BASIC KEYNESIAN MODEL - short-run, demand-driven model - assumes fixed price level firms operating in their "normal" production

n range (where don't need to raise price as Q expands) To model demand at macro level: Aggregate Expenditure (AE) - is the "demand curve" in this model - has same categories as Expenditure GDP: AE = C + Ig + G + Xn - initially assume G = 0 and Xn =0 (no gov't and closed economy, so Xn = 0): AE = C + Ig we model both C and Ig (outline their determinants), then put these together, get AE

Consumption Function Model of Personal Consumption Expenditure: Durable Goods Non-Durable Goods Services Major factors determining these: - income - prices - interest rates - wealth (owned assets) WEALTH EFFECT - consumer confidence To model this, separate income (Y) from others: C = factors other than income + part tied to income (autonomous cons) + (induced cons) Since part of consumption directly related to income, when the state of the economy changes, C automatically changes in same direction - use a linear function to model this:

C = a + bY a = intercept (value of C when Y = 0) b = slope = C/Y = rate of change in C when Y = $1 a = autonomous consumption - positive: when Y = 0, C >0 (people use savings) b = marginal propensity to consume (MPC) - positive: as Y, C - fraction: if Y = $1, C < $1 ex: if MPC = 0.8, if Y = $1, C = $.80, or, for every $1 Y, C rises by $.80 Q: How does the consumption function shift? A: Anything that changes autonomous consumption (intercept) shifts the curve Ex: Interest rates fall durable goods spending (part of C) rises autonomous C rises => larger intercept parallel upward shift of C
a

C C C a Y

Technically: when Y = 0, autonomous C is greater A better way to understand this: C can change even if Y does not ( autonomous C) Interpret this as: for a given Y (=Y1), is greater C Saving Function - with income identity: Y = C + S saving function derivable from consumption function using algebraic substitution: Y = (a + bY) + S S = -a + (1 - b)Y solving for S, gives:

Y1

intercept = autonomous saving slope = marginal propensity to save (MPS) - extra saving when Y rises by $1

Properties: Autonomous saving = - autonomous consumption MPS = 1 - MPC MPC + MPS = 1 Ex: if C = 100 + 0.75Y => S = -100 + 0.25Y To derive this with a graph, need way to have C=Y - use of 45o line
C C=Y 100 o 45 100

C=Y C 100 o 45

Y Break Even Y C = Y, S=0

S SAVING -100 Y

DISSAVING

- vertical distances match each other - saving function derivable from consumption function Implied Saving Function To complete AE (demand), must model investment Investment= Gross Private Domestic Investment Equipment & Software Business (non-residential) construction Residential construction Business Inventories

=> for any Y, height to 45 line is value of C - add consumption function, use height difference to get value of Savings (S)
C C=Y 500 450 S=50 C

o 45 500

Ig = f(interest rates, expected future profit, taxes) Note: Ig f(Y) Ig is autonomous - there is no induced investment no slope term (related to Y) - intercept only ex: Ig = 200 - value changes from different interest rates, etc. - when graph this - get horizontal line at 200 (constant value constant height)
Ig

If Iu > 0 is inventory accumulation sales below expectations When Iu < 0, inventory decumulation sales greater than expected When Iu 0, firms will either sell off (>0) or build up (<0) inventories not at equilibrium AE = C + Ip - planned aggregate expenditures To get AE, add C and Ip for any Y Ex: C = 100 + 0.75Y Ip = 25 AE = C + Ip = (100 + 0.75Y) + 25 AE = 125 + 0.75Y

200

Ig Y

Since modeling equilibrium (sustainable) Y, need to re-consider Ig since part of it is inventories Equilibrium inventories at desired levels Itot = Ip + Iu Total investment = planned I (when inventories at desired levels) + unintended I (difference between actual and expected inventories)

AE AE = C + Ip 125 Y

Equilibrium: Supply/Demand Equilibrium Need AS = AE production = planned expenditure no unintended inventory (Iu = 0)
AS AS AE = C + Ip Y

Q: If this is a demand function, why is it upward sloping? A: It is graphed relative to Y: as Y, AE To model Aggregate Supply (AS): In this model: AS = real GDP = Y To draw a curve where AS = Y, use 45o line
AS AS

Ye = equilibrium real GDP sustainable output This determines: Output and Income Employment and the unemployment rate Capacity utilization in manufacturing Hours per week THERE IS NO GUARANTEE THAT Ye OCCURS AT FULL EMPLOYMENT - Less than full-employment equilibrium - Keynes' contribution to macro

Ye

NOTE: IS NO THEORY OF AS!! - major limitation of this model

Why is this an equilibrium (and sustainable)? Assume that actual Y (Y1) > Ye
AS AS
Y 1 AE 1

Since inventory accumulation NOW signals declining output in the FUTURE, it is called a LEADING ECONOMIC INDICATOR - track these to forecast the economy Rising inventories, or a higher inventory-to-sales ratio, signals future cutbacks in production and employment (possibly a recession) - when GDP data released, we examine category: Business Inventories, see if it signals inventory accumulation that not desired. If so: Adds to current quarter GDP Will bring about slower future growth in GDP MICRO BASIS OF THIS: Inventory accumulation => QS > QD
P P 1 S1 S

AE = C + Ip Y

Ye

At Y1: production exceeds planned expenditure - too little spending to buy what is produced - inventories accumulate (Iu > 0) start of an inventory cycle Firms respond by cutting production. As they do: Employment falls (layoffs) Unemployment rises Y declines from Y1 Output falls until inventories back to desired levels Y back to Ye Y1 too high to be sustained Y1 could possibly be full employment Y

Y 1

D
Q
D

Occurs when P > Pe at Y1 price level is too high to support Y1 Short-run response: S to S1 - this causes less employment, more unemployment Exercise: Replicate this analysis for when Y < Ye Cause and Effect of Equilibrium Alternative equilibrium condition: Y = AE => C + S = C + Ip, so In equilibrium: S = Ip amount of non-spending by households (S) exactly offset by spending added by business (Ip) - Circular Flow result If AE < Y C + Ip < C + S, or S > Ip Inadequate expenditure caused by too little business spending to offset non-spending by households - causes Y to fall

Equilibrium changes when AE changes changes in "other things" of C and/or Ip Application: Decline in interest rates as FED money supply As interest rates fall: C (durable goods), Ip (factory, equipment, housing) AE as autonomous C and I rise
AE,Y AE=Y AE1 AE (original)

Ye

autonomous spending AE Ye This is called Expansionary Monetary Policy FED stimulates economy by raising interestsensitive spending Ye

Y e

THE MULTIPLIER Idea: when autonomous spending changes, income changes in the same direction Intuition: ultimately, the change in income will equal the change in autonomous spending - Generally false! When spending changes, a process of adjustment occurs - not a one-time adjustment (with intuition)
C Spending Income S EQUAL Induced Spending

Q: How much will Y ultimately rise? A: Use equilibrium condition: S = Ip Assume that Ip rises by $200 New equilibrium need S = 200 (so S=Ip again) How do we generate S = 200? Thru Y If MPS = 1/5, then for every Y = $5, S = $1 to get S = $200 when MPS = 1/5, need Y to rise by 5 times that amount need Y = $1,000 Ye = multiplier Ip (original spending) = multiplier $200 (the Ip) = $1,000 multiplier (k) = 5 with an MPS of 1/5 k = 1/MPS = 1/(1 - MPC) since MPC+MPS=1 The multiplier quantifies the multiple by which equilibrium Y changes as spending changes ex: if k = 5 when spending rises by $1, Ye rises by $5

Spending equal Y initially As Y rises, spending automatically rises-as does S C = MPC Y (induced spending change) S = MPS Y (induced leakage change)

A More Concrete View Assume the MPC = 4/5, Ip = +200 income C = MPCY S=MPSY +200 +160 +40 +160 +128 +32 +128 +102.4 +25.6 ~ $500 after

MPS = 0 Y C = 1Y S = 0Y +200 +200 0 +200 +200 0 With no induced S (a leakage), is nothing to slow the process down k = + The larger is the MPC (smaller MPS), the greater is the multiplier (be able to explain why) A large multiplier is bad - it makes the economy volatile - get large Ye whenever spending changes (2) Let MPC = 0 k = 1 (intuition correct) If MPC = 0 MPS = 1 income +200 C = 0Y 0 S = 1Y +200

only 3 rounds
+ $1,000 + $800 + $200 Note: induced spending (C) gets smaller To understand this better, view two extreme cases (1) Let MPC = 1 k = + Why so large a multiplier? When income rises by $1, get C = $1 never-ending rise in Ye since is no S, and impossible to get S = Ip again no induced leakage

Get entire S = +200 in one round As a result, k = 1/MPS = 1/1 = 1 Ye = Ip Intuition assumes no induced spending greater is MPS, smaller is multiplier

RULES: If add induced spending, multiplier rises If add any induced leakage, multiplier falls Imports (leakage) - lower multiplier Income Taxes (leakage) - lower multiplier Another Way to View Multiplier Micro: When demand for a single good changes, it alters the demand for all of its compliments If X = durable good ("big ticket item") Demand for X has large ripple effects throughout the entire economy Macro: this is the multiplier effect DURABLE GOODS SPENDING IS A LEADING INDICATOR OF THE ECONOMY (thru ripple effects that occur in future time periods)

Actual Applications of the Multiplier Multipliers exist at: National level International level Regional level State level Local level Idea: spending at particular level of economy (ex: state) has magnified impact on economic activity there Ex: firm locates in RI with payroll of $1 mil/month RI activity > $1 mil/month Q: How does this come about? A: When factory built, suppliers and other stores locate nearby total $ activity > $1 mil/month

If, in future, factory closes, process reverses loss of factory AND loss of suppliers AND local businesses (ex: restaurants, bars, other stores) fail Downtowns with lots of vacant stores - example of this - multiplier in reverse This causes: Local property values to fall Home sales decline Out-migration of persons Hurts tax base Raises entitlement spending locally Examples: Import competition causing US firms to close Defense cutbacks

ADDING FOREIGN TRADE: OPEN ECONOMY CHANGES When we include foreign trade in the model (an open economy), demand and the multiplier change. This provides another means by which Ye in the US can change Demand: Since Aggregate Expenditure includes the expenditure categories for GDP, it becomes: AE = C + Ip + NX where: NX is net exports, equal to exports (X) minus imports (M) In the Flexible Exchange Rate notes we saw: X = f(exchange rate, YFOR) M = f(exchange rate, Y) where: YFOR is foreign income and Y is US income (these are demand functions, which depend on price and income)

From this: - Since both the exchange rate and foreign income are autonomous, exports are autonomous (equal to a single value) - Graphing exports gives a horizontal line that can shift for changes in either the exchange rate or YFOR - Since imports depend on US income, this is a type of induced spending. Since M is a function of Y, the slope of AE changes when this is included in the model - Money spent on imports flows out of the US economy, so it has a negative sign in NX: higher imports lower NX, decreasing AE as well. Imports are thus an induced leakage. Q: How does AE change when graphed? A: Generally both the intercept and slope change.

Intercept Change: Unless autonomous exports (XA) are equal to autonomous imports (MA): - higher intercept when XA > MA - lower intercept if XA < MA (explain these in terms of leakages/injections) Slope Change: As Y rises, although more $ is spent, the part going to imports leaks out of the US economy. It is the Marginal Propensity to Import (MPM). Leakage amounts: MPS + MPM (higher total) Induced spending: MPC (less than before)
AE,AS AS AE = C + Ip AE = C + Ip + NX
In the graph: - lower intercept with XA < MA - lower slope since with imports, as Y AE for US goods is now less than before

Ye Ye

MULTIPLIER: Since the slope of AE changes with imports, the multiplier in an open economy is lower than that in a closed economy. CLOSED ECONOMY MULTIPLIER: k = 1/MPS = 1/(1 MPC) OPEN ECONOMY MULTIPLIER: k = 1/(MPS + MPM) - The denominator is the sum of two leakage propensities, from savings and imports - In a test question, if you are given the MPC and not the MPS, the MPS can be calculated using the formula: MPS = 1 MPC
C Spending Income S Induced Spending (less than before) New Induced Leakage

Exercise 1: Assume that the economies of our major trading partners slow. Analyze this in terms of the basic macro model. Answer: This indicates an autonomous decline in YFOR that will lower the demand for US exports. X NX AE
AE,AS AS AE = C + Ip + NX AE = C + Ip + NX

Ye

Ye

EQUAL

As AE falls, the decline in spending gets the multiplier, lowering Ye. Employment and income in the US fall, unemployment rises

Exercise 2: Assume that the US dollar depreciates relative to other currencies. Illustrate the effects of this change in the macro model, following the example above. (note: refer to the Flexible Exchange Rate online notes for help with this) Exercise 3: Assume that US interest rates rise relative to those in other countries (the result of, say, tighter monetary policy). Does this alter AE and Ye in the US? Outline the reasons for your response. Exercise 4: If the US inflation rate should rise relative to the inflation rates in the countries of our major trading partners, will this alter AE and Ye in the US? If so, how?

PROBLEMS (1) Use the following data, where Y=real output and C=personal consumption expenditures, and assume that Ip=15: Y C 540 540 560 555 580 570 600 585 620 600 640 615 660 630 (a) What is the value of equilibrium Y? (b) When Y = 560, how much is unintended investment? (c) What is the value of the MPS? (d) What is the value of the multiplier? (2) If nominal income is $15,000 and the CPI is 118, what is the value of real income? (3) If the CPI is 250 in year 1 and 275 in year 2, what is the inflation rate for year 2?