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Menzie D. Chinn Social Sciences 7418

This set of notes outlines the Keynesian model of national income determination in closed and open economy. It then shows how to solve for multipliers. 1. An Expanded Model and Equilibrium Eq.No. Equation (1) (2) (3) (4) (5) (6) (7) (8) (9) Description

Output equals aggregate demand, an equilibrium condition Definition of aggregate demand Consumption function, c1 is the mpc Definition of disposable income Tax function; t 0 is lump sum taxes, t1 is marginal tax rate. Investment function, exogenous Government spending on goods and services, exoagenous Exports, exogenous Imports, exogenous ∂C Note: the marginal propensity to consume out of disposable income is c1 = . ∂ (Y − T ) To simplify matters, for the moment, “close” the economy so that there are no imports and exports, x0 = m0 = 0 . Then (8) and (9) are irrelevant. Substitute (3)-(7) into (2), and substitute (2) into (1): (10) Y = Z = (c0 + c1YD ) + (b0 ) + (GOo ) Y = Z = (c 0 + c1 (Y − (t 0 + t1Y ))) + (b0 ) + (GOo ) Collect up terms: (11) Y = c1 (1 − t1 )Y + Λ 0 where Λ 0 ≡ c 0 − c1 (t 0 ) + b0 + GOo

Y =Z Z ≡ C + I + G + X − IM C = c o + c1YD YD ≡ Y − T T = t 0 + t1Y I = b0 G = GO0 X = x0 IM = m0

Shift “Y” terms to the left hand side: (12) Y − c1 (1 − t1 )Y = Λ 0 Æ Y [1 − c1 (1 − t1 )] = Λ 0

Divide both sides by the term in the square bracket to obtain equilibrium income, Y0: 1

Z Y=Z Z=c1(1-t1)Y+Λ0 Slope = c1(1-t1) Λ0 45° Y0 Figure 1: Equilibrium in the Keynesian Cross Y 2. investment spending ( b0 ). Remember.– affect equilibrium income. Effects of Changes in Autonomous Spending and Multipliers To think about how changes in autonomous spending – the constant in consumption ( c 0 ). Interpretation of (13): equilibrium income is a multiple of the amounts of “autonomous” spending. that Λ 0 ≡ c 0 − c1 (t 0 ) + b0 + GOo . for instance.(13) Y0 = γ Λ 0 let γ = 1 [1 − c1 (1 − t1 )] Where the “0” subscript denotes the equilibrium value of output. however. so the higher lump sum taxes. So if. then: 2 . the only autonomous spending component that changes is government spending (so) ΔΛ = ΔGO . consider a change of income ( ΔY ) as being attributable to changes in each of those autonomous spending components. Notice also that lump sum taxes enter in negatively. government spending ( GO0 ). The higher the level of autonomous spending. Take equation (13): (14) ΔY = γ ΔΛ (holding constant the tax rate). the higher the equilibrium level of income. the lower equilibrium income is.

then: (16) ΔY = γ Δb0 Returning to (15). The $1 in spending is income for others. That spending becomes income for somebody else. $c1 is spent. That can be obtained by dividing both sides by ΔGO : (17) 1 ΔY =γ ≡ ΔGO 1 − c1 (1 − t1 ) Why is the change in income greater than the change in government spending? Consider a $1 increase in government spending.(15) ΔY = γ ΔGO Notice that a similar expression occurs if one holds government spending. Z Y=Z Z=c1(1-t1)Y+Λ1 Z=c1(1-t1)Y+Λ0 ΔY = γ ΔGO Λ1 Λ0 45° Y0 Y1 Y Figure 2: Change in income due to a change in autonomous spending Note that Y1 = Y0 + ΔY. + c1n = for n= ∞ . Adding up the entire sequence of spending. and for simplicity set the marginal tax rate (t1) to zero. lump sum taxes. Returning to (15). 1 − c1 3 . the increase in government spending can interpreted in the following figure. consider what the change in income for a change in government spending is. of that $1. exports and imports constant.. of which (c1)×( $c1).. You should also understand that Λ1 = Λ0 + ΔΛ. one obtains: 1 1 + c1 + c12 + c13 + .

Recall. so γ = (24) becomes: 4 1 . Then [1 − c1 ] . How does it differ from the government spending multiplier? 3. To see this. Substituting this in: (24) v ΔS = −Δc0 + (1 − c1 )γ Δc0 In this economy. and restate (18): (22) (23) S ≡ Y − C = Y − (c0 + c1Y ) ΔS = ΔY − Δc0 − c1 ΔY = −Δc0 + (1 − c1 )ΔY An increase in saving is represented by a decrease in autonomous consumption Δc0 < 0 .See if you can solve for the lump sum tax multiplier. the marginal tax rate is zero (t1=0). which states that individual consumers’ attempts to increase saving will end up decreasing overall saving. G both equal zero). (21b) indicates investment equals the sum of private saving and public saving. assume no government sector (so T. we know (15) or (16) that ΔY = γΔc0 . An interesting aspect of the equilibrium condition that saving equals investment is “Paradox of Thrift”. An Alternative Approach (18) S ≡ YD − C ≡ Y − T − C In a closed economy: (19) Y ≡C + I +G Bringing C to the left hand side. with no government. and subtracting T from both sides: (20) Y −T −C ≡ I + G −T Notice the left hand side of (20) is the same as (18) (21a) S ≡ I + G − T (21b) I ≡ S + (T − G ) The term in the parentheses is the government budget balance.

1. despite the fact that individual households attempt to save more. In the previous section. government spending multiplier is: (29) ΔY 1 = ΔGO 1 − c1 (1 − t1 ) + m1 In this open economy model. the difference between exports and imports. output is lower. aggregate saving remains unchanged. the government spending multiplier is less than that in the closed economy. Suppose we assume net exports. tax lump multipliers).12 5 . If one goes through the same steps as in Section 1. suppose when income rises. At the same time. one obtains: ∂Y (26) (27) Y = Z = (c 0 + c1YD ) + (b0 ) + (GOo ) + ( x0 ) − (m0 + m1Y ) Y = Z = (c 0 + c1 (Y − (t 0 + t1Y ))) + m1Y + (b0 ) + (GOo ) + ( x0 ) − (m0 ) Solving for equilibrium. In particular. The Open Economy Multiplier One important point to realize is that there are different multipliers corresponding to different variables changing (consider the government spending vs. e302_keynesian_s12 21.(25) ΔS = −Δc0 + Δc0 = 0 In other words. More importantly. imports (which enter in negatively in the calculation of net exports) rise with income. net exports depended upon an exogenously determined amount. the multiplier for the same variable will be different if the model changes. depend upon income. one obtains: (28) ⎞ ⎛ 1 Y0 = ⎜ ⎟Λ 0 where Λ 0 ≡ c 0 − c1 (t 0 ) + b0 + GOo + x0 − m0 ⎜ 1 − c (1 − t ) + m ⎟ 1 1 1 ⎠ ⎝ In this case the. 4. consumption rises. This assumption can be incorporated into the export equation thus: (9’) IM = m0 + m1Y ∂imports Note that m1 = . and some of that consumption falls on imported goods. Hence.

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