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Introduction to Macroeconomics

Introduction to Macroeconomics. Chapter 22. Keynesian Macroeconomics. Chapter 22. Keynesian Macroeconomics. 1. John Maynard Keynes 2. Consumption 3. Simple Equilibrium Model 4. Add Investment to the Model 5. Add Government Spending to the Model 6. Autonomous Spending Multiplier

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Introduction to Macroeconomics

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  1. Introduction to Macroeconomics Chapter 22. Keynesian Macroeconomics

  2. Chapter 22. Keynesian Macroeconomics 1. John Maynard Keynes 2. Consumption 3. Simple Equilibrium Model 4. Add Investment to the Model 5. Add Government Spending to the Model 6. Autonomous Spending Multiplier 7. Recessionary, Inflationary, and Output Gaps 8. Government Fiscal Policy

  3. 1. John Maynard Keynes • General Theory… (1936) • Objections to Classical Model • Equilibrium with Unemployment because of inadequate demand • Advocated Activist Government Fiscal Policy • Short-run model of aggregate demand only

  4. 1. John Maynard Keynes Objections to Classical Model • Interest rates, prices, and wages are rigid (“sticky”) • Savings (consumption) is a function of income, not interest rate. • Supply doesn’t create its own demand, it responds to changes in demand

  5. 1. John Maynard Keynes Equilibrium with Unemployment Full-employment output • Horizontal Aggregate Supply Curve • Sticky prices • Interest rates have only a long run effect • Long-run growth factors can be ignored in short-run model AS Equilibrium AD

  6. 1. John Maynard Keynes Keynesian Activist Fiscal Policy • Equilibrium Output less than full-employment output • increase government spending • reduce taxes • Aggregate Demand (AD) shifts to right Full-employment output AS AD

  7. 1. John Maynard Keynes Short-Run Model of Aggregate Demand Only • Changes in Aggregate Supply have no effect on spending (contrary to Say’s Law) • Aggregate Supply responds to changes in demand • Economy can be modeled by looking at Aggregate Demand only

  8. 2. Consumption • Consumption Function • Graph Consumption Function • Autonomous Consumption • Marginal Propensity to Consume • Savings • Marginal Propensity to Save • Average Propensity to Consume Average Propensity to Save

  9. 2. Consumption Consumption Function C = C0 + b • Y C = desired consumption C0 = autonomous consumption b = marginal propensity to consume 0 < b < 1 Y = income

  10. 2. Consumption Graph Consumption Function C = C0 + b • Y Slope = b Intercept = C0

  11. 2. Consumptioon Autonomous Consumption • Autonomous consumption = C0 • Level of consumption at zero income • Consumption independent of the level of income • “Subsistence” level of income

  12. 2. Consumption Marginal Propensity to Consume (MPC) • The change in consumption that results from a $1 change in income • MPC = dC / dY • Slope of the consumption function (b)

  13. 2. Consumption Marginal Propensity to Consume (MPC) MPC = dC / dY = 10 / 15 = 0.667 dC = 10 dY = 15 dC = 10 dY = 15 dC = 10 dY = 15 dC = 10 dY = 15

  14. 3. Simple Equilibrium Model Aggregate Expenditures: AE = C + I + G + NX Assume: • No government, G = 0 • No investment, I = 0 • No international trade, NX = 0 AE = C

  15. 3. Simple Equilibrium Model Aggregate Expenditures AE = C = C0 + MPC • Y Slope = MPC Intercept = C0

  16. 3. Simple Equilibrium Model Equilibrium - the 45o Line • The 45o line: all points that represent potential equilibrium (aggregate expenditures = income) 45o

  17. 3. Simple Equilibrium Model Aggregate Expenditures and the 45o Line 45o Line AE Equilibrium

  18. 3. Simple Equilibrium Model Disequilibrium Income > Spending Undesired Inventory Build 45o Line AE Income < Spending Undesired Inventory Decline

  19. 3. Simple Equilibrium Model Autonomous Consumption Multiplier • Shift in AE - if autonomous consumption increases by $1, how much does national income increase by? • National income increases by the Multiplier times the change in autonomous consumption

  20. 3. Simple Equilibrium Model Shift in Autonomous Consumption Slope = MPC = 0.67 dC0 = ± 5 dY = ± 15

  21. 3. Simple Equilibrium Model Autonomous Consumption Multiplier Spending = Income x Marginal Propensity to Consume

  22. 4. Add Investment to Model • I = I0 = Autonomous Investment Investment independent of the level of income • AE = Consumption + Investment = C + I = C0 + MPC • Y + I0

  23. 4. Add Investment to Model Aggregate Expenditures AE = C + I = C0 + MPC • Y + I0 AE = C + I C Slope = MPC I0 = 10 C0 = 10

  24. 4. Add Investment to Model Aggregate Expenditures and Equilibrium 45o Line AE = C + I Equilibrium C I0 = 10 C0 = 10

  25. 5. Add Government Spending to Model • G = G0 = Autonomous Government Spending Spending independent of the level of income • AE = C + I + G = C0 + MPC • Y + I0 + G0

  26. 5. Add Government Spending Aggregate Expenditures with Equilibrium 45o Line Equilibrium AE = C + I + G C + I C G0 = 10 I0 = 10 C0 = 10

  27. 6. Autonomous Spending Multiplier Autonomous Spending: Spending that is independent of any other variable (e.g., income, prices, interest rate) • C0 = Autonomous Consumption • I0 = Autonomous Investment • G0 = Autonomous Government Spending Autonomous (adj.) - self-governing

  28. 6. Autonomous Spending Multiplier The Multiplier Multiplier = ___1___ 1 - MPC If MPC = 0.9, Multiplier = 10 A $1 increase in autonomous spending leads to a $10 increase in national income If MPC = 0.8, Multiplier = 5 A $1 increase in autonomous spending leads to a $5 increase in national income

  29. 6. Autonomous Spending Multiplier Change in Autonomous Spending 45o Line AE1 C AE0 D A B Change in Automous Spending = CD Change in National Income = AB Marginal Propensity to Consume = Slope = BD / AB

  30. 6. Autonomous Spending Multiplier Graphical Derivation of Spending Multiplier Multiplier = Change in National Income___ Change in Autonomous Spending = AB / CD = AB / (BC - BD) = AB / (AB - BD) where BC = AB for 45o triangle = (AB / AB)______ (AB / AB) - (BD / AB) = 1_____ 1 - (BD / AB) where MPC = BD / AB Multiplier = 1_ __ 1 - MPC

  31. 6. Autonomous Spending Multiplier Algebraic Derivation of Spending Multiplier AE = C + I + G = C0 + MPC • Y + I0 + G0 In equilibrium: Y = AE Y = C0 + MPC • Y + I0 + G0 Y - MPC • Y = C0 + I0 + G0 (1 - MPC) • Y = C0 + I0 + G0 Y = ___1___ • (C0 + I0 + G0) 1 - MPC

  32. 7. Gaps • Recessionary Gap • output in equilibrium less than full-employment output • Inflationary Gap • output in equilibrium greater than full-employment output • Output Gap • difference between actual output and full-employment output

  33. 7. Gaps Gaps and the Keynsian Cross 45o Line Inflationary Gap AE Full-employment Recessionary Gap Output Output Gap Output Gap

  34. 8. Government Fiscal Policy • Lump Sum Tax • Lump Sum Tax Multiplier • Balanced Budget Multiplier

  35. 8. Government Fiscal Policy Lump Sum Tax • Consumption = C0 + MPC • Yd Yd = disposable income = total income (Y) - lump sum tax (T0) • Consumption = C0 + MPC • (Y - T0) = C0 + MPC • Y - MPC • T0 • Multiplier = - MPC_ 1 - MPC

  36. 8. Government Fiscal Policy Derivation of Lump Sum Tax Multiplier AE = C + I + G + NX AE = C0 + MPC • Y - MPC • T0 + I0 + G0 In equilibrium: Y = AE Therefore: Y = C0 + MPC • Y - MPC • T0 + I0 + G0 Y - MPC • Y = C0 - MPC • T0 + I0 + G0 (1 - MPC) • Y = (C0+ I0 + G0) - MPC • T0 Y = 1___ • (C0+ I0 + G0) - MPC_ • T0 1 - MPC 1 - MPC

  37. 8. Government Fiscal Policy Balanced Budget Multiplier

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