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Economics for CED

Economics for CED. Noémi Giszpenc Spring 2004 Lecture 10: Macro: Keynesian Model of Aggregate Demand June 9, 2004. Neoclassical economists assumed. That the employment of labor would be determined by the supply and demand for labor, along with the wage in purchasing power terms.

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Economics for CED

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  1. Economics for CED Noémi GiszpencSpring 2004Lecture 10: Macro: Keynesian Model of Aggregate Demand June 9, 2004

  2. Neoclassical economists assumed • That the employment of labor would be determined by the supply and demand for labor, along with the wage in purchasing power terms. • The employment of labor, together with the productivity of labor, would determine production as measured by RGDP. • Then the Great Crash/Depression of 1929 happened. Economics for CED: Lecture 10, Noémi Giszpenc

  3. 1883-1946 Enter John Maynard Keynes • A theory of “equilibrium” unemployment • Right or wrong, now used to make economic policy and to forecast economic events • Key question: How are national income and expenditure determined? • Recall: components of expenditure are • C (Consumption) • I (Investment) • G (Government purchases) • NX (Net Exports) Economics for CED: Lecture 10, Noémi Giszpenc

  4. Energy Matter Heat Waste A picture of the economy Human Economy goods & services wages & dividends goods & services--Exports payment for purchases payment for purchases labor & ingenuity Natural World Households Business taxes (labor & ingenuity) services & transfers goods & services taxes services & transfers (wages) goods & services--Imports payment for purchases Government Rest of World Economics for CED: Lecture 10, Noémi Giszpenc

  5. Picture showing money flow Disposable Income = Yd Human Economy Output = Y Net Taxes = T Energy Matter Exports = X • Natural World Households Business Private Savings = S Imports = M G = Public Consumption Net Public Savings Government Rest of World Private Consumption = C Heat Waste Investment = I Loan to RoW Banks Economics for CED: Lecture 10, Noémi Giszpenc

  6. Income and Consumption • Keynes theorized a “psychological law”:One more dollar of income would lead to more consumption, but only of part of the dollar: • Fraction spent = marginal propensity to consume (MPC) • A Simple Consumption Function: C = C0 + bY • Where C is Consumption • b is MPC • Y is income • so what’s C0?…Autonomous consumption: the portion of consumption expenditure that does not depend on income. • What you would want to spend even if you had no money. Economics for CED: Lecture 10, Noémi Giszpenc

  7. 45o expenditure C+I C I C0 Ye income/production A simple model • Given C = C0 + bY and Y = C + I + G +NX • And assuming C0 positive, I constant and G, NX 0 • Equilibrium is where expenditure = income(the 45o line) • Or, algebraically: Ye=(C0+I) / (1-MPC) • 1/(1-MPC) is the “autonomous consumption multiplier” Since MPC < 1, multiplier is > 1 • each person's spending is someone else’s income Economics for CED: Lecture 10, Noémi Giszpenc

  8. How to move toward equilibrium? • Inventories: a kind of capital good. • An increase in inventories is an investment. • A decrease in inventories is a negative investment. • If businessmen do not sell as much as they expected, find themselves with more inventories than planned • These increases in inventories are "unintended investment.” • Realized investment is sum of planned investment and unintended inventory increases • In model, I (of C+I) is planned investment. Economics for CED: Lecture 10, Noémi Giszpenc

  9. 45o expenditure C+I C Ye income/production What happens in disequilibrium? • If production is greater than Ye, it exceeds plannedexpenditure. • So, inventories build up. • So, businesses cut back on orders, factories cut back on production, until production falls back to equilibrium level. • If production less, inventories drawn down further than expected, so businesses make extra orders, factories increase production… back to Ye. • A plan-fulfillment equilibrium. Economics for CED: Lecture 10, Noémi Giszpenc

  10. Lots of scope for unemployment • Equilibrium level of production in model depends on planned level of production. • What if producer fears that others will cut back on production? • Assumes spending will be less • Therefore plans to produce less to meet smaller demand • If everyone reasons this way, expectations are fulfilled: aggregate production is less, people have less income, and aggregate demand is smaller • If this happens, there is a recession, and it is a result of a coordination failure Economics for CED: Lecture 10, Noémi Giszpenc

  11. What happens if spending drops? 45o expenditure C+I • Say autonomous spending drops by a certain amount, X. • Equilibrium output drops by the amount times the multiplier: • X/(1-MPC) C’+I X Ye’ Ye income/production Economics for CED: Lecture 10, Noémi Giszpenc

  12. Saving and Investment • Saving = Income – ConsumptionS = Y – C (or Y = C + S) • This is an identity (it’s how it’s defined) • For households, it’s disposable income (net of taxes): • Yd = Y – T; where T is taxes (minus transfers) • Substituting into equilibrium model:Y = C + I + G + NX = S + C + T; so by identity:S = C + I + G + NX – C – T = I + G + NX – T Economics for CED: Lecture 10, Noémi Giszpenc

  13. Where does saving go? • S = I + G + NX – T (by identity) • If trade is balanced, NX = 0. • If the government budget is balanced, G = T. • This would lead to S = I: all household saving going into investment. • If NX > 0 (we export more than we import), some saving goes as a loan to the Rest of the World. • If NX < 0 (trade deficit) RoW loans to us. • If G < T (a government budget surplus), more saving is available to go to investment or as loan to RoW. • If G > T (budget deficit) some saving has to go as loan to government Economics for CED: Lecture 10, Noémi Giszpenc

  14. How to increase saving? • Saving is defined as identity: income minus consumption, S = Y – C • Can reducing consumption lead to more saving? • Reduce autonomous consumption C0 • Ye = (C0+I0)/(1 – MPC). Change to C0-x. • Ye’= Ye – x/(1 – MPC) = (C0-x)/(1 – MPC)+S’ • (after some algebra) S’ = Ye – C = S (no change) Economics for CED: Lecture 10, Noémi Giszpenc

  15. There must be some way! • Let’s try this: decrease the marginal propensity to consume, MPC. • Once again Ye’ < Ye (equilibrium output down) and S’ = S (no change). No dice. • “The paradox of thrift” • In our simple model, saving (S) can’t be different from intended investment, I (in equilibrium). • Illustrates the “fallacy of composition.” Economics for CED: Lecture 10, Noémi Giszpenc

  16. Don’t save: spend and boom! • Increase in autonomous consumption has a multiplier effect (even keeping I constant). • Increase in MPC increases multiplier. • Woohoo! Party! Y is in the house! • Is there a downside? Yes: • Although I does not decrease, proportionally to RGDP, it does decrease. It doesn’t keep up with growth of economy. Economics for CED: Lecture 10, Noémi Giszpenc

  17. Investment isn’t constant anyway • Imagine a business with a steady level of investment, I. (basically replacement) • Demand picks up: in order to meet expanded demand, increase to I*. (expansion) • Increase in I increases total demand by multiplier • Boom! • Say demand eventually steadies. I* falls back down a bit to I*’. (replacement of a bigger stock) • Decrease in I decreases total demand by multiplier • Bust! Economics for CED: Lecture 10, Noémi Giszpenc

  18. Paul Samuelson b. 19151970 Nobel laureate, wrote most successful principles textbook ever Accelerator principle • Amount of investment depends on the rate of increase of production (not just amount) • When demand is increasing, investment has to increase a lot to keep up. • Growth leads to growth, for a while… • When production levels off, investment drops a lot (to replacement levels) • Slowdown leads to more slowing down… • This is where term “business cycles” comes from. Economics for CED: Lecture 10, Noémi Giszpenc

  19. International Trade / “Contagion” • If NX rises, then ceteris paribus, Ye rises (by the multiplier). • So exports more politically popular than imports • But recall: if NX>0, some S has to go as loan to RoW • If a country’s Y increases, buys more of all goods--including imports • Its imports are other countries’ exports • This leads to greater Y in other countries • Busts can also spread from country to country • Especially important for small countries dependent on trade Economics for CED: Lecture 10, Noémi Giszpenc

  20. How to keep track of trade? • Current account measures trade in goods and services (credits increase balance) • Capital account measures trade in investments (debits increase balance) • Credits = LHS; Debits = RHS of accounts • 4 Transactions (see next slide): • U.S. exports a Ford truck for $10K • U.S. purchases Japanese stocks of $5K • U.S. imports French wine for $2K • U.S. imports Brazilian beef for $12K Economics for CED: Lecture 10, Noémi Giszpenc

  21. Current Acct (CA) & Capital Acct (KA)Credit (Cr.) & Debit (Dr.) • U.S. exports a Ford truck for $10K • Cr. CA $10K (inc. NX) • Dr. KA $10K (inc. in FX holdings) • U.S. purchases Japanese stocks of $5K • Dr. KA $5K (inc. in foreign assets) • Cr. KA $5K (dec. in FX holdings) (stock cost us Yen) • U.S. imports French wine for $2K • Dr. CA $2K (dec. NX) • Cr. KA $2K (dec. in FX holdings) Economics for CED: Lecture 10, Noémi Giszpenc

  22. Another accounting detour At this point, NX=$8K,FX=$8K Loan from RoW(net liability) Trade deficit (NX<0) Economics for CED: Lecture 10, Noémi Giszpenc

  23. Government Fiscal Policy 45o C+I+G expenditure C+I • “Fiscal policy” is when national government makes decisions on taxation and spending to influence the level of production and employment. • Increasing the autonomous spending, G, increases Ye by multiplier. • Can increase G to combat unemployment • Can decrease G to combat inflation • What about taxes? C G I C0 Ye income/production Economics for CED: Lecture 10, Noémi Giszpenc

  24. Don’t forget taxes! • Consumption depends on disposable income Yd = Y - T • T is net taxes: sum of income taxes Yt and non-income taxes TX, minus transfers TR •  T  Yd C  Ye • by a “tax multiplier”: MPC/(1-MPC) • Cut in taxes and increase of transfers have same effect on equilibrium aggregate demand • But they have different effects in many other ways, and are likely to affect different people. • And have smaller (indirect) effect than changes in G. Economics for CED: Lecture 10, Noémi Giszpenc

  25. Trygve Haavelmo(b. 1911), 1989 Nobel laureate Bonus: Balanced Budget multiplier • Suppose government increases G and T by same amount, B. •  G  Ye by B/(1-MPC) •  T  Ye by B*MPC/(1-MPC) • Net increase in Ye is B*(1-MPC)/(1-MPC) = B*1 = B • “balanced budget multiplier” is 1 • Probably the only realistic kind of balanced budget: “cyclically balanced budget” • government deficits in recession periods offset by government surpluses in boom periods. Economics for CED: Lecture 10, Noémi Giszpenc

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