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Keynesian Algebra and Etc

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The Keynesian Model

the multiplier, the paradox of thrift, savings and investment, fiscal policy, and the tax multiplier

multiplier – algebra of the model
A simple Keynesian model of the economy with no government or foreign trade can be represented as: Y=C+I (1) where Y is equilibrium output (income), C is aggregate consumption, and I is aggregate investment. Aggregate consumption, or total expenditure by households on final goods and services, is determined by autonomous consumption (a), or the rate of consumer expenditure independent of disposable income, and the marginal propensity to consume (b = mpc), which is the part of each additional dollar of disposable income that is spent on consumption. Thus, the consumption function is: C = a + bY (2)

No government, so Y = Yd
• Note that since there is no government, taxes are zero, so Y = Yd, since: Yd = Y – T Yd = Y – 0 Yd = Y Thus while the consumption function is usually C = a + bYd, here it will simply be: C = a + bY

Investment
• Investment is determined by a complex of factors such as expectations of investors and lending institutions, business confidence, political climate, and so on. For present purposes, what is important is that investment is autonomous—that is, independent—of income. It is also not a simple function of the rate of interest, as in neoclassical loanable funds theory.

solving the equation
Y=C+I C = a + bY (1) (2)

• Substituting equation (2) into equation (1), i.e., replace C with a + bY, we get: • Y = a + bY + I (3) • Subtracting bY from both sides: • Y - bY = a + I (4)

Solving for Y Y .b) = a + I (5) • Dividing both sides by (1 .b): • Ye = 1 (a + I) (6) (1-b) .bY = a + I (4) • Factoring out the Y from the left hand side of equation (4) • Y (1 .

the multiplier Ye = 1 (1-b) (a + I) where 1/(1-b)—or 1 divided by the mps—is the multiplier. The total injections in this simple model are a + I. . the equilibrium level of output (income) is determined by the multiplier and total injections. Therefore. Ye. or the feedback mechanism that amplifies any initial increase (injection) or decrease (withdrawal) in aggregate demand.

75 I = 300 .Keynesian model .numerical example Given: Y=C+I C = a + bY Where: a = 100 b = .

25) x 400 • Y = 4 x 400 • Ye = \$1600 billion .25) = 100 + 300 • Y = (1/.75Y + 300 • Y .Solving for Ye • Y = 100 + .75Y = 100 + 300 • Y (1 .75) = 100 + 300 • Y (...

75) 1600 Se = -100 + .solving for equilibrium consumption and savings • • • • • • • Once we have Ye. we can find Ce and Se: Ce = a + bYe Ce = 100 + ..75 (1600) Ce = 100 + 1200 = 1300 Se = -a + (1 .b)Ye Se = -100 + (1 .25 (1600) = 300 .

double-checking savings • Also: Ye = Ce + Se Ye – Ce = Se 1600 – 1300 = 300 • Also: Se = I (savings = investment at equilibrium) 300 = 300 .

100 + (1 – .75Y a+I S = .75) Y a I = 300 I 0 -a Y1 Y* Y 400 1600 .Keynesian Model 45° Expenditure AS = C + I C = 100 + .

as well as aggregate spneding at full employment. could produce an aggregate output of \$2000. if producing at full employment. given resources and technology. • We can now calculate the values of consumption and savings at full employment.the recessionary gap • Assume that this economy. . and the recessionary gap.

b)Yf = -100 + .25 (2000) = 400 (double-check: Yf – Cf = Sf = 2000 – 1600 = 400) AS@Yf = Cf + I = 1600 + 300 = 1900 gap = Yf – AS@Yf = (2000 – 1900) = 100 = = (Sf – I) = (400 – 300) = = (Yf – Ye)/multiplier = (2000 – 1600)/4 = 100 .full employment and the recessionary gap Cf = a + bYf = 100 + .75 (2000) = \$1600 Sf = -a + (1 .

Keynesian Model 45° Expenditure AS = C + I C = a + bY a+I S = .a + (1 – b) Y a I I 0 -a Y1 Y* Yf Y 1600 2000 .

but may lower aggregate output.the paradox of thrift • An attempt by the economy as a whole to increase aggregate savings not only will not succeed. This is because increased savings at a given level of aggregate income will mean decreased consumption. Thus a smaller marginal propensity to consume will reduce the stimulative effects of investment and other spending. income and employment. .

8Yd • If autonomous investment is equal to \$300 billion then the equilibrium level of output and income is • Ye = 5 (100 + 300) = \$2000 billion • because the multiplier = 1/(1 – b) = 1/(1 . .8) = 5. suppose an economy is characterized by a consumption function: • C = \$100 + ..paradox of thrift • For example.

paradox of thrift • Aggregate consumption is: • C = \$100 + . . • So aggregate savings equals aggregate investment (\$300 billion).8 (\$2000) = \$1700 billion • and aggregate savings is: • S = -\$100 + (1 .8) (\$2000) = \$300 bil..

what will be the effect? .paradox of thrift .25.2 to .example • Suppose some political and or business leaders come out and say we have to save more so the economy can grow. If people comply in such a way that the mps rises from .

75) (\$1600) = \$300 billion .75 (\$1600) = \$1300 billion and savings: • S = -\$100 + (1 .75) = 4. Aggregate consumption is now: • C = \$100 + ... the new equilibrium will be: • Ye = 4 (100 + 300) = \$1600 billion because the new multiplier = 1/(1 .75Yd With \$300 billion in investment.paradox of thrift The new consumption function will be: • C = \$100 + .

but output and employment are much lower. savings is still equal to investment at the same level of \$300.paradox of thrift • Thus. . • So the attempt by the economy as a whole to save more not only did not result in more savings. but actually lowered aggregate output and income by \$400 billion.

and is another example of the paradoxical nature of macroeconomics. It is rooted in the two-sided nature of spending and saving. . it is wonderful to save more. When we just look at one individual firm or household in isolation. for the economy as a whole.paradox of thrift • This is the paradox of thrift. it could be a disaster. we don't see the impact that our actions have on other participants in the economy due to the interdependent nature of economic activity. So while for any one individual.

If income goes up. . increased aggregate savings can throw the economy into a recession. But at a given level of income. then that is a different story. however.paradox of thrift • If. Therefore. consumption and saving both go up. the increased saving is the result of higher incomes. a policy to increase growth by increasing savings has it backwards: savings will increase as a result of growth.

In Keynes. and saving is income not spent. Keynes did not believe it was legitimate to hold income constant when analyzing aggregate saving. . since consumption is a function of disposable income. He also disagreed with the neoclassical belief that saving is primarily a function of the rate of interest. as in neoclassical theory. saving is also primarily a function of disposable income. determined by disposable income and the marginal propensity to consume. S is a passive residual.Keynes’s critique of the neoclassical theory of savings and investment 1.

I .Loanable Funds Market Interest Rate S (Savings) i* I (Investment) 0 S=I S.

Historical experience of the Great Depression: – interest rates very low. – wages low. – how long is the long run?. no investment. no labor demand.Keynes’s critique of the neoclassical theory of savings and investment 2. .

in Keynes the two may be equal at a whole range of potential levels of output and income. but in Keynes I => S through changes in Y and in neoclassical S => I through changes in i. only one of which is full employment.3. while in neoclassical the two may be equal only at full employment. S = I is the macroeconomic equilibrium condition in both Keynes and neoclassical. In addition. .

He also disagreed with the neoclassical view that investment is primarily a function of the rate of interest.4. as in neoclassical theory. Keynes did not believe it was legitimate to hold the state of investor expectations constant in analyzing aggregate investment. Expected profitability of investors and lending institutions both required for investment to take place. .

which is not conducive to statistical probability.5. not risk. even under risk. the confidence of whether one will ‘beat the odds’ is subject to unpredictable variation. In neoclassical theory. Keynes distinguished between risk. He believed most important determinants of investment described by uncertainty. which is calculable. uncertainty in this sense is not recognized. and uncertainty. . Also. Mass psychology subject to waves of optimism and pessimism.

. at least on the surface. not all of which appear immediately relevant. as will many other factors. Business and political climate will influence investment decisions.6.

profit-maximizing institutions and will not pass up the chance to make profits if they believe a loan will be profitable. a ‘pool’ of savings is not necessary to finance investment. They will always make a loan and worry about reserve requirements at the end of the day (often borrowing themselves to meet their requirements).7. In a modern capitalist economy with hightech financial institutions and advanced instruments of credit. . Banks are private.

.8. the rate of interest is not determined by savings and investment. In Keynes. but by the supply and demand for money. This is Keynes’s liquidity preference theory (more on this later).

Separation of ownership and management means those who own do not necessarily know the business well. Makes investment more unstable. and those who manage may have different interests and incentives than if they also owned.9. .

so they sell and because people sell. the value goes down). creates instability. people think an asset’s value is going to go down. Assets are revalued within the space of seconds.10. without having to wait to see if a change is a temporary deviation. Speed of asset revaluation increasingly faster and faster. Selffulfilling prophecies become a characteristic of the system (for example. and ability to react immediately. .

with S = I. • Fiscal policy: the attempt to affect macroeconomic variables (such as C.fiscal policy for full employment: eliminating a recessionary gap • Keynes’s demonstration of the possibility of the economy being in macroequilibrium. I. . below full employment provides a theoretical justification for more interventionist policies by the government. Y) through government spending and tax policies.

Increasing G • If Yf = \$2000 billion and Ye is \$1600. how much does the government have to increase spending to push the economy to Yf? .

Increasing G • If Yf = \$2000 billion and Ye is \$1600. . how much does the government have to increase spending to push the economy to Yf? Not \$400.

how much does the government have to increase spending to push the economy to Yf? Not \$400.Increasing G • If Yf = \$2000 billion and Ye is \$1600. If G increased by \$400 then: Y=C+I+G C = a + bY .

Increasing G • If Yf = \$2000 billion and Ye is \$1600. What happened? .75) * 100 + 300 + 400 = 4 (800) = \$3200 Way past Yf—impossible. If G increased by \$400 then: Y=C+I+G C = a + bY Ye = 1/(1 .. how much does the government have to increase spending to push the economy to Yf? Not \$400. so inflation will occur.

had a multiplier effect. and so increased total output and income not by 400 but by 1600.closing the recessionary gap • The government spending of 400. • How much do we need to increase G by to just get the economy to full employment? • By the size of the gap. = 100 . • gap = Yf – AS@Yf = Sf – I = (Yf – Ye)/mult. like all other autonomous expenditures. or the amount we need to increase total spending (Yf – Ye) divided by 4. in this case of 4.

a + (1 – b) Y I+G a I+G I I 0 -a Y1 Y* Yf Y .Keynesian Model 45° C+I+G Expenditure AS = C + I C a+I+G a+I S = .

S = I + G. (I + G can be thought of as private and public investment) • Notice the aggregate spending function with government (still no foreign trade). and • intersects the 45 degree line at Yf . • has a slope = mpc. or the C + I + G line: • has a y-intercept of (a + I + G).full employment • Notice that at Yf.

a + (1 – b) Y I+G a I+G I I 0 -a Y1 Y* Yf Y .Keynesian Model 45° C+I+G Expenditure AS = C + I C a+I+G a+I S = .

T (3) . we begin with: • Y=C+I+G (1) Then we take our consumption function: • C = a + bYd (2) Only now we have to account for the fact that Y and Yd are not equal • Yd = Y .Multiplier with Taxes • Let's add taxes and government spending into the multiplier formula! First.

tY (5) .Multiplier with Taxes • Yd = Y . Since taxes can be determined by the tax rate times aggregate income: • T = tY (4) Then: • Yd = Y .T (3) because disposable income is aggregate income less taxes.

tY) + I + G (7) .tY) (6) And substituting equation (6) into equation (1): • Y = a + b(Y .Multiplier with Taxes Substituting equation (5) into the consumption function: • C = a + b(Y .

tY) + I + G (7) We then solve for Y: • Y = a + bY .btY + I + G • Y .b + bt) = a + I + G (8) (9) (10) .bY + btY = a + I + G • Y(1 .Y = a + b(Y .

b + bt * (a + I + G) (11) • So the multiplier with taxes is: • 1/(1 . .b + bt) (12) And the multiplier times total injections (a + I + G) will give us the equilibrium level of output and income.Y(1 .b + bt) = a + I + G (10) • Y= 1 1.

& S Does S = I? Why or Why Not? .8Yd I = \$50 G = \$350 t = . T.. value of mult.25 • Find: Ye.Multiplier with taxes – numerical example • Given: C = \$100 + . Yd. C.

Multiplier with taxes – numerical example Ye = 1/(1-b+b[t]) (a + I + G ) = 1/.4 (100 + 50 + 350) = 2.5 (500) = 1250 .

8 x .25]) = 1/.5 [since (.8+.Multiplier with taxes – numerical example Value of the multiplier = 1/(1-b+b[t]) = 1/(1-.8[.25) =.2] .4 = 2.

50 C = a + bYd = 100 + .50 Yd = Y – T = 1250 – 312.50 = 87.8(937.Multiplier with taxes – numerical example • • • • T = .8)937.50 = 937.50 = -100 + 187.25 (1250) = 312.50 .50) = 100 + 750 = 850 S = -a + (1-b)Yd = -100 + (1-.

Multiplier with taxes – numerical example Does S = I? Why or why not? .

Multiplier with taxes – numerical example Does S = I? Why or why not? No.50 = 400 = 400 .50 + 312. total injections = total withdrawals I+G=S+T = 50 + 350 = 87.

50 = 37.Multiplier with taxes – numerical example Does S = I? Why or why not? I+G=S+T= 50 + 350 = 87.50 = 87.50 + 312.50 .50 – 50 = 37.50 = 400 = 400 and the: public deficit = private sector surplus G – T = S – I = 350 – 312.

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