© RAINER MAURER, Pforzheim - 1 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications.

© RAINER MAURER, Pforzheim - 2 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market 4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Invest 4.2.3. Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy 4.3.2. Monetary Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions 4.5.1. Practical Problems of Anti-cyclical Policy 4.5.2. Case Study: Fiscal Policy in Germany 4.5.3. Limits of Government Debt 4.5.4. Case Study: Economic Policy in the Great Recession 4.6. Questions for Review

© RAINER MAURER, Pforzheim - 3 - Prof. Dr. Rainer Maurer 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.

© RAINER MAURER, Pforzheim - 5 - Prof. Dr. Rainer Maurer 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.

© RAINER MAURER, Pforzheim - 6 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory ➤ The World Economic Crisis ■ Cause of the crisis was the collapse of the New York Stock Exchange at October 24 in 1929. ■ Cause of the stock market collapse was an overvaluation of stocks (speculative bubble), which was driven by upcoming new technologies – similar to the „New-Economy-Crash“ (or "dotcom crash") at the start of 2000. ■ Surprising and new was, however, not the stock market collapse but its long and lasting effect on the real economy.

© RAINER MAURER, Pforzheim - 9 - Prof. Dr. Rainer Maurer 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!

© RAINER MAURER, Pforzheim - 11 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory ➤ Such a strong and sustained collapse of the economic development was contradictory to basic results of the neoclassical theory: ■ As analyzed in Chapter 2, a reduction of consumption should increase savings supply and reduce the interest rate, such that investment demand grows and compensates for the decrease of consumption. ■ However, during the world economic crisis, not only consumption demand but also investment demand decreased, because of the worsening of economic prospects of firms. ■ As a result, the saved money was not invested but „hoarded“. ■ In such a case, the neoclassical model predicts a demand gap on the market for goods, which causes a decrease of the price level for goods P↓. ■ This reduction of goods prices should increase the value of real money supply (M/P↓)↑, so that the capital market interest rate decreases i↓. This decrease of the interest rate should then cause an increase of consumption C(i↓)↑ and investment goods demand I(i↓)↑. ➤ This built-in stabilization mechanism (called “Pigou Effect”) should restore the economic equilibrium after a demand shock has hit the economy.

© RAINER MAURER, Pforzheim - 12 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory ➤ Hence according to the neoclassical theory, the “self-healing capacities” of a market economy should autonomously overcome a collapse of the demand for goods. ➤ However, these forces did not work : ■ From 1929 to 1932 production of goods and services decreased by more that 10% per year. ■ Even though the price level for goods decreased, consumption and investment demand did not grow, because people expected a further decrease in prices and postponed consumption and investment into the future. ■ Production of firms simply adjusted to this lower demand. ■ The result was a self-reinforcing “deflation spiral”: A further decrease of the demand for goods! ■ The “self-healing capacities” of the neoclassical theory failed.

© RAINER MAURER, Pforzheim - 13 - Prof. Dr. Rainer Maurer 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 1. …in the short run, goods prices are fix, so that they cannot decrease in case of a reduction of goods demand. As a consequence, he assumed that instead of goods prices the supply of goods adjusts to changes in demand = “Keynesian Price Rigidity”. 2. …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”.

© RAINER MAURER, Pforzheim - 14 - Prof. Dr. Rainer Maurer 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:

© RAINER MAURER, Pforzheim - 17 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory ➤ The second basic difference between Keynesian and neoclassical 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?

© RAINER MAURER, Pforzheim - 18 - Prof. Dr. Rainer Maurer Quelle: The Pricing Behavior of Firms in the Euro Area, EZB (2005) Survey Period 2003-2004; Sample Size 11000 Firms; BE = Belgium, DE= Germany; FR=France, IT=Italy LU= Luxembourg, NL=Netherlands, AT=Austria, PT=Portugal ➤ An large-scale empirical study of the European Central Bank has led to the following result: 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory Percentage Distribution of Firms According Their Frequency of Price Adjustments per Year

© RAINER MAURER, Pforzheim - 19 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory ➤ Surveys for other countries display similar results: Athor Sample Period Industry Sector Average Change per Year: Carlton (1986) 1957-66US Manufacturing Firms1,2 Cecchetti (1986) 1959-73US Newspapers0,2 Blinder (1991) 199172 US Firms1 Kayshap (1995) 1953-87US Mail-Order Companies0,8 Dahlby (1992) 1974-82Canadian Insurances0,8 Bank of England (1996) 1995 654 UK Firms2

© RAINER MAURER, Pforzheim - 20 - Prof. Dr. Rainer Maurer 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?

© RAINER MAURER, Pforzheim - 21 - Prof. Dr. Rainer Maurer 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:

© RAINER MAURER, Pforzheim - 22 - Costs per Price Change Number of Price Changes per Year 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 The costs per price change will typically be constant or slightly increasing, if the number of price changes per year grows. € 3 €

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

© RAINER MAURER, Pforzheim - 24 - Number of Price Changes per Year 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 The return per price change will typically decrease, if the number of price changes per year grows. Return per Price Change The return of 4 price changes per year will normally be lower, since it is not so likely that significant changes of production costs and demand strength will occur every quarter… € 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.

© RAINER MAURER, Pforzheim - 25 - Costs per Price Change Number of Price Changes per Year 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory Return per Price Change 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 More often price changes profitable € Return of an additional price change higher than costs

© RAINER MAURER, Pforzheim - 26 - Costs per Price Change Number of Price Changes per Year 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory Return per Price Change 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 € Return of an additional price change lower than costs Less often price change profitable

© RAINER MAURER, Pforzheim - 27 - Costs per Price Change Number of Price Changes per Year 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory Return per Price Change 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 => Profit maximizing number of price changes per year = 2 €

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

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

© RAINER MAURER, Pforzheim - 30 - Number of Price Changes per Year 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory Return per Price Change 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 Exercise: Assume that the return per price change is given by this curve. Determine the level of the costs per price change, such that it is profit maximizing to adjust prices only one time per year. €

© RAINER MAURER, Pforzheim 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 € Number of Price Changes per Year Costs per Price Change 3 € Total Costs of Price Changes 6 € 9 € Alternative explanation based on total cost and total return functions: 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory

© RAINER MAURER, Pforzheim 0,5 1,0 1,5 2,0 2,5 3,0 3,5 4,0 4,5 5,0 5,5 6,0 € Anzahl der Preisanpassungen pro Jahr 3 € 6 € Total Costs of Price Changes Total Return of Price Changes Total Profit Maximum Total Costs 9 € 12 € 15 € Alternative explanation based on total cost and total return functions: 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory

© RAINER MAURER, Pforzheim - 33 - Prof. Dr. Rainer Maurer 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. ■ 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!

© RAINER MAURER, Pforzheim - 34 - Prof. Dr. Rainer Maurer 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!

© RAINER MAURER, Pforzheim - 35 - Prof. Dr. Rainer Maurer 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…).

© RAINER MAURER, Pforzheim ➤ Since prices are constant and supply always adjust to demand the following equation always holds in the Keynesian model: ➤ For simplicity we will first assume that I and G are constant. ➤ What exactly means C(Y)? ➤ Example: Let the consumption rate be: c = 50% and Y = 100 : - 37 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross"

© RAINER MAURER, Pforzheim - 38 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" ➤ Solving the equation for Y reveals that under these assumptions GDP depends on investment and government consumption only:

© RAINER MAURER, Pforzheim - 39 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" ➤ This means “Everything that increases demand increases GDP”: An increase in investment by1, increases GDP by 1/(1-c) c = 50% An increase in investment by1, increases GDP by 1/(1-0,5)= 2

© RAINER MAURER, Pforzheim - 40 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" ➤ This means “Everything that increases demand increases GDP”: An increase in government consumption by1, increases GDP by 1/(1-c) c = 50% An increase in government consumption by1, increases GDP by 1/(1-0,5)= 2 G

© RAINER MAURER, Pforzheim - 41 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" ➤ This means “Everything that increases demand increases GDP”: ➤ Restriction: This government consumption multiplier is only valid, if government consumption is financed with credits. ➤ As can be mathematically proven, financing government consumption with taxes yields a multiplier of exactly 1 under Keynesian assumptions.

© RAINER MAURER, Pforzheim - 42 - Prof. Dr. Rainer Maurer Quelle: Kapitalismus für Anfänger – Sachcomic, rororo 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" The investment multiplier at work

© RAINER MAURER, Pforzheim - 43 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" Supply of Goods= Income = Y Demand for Goods Graphical exposition of these considerations: C(Y)= 0,5 * Y

© RAINER MAURER, Pforzheim - 44 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" Consumption (C) dependent on GDP (Y) C(Y)= 0,5 * Y Supply of Goods= Income = Y Demand for Goods

© RAINER MAURER, Pforzheim - 45 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G Supply of Goods= Income = Y Demand for Goods Government Consumption = G = 5

© RAINER MAURER, Pforzheim - 46 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G Investment = I = 5 Y D = 0,5*Y+G+I Supply of Goods= Income = Y Demand for Goods

© RAINER MAURER, Pforzheim - 47 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" C(Y) = 0,5 * Y C(Y) + G = 0,5*Y+G Y D = 0,5*Y+G+I 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? At what level of income (Y) does the total demand for goods equal income? Supply of Goods= Income = Y Demand for Goods

© RAINER MAURER, Pforzheim - 48 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" Every point on this 45°-line implies: Demand for Goods = Supply of Goods Supply of Goods= Income = Y Demand for Goods

© RAINER MAURER, Pforzheim - 49 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G Y D = 0,5*Y+G+I The 45°-line reveals the solution: Supply of Goods= Income = Y Demand for Goods

© RAINER MAURER, Pforzheim - 50 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G Y D = 0,5*Y+G+I Consumption = 0,5 * (20) = 10 Gov. Consumption = 5 Investment = 5 Supply of Goods= Income = Y Demand for Goods

© RAINER MAURER, Pforzheim - 51 - Prof. Dr. Rainer Maurer 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: F49-F66

© RAINER MAURER, Pforzheim - 52 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Supply of Goods= Income = Y Demand for Goods What happens, if supply of goods is larger than the equilibrium value Y=20 ? Supply of Goods= 30 Y D = 0,5*Y+G+I

© RAINER MAURER, Pforzheim - 53 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Y D = 0,5*Y+G+I Supply of Goods= Income = Y Demand for Goods Supply of Goods = 30 Demand for Goods = 25 Excess Supply = 5 Since supply (GDP) adjusts to demand, supply falls to the lower demand level Y=25

© RAINER MAURER, Pforzheim - 54 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Y D = 0,5*Y+G+I Supply of Goods= Income = Y Demand for Goods Supply of Goods Demand for Goods = 25 Excess Supply = 5 Since supply (GDP) adjusts to demand, supply falls to the lower demand level Y=25

© RAINER MAURER, Pforzheim - 55 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Y D = 0,5*Y+G+I Supply of Goods= Income = Y Demand for Goods Demand for Goods = 25 Excess Supply = 5 New Supply of Goods = 25 Since supply (GDP) adjusts to demand, supply falls to the lower demand level Y=25

© RAINER MAURER, Pforzheim - 56 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Y D = 0,5*Y+G+I Supply of Goods= Income = Y Demand for Goods Demand for Goods = 22,5 Excess Supply = 2,5 Supply of Goods = 25 Since supply (GDP) adjusts to demand, supply falls to the lower demand level Y=25

© RAINER MAURER, Pforzheim - 57 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Y D = 0,5*Y+G+I Supply of Goods= Income = Y Demand for Goods Since supply (GDP) adjusts to demand, supply falls to the lower demand level Y=22,5 Excess Supply = 2,5 New Supply of Goods = 22,5 Demand for Goods = 22,5

© RAINER MAURER, Pforzheim - 58 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Y D = 0,5*Y+G+I Supply of Goods= Income = Y Demand for Goods Demand for Goods = 21,25 …and so on until Y= 20 is reached! Excess Supply = 2,5 Supply of Goods 22,5

© RAINER MAURER, Pforzheim - 59 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Supply of Goods= Income = Y Demand for Goods We observe this kind of adjustment process if supply is larger than demand Y D = 0,5*Y+G+I Supply of Goods = 30

© RAINER MAURER, Pforzheim - 60 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Supply of Goods= Income = Y Demand for Goods We observe this kind of adjustment process if supply is larger than the equilibrium value of Y=20 Y D = 0,5*Y+G+I Supply of Goods = 20 Demand for Goods = 20

© RAINER MAURER, Pforzheim - 61 - Prof. Dr. Rainer Maurer 3. Das keynesianische Modell der Volkswirtschaft 3.1. Die Struktur des keynesianischen Modells 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:

© RAINER MAURER, Pforzheim - 62 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Supply of Goods= Income = Y Demand for Goods What happens, if supply of goods is smaller than the equilibrium value Y=20 ? Supply of Goods = 10 Y D = 0,5*Y+G+I

© RAINER MAURER, Pforzheim - 63 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Y D = 0,5*Y+G+I Supply of Goods= Income = Y Demand for Goods Demand for Goods = 15 Excess Demand = 5 Since supply (GDP) adjusts to demand, supply grows to the higher demand level Y=15 Supply of Goods = 10

© RAINER MAURER, Pforzheim - 64 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Supply of Goods= Income = Y Demand for Goods In this case, we observe the opposite adjustment process Y D = 0,5*Y+G+I Demand for Goods = 20 Supply of Goods = 20

© RAINER MAURER, Pforzheim - 65 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Supply of Goods= Income = Y Demand for Goods In this case, we observe the opposite adjustment process Y D = 0,5*Y+G+I

© RAINER MAURER, Pforzheim - 66 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Supply of Goods= Income = Y Demand for Goods To sum up: No matter whether supply is larger or smaller than demand, an adjustment process results such that supply finally equals demand. Y D = 0,5*Y+G+I

© RAINER MAURER, Pforzheim - 67 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications Digression: Stability Properties of the Market for Goods Supply of Goods= Income = Y Demand for Goods This means: The equilibrium point Y=20 is stable! Y D = 0,5*Y+G+I

© RAINER MAURER, Pforzheim - 68 - Prof. Dr. Rainer Maurer 3. Das keynesianische Modell der Volkswirtschaft 3.1. Die Struktur des keynesianischen Modells Digression: Result: The equilibrium on the market for goods is stable! In case of excess supply or demand the Keynesian market mechanism is able to trigger an adjustment process that leads to the market equilibrium.

© RAINER MAURER, Pforzheim - 69 - Prof. Dr. Rainer Maurer 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?

© RAINER MAURER, Pforzheim - 70 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G Y D = 0,5*Y+G+I How strong is GDP-growth, if investment grows by 5 ? Supply of Goods= Income = Y Demand for Goods

© RAINER MAURER, Pforzheim - 71 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G Y D = 0,5*Y+G+I Y D = 0,5*Y+G+I+ΔI Increase in Invest- ment by 5 Supply of Goods= Income = Y How strong is GDP-growth, if investment grows by 5 ? Demand for Goods

© RAINER MAURER, Pforzheim - 72 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G Y D = 0,5*Y+G+I Y D = 0,5*Y+G+I+ΔI Supply of Goods= Income = Y Increase in GDP by 10 = 5 * (1/(1-0,5)) Increase in Invest- ment by 5 Demand for Goods

© RAINER MAURER, Pforzheim - 73 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G Y D = 0,5*Y+G+I Y D = 0,5*Y+G+I+ΔI Consumption = 0,5 * 30 = 15 Gov. Consumption = 5 Investment = 10 Supply of Goods= Income = Y Increase in investment by 5 Demand for Goods Consumption = 0,5*20 = 10

© RAINER MAURER, Pforzheim - 74 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G Y D = 0,5*Y+G+I Y D = 0,5*Y+G+I+ΔI 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. Supply of Goods= Income = Y Increase in Invest- ment by 5 Demand for Goods

© RAINER MAURER, Pforzheim - 75 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory ➤ The following diagram graphically illustrates the multiplier effect:

© RAINER MAURER, Pforzheim - 76 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" What causes the multiplier effect? Y D = 0,5*Y+G+I+ΔI Y D = 0,5*Y+G+I C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G 1st: Increase in Demand by 5 Increase in Invest- ment by 5 Supply of Goods= Income = Y Demand for Goods

© RAINER MAURER, Pforzheim - 77 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" Y D = 0,5*Y+G+I+ΔI Y D = 0,5*Y+G+I C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G 2nd: Increase in Income by 5 = ΔY Increase in Invest- ment by 5 Supply of Goods= Income = Y Demand for Goods What causes the multiplier effect?

© RAINER MAURER, Pforzheim - 78 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" Y D = 0,5*Y+G+I+ΔI Y D = 0,5*Y+G+I C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G 3rd: Increase in Consumption by c*ΔY = 0,5 * 5 = 2,5 Supply of Goods= Income = Y Demand for Goods What causes the multiplier effect? Increase in Invest- ment by 5

© RAINER MAURER, Pforzheim - 79 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" C (Y-T) + G C(Y)= 0,5*Y+G Y D = 0,5*Y+G+I+ΔI Y D = 0,5*Y+G+I C(Y)= 0,5 * Y 4th: Increase in Income by ΔY = 2,5 Supply of Goods= Income = Y Demand for Goods What causes the multiplier effect? Increase in Invest- ment by 5

© RAINER MAURER, Pforzheim - 80 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" Y D = 0,5*Y+G+I+ΔI Y D = 0,5*Y+G+I C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G 5th: Increase in Consumption by c*ΔY = 0,5 * 2,5 = 1,25 Supply of Goods= Income = Y Demand for Goods What causes the multiplier effect? Increase in Invest- ment by 5

© RAINER MAURER, Pforzheim - 81 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" Y D = 0,5*Y+G+I+ΔI Y D = 0,5*Y+G+I C(Y)= 0,5 * Y C(Y) + G = 0,5*Y+G etc... Supply of Goods= Income = Y Demand for Goods Increase in Invest- ment by 5 => The primary increase in investment demand by 5 is multi- plied by the additional increase in consumption demand by factor 2 = 1/ (1-0,5).

© RAINER MAURER, Pforzheim - 82 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. 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...

© RAINER MAURER, Pforzheim - 83 - Prof. Dr. Rainer Maurer 3. Das keynesianische Modell der Volkswirtschaft 3.1. Die Struktur des keynesianischen Modells Digression: Will GDP explode? The graphical exposition seems to indicate that the growth of GDP will go on forever, since households increase their consumption additionally after every increase of GDP. However, it is possible to proof mathematically that this intuition is wrong. This follows from the calculation based on levels we have already made: It is possible to show the same based on first differences:

© RAINER MAURER, Pforzheim - 85 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.1. The "Keynesian Cross" ➤ This example shows: ■ If it is possible to increase investment, GDP will grow as a result by a magnitude that is 1/(1-c) as high as the increase in investment. ■ The same holds, if government consumption grows: If government consumption (financed by credits) grows, GDP will grow as a result by a magnitude that is 1/(1-c) as high as the increase in government consumption. ■ Consequently, if the consumption ratio equals c = 0,89 (as for Germany), the multiplier equals 1/(1-0,89) = 9,09. ■ Given the assumptions made, the government can arbitrarily increase GDP! ■ Since the production of GDP needs labor input, the government is able to arbitrarily increase the demand for labor! ■ However, this holds only as long as firms keep their prices constant and adjust their supply to demand, i.e. within a period of one year!

© RAINER MAURER, Pforzheim - 86 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market

© RAINER MAURER, Pforzheim - 87 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.2. 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: 1. the capital market interest rate (i), which represents the costs of investment, and 2. 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.

© RAINER MAURER, Pforzheim - 88 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory Digression: The Difference between the Keynesian and the Neoclassic Investment Function 1. The Keynesian Investment Function: I(i, E(r)) Investment depends negatively on the interest rate, because an increase in the capital market interest rate increases the costs of investment. Investment depends positively on expected investment return, because an increase in expected investment return (at a given interest rate) makes more investment projects profitable. Contrary to the neoclassical model, the investment return is uncertain, since it depends on the demand for goods, which is uncertain under Keynesian assumption. Hence, it is the uncertainty of demand for goods that causes the uncertainty of investment return E(r). 2. The Neoclassical Investment Function: I(i, L) For the same reasons as in Keynesian theory, investment depends negatively on the interest rate. Investment depends furthermore positively on labor input L, since productivity of capital goods is higher, when more worker are available to work with these machines. Since under neoclassical assumptions demand for goods does always equal supply of goods (Say’s Theorem), there is no uncertainty on investment return. Therefore investment return is constant, so that it does not appear in the neoclassical investment function.

© RAINER MAURER, Pforzheim - 89 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.2. The Keynesian Model with Capital Market Investment Interest Rate Investment demand I(i) negatively depends on the interest rate i. I(i, E(r 1 ))

© RAINER MAURER, Pforzheim - 90 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.2. The Keynesian Model with Capital Market Investment Interest Rate Investment demand of firms I(i) positively depends on expected return E(r): If the expected return increases, investment demand increases too. I(i, E(r 2 )) E(r 1 ) < E(r 2 ) I(i, E(r 1 ))

© RAINER MAURER, Pforzheim - 91 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.2. The Keynesian Model with Capital Market Investment Interest Rate Investment demand of firms I(i) positively depends on expected return E(r): If the expected return decreases, investment demand decreases too. I(i, E(r 2 )) E(r 1 ) > E(r 2 ) I(i, E(r 1 ))

© RAINER MAURER, Pforzheim - 92 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.2. The Keynesian Model with Capital Market Demand Investment Interest Rate C(Y)= 0,5* 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 Income = Y I(i, E(r 1 )) Consequently, savings like consumption do not depend on the interest rate! C(Y)+ I(i, E(r 1 )) S= 15 = 0,5*30 S(Y) = 0,5*Y Y = 30

© RAINER MAURER, Pforzheim - 93 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1.2. The Keynesian Model with Capital Market Demand Investment Interest Rate i1i1 C(Y)= 0,5* Y As the capital market diagram now shows, at the resulting interest rate i 1 the demand for investment goods equals I 1 = 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”. Income = Y I(i, E(r 1 )) C(Y)+ I(i, E(r 1 )) S(Y) = 0,5*Y I 1 = 15 I = 15

© RAINER MAURER, Pforzheim - 94 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 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)] 0 = I(i, E(r)) – S(Y) S(Y) = I(i, E(r))

© RAINER MAURER, Pforzheim - 95 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market 4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume

© RAINER MAURER, Pforzheim - 96 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.2.1. 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.

© RAINER MAURER, Pforzheim - 97 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.2.1. Reduction of the Propensity to Consume Source: Bondt, G. J. de (2009), Euro area money demand: empirical evidence on the role of equity and labour markets”, ECB Working Paper.

© RAINER MAURER, Pforzheim - 98 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.2.1. Reduction of the Propensity to Consume Demand Investment Interest Rate i1i1 C(Y)= 0,5* Y C(Y) + 15 I 1 =15 Income = Y I(i, E(r 1 )) Y1Y1 S 1 = 15 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%? S(Y) = 0,5*Y

© RAINER MAURER, Pforzheim - 99 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.2.1. Reduction of the Propensity to Consume Demand Investment Interest Rate i1i1 C(Y)= 0,5* Y C(Y) + 15 I 1 =15 Income = Y I(i, E(r 1 )) Y1Y1 S 1 = 15 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%? S(Y) = 0,5*Y The consumption ratio decreases from c = 50% to c = 25%

© RAINER MAURER, Pforzheim - 100 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.2.1. Reduction of the Propensity to Consume Demand Investment Interest Rate i1i1 C(Y)= 0,5* Y 0,5*Y + 15 I 1 =15 Income = Y I(i, E(r 1 )) Y1Y1 S 1 = 15 S(Y) = 0,5*Y C(Y)= 0,25* Y 0,25*Y + 15 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%

© RAINER MAURER, Pforzheim - 101 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.2.1. Reduction of the Propensity to Consume Demand Investment Interest Rate i1i1 I 1 =15 Income = Y I(i, E(r 1 )) Y2Y2 S 2 = 15 S(Y) = 0,75*Y The consumption ratio decreases from c = 50% to c = 25% C(Y)= 0,25* Y 0,25*Y + 15 => GDP decreases from Y 1 =15 * (1/(1-0,5) = 30 to Y 2 = 15 * (1/(1-0,25) = 20

© RAINER MAURER, Pforzheim - 102 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.2.1. Reduction of the Propensity to Consume Demand Investment Interest Rate i1i1 I 1 =15 Income = Y I(i, E(r 1 )) Y2Y2 S 2 = 15 S(Y) = 0,75*Y 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(Y 1 ) = (1-0,5) * 30 = 0,5 * 30 = 15 = S(Y 2 )= (1 - 0,25) * 20 = 0,75 * 20 C(Y)= 0,25* Y 0,25*Y + 15 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.

© RAINER MAURER, Pforzheim - 103 - Prof. Dr. Rainer Maurer ➤ To sum up: ■ A deterioration of household expectations on the economic development increases the savings ratio and decreases the consumption ratio respectively. ■ This reduction of consumption demand (C(Y)↓) causes a reduction of the supply of goods and hence a reduction of GDP (Y↓), which equals household income (Y↓). ■ This initiates a negative multiplier process: ◆ Household consumption shrinks further, because of lower household income: C(Y↓)↓. ◆ Consequently, consumption demand contracts even further, so that total supply of goods contracts again and consequently household income decreases, so that consumption demand contracts once again and so on… 4. The Keynesian Model and its Policy Implications 4.2.1. Reduction of the Propensity to Consume

© RAINER MAURER, Pforzheim - 104 - Prof. Dr. Rainer Maurer ■ This negative multiplier process keeps on, until the decreased consumption demand plus the (unchanged!) investment goods demand equals again income and GDP respectively: C(Y) + I(i, E(r)) = Y ■ As displayed by the above graphs, the reduction of the consumption ratio to 25% causes via the negative multiplier process a reduction of GDP to 15 * (1/(1-0,25) = 15 * 1,33 = 20. ■ Question: What would be the effect on GDP of a rise of the consumption ratio to 75% ? 4. The Keynesian Model and its Policy Implications 4.2.1. Reduction of the Propensity to Consume

© RAINER MAURER, Pforzheim - 105 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market 4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Invest

© RAINER MAURER, Pforzheim - 106 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.2.2. 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.

© RAINER MAURER, Pforzheim - 107 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.2.2. Reduction of the Propensity to Invest Demand Investment Interest Rate i1i1 C(Y) + 15 I 1 =15 Income = Y I(i, E(r 1 )) Y1Y1 S 1 = 15 What happens, if firms expect a lower investment return r 2 < r 1, because of a deterioration of the economic development and lower their investment from 15 to 5 ? S(Y) = 0,5*Y

© RAINER MAURER, Pforzheim - 108 - Prof. Dr. Rainer Maurer Demand Investment Interest Rate i1i1 C(Y) + 15 Income = Y I(i, E(r 1 )) S 1 = 15 C(Y) + 5 Y1Y1 S(Y) = 0,5*Y I(i, E(r 2 )) 4. The Keynesian Model and its Policy Implications 4.2.2. Reduction of the Propensity to Invest 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.) The demand for investment goods and the demand for credits to finance these investment goods decrease. 1) I 2 =5

© RAINER MAURER, Pforzheim - 109 - Prof. Dr. Rainer Maurer Demand Investment Interest Rate i1i1 C(Y) + 15 Income = Y I(i, E(r 1 )) S 2 = 5 C(Y) + 5 Y2Y2 S(Y) = 0,5*Y I(i, E(r 2 )) 4. The Keynesian Model and its Policy Implications 4.2.2. Reduction of the Propensity to Invest 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. I 2 =5

© RAINER MAURER, Pforzheim - 110 - Prof. Dr. Rainer Maurer Demand Investment Interest Rate i1i1 Income = Y C(Y) + 5 Y2Y2 I(i, E(r 2 )) S 2 = 5 S(Y) = 0,5*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. 4. The Keynesian Model and its Policy Implications 4.2.2. Reduction of the Propensity to Invest I 2 =5

© RAINER MAURER, Pforzheim - 111 - Prof. Dr. Rainer Maurer ➤ To sum up: ■ A deterioration of the expectations of firms on the economic development causes a reduction of the investment demand of firms. ■ This reduction of investment demand (I(i, E(r)↓)↓) causes a reduction of the supply of goods and hence a reduction of GDP (Y↓), which equals household income (Y↓). ■ This initiates a negative multiplier process: ◆ Household consumption shrinks further, because of lower household income: C(Y↓)↓. ◆ Consequently, consumption demand contracts even further, so that total supply of goods contracts again too and consequently household income decreases, so that consumption demand contracts once again and so on… 4. The Keynesian Model and its Policy Implications 4.2.2. Reduction of the Propensity to Invest

© RAINER MAURER, Pforzheim - 112 - Prof. Dr. Rainer Maurer ■ This negative multiplier process keeps on, until the decreased consumption demand plus the investment goods demand equals again income and GDP respectively: C(Y) + I(i, E(r)) = Y ■ As displayed by the above graphs, the reduction of investment demand by 10 causes via the negative multiplier process a reduction of GDP to 10 * (1/(1-0,5) = 20. ■ Question: What would be the effect on GDP of a rise of the investment demand by 10? 4. The Keynesian Model and its Policy Implications 4.2.1. Reduction of the Propensity to Consume

© RAINER MAURER, Pforzheim - 113 - Prof. Dr. Rainer Maurer ➤ To sum up: ■ Equipment investment (=gross investment./. change of inventories./. real estate investment = “investment in machines”) fluctuates significantly pro-cyclically: ◆ During an upswing, equipment investment grows faster than GDP. ◆ During an downswing, equipment investment grows slower than GDP. ■ To the contrary, private consumption displays a significantly weaker correlation with the business cycle. ◆ During a downswing, only a slight weakening of consumption growth becomes apparent. ◆ The consumption ratio, however, is not unambiguously positively correlated with the business cycle. ■ These stylized facts are not singular for Germany: Since the beginning of the 50ties, they show up for all industrialized countries. 4. The Keynesian Model and its Policy Implications 4.2.2. Reduction of the Propensity to Invest

© RAINER MAURER, Pforzheim - 114 - Prof. Dr. Rainer Maurer ➤ Potential Explanations: ■ At first sight, this seems to indicate that primarily expectations of changing investment returns of firms cause business cycle fluctuations. ■ However, it might as well be that these expectations depend on household consumption demand: ◆ A reduction of consumption growth could cause a deterioration of business expectations so that firms reduce their investment. ◆ A rise of consumption growth could cause a amelioration of business expectations so that firms rise their investment. ■ Under such conditions, a relatively small change of household consumption demand could cause big changes of investment demand. ■ Such an effect is called „Accelerator Effect“ 4. The Keynesian Model and its Policy Implications 4.2.2. Reduction of the Propensity to Invest

© RAINER MAURER, Pforzheim - 115 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market 4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Invest 4.2.2. Reduction of the Propensity to Consume 4.2.3. Consequences for the Labor Market

© RAINER MAURER, Pforzheim - 116 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.2.3. 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”

© RAINER MAURER, Pforzheim - 117 - P1P1 w1w1 _ The Effect of the Demand for Goods on the Labor Market L Y L Y(L D1,K 1 ) L D1 (w 1 /P 1,K 1 ) Y(L,K 1 ) L S (w/p) Under the assumptions of the neoclassical model (s. chapter 2.1.) the supply of goods depends on the equilibrium labor input L D (w 1 /P 1,K 1 ) and the given capital stock K 1. The resulting level of GDP is called "Normal Capacity GDP” or (since there is no unemployment) "Full Employment GDP“. L D (w/p,K 1 ) "Normal Capacity GDP" or "Full Employment GDP" Labor Demand of the Neoclassical Model L D1 (w 1 /P 1,K 1 ) Equilibrium Labor Input

© RAINER MAURER, Pforzheim - 118 - P1P1 w1w1 _ The Effect of the Demand for Goods on the Labor Market L Y L Y(L D1,K 1 ) L D1 (w 1 /P 1,K 1 ) Y(L,K 1 ) L S (w/p) 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 K 1, i.e. by L D (w/P,K 1 ), but by the demand for goods Y D. The "short-run" demand for labor therefore equals L D (Y D ) L D (w/p,K 1 ) "Normal Capacity GDP" or "Full Employment GDP" Labor Demand of the Neoclassical Model L D1 (w 1 /P 1,K 1 ) Equilibrium Labor Input

© RAINER MAURER, Pforzheim - 119 - P1P1 w1w1 _ The Effect of the Demand for Goods on the Labor Market L Y L L D1 (w 1 /P 1,K 1 ) Y(L,K 1 ) L S (w/p) If the demand for goods equals the full employment GDP, i.e. Y D = Y(L D1,K 1 ), Keynesian labor demand will equal the equilibrium labor input of the neoclassical model: L D (Y D ) = L D (w 1 /P 1,K 1 ). L D (w/p,K 1 ) "Normal Capacity GDP" or "Full Employment GDP" Keynesian Labor Demand L D (Y D,1 ) Y D,1

© RAINER MAURER, Pforzheim - 120 - P1P1 w1w1 _ The Effect of the Demand for Goods on the Labor Market L Y L L1L1 L1L1 Y(L,K 1 ) L D (Y D,2 ) If the demand for goods falls (for one of the reasons discussed in section 3.2.) below the full employment GDP, i.e. Y D < Y(L D1,K 1 ), Keynesian labor demand will be lower than the equilibrium labor input of the neoclassical model: L D (Y D ) < L D (w 1 /P 1,K 1 ). If the real wage is downward fixed by a collective bargaining contract to the long-run market equilibrium level of w 1 /P 1, the resulting unemployment is called “Keynesian unemployment” Y D,2 Decrease of Keynesian Labor Demand in a Recession L S (w/p) Decrease of GDP below its Full Employment Level in a Recession L D (Y D,1 ) Y D,1 Keynesian Unemployment LMEECB

© RAINER MAURER, Pforzheim - 121 - P1P1 w1w1 _ The Effect of the Demand for Goods on the Labor Market L Y L L1L1 L1L1 Y(L,K 1 ) L D (Y D,2 ) We know from section 3.2. that also the opposite can happen: The demand for goods can grow above full employment GDP, i.e. Y D > Y(L D1,K 1 ). Then Keynesian labor demand will be higher than the equilibrium labor input of the neoclassical model: L D (Y D ) > L D (w 1 /P 1,K 1 ). Since collective bargaining contracts typically allow an increase of wages, wages will grow (also due to overtime premiums). The result is called “Keynesian overemployment” Y D,2 Increase in Short-run Labor Demand in a Boom L S (w/p) Keynesian Overemployment Increase in GDP above its Full Employment Level in a Boom P1P1 w2w2 _ L D (Y D,1 ) Y D,1

© RAINER MAURER, Pforzheim - 122 - Prof. Dr. Rainer Maurer Source: EU-Ameco Database Classification of Business Cycles: Actual GDP Growth > Growth Trend =Upswing Actual GDP Growth < Growth Trend =Downswing

© RAINER MAURER, Pforzheim - 123 - Prof. Dr. Rainer Maurer Classification of Business Cycles: Actual GDP Growth > Growth Trend =Upswing Actual GDP Growth < Growth Trend =Downswing Source: EU-Ameco Database

© RAINER MAURER, Pforzheim - 125 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.2.3. Consequences for the Labor Market ➤ To sum up: ■ Keynesian theory and empirical evidence shows recessions typically come along with an increase in unemployment. ■ This leads to the question, whether the government should intervene in a recession to prevent the emergence of Keynesian unemployment. ■ As the neoclassical model (AU 2.2) has revealed, fiscal as well as monetary policy is without effect under the assumptions of the neoclassical model. ■ In the following, we will analyze whether this result also holds under the assumptions of the Keynesian model.

© RAINER MAURER, Pforzheim - 126 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market 4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Invest 4.2.2. Reduction of the Propensity to Consume 4.2.3. Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy

© RAINER MAURER, Pforzheim - 127 - Prof. Dr. Rainer Maurer ➤ 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 (D G ) the following budget constraint results: ■ G = T + D G ➤ To simplify the following analysis we will analyze only debt financed fiscal policy: ■ G = D G | 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). 4. The Keynesian Model and its Policy Implications 4.3.1. Fiscal Policy

© RAINER MAURER, Pforzheim - 128 - Prof. Dr. Rainer Maurer Y i i#i# C(Y) Y I° I,S Y° D I(i, E(r°)) C(Y) + I° S(Y) = 0,5*Y I° 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 D G =G=5 via the credit market? Y#DY#D Full Employ- ment GDP 4. The Keynesian Model and its Policy Implications 4.3.1. Fiscal Policy

© RAINER MAURER, Pforzheim - 129 - Prof. Dr. Rainer Maurer Y i i#i# C(Y) Y I° I,S I° Y° D I(i, E(r°)) C(Y) + I° S(Y) = 0,5*Y C(Y) + I° + G The rise of government consumption from G=0 to G=5 raises total demand for goods by 5. Y#DY#D 4. The Keynesian Model and its Policy Implications 4.3.1. Fiscal Policy

© RAINER MAURER, Pforzheim - 130 - Prof. Dr. Rainer Maurer Y i i#i# C(Y) Y I° I,S I° Y° D I(i, E(r°)) C(Y) + I° S(Y) = 0,5*Y C(Y) + I° + G I(i, E(r°)) + D G Y#DY#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=D G =5. 4. The Keynesian Model and its Policy Implications 4.3.1. Fiscal Policy

© RAINER MAURER, Pforzheim - 131 - Prof. Dr. Rainer Maurer Y i i#i# C(Y) Y I° I,S I° Y° D I(i, E(r°)) C(Y) + I° S(Y) = 0,5*Y C(Y) + I° + G I(i, E(r°)) + D G 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. Y#DY#D 4. The Keynesian Model and its Policy Implications 4.3.1. Fiscal Policy

© RAINER MAURER, Pforzheim - 132 - Prof. Dr. Rainer Maurer Y i i#i# C(Y) Y S(Y) = 0,5*Y I° I,S I(i, E(r°)) + D G I° Y° D I(i, E(r°)) C(Y) + I° C(Y) + I° + G The rise of GDP to its full employment level Y # D, increases the demand for labor to its full employment level L D (Y # D )=L D (w 1 /P 1,K 1 ), so that the Keynesian unemployment disappears. Y#DY#D 4. The Keynesian Model and its Policy Implications 4.3.1. Fiscal Policy

© RAINER MAURER, Pforzheim - 133 - P1P1 w1w1 _ 4.3.1. Fiscal Policy L Y L Y#DY#D L1L1 L1L1 Y(L,K 1 ) L D (Y° D ) 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 L D (Y° D ) to L D (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 L D (Y # D ) L S (w/p) Keynesian Unemployment L S (w/p)

© RAINER MAURER, Pforzheim - 134 - P1P1 w1w1 _ 4.3.1. Fiscal Policy L Y L Y#DY#D L1L1 L1L1 Y(L,K 1 ) L D (Y° D ) 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 L D (Y° D ) to L D (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 L D (Y # D ) L S (w/p) Disappearance of Keynesian Unemployment L S (w/p)

© RAINER MAURER, Pforzheim - 135 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.1. Fiscal Policy ➤ To sum up: ➤ What happens, if the government rises government consumption from G=0 to G=5 and finances these additional expenditures with new debt via the credit market G=5=D G ? ■ The increase in the demand for goods by government consumption G=5 causes a positive multiplier process (see section 3.1.1). ■ Therefore, GDP grows by G*(1/(1-c)) = 5*(1/(1-0,5)) = 10 from 20 to 30. ■ At a GDP (=income!) of 30, total savings of households equals Y*(1-c) = 30*(1-0,5) = 15. ■ The increase in GDP causes an increase in savings to a level large enough to finance the government demand for additional credits of D G =5, without causing the interest rate to rise! ■ Consequently, contrary to the neoclassical theory, no “Crowding- Out” of private consumption or investment takes place!

© RAINER MAURER, Pforzheim - 136 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.1. Fiscal Policy ■ The rise of government consumption “finances itself” via its expansionary effect on GDP! ■ To produce a higher GDP, firms need more labor input. ■ Consequently, the demand for labor grows. ■ Consequently, Keynesian unemployment – caused by a deterioration of future expectations of firms and/or households – is reduced by the additional government consumption. ■ Caution: ◆ In the above graphical example, an increase in government consumption by G = 5 is just enough to completely eliminate initial unemployment. ◆ This must not necessarily be the case! ◆ If government consumption grows to a higher (lower) level than G=5, the increase in labor demand will be higher (lower) than necessary to establish full employment.

© RAINER MAURER, Pforzheim - 137 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.1. 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.

© RAINER MAURER, Pforzheim - 138 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.1. 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 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! Tax financed fiscal policy?

© RAINER MAURER, Pforzheim - 139 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market 4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Invest 4.2.3. Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy 4.3.2. Monetary Policy

© RAINER MAURER, Pforzheim - 140 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. 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.

© RAINER MAURER, Pforzheim - 141 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ➤ The Determinants of Money Supply: ■ Just like in the neoclassical model, the central bank determines money supply: M S ■ 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 (M S ) divided by the price level P: Total Real Credit Supply = S(Y) + M S / P

© RAINER MAURER, Pforzheim - 142 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ➤ The Credit Market without Money Supply and Demand: i#i# I(i, E(r°)) S(Y) I°

© RAINER MAURER, Pforzheim - 143 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ➤ The Credit Market with Money Supply: i#i# I(i, E(r°)) S(Y) S(Y) + M S / P M S /P I° + R D ° I°

© RAINER MAURER, Pforzheim - 144 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. 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.

© RAINER MAURER, Pforzheim - 145 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ➤ Determinants of Money Demand: ■ Consequently, real money demand depends like in the neoclassical model positively on GDP (Y) : Real Money Demand = R D (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)) + R D (Y)

© RAINER MAURER, Pforzheim - 146 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ➤ The Credit Market without Money Supply and Demand: i#i# I(i, E(r°)) S(Y) I°

© RAINER MAURER, Pforzheim - 147 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ➤ The Credit Market with Money Supply: i#i# I(i, E(r°)) S(Y) S(Y) + M S / P M S /P I° + R D ° I°

© RAINER MAURER, Pforzheim - 148 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ➤ The Credit Market with Money Supply and Money Demand: i#i# I(i, E(r°)) S(Y) I(i, E(r°)) + R D (Y) S(Y) + M S / P M S /P R D (Y) I° + R D ° I°

© RAINER MAURER, Pforzheim - 149 - ➤ The Credit Market with Money Supply and Money Demand: - 149 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy i#i# I° I(i, E(r°)) S(Y) I(i, E(r°))+ R D (Y) S(Y) + M S / P M S /P If money supply (M S /P) equals money demand (R D (Y)), the interest rate equals the natural interest rate, i.e. the interest rate that would result without money. I° + R D ° R D (Y)

© RAINER MAURER, Pforzheim - 150 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ➤ The capital market with money supply and demand can now be inserted into the Keynesian model:

© RAINER MAURER, Pforzheim - 151 - Prof. Dr. Rainer Maurer Y i i° C(Y) Y I° I,S C(Y)+I° I°+R D ° I(i) I° 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. Y° D Y#DY#D Full Employ- ment GDP S(Y°) S(Y°)+M/P 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy Ex. 25, sl. 195 I(i)+R D (Y°)

© RAINER MAURER, Pforzheim - 152 - Prof. Dr. Rainer Maurer Y i C(Y) Y I° I,S C(Y)+I° S(Y°)+M/P+5 I°+R D ° i° I(i)+R D (Y°) I(i) I° What happens now, if the central bank rises money supply and hence total credit supply by ΔM /P= 5 ? Y° D Y#DY#D 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy

© RAINER MAURER, Pforzheim - 153 - Prof. Dr. Rainer Maurer Y i i#i# C(Y) Y I° I,S C(Y)+I° S(Y°)+M/P+5 I(i) I#I# I # +R D ° i° I° The raise of money supply causes a reduction of the interest rate from i° to i #. This rises investment from I° to I #. Y° D Y#DY#D 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy I(i)+R D (Y°)

© RAINER MAURER, Pforzheim - 154 - Prof. Dr. Rainer Maurer Y i i#i# C(Y) Y I,S I° C(Y)+I° S(Y°)+M/P+5 I(i) I#I# I # +R D ° i° C(Y)+I # I#I# I° 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. Y° D Y#DY#D 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy I(i)+R D (Y°)

© RAINER MAURER, Pforzheim - 155 - Prof. Dr. Rainer Maurer Y i i#i# C(Y) Y I,S I° C(Y)+I° S(Y°)+M/P+5 I(i) I#I# I # +R D ° i° C(Y)+I # I#I# The growth of GDP causes a higher demand for labor, so that labor demand grows and Keynesian unemployment disappears. Y° D Y#DY#D 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy I(i)+R D (Y°)

© RAINER MAURER, Pforzheim - 156 - Prof. Dr. Rainer Maurer Y i i#i# C(Y) Y I,S S(Y # )+M/P+5 I#I# I(i)+R D (Y°) I # +R D ° C(Y)+I # I#I# I(i) C(Y)+I° S(Y°)+M/P+5 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. Y° D Y#DY#D 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy

© RAINER MAURER, Pforzheim - 157 - Prof. Dr. Rainer Maurer Y i i#i# C(Y) Y I,S S(Y # )+M/P I#I# I(i)+R D (Y # ) I # +R D ° C(Y)+I # I#I# I(i) C(Y)+I° 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 R D (Y)-curve shifts to the right too. Y° D Y#DY#D 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy

© RAINER MAURER, Pforzheim - 158 - Prof. Dr. Rainer Maurer Y i i#i# C(Y) Y I,S S(Y # ) S(Y # )+M/P I(i) I#I# I(i)+R D (Y # ) I # +R D # C(Y)+I # I#I# To simplify the analysis, we make the assumption that money demand R D (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. Y° D Y#DY#D 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy

© RAINER MAURER, Pforzheim - 159 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ➤ To sum up: the Effects of Monetary Policy ■ An increase in money supply by the central bank of ΔM /P= 5 causes real credit supply to increase by the same amount. ■ This lowers the interest rate, so that investment demand grows by 5: I(i↓)↑ ■ This causes an increase in the demand for goods (= consumption demand + investment demand) by 5. ■ The multiplier process finally yields an increase in GDP by 5 * (1/(1-c)) = 5 * (1/(1-0,5)) = 5 * 2 = 10.

© RAINER MAURER, Pforzheim - 160 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ■ For the production of a higher GDP more labor input is needed, so that labor demand grows from L° to L #. ■ In the above graphical example the increase in money supply is chosen so that the resulting GDP Y # D is large enough to cause an increase in labor demand that completely eliminates unemployment. ■ This is not necessarily the case: ◆ If the increase in money supply by the central bank is not large enough, unemployment will not disappear completely. ◆ If the increase in money supply by the central bank is too large, employment may rise above its long run equilibrium level and an "overheating" of the economy might result.

© RAINER MAURER, Pforzheim - 161 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ■ Beside the increase in labor demand, GDP growth has two further effects: 1. Household savings grow by the increase in GDP times the savings ratio: ΔY * (1-c) = 10 * (1-0,5) = 5. 2. Money demand grows, since the transaction of a higher GDP needs more money: R D (Y # ) > R D (Y°). ■ In the above graphical example, the assumption was made that the increase in savings exactly meets the higher demand for money. ■ This too must not necessarily be the case.

© RAINER MAURER, Pforzheim - 162 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ■ It is as well possible that the increase in money demand is too small (strong), to absorb the higher savings of households. In this case, the interest rate would further decrease (increase). ■ Consequently, investment would further grow (shrink), until GDP-growth (GDP-decrease) would cause a money demand, which adds up with investment demand to total credit supply.

© RAINER MAURER, Pforzheim - 163 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ➤ Why is monetary policy able to cause an economic recovery under Keynesian assumptions, but not under the assumptions of the neoclassical model? ■ Under the assumptions of the neoclassical model, the supply of goods is fixed by the given capital stock and the equilibrium labor input. An increase in the demand for goods cannot cause an increase in the supply of goods: ■ If the central bank increases money supply, so that households demand more goods, this causes excess demand for goods, which causes the price level to increase.

© RAINER MAURER, Pforzheim - 164 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.3.2. Monetary Policy ➤ Why is monetary policy able to cause an economic recovery under Keynesian assumptions, but not under the assumptions of the neoclassical model? ■ In the Keynesian model, goods supply always adjusts to goods demand, ■ An increase in money supply, which causes an increase in demand for goods can therefore cause an increase of total production.

© RAINER MAURER, Pforzheim - 166 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market 4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Invest 4.2.3. Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy 4.3.2. Monetary Policy 4.4. The Long-run Implications of the Keynesian Model

© RAINER MAURER, Pforzheim - 167 - Prof. Dr. Rainer Maurer ➤ 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. 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model

© RAINER MAURER, Pforzheim - 168 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory Digression: Why does price adjustment in a recession or boom increase profits? Firms, which operate in markets with perfect competition, maximize their profits by adjusting their prices to their marginal costs. In a boom situation, they increase their production quantities. Consequently, their marginal costs grow. When they adjust their prices in the long-run, they will therefore raise their prices. In a recession, they reduce their production quantities. Consequently, their marginal costs fall. When they adjust their prices in the long-run, they will therefore lower their prices. In reality many firms operate in markets with monopolistic competition. Consequently, they can practice mark-up pricing, i.e. their prices are always somewhat higher than their marginal costs. In a boom situation, demand grows stronger such that these firms can in the long-run increase their profits by raising their mark-up. In a recession, demand becomes weaker such that these firms can in the long-run increase their profits by reducing their mark-up to stabilize demand.

© RAINER MAURER, Pforzheim - 169 - Prof. Dr. Rainer Maurer ➤ 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)) + R D (Y) ■ If there is an recession, firms will decrease their prices from P° to 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: S(Y) + (M / P # ) ■ Higher investment in turn will increase the demand for goods. 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model > I(i°, E(r)) + R D (Y) I(i°, E(r)) + R D (Y) > =

© RAINER MAURER, Pforzheim - 170 - Prof. Dr. Rainer Maurer P Y C(Y) Y I° Y° C(Y)+I° i°i° I° I,S I(i) I(i)+R D (Y°) I°+R D ° S(Y°)+M/P # S(Y°)+M/P° When the price level of goods prices decreases from P° to P #, the real value of the money offered by the central bank increases: (M D /P↓)↑ This causes an increase in credit supply from S(Y°)+M D /P° to S(Y°)+M D /P # 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model Y#Y# Full Employ- ment GDP P°> P # The resulting lower interest rate i # triggers the same adjustment process as discussed in section “4.3.2. Monetary Policy”! i#i#

© RAINER MAURER, Pforzheim - 171 - Prof. Dr. Rainer Maurer Y C(Y) Y I° Y° C(Y)+I° i°i° I° I,S I(i) I(i)+R D (Y°) I # +R D ° i#i# I#I# S(Y°)+M/P # 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 #. 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model Y#Y#

© RAINER MAURER, Pforzheim - 172 - Prof. Dr. Rainer Maurer Y C(Y) Y I#I# Y° C(Y)+I° i°i° I° I,S I(i) I(i)+R D (Y°) I # +R D ° i#i# I#I# C(Y)+I # Y#Y# S(Y°)+M/P # 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. 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model

© RAINER MAURER, Pforzheim - 173 - Prof. Dr. Rainer Maurer Y C(Y) Y I#I# I,S I(i)+R D (Y # ) i#i# I#I# C(Y)+I # S(Y # )+M D /P # S(Y°)+M/P # I # +R D # The resulting rise of GDP from Y° D to Y # D increases household savings from S(Y°) to S(Y # ) and money demand from R D (Y°) to R D (Y # ). Under the assumption that savings supply and money demand grow by the same margin the interest rate i # stays constant. 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model I(i)+R D (Y°) Y°Y#Y#

© RAINER MAURER, Pforzheim - 174 - Prof. Dr. Rainer Maurer Y C(Y) Y I#I# Y#Y# I,S I(i) I(i)+R D (Y # ) i#i# I#I# C(Y)+I # S(Y # )+M/P # I # +R D # i°i° 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. 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model (->Exercise 27)

© RAINER MAURER, Pforzheim - 175 - Prof. Dr. Rainer Maurer ➤ Tu sum up: ■ Starting point of the analysis was a recession, i.e. a situation where firms had adjusted their supply of goods to a reduction in the demand for goods, while they kept their prices constant. ■ This reduction in the supply of goods caused a reduction of GDP production below the full employment level. ■ Therefore, the variable production costs of firms fall below the price of goods. ■ Therefore, profit maximizing firms can increase their profits by lowering their prices. ■ Consequently, when firms start with the adjustment of prices, they will lower their prices so that the price level of all goods decreases. 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model

© RAINER MAURER, Pforzheim - 176 - Prof. Dr. Rainer Maurer ■ This reduction of goods prices (P↓) causes an increase in the real value of the money offered by the central bank as a credit (M): 1) (M / P↓ )↑ ■ Since money is offered as a credit to the credit market, this means that the real supply of credits increases. ■ This increase in the real credit supply lowers the interest rate so that investment of firms increases. ■ This rise of investment causes an increase in the demand for investment goods, so that the total demand for goods increases. 1 ) In a nominal formulation of the credit market, the fall of goods prices causes the nominal demand for credits to decrease stronger than the nominal supply of credits, so that the resulting excess supply of nominal credits lowers the interest rate. Consequently, both ways of representing the credit market (the nominal and the real) yields the same result. The real representation is used here, because it facilitates the graphical analysis. (for a more detailed description see the digression in AU 2, slides 90 - 91). 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model

© RAINER MAURER, Pforzheim - 177 - Prof. Dr. Rainer Maurer ■ Since firms adjust their supply of goods always to the demand for goods, they raise their production of goods. ■ Since a higher production of goods needs more labor input, firms demand more labor on the labor market. ■ Consequently, Keynesian unemployment shrinks and households receive more income. ■ A higher household income causes households to consume more C(Y↑)↑, so that a multiplier effect results (see section 3.1.1 above) ■ Consequently, the production of goods grows even more and simultaneously the demand for labor. ■ When the production of goods has reached its normal level of capacity utilization, a further reduction of prices does not increase profits anymore so that firms stop lowering their prices. 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model

© RAINER MAURER, Pforzheim - 178 - Prof. Dr. Rainer Maurer ■ Finally, two secondary effects must be taken into account: ◆ On one hand, the increase in GDP causes an increase in household savings by ΔS = ΔY * (1-c). ◆ On the other hand, the increase in GDP causes an increase in the transaction demand for money : R D (Y↑)↑ ■ This means that on the capital market, credit supply grows (caused by the increase in household savings) and credit demand grows (caused by the increase in money demand). ■ If this increase in credit demand exactly equals the increase in credit supply, the interest rate stays constant. 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model

© RAINER MAURER, Pforzheim - 179 - Prof. Dr. Rainer Maurer ■ If the increase in credit supply were stronger than the increase in credit demand, a further decrease in the interest rate would evolve, which would cause a further increase in investment demand. ■ This process would hold on, until the increase in money demand is sufficient to absorb the increase in credit supply. ➤ After this adjustment process has taken place, the economy is in a new equilibrium without unemployment. 4. The Keynesian Model and its Policy Implications 4.4. The Long-run Implications of the Keynesian Model

© RAINER MAURER, Pforzheim - 180 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market 4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Invest 4.2.3. Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy 4.3.2. Monetary Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 181 - Prof. Dr. Rainer Maurer ➤ 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). 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 182 - Prof. Dr. Rainer Maurer ➤ 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: 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 183 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy Ideal Case: No Implementation Lag => No Danger of Overheating: Fiscal Policy becomes effective: G↑ No reason for price adjustment, since the recession is already overcome! 1 Year 1,5 Year 0,5 Year Start of Re- cession: Y D ↓ Implementation Lag of Fiscal Policy = 0 Year Start of Price Adjustment by Firms = 1 Year => Increase in Demand for Goods: Y D ↑ No Overheating, since no price adjustment takes place! => Overcoming of Recession before 1 year is over!

© RAINER MAURER, Pforzheim - 184 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy Fiscal Policy becomes effective: G↑ Firms decrease Prices: P↓ => i↓=>I(i)↑ 1 Year 1,5 Year 0,5 Year Start of Re- cession: Y D ↓ Implementation Lag of Fiscal Policy = 1 Year Start of Price Adjustment by Firms = 1 Year => Increase in Demand for Goods: Y D ↑ Twofold Demand Effect : Y D ↑+Y D ↑ => Over- heating of the Econo- my Realistic Case: Implementation Lag => Danger of Overheating:

© RAINER MAURER, Pforzheim - 185 - Prof. Dr. Rainer Maurer ➤ Overheating by fiscal policy (see also exercise 27) : ■ In this case, the increase in the demand for goods caused by the reduction of prices by firms will be boosted by the additional demand for goods from the government. ■ As a consequence the demand for goods grows so strong that total demand for goods exceeds the full employment level. ➤ Overheating can of course also be caused by monetary policy: ■ In this case, the reduction of the interest rate caused by the reduction of prices will be boosted by the increase in credit supply of monetary policy. ■ As a consequence the demand for investment goods grows so strong that total demand for goods exceeds the full employment level. 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 186 - Prof. Dr. Rainer Maurer ➤ As a consequence, the resulting excess demand for goods causes in the long run (when firms start to adjust their prices) 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. 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 187 - Prof. Dr. Rainer Maurer ➤ 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 LagOutside Lag 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy 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.

© RAINER MAURER, Pforzheim - 188 - Prof. Dr. Rainer Maurer ➤ The inside lag of fiscal policy has two sources: 1. 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 expectations 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. 2. 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”) 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 189 - Prof. Dr. Rainer Maurer ➤ 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. 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 190 - Prof. Dr. Rainer Maurer ➤ 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 LagOutside Lag 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy 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.

© RAINER MAURER, Pforzheim - 191 - Prof. Dr. Rainer Maurer ➤ 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. forecasts of economic ■ 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 such as difficult as forecast of meteorological or ecological phenomena. ■ The following graph gives an example how difficult economic forecasting can be. 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 192 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy Red Line: Actual US- unemployment rate. Blue lines: Forecasts of the US-unemployment rate (average value of 20 US forecast institutes) Mankiw, Gregory; Macroeconomics, Worth Publishers, S. 384 Quelle: Mankiw, Gregory; Macroeconomics, Worth Publishers, S. 384

© RAINER MAURER, Pforzheim - 193 - Prof. Dr. Rainer Maurer ➤ 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 would actually try to reduce business cycle fluctuations. ■ Instead they would use their economic policy instruments to increase the probability of being reelected. 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 194 - Prof. Dr. Rainer Maurer ■ 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. 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 195 - Prof. Dr. Rainer Maurer ➤ 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: 1.The implementation lag 2.The Forecast Problem 3.The Policy Problem 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 196 - Prof. Dr. Rainer Maurer ➤ 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. 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 197 - Prof. Dr. Rainer Maurer Quelle: ECB 1) Private Haushalte; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft 2) Unternehmen außerhalb des Finanzsektors; Laufzeit 1-5 Jahre; Zinsfixierung; Neugeschäft

© RAINER MAURER, Pforzheim - 198 - Prof. Dr. Rainer Maurer The Empirical Effect of Monetary Policy (USA, 1965:3 -1995:3) Source: Christiano/Eichenbaum/Evans (2006), „Nominal Rigidities and the Dynamic Effects of a Shock to Monetary Policy“, Quarters % % % % % %

© RAINER MAURER, Pforzheim - 199 - Prof. Dr. Rainer Maurer ➤ 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. 4. The Keynesian Model and its Policy Implications 4.5.1. Practical Problems of Anti-cyclical Policy

© RAINER MAURER, Pforzheim - 200 - Prof. Dr. Rainer MaurerMacroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market 4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Inves 4.2.3. Consequences for the Labor Markett 4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy 4.3.2. Monetary Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions 4.5.1. Practical Problems of Anti-cyclical Policy 4.5.2. Case Study: Fiscal Policy in Germany

© RAINER MAURER, Pforzheim - 201 - Prof. Dr. Rainer Maurer ➤ 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: 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.2. Case Study: Fiscal Policy in Germany

© RAINER MAURER, Pforzheim - 202 - figProf. Dr. Rainer Maurer GDP-Level Time 0 UPSWING DOWN- SWING UPSWING GDP with perfect anti-cyclical fiscal policy Actual GDP without anti-cyclical fiscal policy Budget Surplus The Theory of Anti-Cyclical Fiscal Policy + − Budget Deficit = T-G < 0 Budget Surplus = T-G > 0

© RAINER MAURER, Pforzheim - 203 - Prof. Dr. Rainer Maurer ➤ Based on the concept of anti-cyclical fiscal policy, the “Law for Stability and Growth” (Stabilitäts- und Wachstumsgesetz) was implemented by the minister of economic affairs Karl Schiller in 1967. ➤ This law was considerably influenced by the experience of having successfully managed the first large recession of the post-war period (1966-67) with the help of Keynesian inspired fiscal policy. ➤ One important purpose of this law was the reduction of the inside implementation lag in the execution of Keynesian business cycles policies. 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.2. Case Study: Fiscal Policy in Germany

© RAINER MAURER, Pforzheim - 204 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.2. Case Study: Fiscal Policy in Germany ➤ The policy instruments of the Law for Stability and Growth: ■ Authorization (but no obligation) of the federal government to immediately change government consumption in the face of an “economic imbalance on the goods market”: ◆ In a period of economic boom, the reduction of government consumption should be used to amortize government debt. ◆ In a recession, the increase in government consumption should be financed with debt up to a volume of 5 Bn. €. ➤ Consequently, ■ in a boom, we should observe a surplus in the government budget and ■ in a recession, we should observe a deficit in the government budget.

© RAINER MAURER, Pforzheim - 206 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.2. 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 (= D G,t ) over the past, we receive the level of accumulated government debt: LAD G,t = D G,t + D G,t-1 + D G,t-2 + D G,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: LAD G,t / GDP t ➤ 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.

© RAINER MAURER, Pforzheim - 208 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory Digression: Causes for the increase in the dept-to-GDP ratio in Germany ■ Expansion of welfare state services at the beginning of the seventies by the government under chancellor Willy Brand (extension of retirement entitle- ments, increase in investments in social housing, increase in housing allowances, increase in government subsidies for the acquisition of personal assets). ■ Decrease in GDP-Growth and government revenues in the course of the oil crisis of 1973. ■ Strong upward trend of unemployment since the beginning of the seventies and the resulting increase in government unemployment allowances and other social transfers. ■ Extension of active employment policies by the government of chancellor Schmidt and the financial aftermaths of the social policy initiatives of the government of chancellor Brandt. ■ Decrease in GDP-growth and government revenues during the oil crises at the beginning of the eighties. ■ Nullification of the consolidation records of the government under chancellor Helmut Kohl by the economic design of the German unification by the same government. ■ This shows, government budget policy is mainly determined by political developments – there seems to be no room to take care for economic concepts like the theory of anti-cyclical business cycle policy.

© RAINER MAURER, Pforzheim - 209 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.2. Case Study: Fiscal Policy in Germany

© RAINER MAURER, Pforzheim - 210 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.2. 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? Does this make sense?

© RAINER MAURER, Pforzheim - 211 - Prof. Dr. Rainer MaurerMacroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market 4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Inves 4.2.3. Consequences for the Labor Markett 4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy 4.3.2. Monetary Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions 4.5.1. Practical Problems of Anti-cyclical Policy 4.5.2. Case Study: Fiscal Policy in Germany 4.5.3. Limits of Government Debt

© RAINER MAURER, Pforzheim - 212 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.5.3. 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 ( τ max * Y t ): ■ 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. Present value of future tax payments Present value of future interest payments ≤ This equation shows that the “debt-to-GDP ratio” LAD t / Y t is a reasonable empirical measure for sustainability of government debt.

© RAINER MAURER, Pforzheim - 213 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.5.3. 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:

© RAINER MAURER, Pforzheim - 217 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.5.3. 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:

© RAINER MAURER, Pforzheim - 218 - Prof. Dr. Rainer Maure ➤ Self-fulfilling expectations of government bankruptcy: Doubts come up concerning the ability of a government to repay all debt. Sales lead to fall in market prices of government bonds Fall in market price = Increase of effective interest rate Ability of government to repay debt falls. Higher interest rates increase costs of revolving government debt. 4. The Keynesian Model and its Policy Implications 4.5.3. Limits of Government Debt

© RAINER MAURER, Pforzheim - 220 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.5.3. 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:

© RAINER MAURER, Pforzheim - 223 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.5.3. 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: If the debt-to-GDP ratio shall stay constant, the change of the debt-level (=deficit) in percent of GDP must equal the growth rate of GDP (=the change of GDP in percent of GDP).

© RAINER MAURER, Pforzheim - 224 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.5.3. Limits of Government Debt ➤ Is there an economic limit for government debt? ■ Multiplying both sides of the equation with the interest rate i t yields: ■ This means that, since in normal times the interest rate i t is larger than GDP growth ∆Y t /Y t such that i t / (∆Y t /Y t ) >1, interest payments are larger that the possible new deficit. 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! 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! Debt cannot be completely financed with new debt !

© RAINER MAURER, Pforzheim - 225 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.5.3. 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!

© RAINER MAURER, Pforzheim - 226 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4.5.3. Limits of Government Debt ➤ Is there a “moral” limit for government debt? 1.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“. 2.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!

© RAINER MAURER, Pforzheim - 227 - Prof. Dr. Rainer MaurerMacroeconomics 4. The Keynesian Model and its Policy Implications 4.1. The Keynesian Theory 4.1.1. The "Keynesian Cross" 4.1.2. The Keynesian Model with Capital Market 4.2. Demand-side Shocks 4.2.1. Reduction of the Propensity to Consume 4.2.2. Reduction of the Propensity to Invest 4.2.3. Consequences for the Labor Market 4.3. Fiscal and Monetary Policy in the Keynesian Model 4.3.1. Fiscal Policy 4.3.2. Monetary Policy 4.4. The Long-run Implications of the Keynesian Model 4.5. Policy Conclusions 4.5.1. Practical Problems of Anti-cyclical Policy 4.5.2. Case Study: Fiscal Policy in Germany 4.5.3. Limits of Government Debt 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 228 - Prof. Dr. Rainer Maurer 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 230 - Prof. Dr. Rainer Maurer Private Consumption in Current Prices, Billion Euro Quelle: Statistisches Bundesamt 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 231 - Prof. Dr. Rainer Maurer Gross Investment in Current Prices, Billion Euro Quelle: Statistisches Bundesamt 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 232 - Prof. Dr. Rainer Maurer ➤ 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” 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 233 - Prof. Dr. Rainer Maurer Exports./. Imports in Current Prices, Billion Euro Quelle: Statistisches Bundesamt 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 234 - Prof. Dr. Rainer Maurer Production in Manufacturing, 2005 = 100 Quelle: Statistisches Bundesamt As postulated by the Keynesian model firms adjust their production in the short-run to the demand for goods. 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 235 - Prof. Dr. Rainer Maurer ➤ As the data reveal, the current 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: 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 236 - Prof. Dr. Rainer Maurer USA Germany Decrease in Real Estate Prices Net Wealth Loss of Households Reduction in Con- sumption Demand Reduction in Investment Demand Reduction in Demand for Consumption and Investment Goods from Germany Reduction in Credit Supply by US Banks Loss of Credit Receivables of Ger. Banks Loss of Credit Receivables of US Banks German Consumption Relatively Stable Reduction in Credit Supply by Ger. Banks Reduction in Investment Demand Reduction of Export Demand Reduc- tion of Produc- tion in Ger- many 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 237 - Prof. Dr. Rainer Maurer ➤ 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 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 238 - Prof. Dr. Rainer Maurer ➤ 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 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 239 - Prof. Dr. Rainer Maurer ➤ Monetary Policy Measures: 4. The Keynesian Model and its Policy Implications 4. The Keynesian Model and its Policy Implications 4.5.4. Case Study: Economic Policy in the Great Recession

© RAINER MAURER, Pforzheim - 243 - Prof. Dr. Rainer Maurer 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 E-Mail.

© RAINER MAURER, Pforzheim - 244 - Prof. Dr. Rainer Maurer 4.6. Questions for Review 1.What empirical developments in the course of the world economic crisis contradict neoclassical theory? 2.What are the two main differences between Keynesian and neoclassical theory. 3.What is the difference between the Keynesian and neoclassical consumption function and what implications does this have for the savings decision of households. 4.What is the economic explanation for the observed lagged price adjustment of firms? 5.Why do firms adjust their supply of goods to the household demand for goods in the Keynesian model? 6.What value has the Keynesian investment multiplier for a consumption ratio of 80%? 7.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. ? 8.Give a verbal explanation of the multiplier process.

© RAINER MAURER, Pforzheim - 245 - Prof. Dr. Rainer Maurer 4.6. Questions for Review C, I, G Y 9.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%?

© RAINER MAURER, Pforzheim - 246 - Prof. Dr. Rainer Maurer 4.6. Questions for Review C, I, G Y 10.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?

© RAINER MAURER, Pforzheim - 247 - Prof. Dr. Rainer Maurer 4.6. Questions for Review 11.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”? 12.What possibilities does a government have under the assumptions of the “Keynesian Cross” to increase GDP? 13.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? 14.How does the “Keynesian Cross” have to be modified, if the capital market is taken into account? 15.What factors affect money demand of households and firms under the assumptions of the Keynesian model and what is their economic explanation?

© RAINER MAURER, Pforzheim - 248 - Prof. Dr. Rainer Maurer Investment Interest Rate i1i1 C(Y)= (2/3)* Y C(Y) + I(i) I(i, E(r 1 )) Y1Y1 S(Y 1 ) = (1/3) * 30 I1I1 16.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? 4.6. Questions for Review Demand Income

© RAINER MAURER, Pforzheim - 249 - Prof. Dr. Rainer Maurer Investment Interest Rate i1i1 C(Y)= (1/3)* Y C(Y) + I(i) I(i, E(r 1 )) Y1Y1 S(Y 1 )= (2/3) * 15 I1I1 17.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? 4.6. Questions for Review Demand Income

© RAINER MAURER, Pforzheim - 250 - Prof. Dr. Rainer Maurer Demand Investment Interest Rate i1i1 C(Y)= (2/3)* Y C(Y) + I(i) I(i, E(r 1 )) Y1Y1 I1I1 18.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? 4.6. Questions for Review Income S(Y 1 )

© RAINER MAURER, Pforzheim - 251 - Prof. Dr. Rainer Maurer Investment Interest Rate i1i1 I(i, E(r 1 )) S(Y 1 ) I1I1 19.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? 4.6. Questions for Review C(Y)= (1/3)* Y C(Y) + I(i) Y1Y1 Income

© RAINER MAURER, Pforzheim - 252 - Prof. Dr. Rainer Maurer Demand Investment Interest Rate i1i1 C(Y)= 0,5* Y C(Y) + I(i) Income I(i, E(r 1 )) Y1Y1 I1I1 Y#Y# 20.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? 4.6. Questions for Review S(Y 1 )

© RAINER MAURER, Pforzheim - 253 - Prof. Dr. Rainer Maurer Demand Investment Interest Rate i1i1 C(Y)= 0,5* Y C(Y) + I(i) Income I(i) Y1Y1 I1I1 Y#Y# 21.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 M S /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). I(i)+ R D (Y) S(Y 1 ) + M/P 4.6. Questions for Review S(Y 1 )

© RAINER MAURER, Pforzheim - 254 - Prof. Dr. Rainer Maurer 4.6. Questions for Review 22.Explain how a recession can be overcome with the help of fiscal and monetary policy under the assumptions of the Keynesian model. 23.Explain the practical problems of fiscal and monetary policy in realtiy. 24.Explain the mechanism that help to overcome a recession under the assumptions of the Keynesian model of the long run.

© RAINER MAURER, Pforzheim - 255 - Prof. Dr. Rainer Maurer Demand Investment Interest Rate i1i1 C(Y)= 0,5* Y C(Y) + I(i 1 ) Income I(i, E(r 1 )) Y1Y1 S(Y 1 ) I1I1 25.How does an increase in money supply from M 1 /P by 5 units to M 2 /P = M 1 /P+5 affect the economy? I(i, E(r 1 ))+ R D (Y 1 ) S(Y 1 ) + M 1 /P I1I1

© RAINER MAURER, Pforzheim - 256 - Prof. Dr. Rainer Maurer Demand Investment Interest Rate i1i1 C(Y)= 0,5* Y C(Y) + I(i) Income I(i, E(r 1 )) Y1Y1 I1I1 26.How does an increase in government consumption from G 1 =0 to G 2 =10 affect the economy, if this increase is financed by credits. S(Y 1 ) 4.6. Questions for Review

© RAINER MAURER, Pforzheim - 257 - Prof. Dr. Rainer Maurer 27.This economy is in a boom, where the current GDP Y 1 lies above full employment GDP Y #. Analyze what happens in the long-run, if firms begin to adjust their prices. 4.6. Questions for Review Demand Investment Real Interest i1i1 C(Y)= 0,5* Y C(Y) + I(i 1 ) Income I(i, E(r 1 )) Y1Y1 S(Y 1 ) I1I1 I(i, E(r 1 ))+ R D (Y 1 ) S(Y 1 ) + M 1 /P 1 Y#Y#

© RAINER MAURER, Pforzheim - 258 - Prof. Dr. Rainer Maurer Investment Interest Rate i1i1 I(i, E(r 1 )) S(Y 1 ) I1I1 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? 4.6. Questions for Review C(Y)= (1/3)* Y C(Y) + I(i) Income Y#Y# Demand

© RAINER MAURER, Pforzheim - 1 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications.

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© RAINER MAURER, Pforzheim - 1 - Prof. Dr. Rainer Maurer Macroeconomics 4. The Keynesian Model and its Policy Implications.

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