MACROECONOMICS 1

KEYNESIAN (I)
ROLE OF AGGREGATE DEMAND
 INTRODUCTION

• Developed against the background of the Great Depression of the

1930s.

• Founder: John Maynard Keynes, who authored the book ‘The General
Theory of Employment, Interest and Money.’

• According to the Keynes’s theory, the high unemployment was a result

of deficiency in AD and AD was too low because of inadequate
investment (I). This provided the basis for economic policies to combat
unemployment by stimulating AD.

• Keynes’s theory advocates using monetary and fiscal policies to

regulate AD.

2
 INTRODUCTION

• Circular Flow of Income and Output

3
 SIMPLE KEYNESIAN MODEL

• At equilibrium, the output must equal AD.

Y = AD

• AD comprises C, I and G
AD = C + I + G (assumption: closed economy)

• Thus;
Y = AD = C + I + G (1)

• Assume that national income paid to households in return for factor

services (wages, interest, rent and dividends) is either C, S or paid out
in T.
Y=C+S+T

4
 SIMPLE KEYNESIAN MODEL

• Therefore:
C+S+T=C+I+G
S+T=I+G (2)
• S and T are leakages.
• Part of the income that is saved is held in the form of some
financial asset (currency, bank deposits, bonds, equities) whilst
taxes are paid to the government.
• I and G are injections.

5
 SIMPLE KEYNESIAN MODEL

• At equilibrium: I = Ir (3)
where I = desired investment and Ir = realized investment

• Ir may differ from I due to inventory investment. Therefore (Ir –

I) is the unintended inventory accumulation, as shown
below:
Y > AD
C + Ir + G > C + I + G
Ir > I

6
 SIMPLE KEYNESIAN MODEL

• (I – Ir) is the unintended inventory shortfall, as shown below:

AD > Y
C + I + G > C + Ir + G
I > Ir

• If Y > AD, Ir > I, Y will fall as firms cut production to reduced the
inventory levels.
• If Y < AD, Ir < I, Y will rise as firms increase production to
increase the inventory levels.

7
 SIMPLE KEYNESIAN MODEL

• Level of C is a stable function of Yd where

Yd = Y-T
• Thus;
C = a + bYd where a > 0, 0 < b < 1
a = measure of the effect on C of other variables
b = marginal propensity to consume
= ΔC/ΔYd
• Figures 5.1 and 5.2

8
 SIMPLE KEYNESIAN MODEL

• Since Y = C + S + T and Yd = Y –T
Y–T=C+S
Yd = C + S

• S = -a + (1-b)Yd
where;
(1-b) = marginal propensity to save (MPS)
= ΔS/ΔYd

9
 SIMPLE KEYNESIAN MODEL

• Keynes believed that;

a) The underlying causes of changes in AD (and Y) are
autonomous components of AD (components determined
independently of current Y).
b) I was the mostly highly variable of the autonomous
components of AD and, therefore, responsible for income
instability.
• I depends on r and πe.

10
 SIMPLE KEYNESIAN MODEL

• How are expectations formed?

• Extrapolate past trends into the future, ignoring possible
future changes unless there is specific information.

• Since expectations can frequently shift in response to new

information, I is considered unstable.

• G is assumed to be controlled by the policymaker and

therefore does not depend on Y. So is T.

• I and G are autonomous expenditures.

• I, G and T are exogenous variables. Y is endogenous.

11
 EQUILIBRIUM INCOME: 3-SECTOR

• If it is a fixed tax (T):

Y=C+I +G
= a + bYd + I + G
= a + b(Y – T) + I + G
= a + bY – bT + I + G

Y – bY = a – bT + I + G
Y(1 – b) = a – bT + I + G
Y = [1/(1-b)](a – bT + I + G)
• Figure 5.3

12
 EQUILIBRIUM INCOME: 3-SECTOR

• If it is a proportional tax (tY):

Y=C+I +G
= a + bYd + I + G
= a + b(Y – tY) + I + G
= a + bY – btY + I + G

Y – bY + btY = a + I + G
Y(1 – b + bt) = a + I + G
Y = [1/(1-b+bt)](a + I + G)

13
 EQUILIBRIUM INCOME: 3-SECTOR

• Y = (autonomous expenditure multiplier) x (autonomous expenditures)

• Therefore, 1/(1-b) is an autonomous expenditure multiplier.

• Since 0 < b < 1,

1/(1-b) > 1 where 1/(1-b) = 1/(1 - MPC)

• A given change in the autonomous component of AD causes a larger

change in equilibrium income because of the multiplier.

14
 EQUILIBRIUM INCOME: 3-SECTOR

• ΔY = [1/(1-b)]ΔI
ΔY/ΔI = 1/(1-b) = 1/(1-MPC) = 1/MPS

• Effects of an increase in I (Figure 5.4).

• Multiplier concept is central to the Keynes’s theory.
• It explains how shifts in I set off a process that causes both I
and C to vary.
• In short, the multiplier shows how shocks to one sector are
transmitted throughout the economy.

15
 EQUILIBRIUM INCOME: 3-SECTOR

• Similarly,
ΔY = [1/(1-b)]ΔG
ΔY/ΔG = 1/(1-b)

ΔY = [-b/(1-b)]ΔT
ΔY/ΔT = -b/(1-b)

• Effects of an increase in T (Figure 5.5).

16
 EQUILIBRIUM INCOME: 3-SECTOR

• The T multiplier is one less in absolute value than the G

multiplier.
• If there is a combination of an increase in G accompanied by an
equal increase in T:
ΔYΔG + ΔY/ΔT = 1/(1-b) + [-b/(1-b)] = 1

• Balanced budget multiplier – changes in T have a smaller per-

dollar impact on Y than G.
• Assume I declines. Show how fiscal policy can be used to
stabilise the economy and restore equilibrium (Figure 5.6)

17
FOUR-SECTOR: OPEN ECONOMY

• Y=C+I+G+X–Z
Where; X = exports
Z = imports

• Z = u + vY u > 0, 0<v<1
Where;
u = autonomous component of imports
v = marginal propensity to import (ΔZ/ΔY)

• X is exogenous as it is determined by foreign income.

18
 EQUILIBRIUM INCOME: 4-SECTOR

• If it is a fixed tax (T):

Y=C+I+G+X–Z
= (a + bYd) + I + G + X – (u + vY)
= a + b(Y –T) + I + G + X – u – vY
= a + bY –bT) + I + G + X – u – vY
Y – bY + vY = a + I + G + bT + X – u
Y(1 – b + v) = (a + I + G + bT + X – u)
Y = [1/(1 – b + v )] (a + I + G + bT + X – u)
= (multiplier)(autonomous expenditures)
Y = [1/(1 – b + v )] (a + bT – u + I + G + X)

19
 EQUILIBRIUM INCOME: 4-SECTOR

• If it is a proportional tax (tY):

Y=C+I+G+X–Z
= (a + bYd) + I + G + X – (u + vY)
= a + b(Y –tY) + I + G + X – u – vY
Y – bY + btY + vY =a+I+G+X–u
Y(1 – b + bt + v) = (a + I + G + X – u)
Y = [1/(1 – b + bt + v )] (a + I + G + X – u)
= (multiplier)(autonomous expenditures)
• See Figures 5.7 and 5.8

20
 EQUILIBRIUM INCOME: 4-SECTOR

• Compare the multiplier of a closed economy with open

economy:
1/(1 - b) > 1/(1 – b + v) for fixed tax (T)
1/(1- b + bt) > 1/(1 – b + bt + v) for proportional tax (tY)

• Why?
• The increase in imports per unit of income constitutes an
additional leakage from the circular flow of domestic income
at each round of the multiplier process and reduces the
value of the multiplier.

21
 EQUILIBRIUM INCOME: 4-SECTOR

ΔY/ΔX = 1/(1-b+v) → Y↑
ΔY/ΔI = 1/(1-b+v) → Y↑
ΔY/ΔG = 1/(1-b+v) → Y↑

• But;
ΔY/Δu = -1/(1-b+v) → Y↓

22