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Intermediate Macroeconomics

The Keynesian Model

Chapter 5 The Keynesian Model

1. 2. 3. 4. 5. 6. 7. 8.

Simple Keynesian model Aggregate expenditures Equilibrium Consumption function Autonomous spending Autonomous spending multiplier Government fiscal policy Automatic stabilizers

Intermediate Macroeconomics

1. Simple Keynesian Model
Macroeconomics in a recession: • Classical macro theory: – Prices will fall thereby stimulating demand. – Interest rates will fall thereby stimulating investment. • Keynesian macro theory: – Prices, wages and interest rate are fixed. – Government fiscal policy stimulus needed.

2. Aggregate Expenditures

AE = C + I + G + NX
C = Consumption I = Private Domestic Investment G = Government Spending NX = Net Exports (Exports - Imports)

Intermediate Macroeconomics

Intermediate Macroeconomics

3. Equilibrium

4. Consumption Function

Y = AE
Undesired Inventory Build: Undesired Inventory Draw: where, Y > AE Y < AE

C = C0 + c ( Y
Co = Autonomous consumption c = Marginal propensity to consume out of income (MPC) Y = Income

Y = National Income AE = Aggregate Expenditures

Intermediate Macroeconomics

Intermediate Macroeconomics

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Consumption Function C = C0 + c ( Y 5000 Desired Consumption 4000 3000 2000 1000 0 0 1000 2000 3000 4000 5000 Income Dissaving 5.1000) / (5000 .8 Intermediate Macroeconomics 2 . prices. Aggregate expenditures restated • Given: AE = C + I + G + NX C = C0 + c ( Y I = I0 G = G0 NX = 0 • Step 1. State the Equilibrium Condition: Y = AE Step 3.0) Intermediate Macroeconomics = 0. Autonomous Spending Multiplier Equilibrium model solution 6.0) = 0.500) / (2500 . Autonomous spending multiplier Steps 2 and 3 AE C AE = (C0 + I0 + G0) + c ( Y 5000 4000 3000 2000 1000 0 0 1000 2000 3000 4000 5000 6000 7000 Income Step 2. Substitute AE from Step 1 into Step 2: Y = C0 + c ( Y + I0 + G0 or Y = (C0 + I0 + G0) + c ( Y Intermediate Macroeconomics 45o Line (AE = Y) all possible equilibria 5000 C0 + I0 + G0 + NX = 1000 MPC = slope of consumption line = slope aggregate expenditure line = (5000 .g. Substitute aggregate expenditures from Step 1 into equilibrium condition in Step 2 Step 4.self-governing Intermediate Macroeconomics 2500 2500 Saving C0 = 500 c = MPC = slope of consumption function = (2500 . Solve for Y (national income) Intermediate Macroeconomics 6.) .8 6.. Restate aggregate expenditures Step 2.4. Autonomous Spending Multiplier Aggregate expenditures curve 7000 6000 5000 Expenditures 6. Autonomous Spending Multiplier Step 1. interest rate) • C0 = Autonomous Consumption • I0 = Autonomous Investment • G0 = Autonomous Government Spending Autonomous (adj. State the equilibrium condition Step 3. Substitute into equation for aggregate expenditures: AE = C0 + c ( Y + I0 + G0 Intermediate Macroeconomics Step 1. Autonomous Spending Spending that is independent of any other variable (e. income.

State the Equilibrium Condition: Y = AE Step 3.c ( t ( Y . Government Fiscal Policy Step 1. NX = 0 YD = Y . Autonomous spending multiplier Step 4.6.c ( (1 .c ( T0 + c ( TR + (c .t)( Y Y .c ( T0 + c ( TR Intermediate Macroeconomics 7. Substitute AE from Step 1 into Step 2: Y = C0 + I0 + G0 + c ( Y . Restate aggregate expenditures AE = C + I + G + NX = C0 + c ( YD + I0 + G0 = C0 + c ( (Y .T0 + TR) + I0 + G0 = C0 + I0 + G0 + c ( Y . Government Fiscal Policy Steps 2 and 3 7.T0) [1 .t )] Step 2. Solve for National Income (Y) Y = C0 + I0 + G0 + c ( Y . G = G0. Government Fiscal Policy Step 4.c ( T0 + c ( TR Y = C0 + I0 + G0 .or G0 Equilibrium model solution: Y = (C0 + I0 + G0) + c ( Y Y .t )( Y = C0 + I0 + G0 + c ( (TR .c ( T0 + c ( TR Intermediate Macroeconomics Intermediate Macroeconomics 3 .MPC Intermediate Macroeconomics Intermediate Macroeconomics 7. Government Fiscal Policy Given Equations: AE = C + I + G + NX C = C0 + c ( YD I = I0. Autonomous Spending Multiplier Change in Y = Multiplier ( Change in C0. Solve for National Income (Y) 6. I0.t )] ( Y = C0 + I0 + G0 + c ( (TR .c ( (1 .c ( t ( Y .c ( Y = C0 + I0 + G0 (1 .c ( t ( Y .c) ( Y = C0 + I0 + G0 Y= 1 ( (C0 + I0 + G0) 1-c Y= 1 ( (C0 + I0 + G0) 1-c Autonomous Spending Multiplier: 1 1-c or 1 1 .c ( (1 .t ( Y .T0) Y= 1 ( [C0 + I0 + G0 + c ( (TR .T0)] [1 .c ( t)( Y Y = C0 + I0 + G0 .T0 + TR YD = disposable income t ( Y = income tax revenues T0 = lump sum tax TR = gov’t transfer payments Intermediate Macroeconomics 7.c ( T0 + c ( TR + c ( (1 .t ( Y .

Automatic Stabilizers Economy Moves Into Recession Inflation Desired Policy Government Spending Taxes Actual Outcomes G .T0)] 1-c Multiplier (assume )C0 = )I0 = )TR = 0): )Y = 1 ( ( ) G0 . Government Fiscal Policy Balanced budget multiplier • Spending multiplier (assume no income tax) 1 1–c 7.c ( ) G0) 1-c = 1 ( ( 1 – c) ( ) G0 1-c = 1 ( ) G0 Multiplier = 1 Intermediate Macroeconomics • Lump Sum tax multiplier .c = 1–c =1 1–c 1–c 1-c Intermediate Macroeconomics 8.Income Tax Receipts n/c n/c Increase n/c Decrease n/c n/c Decrease n/c Increase Increase Decrease Decrease Increase Intermediate Macroeconomics 4 . Government Fiscal Policy Multipliers Assume c (marginal propensity to consume) = 0.8 7. Government Fiscal Policy Balanced Budget Multiplier From Step 4 (assume t = 0): Y = 1 ( [C0 + I0 + G0 + c ( (TR .3 1 – c ((1-t) c = 1.0) Income Tax (t = 0. TA – Lump Sum Tax t(Y .1.c ( ) T0) 1-c Balanced Budget () G0 = ) T0): )Y = 1 ( ( ) G0 .c 1-c • Balanced budget multiplier: spending multiplier – lump sum tax multiplier 1 .8 1 – c ((1-t) • \$1 increase in lump sum taxes Intermediate Macroeconomics Intermediate Macroeconomics 7.8 1 – c ((1-t) c = . Government Fiscal Policy Balanced budget multiplier No Income Tax (t = 0.c =-4 1-c 1 = 2.Social Security Benefits TR – Unemployment Comp.Defense Spending TR .7.3) • \$1 increase in government spending matched by Autonomous Spending Transfer Payment Lump Sum Tax 1 =5 1-c c =4 1-c .