MTP

SESSION 5

Reading
1. This set of slides
2. From the Blanchard 6th Ed.:
Chapter 3 – entire chapter
Income
Determinatio
n
Goods
Market : the The Simple Keynesian Framework
short run
Setting up the model:
Resources / capacity is under utilized (short run)
No govt. , no foreign trade (simplifying assumption)

Consumption is directly related to income

C = planned consumption expenditure of the households
= C(Y)
As income of the household changes, consumption also changes.
But changes in consumption < changes in income
C=a+c.Y
a : minimum autonomous consumption
c : Marginal propensity to consume = ΔC/ΔY
c is a positive fraction.

Investment is autonomous I = Io
Aggregate expenditure is a measure of aggregate demand (AD) of the
economy.
AD = C + I = a + cY + Io
Income is a measure of aggregate output supply
AS = Y
Macroeconomic Equilibrium: AD = AS

Equilibrium level of income Y* = (a + I) / (1-c)

Given under-utilized capacity,

If AD > AS then output will increase.
If AD < AS then output will fall.
 How is the equilibrium reached?
AD , AS AS = Y

If AS = Y1, AD > AS
C
Sellers find that there is excess
demand in the market. They revise
their production upward in the next
AD = a + Io + c . period. As a result agg. Output rises.
Y Demand existing, (AD > AS) all the
D
output is sold. Income rises. This
continues till Y reaches Y*.
E
A If AS = Y2, AD < AS

[ a + Io ] Sellers find that there isn’t enough

takers of their products in the market.
They revise their production
B downward in the next period. As a
result agg. Output falls. If there still
remains some excess supply, output
AS or Ykeeps falling till a state comes when
Y1 Y* Y2
all the output is sold. Income falls.
This continues till Y reaches Y*.
Is the economy then always in equilibrium?

NO.

It can be said that the economy moves towards equilibrium.

There may be shocks or external influences disturbing the parameters (c, Io

etc.) which in turn disturb the equilibrium.

Once disturbed, the economy again moves towards equilibrium.

What happens to national income if firms decide to increase investment?

Now I = I1 = I0 + Δ I

I↑ → AD↑ → Y↑

Y* = (a + I) / (1 – c)
Income should increase to Y’ = (a + Io + Δ I ) / (1 – c)

Increase in income = Δ Y = Y’ – Y* = Δ I / (1 – c)

ΔY > ΔI

Δ Y / Δ I = multiplier = 1 / (1-c) > 1

AD , AS AS = Y
AD = a + Io + ∆I +
C c.Y

AD = a + Io + c.Y

E F
∆I A

[ a + Io ]

AS or Y
Y1 Y* Y2
Δ Y = Δ I/(1 – c)
 Why is ΔY > ΔI?

I ↑ by ΔI
→ AD ↑ by ΔI
→ AD > AS, and AD – AS = ΔI
→ Y ↑ by ΔY = ΔI
→ C ↑ by c . Δ Y = c . ΔI Total increase in output ΔY
→ AD ↑ by c . ΔI = ΔI + c ΔI + c22 ΔI + c33 ΔI + c44 ΔI +
→ Y ↑ by ΔY = c . ΔI ……
= ΔI (1 + c + c22 + c33+….)
→ C ↑ by c . ΔY = c22 . ΔI
= ΔI / (1 - c )
→ AD ↑ by c22 . ΔI
→ Y ↑ by ΔY = c22 . ΔI
→ C ↑ by c22 . ΔY = c33 . ΔI
…… and so on
Exercise

1. If C = 10 + .9Y and Io = 60, what is the level of unplanned inventory

accumulation at Y = 850?

2. Current consumption by the households is 60% of GDP. If firms

decide to increase investment to $320 million in capital goods this
year from of $200 million in the last year. How much will the GDP
increase?
Operation of the multiplier is crucially dependent on the
assumption that unutilized resources are available in abundance.

Supply side bottle necks adversely affect the multiplier operation.

If some crucial input is in limited supply, income expansion will
halt.

If AD rises beyond full-employment level of output, then it is the

price level that would rise, not output.
A few events are perceived as indication of growth in the near future.

A rise the Sensex

strengthening of the Rupee

Many a times such perceptions are misplaced.

Growth is enhanced by sustained increase in I or G or C or X-M.

Policies need to encourage / incentivise these sustainably.
 When investment is induced:

With increased level of economic activity, firms will be induced to make

planned investments.

Say, I=b+d.Y
Where b = autonomous investment
d. Y = induced investment

How will this affect the multiplier?

Multiplier with induced investment = 1 / (1 – c – d )
1 / (1 – c – d ) > 1 / (1 – c )

I↑ → AD ↑ → Y ↑
→ C ↑ ….
→ I ↑ ….
Exercise

Consider an economy with only the household and the firms.

Aggregate consumption expenditure = C = 100 + 0.8Y; Planned Investment
expenditure by firms = 80 + 0.4Y, where Y is the GDP.

a) What is the equilibrium GDP?

b) In the year 1996 the total value of aggregate output was 500, should the
economy move towards the equilibrium?
c) If the parameters do not change where do you forecast the output in the future?
AD , AS AS = Y
. 2Y
+ 1
0
18
=
AD

AS or Y
Economy with government

C = a + cY
I = Io say
G = Go decided by the government

AD = C + I + G = [a + Io + Go] + cY
AS = Y

Equilibrium level of income: Y* = [a + Io + Go] / (1 – c)

Fiscal Policy : Increase in government’s spending

Government exp. Multiplier = 1 / (1-c)
Economy with the ‘government’ and ‘rest of the world’

C = a + cY Imports reduce the multiplier.

I = Io say
G = Go decided by the government Should we then restrict imports?
X = Xo No, because if we restrict
M = f + mY imports, other nations will
retaliate by restricting imports as
well.
AD = C + I + G + X - M = [a + Io + Go + Xo - f] + (c – m)Y
AS = Y Þ Our exports will fall
Þ AD will fall
Equilibrium level of income: Y* = [a + Io + Go + Xo - f] / (1 – c + m) Þ We will face recession

Open Economy Government exp. Multiplier = 1 / (1-c+m)

 1. Stock Market Crash 1929
In 1920s the US stock market went through historic expansion.
Everyone invested in stocks. Some even mortgaged their houses

Reasons to invest in the stock market.

Þ October 1929 – share prices started the inevitable decline
behind Great Þ Panic selling
Þ Stock prices fell 33% in 2 months
Depression of Þ Shock and loss of consumers’ and investors’ confidence
Þ C and I fell drastically
1929-33 Þ AD fell
Þ Output fell with loss of jobs
Þ Downward spiral leading up to a depression

https://www.britannica.com/story/caus
es-of-the-great-depression

Reasons
behind Great
Depression of
1929-33
https://www.history.com/topics/great-
depression/bank-run#:~:text=Another
%20phenomenon%20that
%20compounded%20the,often
%20leading%20to%20bank%20failure.
2. Bank runs
Stock market crash 1929
But banks held stocks as investments
Þ People panicked that their wealth were not in safe hands in
the banks
Þ Depositors started withdrawing money in large numbers
Þ banks could not replay depositors
Þ Bank failure (Some 1300 banks failed to repay)
Þ People started hoarding money
Þ C fell
Þ AD fell
Þ Output and employment fell
Þ Downward spiral to a depression
 3. The gold standard

Through the depression Y and P fell in USA

Þ US imports fell and exports rose
Reasons Þ Trade surplus for USA
Þ Flow of Gold from other countries (Europe) + threat of
behind Great devaluation of European currencies
Þ Others (Europe) increased interest rates to attract capital
Depression of flows by contracting Money Supply

1929-33 Þ Decline in P and Y in Europe

Þ Worldwide economic decline

https://www.britannica.com/story/caus
es-of-the-great-depression
 4. Decline in international lending

US interest rates in the 1920s were high

Þ Lending to other countries (Germany, Argentina, Brazil)
reduced
Þ Growth in those countries fell
Þ Imports of those countries fell
Reasons Þ AD for US fell
Þ US also suffered
behind Great
Depression of 5. Smoot-Hawley Tariff Act 1930

1929-33 US imposed steep tariffs (averaging 20 percent) on a wide range

of agricultural and industrial products
Þ Retaliatory tariffs by other countries
Þ Export demand of many countries including US fell
Þ Cumulative effect on AD
Þ Recession
https://www.britannica.com/story/caus
es-of-the-great-depression
 1. Partial abandonment of the gold standard in
1931
Sources of
Recovery 2. Fiscal expansion (New Deal and social welfare
programs)
from the
Great 3. Increase in defense expenditure during WW2
Depression

https://www.britannica.com/story/caus
es-of-the-great-depression