The Keynesian Model

the multiplier, the paradox of thrift,

savings and investment, fiscal
policy, and the tax multiplier
 multiplier – algebra of the model
A simple Keynesian model of the economy with no
government or foreign trade can be represented as:
Y=C+I (1)
where Y is equilibrium output (income), C is aggregate
consumption, and I is aggregate investment.
Aggregate consumption, or total expenditure by
households on final goods and services, is determined
by autonomous consumption (a), or the rate of
consumer expenditure independent of disposable
income, and the marginal propensity to consume (b =
mpc), which is the part of each additional dollar of
disposable income that is spent on consumption.
Thus, the consumption function is:
C = a + bY (2)
 No government, so Y = Yd
• Note that since there is no government,
taxes are zero, so Y = Yd, since:
Yd = Y – T
Yd = Y – 0
Yd = Y
Thus while the consumption function is
usually C = a + bYd, here it will simply be:
C = a + bY
 Investment
• Investment is determined by a complex of
factors such as expectations of investors
and lending institutions, business
confidence, political climate, and so on.
For present purposes, what is important is
that investment is autonomous—that is,
independent—of income. It is also not a
simple function of the rate of interest, as in
neoclassical loanable funds theory.
 solving the equation
Y=C+I (1)
C = a + bY (2)

• Substituting equation (2) into equation (1),

i.e., replace C with a + bY, we get:
• Y = a + bY + I (3)
• Subtracting bY from both sides:
• Y - bY = a + I (4)
 Solving for Y
Y - bY = a + I (4)

• Factoring out the Y from the left hand side

of equation (4)
• Y (1 - b) = a + I (5)
• Dividing both sides by (1 - b):
• Ye = 1 (a + I) (6)
(1-b)
 the multiplier
Ye = 1 (a + I)
(1-b)

where 1/(1-b)—or 1 divided by the mps—is the

multiplier, or the feedback mechanism that
amplifies any initial increase (injection) or
decrease (withdrawal) in aggregate demand.
Therefore, Ye, the equilibrium level of output
(income) is determined by the multiplier and
total injections. The total injections in this
simple model are a + I.
 Keynesian model - numerical
example
Given:
Y=C+I
C = a + bY
Where:
a = 100
b = .75
I = 300
 Solving for Ye
• Y = 100 + .75Y + 300
• Y - .75Y = 100 + 300
• Y (1 - .75) = 100 + 300
• Y (.25) = 100 + 300
• Y = (1/.25) x 400
• Y = 4 x 400
• Ye = 1600
solving for equilibrium consumption
and savings
• Once we have Ye, we can find Ce and Se:
• Ce = a + bYe
• Ce = 100 + .75 (1600)
• Ce = 100 + 1200 = 1300
• Se = -a + (1 - b)Ye
• Se = -100 + (1 - .75) 1600
• Se = -100 + .25 (1600) = 300
 double-checking savings
• Also:
Ye = Ce + Se
Ye – Ce = Se
1600 – 1300 = 300
• Also:
Se = I (savings = investment at equilibrium)
300 = 300
 Keynesian Model
45°

Expenditure AS = C + I

C = 100 + .75Y

a+I
S = - 100 + (1 – .75) Y

a I = 300
I

0
Y1 Y* Y
-a
400 1600
 the paradox of thrift
• An attempt by the economy as a whole to
increase aggregate savings not only will
not succeed, but may lower aggregate
output, income and employment. This is
because increased savings at a given
level of aggregate income will mean
decreased consumption. Thus a smaller
marginal propensity to consume will
reduce the stimulative effects of
investment and other spending.
 paradox of thrift
• For example, suppose an economy is
characterized by a consumption function:
• C = 100 + .8Yd
• If autonomous investment is equal to 300
billion then the equilibrium level of output
and income is
• Ye = 5 (100 + 300) = 2000 billion
• because the multiplier = 1/(1 – b)
= 1/(1 - .8) = 5.
 paradox of thrift
• Aggregate consumption is:
• C = 100 + .8 (2000) = 1700 billion
• and aggregate savings is:
• S = -100 + (1 - .8) (2000) = 300 bil.
• So aggregate savings equals aggregate
investment (300 billion).
 paradox of thrift - example
• Suppose some political and or business
leaders come out and say we have to save
more so the economy can grow. If people
comply in such a way that the mps rises
from .2 to .25, what will be the effect?
 paradox of thrift
The new consumption function will be:
• C = 100 + .75Yd
With 300 billion in investment, the new equilibrium
will be:
• Ye = 4 (100 + 300) = 1600 billion
because the new multiplier = 1/(1 - .75) = 4.
Aggregate consumption is now:
• C = 100 + .75 (1600) = 1300 billion
and savings:
• S = -100 + (1 - .75) (1600) = 300 billion
 paradox of thrift
• Thus, savings is still equal to investment at
the same level of 300, but output and
employment are much lower.
• So the attempt by the economy as a
whole to save more not only did not result
in more savings, but actually lowered
aggregate output and income by 400
billion.
 paradox of thrift
• This is the paradox of thrift, and is another
example of the paradoxical nature of
macroeconomics. It is rooted in the two-sided
nature of spending and saving. When we just
look at one individual firm or household in
isolation, we don't see the impact that our
actions have on other participants in the
economy due to the interdependent nature of
economic activity. So while for any one
individual, it is wonderful to save more, for the
economy as a whole, it could be a disaster.
 paradox of thrift
• If, however, the increased saving is the
result of higher incomes, then that is a
different story. If income goes up,
consumption and saving both go up. But
at a given level of income, increased
aggregate savings can throw the economy
into a recession. Therefore, a policy to
increase growth by increasing savings has
it backwards: savings will increase as a
result of growth.
 Increasing G
• If Yf = $2000 billion and Ye is $1600, how
much does the government have to
increase spending to push the economy to
Yf?
 Increasing G
• If Yf = $2000 billion and Ye is $1600, how much
does the government have to increase
spending to push the economy to Yf? Not $400.
 Increasing G
• If Yf = $2000 billion and Ye is $1600, how much
does the government have to increase
spending to push the economy to Yf? Not $400.
If G increased by $400 then:
Y=C+I+G
C = a + bY
 Increasing G
• If Yf = $2000 billion and Ye is $1600, how much
does the government have to increase
spending to push the economy to Yf? Not $400.
If G increased by $400 then:
Y=C+I+G
C = a + bY
Ye = 1/(1 - .75) * 100 + 300 + 400
= 4 (800)
= $3200
Way past Yf—impossible, so inflation will occur.
What happened?
 closing the recessionary gap
• The government spending of 400, like all other
autonomous expenditures, had a multiplier
effect, in this case of 4, and so increased total
output and income not by 400 but by 1600.
• How much do we need to increase G by to just
get the economy to full employment?
• By the size of the gap, or the amount we need
to increase total spending (Yf – Ye) divided by
4.
• gap = Yf – Actual output
• Increase in G : (Yf – Actual output)/multiplier
• Increase in G: 400/4 = 100
 Keynesian Model
45°

C+I+G

Expenditure AS = C + I

a+I+G

a+I
S = - a + (1 – b) Y
I+G I+G
a I
I

0
Y1 Y* Yf
Y
-a
 full employment
• Notice that at Yf, S = I + G; (I + G can be
thought of as private and public investment)
• Notice the aggregate spending function with
government (still no foreign trade), or the C + I
+ G line:
• has a y-intercept of (a + I + G);
• has a slope = mpc; and
• intersects the 45 degree line at Yf
 Keynesian Model
45°

C+I+G

Expenditure AS = C + I

a+I+G

a+I
S = - a + (1 – b) Y
I+G I+G
a I
I

0
Y1 Y* Yf
Y
-a
 Multiplier with Taxes
• Let's add taxes and government spending
into the multiplier formula!
First, we begin with:
• Y = C + I + G (1)
 Then we take our consumption function:
• C = a + bYd (2)
 Only now we have to account for the fact that
Y and Yd are not equal
• Yd = Y - T (3)
 Multiplier with Taxes
• Yd = Y - T (3)
because disposable income is aggregate
income less taxes.
Since taxes can be determined by the tax rate
times aggregate income:
• T = tY (4)
Then:
• Yd = Y - tY (5)
 Multiplier with Taxes
Substituting equation (5) into the
consumption function:
• C = a + b(Y - tY) (6)
And substituting equation (6) into equation
(1):
• Y = a + b(Y - tY) + I + G (7)
 Y = a + b(Y - tY) + I + G (7)

We then solve for Y: 

• Y = a + bY - btY + I + G (8)

• Y - bY + btY = a + I + G (9)
 
• Y(1 - b + bt) = a + I + G (10)
 Y(1 - b + bt) = a + I + G (10)

• Y= 1 * (a + I + G) (11)
1- b + bt
•  
So the multiplier with taxes is:
• 1/(1 - b + bt) (12) 
And the multiplier times total injections (a + I + G)
will give us the equilibrium level of output and
income.
 Multiplier with taxes – numerical
example
• Given:
C = $100 + .8Yd
I = $50
G = $350
t = .25
• Find: Ye, value of mult., T, Yd, C, & S
Does S = I? Why or Why Not?
 Multiplier with taxes – numerical
example
Ye = 1/(1-b+b[t]) (a + I + G )
= 1/.4 (100 + 50 + 350)
= 2.5 (500)
= 1250
 Multiplier with taxes – numerical
example
Value of the multiplier
= 1/(1-b+b[t])
= 1/(1-.8+.8[.25])
= 1/.4 = 2.5

[since (.8 x .25) =.2]

 Multiplier with taxes – numerical
example
• T = .25 (1250) = 312.50
• Yd = Y – T = 1250 – 312.50 = 937.50
• C = a + bYd = 100 + .8(937.50)
= 100 + 750 = 850
• S = -a + (1-b)Yd = -100 + (1-.8)937.50
= -100 + 187.50 = 87.50
 Multiplier with taxes – numerical
example
Does S = I? Why or why not?
 Multiplier with taxes – numerical
example
Does S = I? Why or why not?
No, total injections = total withdrawals
I+G=S+T
= 50 + 350 = 87.50 + 312.50 = 400 = 400
 Multiplier with taxes – numerical
example
Does S = I? Why or why not?
I+G=S+T=
50 + 350 = 87.50 + 312.50 = 400 = 400
and the:
public deficit = private sector surplus
G – T = S – I = 350 – 312.50 = 87.50 – 50
= 37.50 = 37.50