ECN 60204 Macroeconomics

The Keynesian Income &

Expenditure Model:
The Open economy
 Lecture 5
Keynesian Model: Open economy
1. The Three-sector Economy: government
2. Effects of Taxes
3. Equilibrium Income
4. The Four-sector (open) economy: net exports
5. Equilibrium Changes
6. The Expenditure & Income Model with the
Aggregate Demand & Supply Model

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In developing the framework for the Aggregate
Expenditure Model we will assume (initially):
•Short run
•Wages are fixed
•Prices are fixed
When we include the Aggregate Expenditure Model with
the Aggregate Supply and Demand Model (in the last
few slides of this lecture) we will assume:
•Short run
•Wages fixed
•Prices are flexible
Then we look into the Aggregate Expenditure Model
and the Aggregate Supply and Demand Model when we
assume:
•Long run
•Wages and prices are flexible 3
The Income and Expenditure Model:
Open Economy:

Y = C + I + G + NX
Three Sector Economy
Trade with rest of
the world (X – M)
Y = real GDP

4
 1. Introducing Government Sector
The government sector introduces 3 new
variables into the basic Keynesian model:
G= Government purchases goods &
services
Adds directly to AE
Treat as autonomous G
TR = Govt Transfer Payments
Adds to disposable income and then
C
Treat as autonomous TR
TA = Tax receipts, T + tY

2 types of taxes: Autonomous tax, T

Induced tax, tY

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 Effects of Taxes: Disposable Income &
Consumption

(i) New Consumption Function

Because of taxes and transfer payments, have to base
consumption on YD rather than gross income, Y

YD = Y – TA + TR
tu te
s ti
TA = T + ty b
su
C = a + bYD
YD = Y – (T + ty) + TR
= Y – T – ty + TR

C = a + b (Y – T – tY + TR)
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 Autonomous & Induced Expenditure
AE = C + I + G
C = a + b(Y – T – tY + TR)
AE = a + b(Y – T – tY + TR) + I + G
= a + bY– btY – bT + bTR + I + G
b (1– t )Y
Rearranging gives:
AE = a – bT + bTR + I + G + b (1– t )Y

Autonomous Induced expenditure

expenditure, A Given t < 1, b < 1
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 Effects of Taxes, T and t
expenditure $billions
Aggregate planned
AE= Y
AE0 = A + bY

a
AE1 = A + b(1– t )Y
b AE3 = A – bT + b(1– t )Y

c
– bT

450
Y2 Y1 Y0 Real GDP $billions

t makes AE curve flatter (income tax lowers the tax adjusted

mpc, b(1 – t) )
 autonomous tax, bT shifts the AE curve downwards 8
Effects of Government Expenditure: G
expenditure $billions
Aggregate planned

AE= Y

AE2 = A + G + b(1– t )Y
b AE3 = A + bTR + b(1– t )Y
c AE1 = A + b(1– t )Y
a
G bTR

450
Y0 Y2 Y1 Real GDP $billions
 G shift the AE curve upwards
TR shifts the AE curve upwards but by bTR – its effect on9
AE less than effect of G
 Equilibrium in a 3-sector economy
• With new AE where
AE = a – bT + bTR + I + G + b(1– t )Y

AE = A + b(1– t )Y

• At equilibrium: Y = AE
 Y = A + b(1 – t)Y
Y – b(1 – t)Y = A
[1 – b(1 – t)]Y = A
Y= 1 .A
1–
Multiplier,  10
b(1 – t)
Application Ex. 1 Three- Sector Economy
Autonomous consumption, a = $20 billion
Investment, I = $80 billion
Government expenditure, G = $100b
Transfer Payments, TR = $20b
Autonomous taxes, T = $5b
mpc = 0.9
Personal household income tax, t = 0.3 (30% of income)

Calculate / determine with detailed workings:

a)the consumption function
b)the aggregate Expenditure function
c)Equilibrium real GDP, Y0
d)the autonomous expenditure multiplier, a

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 The Four-sector (Open) economy: NX

AE = a + b (Y – T – t Y + TR) + I + G + NX

NX = X – IM where IM = mY + M
M = autonomous
NX = X – mY – M mY = induced import

AE = a + b (Y – T – t Y + TR) + I + G + X – mY - M

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 Equilibrium in a Four-sector economy
AE = C + I + G + NX
= a + b (Y – T – t Y + TR)+ I + G + NX
= a – bT + bTR + I + G + b(1– t )Y + X – mY – M

= a – bT + bTR + I + G + X – M + b(1– t )Y – mY
autonomous expenditure induced expenditure

AE = A + b(1– t )Y – mY
• At equilibrium: Y = AE
 Y = A + b(1 – t)Y – mY
Y – b(1 – t)Y + mY = A
Y[1 – b(1 – t) + m] = A
Multiplier, 
Y= 1 .
A 1 – b(1
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 Application Exercise 2 Four Sector Economy
a = $20b I = $80b G = $100b
TR = $20b b = 0.9 t = 0.3 T = $5b

Export, X = $10b
Induced import, m = 0.1 (10% of imports)
Autonomous imports, M = 0

Calculate / determine with detailed workings:

a) the consumption function
b) the aggregate expenditure function
c) Equilibrium real GDP, Y0
d) the autonomous expenditure multiplier, 
e) the change in equilibrium income if government expenditure
increases by $10b
f) The new equilibrium real GDP as a result of the changes in (e)
g) Draw an aggregate expenditure diagram with the results obtained
above and explain the multiplire effects of the increase in
government expenditure on the equilibrium GDP, Y 14
 Application Ex. 2 ….cont
a = $20b I = $80b G = $100b
TR = $20b b = 0.9 t = 0.3 T = $5b
X = $10b m = 0.1 M=0
(a) C = a + bYD
Given YD = Y – tY – T + TR (Given TA = T + tY )
C = a + b(Y – t Y – T + TR)
= 20 + 0.9(Y – 0.3Y – 5 + 20)
= 33.5 + 0.63Y
autonomous consumption Induced consumption

(b) AE = C + I + G + NX
Given C = 33.5 + 0.63Y
 AE = 33.5 + 0.63Y + I + G + (X – 0.1Y)
= 33.5 + 0.63Y + 80 + 100 + 10 – 0.1Y
= 223.5 + 0.53Y
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Autonomous expenditure Induced expenditure
 Application Ex. 2 ….cont

(c) Y = AE (e) A = G = 10
AE = 223.5 + 0.53Y Y =  x A
Y = 223.5 + 0.53Y
= 2.1277 x 10
= $475.5b
= $21.28b
(d) a = 1 .
1 - b(1 - t) + m
(f) Y2 = Y1 + Y
= 1 .
1 – 0.9(1 – Given Y1 = $21.28b (see
0.3) + 0.1
answer for (e)
= 1 .
1 – 0.63 + 0.1  Y2 = 475.5 + 21.28
= 2.13 = 496.77
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 Application Ex. 2 …..cont
(g) Draw an aggregate expenditure diagram with the results
obtained above and explain the multiplier effects of the increase
in government expenditure on the equilibrium GDP, Y
G  by $10b
AE At Y = 475.5, AE > Y (e > a)
AE=Y
AE2 Stock shortage (-)
b

e
485.5  AE1
Signal for firms to increase production
a
475.5  As firms  production, employment , Y
G = 10
Multiplier effect: as Y, C  and Y further
Y =  x G
= 21.77
45o The effect on Y is Y > G so
Real GDP that the economy arrives at new
475.5 496.77 $’000m
equilibrium at point b at Y = 496.7
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The Keynesian Aggregate Expenditure
& Aggregate Supply & Demand
Models
- Equilibrium Changes

Short Run
Long Run

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 expenditure
Aggregate
Short 
b AE1

Run AE2 Aggregate

a Expenditure
G = 10
 Model
Y = G = 21.77
45o
Real GDP
Price 475.5 496.77 $’000m
level

Aggregate
Prices fixed (for Supply and
a b
the moment) P1  
Demand
AD2 Model
AD1

19
475.5 496.77 Real GDP
$’000m
 Short Run
Aggregate expenditure
AE=Y Prices now flexible but
AE2
b
 wages fixed (short run)
AE3
$billions  Real wealth cause
c AE1
 consumption to fall (NX also
a if include international
 substitution effects)
Sets off multiplier effect
as some real GDP falls
45o
475.5 485 496.77 Real GDP $billions
Price Level

Price  gives incentive

LAS SAS1 for output to  & helps
to resolve part of goods
c shortage
105 
Other part of the shortage is
100  b AD > SAS (-) resolved when real wealth
a AD2 (don’t forget substitution
effects) as price 
AD1
Y =  x G Economy expands (net off the
Real GDP
wealth & sub effects) &
475.5 485 496.77 20
reaches equilibrium at pt c
Let’s re-cap and see where we are now – we have:

•developed the framework for the 3 and 4 sector aggregate

expenditure model
•Seen some application exercises where we
calculated/determined AE function, real GDP and drawn the
AE diagram using the results
•incorporated the aggregate expenditure framework with the
aggregate supply and demand model and assumed a fixed
price initially.
•Then assumed a flexible price (although still assuming
fixed wages i.e. short run

Big Question: what if we look at the LONG-RUN when

prices and WAGES become flexible
 Equilibrium in the Long Run when
Wages are Flexible

In the long – run the economy is “self adjusting”

Meaning?
The economy will tend to find full-employment
from a recession or inflation gap

This works only if wages are flexible

Once at full employment, economy is stable, ceteris

paribus.
 AE AE=Y
Full Employment Equilibrium

AE1

a
475.5 

45o
Real GDP
Price 475.5 $billions
level
LAS SAS1
Point a - Economy is stable at
full employment i.e.
Actual GDP = Potential GDP
105  = $475.5 billion
a

AD1

Real GDP 23
900 $billions
 AE AE=Y
Inflation Gap – Long Run Adjustment
AE1
AE2 Point C – shortages in the
c
 labour force - Money wages
d
475.5  C as real
wealth Sets off multiplier effect
Y =  x C as real GDP falls
45 o

Real GDP
Price 475.5 485 $billions
level SAS2
LAS SAS1
d The other part of shortage is solved
110  Real wealth as P
c
105  SAS < AD (-)
In the long run the
AD
economy “self-adjusts”
back to full employment
One part of shortage
equilibrium at point d where
Inflation is solved when P
gap will output Y =475.5
Real GDP 24
475.5 485 $billions
AE AE=Y
d AE3
Recession gap – Long Run
 AE1 Adjustment
c
460  Point C – recession,
C as real unemployment
wealth Money wages
Sets off multiplier effect
Y =  x C as real GDP rises
45o
Real GDP
Price 460 475.5 $’000m
level P will force LAS In the long run the economy
production to “self-adjusts” comes back to
fall & resolve SAS1 full employment at point d
part of surplus
SAS2

103 c  SAS > AD (+) The other part of

d surplus is solved when
100
Recession Real wealth as P
AD
gap
Real GDP 25
460 475.5 $’000m
 NEXT WEEK
• Demand –side Policy: Fiscal Policy

• Budget deficits,/ surpluses & business cycles,

tax & transfer payments multiplier, role of
automatic stabilisers

• More calculations
• More AD/AS
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