𝑒𝑟𝑒 𝐵=𝑃𝑟𝑖𝑚𝑎𝑟𝑦 𝐷𝑒𝑓𝑖𝑐𝑖𝑡=𝐺 −𝑇−𝑖∗𝐿𝐴𝐷 => (δ 𝑙𝑎𝑑)/(δ 𝑡)=((B+ i∗LAD) ∗GDP) -(δ GDP)/(δ t) ∗LAD)/〖GDP〗^2 (δ 𝑙𝑎𝑑)/(δ 𝑡)= 0 <=> 0 =((B+ i∗LAD) ∗GDP) –((δ GDP)/(δ t)) * LAD)/〖GDP〗^2 -B/GDP =(i∗LAD ) –((δ GDP)/(GDP)) * LAD)/〖GDP〗 -B/GDP =( i -(δ GDP)/(GDP) )*LAD /〖GDP〗 -B/GDP =( interest rate –GDP growth ) * (LAD/GDP) If GDP-growth is smaller than the interest rate => -B>0 <=> B<0 => 𝐺 −𝑇−𝑖∗𝐿𝐴𝐷 < 0 <=>𝐺 - 𝑖∗𝐿𝐴𝐷 < 𝑇 => Wenn Transversalitätsbedingung gilt, dann ist Primärüberschuss notwendig damit Schuldenstandsquote konstant! If the debt-to-GDP ratio shall stay constant, the change of the debt-level (=deficit) in percent of the change of GDP must equal the debt-to-GDP-ratio. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 223

4. The Keynesian Model and its Policy Implications Limits of Government Debt Is there an economic limit for government debt? Multiplying both sides of the equation with the interest rate it yields: This means that, since in normal times the interest rate it is larger than GDP growth ∆Yt/Yt such that it / (∆Yt/Yt) >1, the possible new deficit has to be smaller than interest payments. In other words: In other words: Interest payments cannot be financed with new credits in the long-run, if the debt-to-GDP ratio shall stay constant! 100 % = 1,5 * (100 % / 1,5) = 1,5 * (66,6 %) Definition: 𝑙𝑎𝑑 = 𝐿𝐴𝐷 / GDP => (δ 𝐿𝐴𝐷)/(δ 𝑡)=𝐺 −𝑇=𝐵+𝑖∗𝐿𝐴𝐷 𝑤ℎ𝑒𝑟𝑒 𝐵=𝑃𝑟𝑖𝑚𝑎𝑟𝑦 𝐷𝑒𝑓𝑖𝑐𝑖𝑡=𝐺 −𝑇−𝑖∗𝐿𝐴𝐷 => (δ 𝑙𝑎𝑑)/(δ 𝑡)=((B+ i∗LAD) ∗GDP) -(δ GDP)/(δ t) ∗LAD)/〖GDP〗^2 (δ 𝑙𝑎𝑑)/(δ 𝑡)= 0 <=> 0 =((B+ i∗LAD) ∗GDP) –((δ GDP)/(δ t)) * LAD)/〖GDP〗^2 -B/GDP =(i∗LAD ) –((δ GDP)/(GDP)) * LAD)/〖GDP〗 -B/GDP =( i -(δ GDP)/(GDP) )*LAD /〖GDP〗 -B/GDP =( interest rate –GDP growth ) * (LAD/GDP) If GDP-growth is smaller than the interest rate => -B>0 <=> B<0 => 𝐺 −𝑇−𝑖∗𝐿𝐴𝐷 < 0 <=>𝐺 - 𝑖∗𝐿𝐴𝐷 < 𝑇 => Wenn Transversalitätsbedingung gilt, dann ist Primärüberschuss notwendig damit Schuldenstandsquote konstant! To keep the debt-to-GDP ratio constant, a part of tax-income must be used to finance interest payments! <=> Taxes cannot be completely spent for government consumption! Prof. Dr. Rainer Maurer <=> Debt cannot be completely financed with new debt ! Prof. Dr. Rainer Maurer 224

4. The Keynesian Model and its Policy Implications Limits of Government Debt Is there an economic limit for government debt? As a consequence: If debt is completely financed with new debt, the debt-to-GDP ratio will grow! Definition: 𝑙𝑎𝑑 = 𝐿𝐴𝐷 / GDP => (δ 𝐿𝐴𝐷)/(δ 𝑡)=𝐺 −𝑇=𝐵+𝑖∗𝐿𝐴𝐷 𝑤ℎ𝑒𝑟𝑒 𝐵=𝑃𝑟𝑖𝑚𝑎𝑟𝑦 𝐷𝑒𝑓𝑖𝑐𝑖𝑡=𝐺 −𝑇−𝑖∗𝐿𝐴𝐷 => (δ 𝑙𝑎𝑑)/(δ 𝑡)=((B+ i∗LAD) ∗GDP) -(δ GDP)/(δ t) ∗LAD)/〖GDP〗^2 (δ 𝑙𝑎𝑑)/(δ 𝑡)= 0 <=> 0 =((B+ i∗LAD) ∗GDP) –((δ GDP)/(δ t)) * LAD)/〖GDP〗^2 -B/GDP =(i∗LAD ) –((δ GDP)/(GDP)) * LAD)/〖GDP〗 -B/GDP =( i -(δ GDP)/(GDP) )*LAD /〖GDP〗 -B/GDP =( interest rate –GDP growth ) * (LAD/GDP) If GDP-growth is smaller than the interest rate => -B>0 <=> B<0 => 𝐺 −𝑇−𝑖∗𝐿𝐴𝐷 < 0 <=>𝐺 - 𝑖∗𝐿𝐴𝐷 < 𝑇 => Wenn Transversalitätsbedingung gilt, dann ist Primärüberschuss notwendig damit Schuldenstandsquote konstant! Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 225

4. The Keynesian Model and its Policy Implications Limits of Government Debt Is there a “moral” limit for government debt? Not future generations, but future tax payers pay for today debt: Interest for government debt accumulated by current generations, will not be paid by future generations, but by future tax payers to future owners of government bonds. Therefore, the money stays „within the generation“. Every generation does not only inherit debt, …but also net wealth like infrastructure, physical capital (machines, buildings…), technical knowledge, institutions, human capital… The yearly monetary and non-monetary return, of this net wealth, is opposed to the interest payments, which have to be paid to the owners of government bonds. Is this return equal to the costs of interest payments, future tax payers suffer no net loss! Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 226

4.1. The Keynesian Theory The "Keynesian Cross" The Keynesian Model with Capital Market 4.2. Demand-side Shocks Reduction of the Propensity to Consume Reduction of the Propensity to Invest Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model Fiscal Policy Monetary Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions Practical Problems of Anti-cyclical Policy Case Study: Fiscal Policy in Germany Limits of Government Debt Case Study: Economic Policy in the Great Recession Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 227

4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 228

4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession Extension of short-time working benefits Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 229

Private Consumption in Current Prices, Billion Euro
4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession Private Consumption in Current Prices, Billion Euro Prof. Dr. Rainer Maurer Quelle: Statistisches Bundesamt Prof. Dr. Rainer Maurer 230

Gross Investment in Current Prices, Billion Euro
4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession Gross Investment in Current Prices, Billion Euro Prof. Dr. Rainer Maurer Quelle: Statistisches Bundesamt Prof. Dr. Rainer Maurer 231

4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession The expenditure account of GDP show the components of the demand for domestic goods: Y = C + I + G + EX – IM <=> BIP = Consumption + Gross Investment + Government Consumption + Exports - Imports “Net Exports” Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 232

Exports ./. Imports in Current Prices, Billion Euro
4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession Exports ./. Imports in Current Prices, Billion Euro Prof. Dr. Rainer Maurer Quelle: Statistisches Bundesamt Prof. Dr. Rainer Maurer 233

Production in Manufacturing, 2005 = 100
4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession Production in Manufacturing, 2005 = 100 As postulated by the Keynesian model firms adjust their production in the short-run to the demand for goods. Prof. Dr. Rainer Maurer Quelle: Statistisches Bundesamt Prof. Dr. Rainer Maurer 234

4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession As the data reveal, the recession was mainly caused by a reduction of investment and export demand. The reason for the reduction of investment and export demand was the bursting of a speculative bubble on the US real estate market. The causal chain behind the development is relatively complex, as the following chart shows: Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 235

4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession USA Germany Decrease in Real Estate Prices Loss of Credit Receivables of US Banks Loss of Credit Receivables of Germ. Banks Net Wealth Loss of Households Reduction in Credit Supply by US Banks Reduction in Credit Supply by Ger. Banks German Consumption Relatively Stable Reduction in Con-sumption Demand Reduc-tion of Produc-tion in Ger-many Reduction in Investment Demand Reduction in Investment Demand Reduction of Export Demand Reduction in Demand for Consumption and Investment Goods from Germany Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 236

4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession Fiscal Policy Measures in Germany: “Konjunkturpaket I” of November 2008 with a total volume of about 100 Bn. €: Subsidization of building investment: energy saving investments Subsidization of investment in equipment: extension of write-off possibilities Extension of child allowances and other family support benefits Increase of credit supply for midsize companies: Sonderprogramm KfW – Bank 100 / 2500 = 4 % BIP / economic stimulus package economic stimulus package Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 237

4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession Fiscal Policy Measures in Germany: “Konjunkturpaket II” of January 2009 with a total volume of about 50 Bn. €: Reduction of income tax Reduction of health insurance allowances Additional Extension of child allowances Subsidization of private demand for cars (“Cash for clunkers”) Municipal investment program: Improvement of infrastructure 50 / 2500 = 2 % BIP / economic stimulus package Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 238

4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession Monetary Policy Measures: Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 239

Geldpolitische Maßnahmen:
4. The Keynesian Model and its Policy Implications Case Study: Economic Policy in the Great Recession Geldpolitische Maßnahmen: Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 240

4.6. Questions for Review You should be able to answer the following questions at the end of this chapter. All of the questions can be answered with the help of the lecture notes. If you have difficulties in answering a question, discuss this question with me at the end of the lecture, attend my colloquium or send me an . Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 243

4.6. Questions for Review What empirical developments in the course of the world economic crisis contradict neoclassical theory? What are the two main differences between Keynesian and neoclassical theory. What is the difference between the Keynesian and neoclassical consumption function and what implications does this have for the savings decision of households. What is the economic explanation for the observed lagged price adjustment of firms? Why do firms adjust their supply of goods to the household demand for goods in the Keynesian model? What value has the Keynesian investment multiplier for a consumption ratio of 80%? What is the increase in GDP under the assumption of the “Keynesian Cross”, if the consumption ratio is 75% and investment grows by 1 Bn. ? Give a verbal explanation of the multiplier process. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 244

4.6. Questions for Review Plot the following consumption function in this diagram: C(Y) = 0,8 * Y. How does this function change, if the consumption ratio decreases to 40%? C, I, G Y Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 245

4.6. Questions for Review Determine (given the assumptions of the Keynesian Cross) GDP, if investment demand equals 5, government consumption equals 5 and the consumption function equals C(Y) = (1/3)*Y. How does GDP change, if government consumption grows by 10? C, I, G Y Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 246

4.6. Questions for Review Why does an increase in the demand for investment goods leads to an increase in GDP that is larger than the increase in the demand for investment goods under the assumption of the “Keynesian Cross”? What possibilities does a government have under the assumptions of the “Keynesian Cross” to increase GDP? Discuss the difference between the neoclassical and the Keynesian consumption function on the background of your own consumption behavior: Do you have a Keynesian or a neoclassical consumption function? How does the “Keynesian Cross” have to be modified, if the capital market is taken into account? What factors affect money demand of households and firms under the assumptions of the Keynesian model and what is their economic explanation? Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 247

4.6. Questions for Review Interest Rate Demand S(Y1) = (1/3) * 30 C(Y) + I(i) C(Y)= (2/3)* Y i1 I(i, E(r1)) I1 Investment Y1 Income Caused by a deterioration of expectations, households lower their consumption ratio from 2/3 to 1/3 of their income. How does this reduction affect GDP in the above diagram? Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 248

4.6. Questions for Review Interest Rate Demand S(Y1)= (2/3) * 15 i1 C(Y) + I(i) C(Y)= (1/3)* Y I(i, E(r1)) I1 Investment Y1 Income Caused by a better economic outlook, households increase their consumption ratio from 1/3 to 1/2 of their income. How does this increase affect GDP in the above diagram? Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 249

4.6. Questions for Review Interest Rate Demand S(Y1) C(Y) + I(i) C(Y)= (2/3)* Y i1 I(i, E(r1)) I1 Investment Y1 Income Firms expect a decrease in investment returns and do therefore reduce their demand for investment goods by 5 units. How does this reduction affect GDP in the above diagram? Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 250

4.6. Questions for Review Interest Rate S(Y1) C(Y) + I(i) i1 C(Y)= (1/3)* Y I(i, E(r1)) Y1 I1 Investment Income Caused by a better economic outlook, firms expect a higher return on investment and increase their demand for investment goods by 10 units. How does this behaviour affect GDP in the above diagram? Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 251

4.6. Questions for Review Interest Rate Demand S(Y1) i1 C(Y) + I(i) C(Y)= 0,5* Y I(i, E(r1)) Investment Y1 Income I1 Y# The above economy is in a recession with Keynesian unemployment. To reestablish full employment, GDP must reach a level of Y# = 30 . Present government consumption is G = 0. What increase in government consumption is necessary to reestablish full employment, if government consumption is completely financed with credits? Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 252

4.6. Questions for Review Interest Rate Demand S(Y1) S(Y1) + M/P C(Y) + I(i) i1 C(Y)= 0,5* Y I(i)+ RD(Y) I(i) Investment I1 Y1 Y# Income The above economy is in a recession with Keynesian unemployment. To reestablish full employment, GDP must reach a level of Y# = 20 . What increase in money supply MS/P is necessary to reestablish full employment? (Assume that the effect of an increase in savings is always absorbed by a corresponding increase in money demand). Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 253

4.6. Questions for Review Explain how a recession can be overcome with the help of fiscal and monetary policy under the assumptions of the Keynesian model. Explain the practical problems of fiscal and monetary policy in realtiy. Explain the mechanism that help to overcome a recession under the assumptions of the Keynesian model of the long run. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 254

Interest Rate Demand S(Y1) S(Y1) + M1/P C(Y) + I(i1) i1 I(i, E(r1))+ RD(Y1) C(Y)= 0,5* Y I(i, E(r1)) I1 I1 Investment Y1 Income How does an increase in money supply from M1/P by 5 units to M2/P = M1/P+5 affect the economy? Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 255

4.6. Questions for Review Interest Rate Demand S(Y1) i1 C(Y) + I(i) C(Y)= 0,5* Y I(i, E(r1)) Investment Y1 Income I1 How does an increase in government consumption from G1=0 to G2=10 affect the economy, if this increase is financed by credits. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 256

4.6. Questions for Review Real Interest Demand S(Y1) S(Y1) + M1/P1 C(Y) + I(i1) i1 I(i, E(r1))+ RD(Y1) C(Y)= 0,5* Y I(i, E(r1)) Investment I1 Y# Income Y1 This economy is in a boom, where the current GDP Y1 lies above full employment GDP Y#. Analyze what happens in the long-run, if firms begin to adjust their prices. Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 257

4.6. Questions for Review Interest Rate Demand S(Y1) C(Y) + I(i) i1 C(Y)= (1/3)* Y I(i, E(r1)) I1 Investment Y# Income 28. The above economy is in a recession with Keynesian unemployment. To reestablish full employment, GDP must reach a level of Y# = 20 . Present government consumption is G = 0. What increase in government consumption is necessary to reestablish full employment, if government consumption is completely financed with taxes levied upon household income? Prof. Dr. Rainer Maurer Prof. Dr. Rainer Maurer 258 258

Macroeconomics 4. The Keynesian Model and its Policy Implications

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Macroeconomics 4. The Keynesian Model and its Policy Implications

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