EIA2002 MACROECONOMICS II

LECTURE 2
The Keynesian System: The Role of Aggregate Demand
Content

1. Introduction: The Problem of Unemployment

2. The Simple Keynesian Model: Conditions for Equilibrium Output
3. The Components of Aggregate Demand
4. Determining Equilibrium Income
5. Changes in Equilibrium Income
6. Fiscal Stabilisation Policy
7. Exports and Imports in Simple Keynesian
8. Conclusion

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 Introduction: The Problem of Unemployment

• Keynesian economies developed amid the

Great Depression in 1930s which caused
significant increase in unemployment and
contraction in GDP
• John Maynard Keynes – The General Theory
of Employment, Interest and Money is the
foundation of the Keynesian system
• According to the Keynes theory, the high
unemployment was due to deficiency in AD
• Highlighted the role of Fiscal Policy in
stimulating AD, and thus creating
employment – expansionary fiscal policy
• In classical - Changes in tax or government
spending (FP) will not affect AD

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 The Simple Keynesian Model: Conditions For Equilibrium Output
• The Keynesian system is based on the principle • Rewriting equation in equilibrium:
of aggregate demand, which can be stated as C + S + T = Y = C + I + G or
follows: S +T = I + G
✓ in the SR (that is, the time period in which
productive capacity is fixed within narrow • Incorporating realized investment which appears
limits), real output and employment are in national income accounts and not the
determined by aggregate demand. investment that desired by firms
• Aggregate demand (AD) is defined as total or C + Ir + G = C + I + G or
aggregate spending for newly produced goods Ir = I
and services
• At equilibrium level of output requires output = • Three conditions for equilibrium:
AD Y=E=C+I+G
✓ Y = E, where Y is output and E is AD or S +T = I + G
desired expenditure on output Ir = I
• Assumptions involved are:
a. No external sector
Y=E=C+I+G
b. No depreciation
c. GDP = National Income, so
Y = C + S +T
d. Aggregate price level is fixed – all variables
are changes in real terms (real variables)
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 The Simple Keynesian Model: Conditions For Equilibrium Output
• Flow from business to household – payments for
factor services = national income
• Flow from household to business – consists of
the factor services supplied by the household
sector
• National income to household is distributed
into:
a. Flow of C that goes back to business
sector as a demand for output
b. Savings (leakages from the central loop)
c. Taxes
• Savings – part of income that are saved in the
form of financial asset (currency, deposits &
bonds) • Explanation on the unintended inventory
• Net taxes – tax paid to the government minus accumulation which is Ir - I
transfer payments (social welfare) to the
household • When Y < E – demand exceeds production,
• Investment (injection) - flow from financial there is an inventory shortfall (Ir < I) and a
markets to the business sector tendency for output to increase and at
• Government spending – demand for output which level AD = Y
from businesses

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 The Components of Aggregate Demand

CONSUMPTION
• Consumer demand is a stable function of
disposable income (YD)
• YD = Y – T (national income – taxes)
• Consumption function:
C = a + b Yd, a>0, 0 < b < 1
• Intercept a is positive, the value of
consumption when YD = 0
• Parameter b is the slope of the function
(marginal propensity to consume) – the
increase in C per unit increase in YD
∆𝐶
𝑏=
∆YD

• b>0, the increase in consumption with

increase in disposable income but the
increase in consumption will be less than the
increase in disposable income (b<1)

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 The Components of Aggregate Demand

SAVINGS

• From the definition of national income,

𝑌 = 𝐶 + 𝑆 + 𝑇
• We can write
𝑌𝐷 = 𝑌 – 𝑇 = 𝐶 + 𝑆

• Therefore, disposable income is by

definition, consumption plus saving

• Consumption-income relationship implicitly

determines the saving-income relationship
𝑆 = − 𝑎 + (1 – 𝑏) 𝑌𝐷
• If a one-unit increase in 𝑌𝐷 leads to an increase
• If consumption is a units with 𝑌𝐷 equal to of 𝑏 units in consumption, the remainder of the
0, then at that point one-unit increase (1 – 𝑏) is the increase in saving:
𝑆 = 𝑌𝐷 – 𝐶 = 0 – 𝑎 ∆𝑆
=−𝑎 =1 −𝑏
∆𝑌𝐷

• This increment to saving per unit increase in

disposable income (1 – 𝑏) is called the marginal
propensity to save (MPS)
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 The Components of Aggregate Demand

INVESTMENT GOVERNMENT SPENDING

• Keynes believe that changes in investment
expenditure were one of the major factors
responsible for changes in income
• It is an autonomous component of AD
• What determines investment?
❑ The interest rate – cost of borrowing.
Therefore, investment is inversely related to
the interest rate
• Government spending (G) is the second
element of autonomous expenditures
• G is controlled by policymakers, as such do
not directly depend on the level on income
• Level of tax receipts (T) is controlled by the
policymaker and is a policy variable

❑ The state of business expectations -

Business managers expectations about
future profitability are a central element in
Keynes’s analysis of the source of economic
instability
• These factors cause investment demand to be
unstable
• Investment expenditure is autonomous and
responsible for instability in income

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 Determining Equilibrium Income

• The first form for an equilibrium level of • Substituting the consumption equation, we
income ത the equilibrium level of
can solve for 𝑌,
Y=C+I+G income:
• The level of equilibrium income (Y) is the Y=C+I+G
endogenous variable to be determined Y + a + bY – bT + I + G
• I, G and T are exogenous variables Y = a + bY – bT + I + G
determined by factors outside the model Y - bY = a– bT + I + G
• C which is the induced expenditure Y (1 – b) = a– bT + I + G
determined endogenously by the 𝟏
𝑌ത = 𝒂 − 𝒃𝑻 + 𝑰 + 𝑮
consumption function 𝟏−𝒃
C = a + b YD = a + b(Y – T)
C = a + bY – bT

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 Determining Equilibrium Income

Panel (a)
• Income is measured along horizontal axis and
the components of AD on the vertical
• The 450 line – all points along this line indicate
that aggregate expenditure = aggregate output
• Line C + I + G = aggregate expenditure (E)
schedule (I and G are autonomous expenditure
components and do not depend on income),
therefore it lies above the consumption function
by a constant amount

Panel (b)

• The line I + G is horizontal due to autonomous

expenditure and not dependent on income
• S + T is upward sloping which varies positively
with income
• At equilibrium:
❑ The 450 line crosses over C + I + G
❑ AD = Y
❑ S +T = I + G
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 Determining Equilibrium Income
Why other points cannot be equilibrium?
• For example, at YL AD exceeds income
• C + I + G is above the 45o line
• I + G > S +T
• Y = YL (C + I + G) > C + Ir + G
• I > Ir (desired investment > actual investment)
• There will an unintended inventory shortfall and
tendency for output to rise

• ത at which
For example, if the income level is above 𝑌,
level Y > AD
• C + I + G is below the 45o line
• S +T > I + G
• Y = C + Ir + G > YL (C + I + G)
• Ir > I (actual investment > desired investment).
• There will an unintended inventory and tendency for
output to fall

ത
At 𝑌:
❑ Y =AD
❑ No tendency for unintended inventory shortfall
or accumulation
❑ No tendency for output to change

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 Multipliers

• (a) Is autonomous component of C

Equilibrium is when and (-bT) is the autonomous effect
𝟏 autonomous expenditures of tax collections on AD. Therefore,
ഥ=
𝒀 𝒂 − 𝒃𝑻 + 𝑰 + 𝑮
𝟏−𝒃 a –bT determines the height of the
C function
• G + I affect AD at given income.
They are the autonomous factors
ഥ = (autonomous expenditure multiplier) x
𝒀 affecting AD
(autonomous expenditures)
Every dollar of
autonomous
Fraction of any increment expenditure is
to YD that goes to C multiplied by this
factor to get its
contribution to
equilibrium income Simple Keynes’s theory includes:
❑ C is a stable function of income, i.e. MPC is stable
• Thus 1/(1 − 𝑏) is called the aggregate ❑ Changes in income come primarily from changes in the
expenditure multiplier or autonomous autonomous component of AD, especially I
expenditure multiplier. It is positive. An increase ❑ A given change in an autonomous component of AD causes
in autonomous spending has a amplified impact a large change in equilibrium income due to multiplier effect
on GDP ❑ Without G, income will become unstable because of
instability of investment
• But – 𝑏/(1 − 𝑏) is the tax multiplier. It is ❑ Government could intervene and counteract the effects of
negative. An increase in taxes reduces GDP. This shifts in investment through G and T
implies that deficit spending can have a powerful ❑ Changes in G and T could keep the sum of the autonomous
effect for stimulating the economy. expenditure constant when there is an undesirable changes
in Investment
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 Changes in Equilibrium Income due to Changes in Investment

Change in autonomous Investment • With the other elements of autonomous

• Consider a change in autonomous investment (I) expenditures fixed, change in equilibrium income as
with all other variables remain unchanged investment changes as:
• Change in equilibrium income is ∆Y = ∆ I + ∆C

1 ∆𝑌ത 1 ∆Y - ∆C = ∆ I or ∆S = ∆I
∆𝑌ത = ∆𝐼 or =
1−𝑏 ∆𝐼 1−𝑏
• A unit change in (I) causes a change in Y by 1/(1-b) • With T and G are fixed, S must rise as the same
unit amount of I
• If 𝑏 is 0.8,Y changes by 5 units for each unit of ∆I
• This is called the multiplier effect or ripple effect S +T = I + G
• Assumption: If there is an increase in investment, • Restoring equilibrium requires that income rise by
then output increases which increase payments to enough to new S = new I
factors of production such as wages. This then • As ∆S = (1 – b) ∆Y, we have an equation:
translate into higher demand from households
following higher disposable income amid a fixed T. ∆I = (1 – b) ∆Y
• Consumption will increase but less than increase in
income. If I increase by 100 units with mpc at 0.8,
∆𝑌ത 1 1 1
there would be an additional 80 units of consumer = 1−𝑏 = 1−𝑀𝑃𝐶 = 𝑀𝑃𝑆
demand. This 80 units of demand increases ∆𝐼
production which then creates second round effect.
• If MPC = 0.8, then marginal propensity to save (MPS)
There will be a further increase in consumer
is 1 – b = 0.2
demand by 64 unit if mpc is 0.8 (80 x 0.8)
• For each dollar increase in income will generate 20
• The reason why income increases more than
cents worth of new savings
the increase in investment
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 Changes in Equilibrium Income due to Changes in Investment

• Initial investment is at I0 and Government spending and

taxes are G0 and T0, equilibrium income is 𝑌ഥ0
• Assumption: Investment increases to I1
❑ The AD schedule shifts by ∆I (I1 - I0)
❑ 𝐸0 = 𝐶 + 𝐼0 + 𝐺0 to 𝐸1 (= 𝐶 + 𝐼1 + 𝐺0 )
❑ The I0 + G0 schedule shifts up by the same amount
to I1 + G0
❑ Equilibrium is restored at 𝑌ഥ1
❑ Income is now equal to increase in I + induced ∆𝐶
❑ Saving has also increased by the same amount as
investment (∆𝑆 = ∆𝐼 )

• Central to Keynes’s theory is the concept of multiplier

• The multiplier shows how shocks to one sector are
transmitted throughout the economy
• The theory also implies that other components of
autonomous expenditure affect the overall level of
equilibrium income
• The effect on equilibrium income of a change in each of
the policy-controlled elements of autonomous
expenditures, G and T are showed in the following
explanations

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 Changes in Equilibrium Income due to Changes in Investment
Change in Government Spending (G)
1 ∆𝑌ത 1
• ∆𝑌ത = ∆𝐺 or =
1−𝑏 ∆𝐺 1−𝑏
• Similar effect of investment.The increase in G increases C
• Assumption: Investment increases to G1
❑ The AD schedule shifts
❑ 𝐸0 = 𝐶 + 𝐼0 + 𝐺0 to 𝐸1 (= 𝐶 + 𝐼0 + 𝐺1 )
❑ The I0 + G0 schedule shifts up by the same amount to
I0 + G1
❑ Equilibrium is restored at 𝑌ഥ1
Change in Taxes (T)
1 ∆𝑌ത −𝑏
• ∆𝑌ത = (−𝑏)∆𝑇 or =
1−𝑏 ∆T 1−𝑏
• A tax increase lowers disposable income (Y – T)
• 𝐴𝐷 schedule shifts down as it reduces C and 𝑆 + 𝑇 up
• Equilibrium is falls from 𝑌ഥ0 to 𝑌ഥ1
• 𝐴𝐷 schedule shifts down by −𝑏∆𝑇 : by only a fraction (𝑏)
of the increase in taxes
Reason: a one dollar increase in taxes reduces disposable income by
one dollar but lowers by only 𝑏 dollars. The rest of the one dollar
decline in disposable income is absorbed by a fall of (−𝑏) dollars in
saving. Unlike changes in 𝐺 and 𝐼 earlier, which have a dollar-for-dollar
effect on autonomous 𝐴𝐷, a one-dollar change in tax shifts 𝐴𝐷 only a
fraction (−𝑏) of one dollar. It is this fraction (−𝑏) times the
autonomous expenditure multiplier, 1/(1 − 𝑏) that gives the effect on
equilibrium income of a one dollar change in taxes, −𝑏/(1 − 𝑏).
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 Government Spending vs Taxes Multipliers

• The tax multiplier is one less in absolute value
than the government expenditure multiplier
• This reflects that tax changes have a smaller per-
dollar impact on equilibrium income than do
spending changes
• A one dollar increase in G financed by a one
dollar increase in taxes increases equilibrium
income by 1 dollar termed as balanced budget,
which has multiplier is 1.
As an example, if the 𝑀𝑃𝐶 = 0.9 , then
1/(1 – 0.9) = 1/(0.1) = 10
For every $1 increase in government
spending, GDP will increase by $10
But also for every $1 that taxes are
increased, GDP falls by $9

With a balanced budget ( 𝐺 = 𝑇 ), every

$1 increase in 𝐺 will increase 𝐺𝐷𝑃 by only
∆𝑌ത ∆𝑌ത 1 −𝑏 1 −𝑏 $1.
+ = + = =1
∆𝐺 ∆𝑇 1−𝑏 1−𝑏 1−𝑏

Government Tax Balanced

spending multiplier Budget
multiplier multiplier

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 Fiscal Stablisation Policy
• Economy is in equilibrium at a full-employment
(potential) level 𝑌ത𝐹 with aggregate demand at
• 𝐸𝐹 equal to (𝐶 + 𝐼0 + 𝐺0 )
• Assume autonomous investment decline from 𝐼0 to
𝐼1 as a result of an unfavourable change in business
expectations
• In the absence of a policy action, 𝐴𝐷 declines to
• 𝐸1 = (𝐶 + 𝐼1 + 𝐺0 )
• The new equilibrium income is below full
employment at 𝑌ത𝐿
• With a fiscal policy response, G increases by an
amount sufficient to restore equilibrium at 𝑌ത𝐹
• A rise of government spending from 𝐺0 to 𝐺1 shifts
𝐴𝐷 curve back to
• 𝐸𝐹 now equal to (𝐶 + 𝐼1 + 𝐺1 )

• A tax cut could also be used to restore equilibrium

• Because the tax multiplier is smaller, the appropriate
tax cut would be larger than the required spending
increase

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 Exports and Imports in Simple Keynesian Model

• Open economy:Y = C + I + G + (X – M) • If b = 0.8 and v = 0.3

• Assumption: YD = Y (no changes in tax), relative Closed Economy Open Economy
prices and exchange rates are fixed
• Imports (Z) depends on income and will have 1 1
𝑌ത = 𝑌ത =
autonomous component: Z = u + vY, u > 0, 0 < v < 1−𝑏 1−𝑏+𝑣
1 1 1
• u is the autonomous component of imports and v is 𝑌ത = 𝑌ത =
1 − 0.8 1 − 0.8 + 0.3
the marginal propensity to import which is the
increase in import demand per unit increase in GDP 1 1
• Demand for exports depends on foreign income, 𝑌ത = =5 𝑌ത = =2
0.2 0.5
therefore it is exogenous
• Equations: 𝑌ഥ = 𝑎 + 𝐼 + 𝐺 𝑌ഥ = 𝑎 + 𝐼 + 𝐺 + 𝑋 − 𝑢

𝑌=𝐶+𝐼+𝐺+ 𝑋−𝑀 • When the economy is more open, the lower will be
the impact of autonomous multiplier such as an
𝑌 = 𝑎 + 𝑏𝑌 + 𝐼 + 𝐺 + 𝑋 − 𝑢 − 𝑣𝑌 increase in G
• For example, if C increases with higher G, there will be
C
higher demand for M which translate to lower Y
-Z
• Increase in X = Increase in I or G (will increase
𝑌 − 𝑏𝑌 + 𝑣𝑌 = 𝑎 + 𝐼 + 𝐺 + 𝑋 − 𝑢 equilibrium Y
1 −𝑏+𝑣 𝑌 =𝑎+𝐼+𝐺+𝑋 −𝑢 • However, an autonomous increase in u will cause a
decline in equilibrium income as there is a shift from
1 domestically produced goods to foreign goods
𝑌ത = (𝑎 + 𝐼 + 𝐺 + 𝑋 − 𝑢)
1−𝑏+𝑣 • The reason for at times nations tried to stimulate the
autonomous
autonomous expenditure
expenditures
domestic economy by promoting X and restricting M
multiplier
LECTURE 2 20
Conclusion

• This model is incomplete as need to consider money and interest rate, behaviour
of prices and wages
• In simple Keynesian model - AD plays a crucial role in income determination
• Changes in autonomous elements of AD, especially investment demand, are the
key factor causing changes in the equilibrium level of income
• The model also emphasise the role of stabilization policies in managing AD to
cushion equilibrium output from shifts in the unstable investment demand

LECTURE 2 21