Unit 14

UNEMPLOYMENT AND FISCAL POLICY

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 Unit 14 Roadmap
• The transmission of shocks: The multiplier process – 14.1
• The multiplier model (consumption) – 14.2
• Household target wealth – 14.3
• Investment – Unit 14.4
• The role of government – Unit 14.5
• Stabilising the economy – Unit 14.6
• The multiplier in practice – Unit 14.7
• The government’s finances – Unit 14.8
• Aggregate demand and unemployment – Unit 14.10

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 Learning outcomes (Part 1)
• Calculate and interpret the Keynesian multiplier.
• Interpret, calculate and explain the components of the consumption
function.
• Interpret, calculate and explain the components of the aggregate demand
function.
• Draw the consumption function and indicate the value of each component
on the graph.
• Draw the goods market equilibrium graph.
• Explain the goods market equilibrium and translate changes in
consumption (C) and Investment (I) onto a graph.
• Explain the multiplier process.
• You must be able to draw graphs, annotate and interpretate them correctly
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 The Context for This Unit
Aggregate demand (real GDP) can fluctuate due to
consumption and investment decisions. (Unit 13)
GDP = C + I + G + NX and NX = (X – M)
The aggregate decisions of households and firms can
destabilize the economy.
• How can government intervene to stabilize the economy?
• Why are government policies sometimes ineffective?
• How can we model the link between output and
unemployment?
 Keynesian theory and economic stability
• Keynes believed that the cause of
the Great Depression (1929-1933)
was an unusually low level of
aggregate spending
• This diagnosis suggests an
immediate remedy: use government
policies to increase aggregate
spending [Unit 9.6-9.7]
• Extra income leads to extra
spending, which leads to further
increases in output and income. The
process continues around and
around the circular flow 5
 Keynesian model assumptions:
1. Demand creates its own supply.
2. The aggregate price level remains fixed. This means that all variables are real
variables, and all changes are in real terms. (Therefore if aggregate demand
increases, output will increase, prices remaining the same.)
3. The economy has excess production capacity.
4. The economy is closed — there is no export and import. (This only applies to
the initial simple Keynesian model)
5. We are building our model in a goods market. There is no monetary market
6. Our equilibrium model is in the short run – Keynes believed that we are all
dead in the long run anyway
 Remember unit 9: Increased government Expenditure
Figure 9.15: A firm raises output and employment
following an increase in demand as a result of

Government
by expanding
aggregate demand
monetary or fiscal policy

• monetary policy
• fiscal policy
 US War on Poverty
President Roosevelt’s
begins: 1964 Start of
New Deal: 1933-36
40% US deploys ground troops global
End of in Vietnam: financial
End of
Government revenue (as a percent

WWII: 1945 1965 crisis: 2008

WWI: 1918
30% Start of
of GNP) / GDP growth (%)

Great 1970s
Depression:
20% 1929

10%

0%

-10%

-20%
1870
1875
1880
1885
1890
1895
1900
1905
1910
1915
1920
1925
1930
1935
1940
1945
1950
1955
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
2010
2015
GDP growth Government size
Stabilisation policy and South Africa
 Main aim of unit 14 Part 1
• Building the Keynesian multiplier model (in TWO STEPS) that helps us
to understand how the decisions of households (C) and firms (I) affect
real GDP/ aggregate demand (AD)/output.

• Step 1: Build the consumption function (households only)

• Step 2: Build the AD function by adding I (firms) to C.

• Then we will evaluate the equilibrium of this model.

14.1 the Keynesian multiplier effect
 The Keynesian multiplier effect in a private
economy
• A private economy only has households and firms.

• We are only looking at consumption (C) by households and

Investment (I) by firms in this private economy.

• Later in the unit we will add the other components…..

 14.1 Transmission of shocks: Multiplier process
Remember (Unit 13):
• Firm and household spending behaviour affect the economy
• Changes in current income influence spending, affecting the income of
others –
• so indirect effects through the economy amplify the direct effect of a
shock to aggregate demand (often shortened to AD)
Part 1: AD = C + I
Part 3: AD = C + I + G + NX

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 14.1 Transmission of shocks: Multiplier process

AD = C + I
Changes in household consumption (C) and investment by
firms (I) affects real GDP (output).

The Keynesian multiplier is a tool that helps us to understand

how changes in C and I have an effect on real GDP (output).

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 14.1 Transmission of shocks: Multiplier process
The Keynesian multiplier helps us understand:

1. How the impact of firms and households’ spending decisions will affect
the whole economy.

2. How large the direct and indirect change will be on real GDP

3. Part 3: And/ or what the effect of lower government spending will be,
etc… (this we discover as we build our model)

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 Let us look at C(onsumption)
• Consumption is defined as expenditure on goods and services by
households in the economy.
• There will be consumption even with no income – that is known as
autonomous consumption and indicated as co
• Once there is income the consumer spend part of it.
• Therefore, the consumer spends part of his income and saves the rest.
• Incomeconsumer = co + saved part of (higher) income + consumption part of
(higher) income (called induced consumption).
• saved part of (higher) income = MPS(Y)
• consumption part of (higher income) =MPC (Y) = c1(Y)
• MPS + MPC = 1
 Yd = C + S
part of the income
is consumed the rest is saved
part of income part of income saved
consumed = MPS
= MPC marginal propensity to save (MPS),
the change in savings when disposable
income changes by one unit

MPC + MPS = 1
 How do we calculate MPS and MPC?
∆
• MPS = where Y = Income or GDP (expenditure and income method)
∆

∆
• MPC =
∆

• Remember MPC + MPS = 1 …… Why?

Side note
MPC = marginal propensity to consume
MPS = marginal propensity to save
 Homework:
Explain MPC and MPS in your own words.
 14.2 The Keynesian multiplier model

Now that we have seen how the multiplier process

works, let’s look at the multiplier model.
 REMEMBER
Figure 13.6. The circular flow model

simple model:
private economy
2 sectors
Households – C
Firms – I

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 Consumption function:
• Remember: MPC = c1 and autonomous consumption is c

• C = co + c1(Y)
Going back
• Therefore:
• AD = co + c1(Y) + Io in a private economy.

• So how will changes in C and I have an effect (plus the size thereof) on
the economy?
 The consumption function
• The consumption function is the first component of the Keynesian
multiplier model.

• It shows the various components of household consumption and how

households respond to changes in consumption.

NB!!!! The consumption function is NOT the aggregate demand

function. It is a component of the aggregate demand function.
 Keynesian Multiplier (k) model:
Consumption function (C) consumption
dependent on

C = co + c1 x (Yd) income, the

variable
amount
Sometimes
autonomous consumption called induced
= the fixed amount spent,
consumption
independent of income

MPC = marginal (disposable) income

propensity to
consume
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 Keynesian Multiplier model (k): Aggregate consumption:
= 0 + 1

= autonomous consumption
0
= the fixed amount spent, independent of income (necessities
such as food, shelter, clothing)

Expectations about future income are reflected in autonomous

consumption
 Keynesian Multiplier model: Aggregate consumption:
= 0 + 1

1 = consumption dependent on income

= the variable amount

If marginal propensity to consume is 0.6 then consumption, if a

consumer earns R1 more, increases by:

R1*0.6 = 0.60c
Slope of consumption function = marginal propensity to consume (c1), the change
in consumption when disposable income changes by one unit.
→ c1 is positive, but less than 1:
part of the income is consumed – the rest is saved
 C = -714 + 1.006 Yd C = 21 380 + 0.672 Yd
Cons = Private consumption expenditure at Cons = Private consumption expenditure at
current prices constant prices
YPDI = Personal disposable income (after tax YPDI = Personal disposable income at constant
income) at current prices prices
Example: Multiplier effect (consumption
only)
Y=X
 450 Line
This line is used to indicate on our graphs all the combinations where
output (income), Y is equal to Aggregate Demand (AD). The market is in
equilibrium at all points along this 45o line.
On the 45o line, Y = X
 The Keynesian Multiplier
The multiplier represents the relative magnitude of total
change in output (real GDP) as a result of an initial change in
autonomous expenditure.

or

If R1 is spent in the economy, by how much will that R1

change the real GDP of that economy.
 The multiplier effect
• The total change in output can be greater than the initial
change in C or I because of the circular flow of expenditure,
income, and output.

• If multiplier = 1: the increase in real GDP is equal to the

initial increase in spending
• If multiplier > (<) 1: the total increase in real GDP > (<) the
initial increase in spending
 Keynesian Multiplier process
• The multiplier process helps us to explain why real GDP increases more
than the initial increase in (investment) spending in a goods market.
• The process is explained through the aggregate consumption function =
consumption spending (C) for the economy as a whole
→ combining the behaviour of consumption smoothing and non-
consumption smoothing households
• Consumption depends on income
• For consumption smoothing households: an increase in income will not increase
their consumption one-for-one, or even at all.
• Non-smoothing households will increase their current consumption one for one in
response to a temporary increase in their income.
• The multiplier is > 1, if the additional consumption spending resulting from a
temporary increase in income is greater than zero but less than 1 (e.g.,60 cents)
 Math of the Keynesian multiplier
• Y = co + c1(Y) (looking at a private economy model – I staying
constant)
• Y –c1(Y) = co
• Y(1 – c1) = co (Y (mps) = co )
Co Co
Y = which is also Y =
1 – mpc mps

Multiplier thus or (for a private economy)

mpc mps
 Conclusion:
• We started our model in a private economy with only Households
(HH)

• Next we add investment, then government expenditure and finally we

get to a public (or open) economy
 Exercise 1 (Step 1)
Information: When Y= 0, C = 400 and when Y = 1000, C = 1000
Using the information provided:
• Draw a graph illustrating the 45-degree line in the goods market.
• What is the value of autonomous consumption(Co)?
• Calculate the c1.
• What is the equation of the Consumption function?
• On the same graph (as in 1) draw the aggregate consumption line and illustrate
where (in the absence of Investment) this economy would be in "equilibrium".
• Calculate the value of MPS.
• Calculate the value of the Keynesian multiplier (k).
 Keynesian Multiplier model: Aggregate
demand function
• We have now set up the consumption function (households).

• We now add investment (firms) to the consumption function.

• Adding firm’s investment to the consumption function gives us the

complete aggregate demand function (AD= C + I) for a private
economy (households and firms only). Our economy is private,
meaning no Government expenditure, no taxes and no trade with
other countries.
Multiplier model: Aggregate demand function
• How shocks are transmitted through the economy : Look at output
produced and aggregate demand.
• Output=aggregate demand for goods produced in the home economy
Y=AD
• The 45-degree line shows all the combinations where output (Y)=X
aggregate demand (AD).
• Considering Investment as the other expenditure component of our
model:
Aggregate demand= consumption + Investment
AD= C + I
= C0 + C1y + I 41
Multiplier model: Goods market equilibrium
• Aggregate demand (AD) =
consumption function + investment
• Investment is assumed to be
independent of output (Y)

• The slope of AD line is below 45°

because the c1<1

• 45° line is where Y (income) = AD

Figure 14.4 Goods market equilibrium: The multiplier diagram.

Goods market equilibrium: Y = AD

 The Keynesian multiplier process
Decrease in investment →
decrease in aggregate
demand → lower output and
income → further decrease in
demand and income → new
equilibrium (Z)
 Changes in consumption function
Credit constraints and consumption smoothing is reflected in the
slope of the AD curve and the size of the multiplier.

Consumption decisions can also shift the AD curve.

• e.g. a decrease in house prices will be bad news for a household
with a mortgage. They may choose to save more (precautionary
saving) and hence their autonomous consumption would fall.
 The Keynesian multiplier effect
• The total change in output can be greater than the initial change
in C or I because of the circular flow of expenditure, income, and
output.

• If multiplier = 1: the increase in GDP is equal to the initial

increase in spending
• If multiplier > (<) 1: the total increase in GDP > (<) the initial
increase in spending
14.2 Keynesian Multiplier model: Aggregate
demand function
Remember: We are ultimately interested in how changes in C or I
results in changes in output and employment (Unit 9.7)

• Low output high unemployment

• High output low unemployment

Determine this position of the economy by analysing the individual

components of aggregate demand function
 Keynesian Multiplier (k)…..
To assess the end-result (the amount Y has changed) as the Keynesian
multiplier(k) works its way through the economy with a change in an
expenditure component, we multiply the simply multiplier with the
amount the component that has changed with e.g.
• Y = k* Io or Y = k* Co
 Exercise
1) In a model where we only consider consumption and investment, if the MPS is 0.2 what is the MPC?

2) Calculate the Keynesian multiplier (k).

3) Given that consumption expenditure when disposable income is zero is R3500:

Determine the consumption function (using the C and I model only)
If I = R500, what would the aggregate demand (AD) function be?
4) If Investment increases by R500, what is the change in output/AD?

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Part 1: Comprehensive exercise