Download Chapter 1

Basic Keynesian Model
Keynesian Cross Diagram
Measuring the macroeconomy
 GNPpm = GDP – factor incomes from abroad + factor incomes of







Pág.2
foreigners
NetNPpm = GNPpm - Depreciation
NNP at factor costs = Net National Product – Net indirect taxes +
Subsidies (NNP=net national product at factor costs)
NI (National Income) = NNPcf
Personal Dispousable Income (PDI = Family income = NI – Direct
taxes + Transfers - Profits + Undistributed profits
Personal Disposable Income (PDI = Family income )= Consumption
Spending + Savings
Consumer price index: the CPI measures the price increase of a merket
basket fo goods representative of the purchases of a typical household
The Unemployment rate: The unemployed are people who want to
work and are actively looking for jobs but have not yet found one. The
unemployment rate is equal to the number of unemployed people
divided by the total labor force.
Macroeconomic model
Sectors
Markets
Functions
Endogenous
Policies
variables
• Demand side
•Households
•Goods and
• C, I, G, X,Q,
• Y (GDP)
• Firms
Services
T,S.
• P (CPI)
• Government
•Financial
• Foreign Sector
wealth:
•L, M/P.
− Money.
− Bonds.
•U
(Unemployment)
• er (Exchange
rates)
• r (Interest rates)
•Trabajo
Pág.3
• Ls, Ld.
− Fiscal.
− Monetary.
− Trade and
Exchange rates
policies.
• Supply side:
− Incomes.
− Structural.
Key concepts
 GDP composition
 The demand of goods and services
 The equilibrium
Pág.4
Intended expenditure or aggregate
demand components
Pág.5
C
C
C
Cpriv
+I
+I
+I
+ Cpub
+G
+G
+G
+ Ipriv
= Internal
+X
+ Ipub
+X
+X
= Final
+X
-Q
GDP mp
-Q
GDP mp
-Q
GDP mp
-Q
GDP mp
The circular flow of economic activity
GOODS AND SERVICES
EXPENDITURE (FLOW OF EXPENDITURE)
MARKET
GOODS &
SERVICES
HOUSEHOLDS
(CONSUMPTION)
MONETARY FLOW
MERCADO DE
FACTORES DE
PRODUCCION
REAL FLOW
INCOMES –WAGES ((FLOW OF
INCOMES)
FACTORS
Pág.6
Demand varies, production
Production varies, income varies
Income varies, demand varies
FIRMS
(PRODUCTION)
National income identity
 Production is equal to income. Then:
Y  AD
Y  C  I G  X Q
Y  C  I  G  NX
S  I  G  NX
 This last equation states that savings should be sufficient for
financing the investment spending, the budget deficit
and the trade deficit. In other words, increases in
budget or trade deficits unless accompanied by an equal
increase in savings will lead to the crowding out of
investment
Pág.7
Short-run macroeconomic models
 Keynesian model (Endogenous variable: Income)
 Fixed prices
 Pure exchange economy. No money
 IS-LM Model (Endogenous variables: income-interest rate)
 Fixed prices
 Monetary economy
 Open economy without capital flows
 IS-LM with capital mobility (Mundell-Fleming) (Endogenous variables:
Income-interest rates)
 Fixed prices
 Monetary economy
 Open economy with capital flows
 Aggregate supply and demand model (Endogenous variables: Prices-
Income). AS-AD diagram
 Sticky prices
 Monetary economy
Pág.8
 Dynamic AS-AD model (endogenous variables: inflation rates and income)
Keynesian model: assumptions
 Government sector:
Taxes  tax rate· Income
T  t·Y
(0<t<1)

Budget deficit (BS) is defined by the difference between taxes and the
sum of government purchases (G) and transfers (TR).
BS  t·Y - Go - TRo
 Open Economy: net export is a decreasing function of national income.
The coefficient m, is the marginal propensity to import.
o
NX  NX - m·Y
 No money
 Fixed prices: no inflation nor deflation
Pág.9
Keynesian model
 In this model a macroeconomic equilibrium is reached when actual ouput
Y, is equal to intended spending. Hence, the level of the aggregate
demand determines the income level.
Production  Income  Expenditure or Aggregate demand
Y  Yincome  AD
 AD Components
 Consumption spending (C),
 Investment spending (I),
 Government purchases, G,
 Investment spending, I.
 Therefore Y+Q-X is equal to:
and
Y Q - X  C  I G
Y  C  I G  X -Q
Being X and Q, export and import, respectively.
Pág.10
Keynesian model
 Equations:
(1) Y  AD
(2) AD  C  I  G  X - Q
(3) C  Co  cYd
(4) Yd  Y - tY  TRo
(5) I  Io
(6) G  Go
(7) X  Xo  xY *
(8) Q  Qo  mY
 Susbtracting (7) - (8), s:
X  Q  Xo  Qo  xY *  mY (9)


NXo
Pág.11
Keynesian model
 Ecuaciones del modelo:
(1) Y  AD
(2) AD  C  I  G  X - Q
(3) C  Co  cYd
(4) Yd  Y - tY  TRo
(5) I  Io
(6) G  Go
(7) X  Xo  xY *
(8) Q  Qo  mY
 Substituting (4) in (3)
C  Co  cY  tY  TRo   Co  c(1  t)Y  cTRo (10)
Pág.12
Simple keynesian model
(1) Y  DA
(2) DA  C  I  G  X - Q
(5) I  Io
(6) G  Go
(9) C  Co  c(1- t)Y  cTRo
(10) XN  XNo - mY
 Substituting (5), (6), (9) y (10) in (2)
DA  Co  c(1 t)Y  cTRo  Io  Go  XNo  mY (11)
Pág.13
Keynesian model
 Equations are now:
(1) Y  AD
(11) AD  Co  c(1  t)Y  cTRo  I o  Go  NX o  mY
 Substituting (11) into (1) :
Y  Co  c(1  t)Y  cTRo  I o  Go  NX o  mY
Y  c(1  t)Y  mY  Co  cTRo  I o  Go  NX 0
Y(1  c(1  t)  m)  Co  cTRo  I o  Go  NX 0


1
 C  cTR  I  G  NX 
Y
o
o
o
o
0












1  c(1  t)  m

 autonomousexpenditure component 
Pág.14
multiplier
Keynesian model
 In compact form:








1
Y
C  cTR  I  Go  XNo
 Y  α·A0


ooo
1  c(1  t)  m 




expenditure component
 autonomous
multiplier
 


 

A
0



 ¿Qué dice aquí?
 The equilibrium level of income is determined by the multiplier and by the
autonomous expenditure component.
 Any increase in autonomous spending or any increase in the multiplier will
change national income.
 Proof:
dY  dα·A0  dA0 ·
Pág.15
Keynesian model
 dAo:
dAo  dC  dcTR  dTRo c  dI  dGo  dNX o
o
o
o
 Interpretation
 Any change in autonomous consumption spending, autonomous investment
spending, marginal propensity to consume out of disposable personal income ,
ttransfers, government purchases or autonomous net export will increase
autonomous spending .
 On the other hand, any change in t, m or c will change the multiplier value
d11 - c(1 - t)  m   d 1 - c(1 - t)  m ·1

2
1 - c(1 - t)  m 
 d1  dc(1  t)  d(1  t)c  dm


2
1 - c(1 - t)  m 
dc  tdc  d1  dtc  dm
(1  t)dc  dtc  dm


1 - c(1 - t)  m 2
1 - c(1 - t)  m 2
dα 
Pág.16
Check
 By using the last equation
 we can check that
Pág.17
 Co 

 Go 
 TRo 
  A0  Y
 NXo
 I0 

 c 
c 

 m    Y
 t 
Types of changes in the exogenous
variables
 Exogenous variables in the model can be splitted into two
groups: a) variables depending on the individual’s decisions:
(c, I, m); variables determined by authorities (Government
or Central Bank):G, TR, XN, t. Changes in G, TR, XN and t
are fiscal and trade policy variables. Changes in this variables
are policy shocks.
 Since changes in G, TR y t, will lead changes in budget
surplus, they are defined as fiscal policy instruments.
 Changes in tariffs or in the exchange rate in order to change
NXo, are trade policy instruments.
Pág.18
Expansionary vs. Contractionary
policies
 If as a result of any kind of policy shock income increases,
this policy is expansionary. The so-called contractionary
policies lead income decreases.
 For instance,
 Increase in G : Fiscal policy expansionary
 A tax cut: Fiscal policy expansionary
 Decrease in TR: Fiscal policy contractionary
 A cut in tariffs:Trade policy contractionary
 A decreaase in the marginal propensity to consume (NO policy)
Pág.19
Demand (AD), Production (Y)
The model
Pág.20
HORIZONTAL AXIS:
INCOME (Y)
VERTICAL AXIS:
DEMAND(AD)
Renta,Y
45º LINE: EQUILIBRIUM CONDITION Y=DA
Demand (AD), Production (Y)
45o LINE
Pág.21
Y=AD
SLOPE= 1
Y1
Y1
INCOME,Y
THE INTENDED EXPENDITURE OR AD
DA  Co  c(1  t)Y  cTRo  I o  Go  NX o  mY  A0  (c(1 - t) - m)Y
45o LINE
AD
AD
AD  A0  (c(1 - t) - m)Y
 
number
SLOPE AD=c(1-t)-m
Ao
number
dAD
 c(1  t)  m  0
dY
intercept :
Si Y  0 AD  Ao
Pág.22
Y
THE EQUILIBRIUM
AD
45o LINE
AD
E
EQUILIBRIUM:
Y = DA
AUTONOMOUS SPENDING
Pág.23
Y
¿HOW AN INCREASE IN NET EXPORT WOULD
AFFECT THE EQUILIBRIUM INCOME?
AD
Y=AD
E’
AD1=A1+(c(1-t)-m)Y
Y1
ADo=Ao+(c(1-t)-m)Y
A1
E
Yo
Ao
45º
Pág.24
Yo
Y1
INCOME,Y
HIGHLIGHTS
From this model, what are the
recipes for the crisis
 C and I will decrease in recessions
 Howver, Government could increase G (government purchases):
 Government intervention vs. laissez faire-laissez-passer.
 Key argument: multiplier effect.
Pág.25
Multiplier effect
For simplicity suppose that we are in a closed economy, and
suppose that Government increases the government purchases.
 The increase in government purchases by 1 euro changes intended
spending by 1 euro and income in 1 euro. After tax, 1-t euros will
be disposable for consumption . Therefore, the consumption
spending will increase in c(1-t) euros, so the intended spending
goes up and income will also increase in c(1-t).
 This new increase in income, will lead a new increase in
consumption spending of ….
 The sum of the initial effects and the rest of induced effects
determines that the multiplier will be higher than 1.

Pág.26
Fiscal policy and Budget surplus
How an increase in G would affect the budget
deficit?
SP  t·Y - Go - TRo
Pág.27
How an increase in G would affect the budget
deficit?
BS  t·Y - Go - TRo
 Taking differences
dBS  dt·Y  dY·t - dGo - dTRo
 The increase in income from the increase in
government purchases is , dY=αdG then:


t
dBS  αdG·t - dG  αt  1dG  
 1dG 
 1 - c(1 - t)  m

 t - 1  c(1 - t)  m 
 (c - 1)(1 - t)  m 

dG  
dG  0
 1 - c(1 - t)  m 
 1 - c(1 - t)  m 
Pág.28
Extensions
An increase in the Government purchases
AD
Y=AD
E’
AD1=A1+(c(1-t)-m)Y
Y1
ADo=Ao+(c(1-t)-m)Y
A1=C0+I0+G1+cTRo+NXo
Yo
Ao=C0+I0+G0+cTRo+NXo
Pág.30
E
45º
Yo
Y1
Income,Y
An Increase in the Transfers
AD
Y=AD
E’
AD1=A1+(c(1-t)-m)Y
Y1
ADo=Ao+(c(1-t)-m)Y
A1=C0+I0+G0+cTR1+NXo
Yo
Ao=C0+I0+G0+cTRo+NXo
Pág.31
E
45º
Yo
Y1
INCOME,Y
An increase in the tax rate
AD
Y=AD
E
AD0=Ao+(c(1-t)-m)Y
Yo
AD1=Ao+(c(1-t1)-m)Y
Y1
E’
Ao=C0+I0+G0+cTRo+NXo
45º
Pág.32
Y1
Yo
Income,Y