Keynesian Macroeconomics: Aggregate Demand

and the Multiplier Effect

• John Maynard Keynes, The General Theory of Employment, Interest and

Money (1936)

• Great Depression (1929-1938) shows possibility of underemployment

equilibrium -- actual GDP had not been equal to potential for
years.

• The Keynesian model distinguishes:

– Actual GDP -- what GDP happens to be right now
– Potential GDP -- full employment GDP
– Equilibrium GDP -- a level of GDP at which there are no forces
tending to change the level of GDP.
John Maynard Keynes, 1919 and 1945
The Keynesian system: Planned and actual investment
Investment has three components:
• Plant and equipment -- drill presses, factory buildings, etc.
• Residential investment -- new housing construction
• Inventory investment -- Change in Business Inventories

The first two are consciously planned (although plans can change, and
typically do during a recession);
inventory investment can be unplanned -- if a store fails to sell what it
had expected to, it winds up with more inventory than it had expected.
Stores with unplanned inventory investment will cut back on orders --
resulting in reduced production at the factory, layoffs and recession.
The Consumption Function: the key to Keynes
Consumption depends on the level of DISPOSABLE INCOME
(disposable personal income = income - taxes = Y - T)
Some consumption is autonomous (= “independent” of DPI):
it may depend on other factors such as wealth or stock
values. (even at zero income, Bill Gates would consume something)
The consumption function proposed by Keynes is:

C = C0 + Cy ( Y - T)
C0 = Autonomous consumption
Cy = Marginal propensity to consume
The marginal propensity to consume plays a central role in
the Keynesian system. Keep your eye on the MPC in the following
slides.
Income (DPI = Disposable Personal Income) and
Consumption
(PCE = Personal Consumption Expenditures)
(U.S., 1960.Q1 to 2001.Q3, data from FRED:
Federal Reserve Economic Data
Regression line:
PCE = - 71.23 + 0.93 DPI
The Keynesian model: National income identity and equilibrium
The National income identity is:
Y = C + I + G + NX
The Keynesian equilibrium equation is:

Y = C0 + Cy ( Y - T) + Ip + G + NX

Notice that C has been replaced by the consumption function, and

investment by planned investment.

Given values for autonomous consumption = 300

for the marginal propensity to consume = 0.8
for planned investment = 1500
and finally for G = 1200, T = 1000, and NX = 500
the equation can be solved for Y.
Keynesian equilbrium: Solution procedure
Start with the equation in general form:

Y = C0 + Cy ( Y - T) + Ip + G + NX
Substitute in the given numbers:
Y = 300 + 0.8 ( Y - 1000) + 1500 + 1200 + 500
Collect all the constant terms:
Y = 3500 + 0.8Y - 800
Y = 2700 + 0.8Y
Subtract 0.8 Y from both sides of the equation:

0.2 Y = 2700
Finally, multiply both sides by 1 / 0.2 = 5

Y = 5 (2700) = 13, 500

The Multiplier
Rerun the previous exercise, raising planned investment by 500.
Y = 300 + 0.8 ( Y - 1000) + 2000 + 1200 + 500
Collect all the constant terms:
Y = 4000 + 0.8Y - 800
Y = 3200 + 0.8Y
Subtract 0.8 Y from both sides of the equation:

0.2 Y = 3200
Finally, multiply both sides by 1 / 0.2 = 5
Y = 5 (3200) = 16, 000
GDP is UP BY 2,500, NOT up by only 500.
Investment spending has a MULTIPLIER EFFECT of 5
The Multiplier: Government Spending and Net Exports
Instead of raising planned investment by 500, as on the last slide:
• Raise Government Spending by 500
• Raise Net Exports by 500
• Cut taxes by 500

What happens in each case?

You should find that the increases in government spending and
in investment raise income by 2,000 -- that the multiplier for
investment, government spending and net exports is exactly the
same.
Hence the major policy proposals made by Keynes:
-- raise government spending to expand the economy.
-- ensure stability in the world trading system (IMF, WTO)
The Tax Multiplier
Tax cuts have a multiplier effect, but not the same effect as direct
government spending. Reason: part of any tax cut is saved, not
spent.Consider the tax cut of 500:

Y = 300 + 0.8 ( Y - 500) + 1500 + 1200 + 500

Collect all the constant terms:

Y = 3500 + 0.8Y - 400 or Y = 3100 + 0.8Y

Subtract 0.8 Y from both sides of the equation:
0.2 Y = 3100
Finally, multiply both sides by 1 / 0.2 = 5

Y = 5 (3100) = 15, 500

GDP is UP BY 2,000, NOT up by 2,500 as with investment.
Tax cut has a MULTIPLIER EFFECT of 4.0 ( not 5.0 )