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Chapter 23 The Keynesian Framework Copyright © 2009 Pearson Addison-Wesley. All rights reserved. Learning Objectives • See the differences among saving, investment, desired saving, and desired investment and explain how these differences can generate short run fluctuations in real GDP • Understand the Keynesian cross and determination of an equilibrium level of income • Analyze autonomous changes in macroeconomic variables and their potential to cause economic fluctuations Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-2 Learning Objectives (Cont.) • Define the liquidity preference theory and its role in determining interest rates • Comprehend the Keynesian theory of monetary policy and its role in impacting the economy • Understand the Keynesian version of aggregate demand/aggregate supply analysis Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-3 Introduction • In 1936, John Maynard Keynes published The General Theory of Employment, Interest and Money • Concerned with short-run as compared to the Classical Economists who focused on long-run • Argued that free market forces could take considerable time to adjust • In the short run there could be lengthy periods of underemployment Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-4 Introduction (Cont.) • Preoccupied with what determined the level of real economic activity during long periods of recession or depression • If economy were sufficiently depressed, could experience increases in real output without any increase in the price level • Assumed that the price level is fixed • Focused on aggregate demand and supply since full employment was irrelevant Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-5 When Saving Doesn’t Equal Investment • Classical economists stated that equilibrium existed when total saving desired by households equals total investment desired by firms • However, Keynes asked what happens when desired savings exceeds desired investment and prices were not free to adjust – Prices are sticky and will not decline as inventories build up Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-6 When Saving Doesn’t Equal Investment (Cont.) – Wages are resistant to decreases – Since interest rates are determined in the money market, fluctuations will not necessarily equilibrate desired saving and desired investment – Therefore, since prices will not fall, both real output and income will decline until desired savings equaled desired investment at a lower equilibrium GDP Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-7 Consumption and Simple GDP Determination • Figure 23.1 represents the Keynesian cross diagram • Real income and real output are measured in the horizontal axis (Income: Y) • Different types of expenditures are measured on the vertical (Expenditure: E) • A 45 degree line from origin traces the equilibrium condition where E = Y Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-8 FIGURE 23.1 Spending determines income. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-9 Consumption and Simple GDP Determination (Cont.) • Expenditure takes two forms—consumption and investment – Consumption Function (C) • Consumption is a linear function of income (Y) • C = a + bY • “b” is equal to the slope of the consumption line Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-10 Consumption and Simple GDP Determination (Cont.) – Consumption Function (C) (Cont.) • Marginal propensity to consume (MPC) – The slope of the consumption functions (b) – how much additional consumption would result from a $1 increase in income and is always less than 1 • “a” of the consumption function represents consumption level if income were equal to zero • The consumption function will shift up or down if the value lf “a” changes due to increased/decreased personal wealth Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-11 Consumption and Simple GDP Determination (Cont.) – Investment (I) • A relationship between the rate of interest on bonds and the level of investment spending by business firms • A negative relationship—when interest rates fall, investment spending will increase • Entrepreneurs invest as long as the rate of return on investment exceeds the rate of interest • If the rate of interest is given, the level of investment will be constant and not a function of income Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-12 Consumption and Simple GDP Determination (Cont.) • Total expenditure is equal to the sum of consumption which varies with income and investment which is constant (E = C + I) • At points along the 45 degree line, total expenditure (E) is equal to total income (Y) • Since desired savings is equal to Y – C and E = Y, it follows that along the 45 degree line desired savings is equal to desired investment (S = I) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-13 Consumption and Simple GDP Determination (Cont.) • Savings Function (Figure 23.2) – The marginal propensity to save (MPS) is equal to 1 – MPC and less than 1 – This represents the slope of the savings function which graphs a linear relationship between savings and income S = -a + (1 - b)Y Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-14 FIGURE 23.2 Saving and investment determine income. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-15 Consumption and Simple GDP Determination (Cont.) • Savings Function (Figure 23.2) (Cont.) – The economy is in equilibrium at an income level where the savings function is equal to a fixed investment – This level of income is identical to the level where the total expenditure function crosses the 45 degree line Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-16 Changes in GDP • The equilibrium level of income will not change unless there is a change in the consumption or investment functions • This equilibrium would be a desirable outcome if level of income (output) was at full employment level Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-17 Changes in GDP (Cont.) • Keynes argued that since the level of investment is highly unstable, it is likely that the equilibrium output level will not equal the full employment level of output • If entrepreneurs became uncertain about the future, investment spending would decline (total expenditure function would shift down) and equilibrium would be established at a lower level of GDP Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-18 Changes in GDP (Cont.) • Multiplier—actual decline in GDP will be a multiple of the reduction in investment spending – When investment declines, income begins to decline – This induces a reduction in consumer spending, further lowering the level of income Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-19 Changes in GDP (Cont.) • Multiplier (Cont.) – The total change in income is related to the initial decline in investment through the multiplier, which takes the following form Multiplier 1 (1 b) Where: b = marginal propensity to spend Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-20 Changes in GDP (Cont.) • Multiplier (Cont.) – Therefore, the total change in income resulting from a change in investment is: 1 Y I 1b Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-21 Autonomous versus Induced Changes in GDP • Figures 23.3 and 23.4 suggest that anything that shifts the position of the total desired spending function will alter GDP • Such shifts are produced by autonomous spending changes which are independent of GDP • However, the multiplier was based on the idea that autonomous spending changes will induce further changes in spending Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-22 FIGURE 23.3 A decline in investment spending reduces Y by a multiple of the change in investment. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-23 FIGURE 23.4 A decline in investment spending reduces Y by a multiple of the change in investment. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-24 Autonomous versus Induced Changes in GDP (Cont.) • The larger the marginal propensity to spend (b), the greater the induced change in spending • Keynes argued that consumption spending is largely induced, while investment spending is largely autonomous—dependent on expected rate of return on capital and rate of interest Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-25 Autonomous versus Induced Changes in GDP (Cont.) • Exports and Imports – The multiplier expression can be modified to take account of changes in other components of spending – Exports add to aggregate demand and imports reduce aggregate demand and these changes are impacted by the multiplier Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-26 Government to the Rescue • Keynes was concerned that changes in autonomous spending would cause wide fluctuations in economic activity • Government spending was necessary to offset the changes in autonomous spending and restore the economy to full employment • Therefore, total spending is the sum of consumer, investment, and government expenditures Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-27 Government to the Rescue (Cont.) • Figure 23.5 demonstrated the effect of additional government spending to raise the income level of the economy, ideally to the full employment level – Government spending (G) is added to C + I – This increases spending in the economy to C+ I+G – Total impact of additional government spending is enhanced through the multiplier Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-28 FIGURE 23.5 Adding government spending raises income. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-29 Government to the Rescue (Cont.) • Figure 23.6 shows the effect of increasing taxes which lowers income – Government usually finances spending by taxation – Taxation will reduce disposable income which further reduces income through the multiplier Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-30 FIGURE 23.6 Introducing taxes lowers income. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-31 Government to the Rescue (Cont.) – Government spending and taxes can be changed by government policy to buffer the effects of changes in autonomous spending – Fiscal policy—deliberate manipulation of taxes or government spending to achieve a desired level of income consistent with full employment Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-32 Money and Rate of Interest • Keynes stated that interest rates were determined by the supply of and demand for money rather than by savings and investment • Money might affect the level of real economic activity, only to the extent that it influenced the rate of interest • Changes in the interest would alter desired investment spending and thereby the change the level of GDP Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-33 Money and Rate of Interest (Cont.) • The Keynesian system of income determination deals only with flows in the economy—consumption, saving, investment and income over a period of time • These flows deal in real goods and services and not financial transactions • Keynes introduced the idea that money is a financial asset, held in an individual’s portfolio and is part of an individual’s wealth Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-34 Money and Rate of Interest (Cont.) • Demand for Money (Figure 23.7) – Public’s portfolio consists of two types of assets— money and all other assets (represented by bonds) – Money is liquid—risk free, but does not earn interest – However, the price of bonds can vary in terms of money, so the owner can suffer capital losses or reap capital gains, depending on changes in interest rates Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-35 FIGURE 23.7 Keynesian interest theory. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-36 Money and Rate of Interest (Cont.) • Demand for Money (Figure 23.7) (Cont.) – Money is a riskless asset, and bonds are risky assets – Therefore, more bonds in a portfolio means more risk – The decision regarding the composition of a portfolio between money and bonds will be determined by the overall expected return, the “average” interest rate, on bonds – The demand for money, liquidity preference, is a function of the rate of interest Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-37 Money and Rate of Interest (Cont.) • Demand for Money (Figure 23.7) (Cont.) – The demand for money is negatively sloped with respect to interest – Speculative demand for money—individuals hold more money (fewer bonds) at low interest rates since they expect interest rates to rise in the future which will cause a capital loss on bond holdings – At low rates of interest, individuals have a small opportunity cost of forgoing interest by holding money and prefer liquidity Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-38 Money and Rate of Interest (Cont.) • Demand for Money (Figure 23.7) (Cont.) – Individuals are risk averse— hold bonds only if rate of interest is high enough to compensate for the risk of holding bonds – The supply of money is assumed to be constant and does not vary with interest rates – The equilibrium level of interest is the intersection of the supply and demand curves (Figure 23.7) Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-39 Monetary Policy • Changes in the demand for or supply of money will cause a change in equilibrium rate of interest and impact investment spending • Cost of Capital Effect (Figure 23.8) – Demonstrates the effect of increasing the money supply relative to equilibrium interest rates – Demand for money does not change, only the supply of money increases Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-40 FIGURE 23.8 Effect on the interest rate of changing the money supply. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-41 Monetary Policy (Cont.) • Cost of Capital Effect (Figure 23.8) (Cont.) – Increased money supply indicates cash balances are too high so individuals purchase stocks which increases the price and lowers the interest rate – A lower interest rate will stimulate investment spending and higher GDP via the multiplier – Decrease in the money supply would have the opposite effect Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-42 Monetary Policy (Cont.) • Negative relationship between the demand for money and the rate of interest provides a link between changes in the supply of money and level of economic activity • Liquidity Trap (Figure 23.9) – However, under certain economic conditions, increased supply of money will not lower the rate of interest – At low rates of interest the demand for money becomes perfectly horizontal Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-43 FIGURE 23.9 Keynesian liquidity trap. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-44 Monetary Policy (Cont.) • Liquidity Trap (Figure 23.9) (Cont.) – At these low rates, individuals expect interest rates to increase and consider holding bonds too risky – Liquidity trap—any increase in money supply will simply be held by the public (hoarding) and none of the increased liquidity would spill over to the bond market – In this range of money demand, monetary policy is completely ineffective Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-45 Monetary Policy (Cont.) • Wealth Effect – It is possible that consumers may change their spending in response to variations in the interest rate – Lowering of interest results in higher prices of bonds and consumers feel wealthier – Based on this wealth effect, consumers will spend more, thereby causing the consumption function to shift upward Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-46 Monetary Policy (Cont.) • Monetary Policy and International Trade (Exchange Rate Effect) – Although exports and imports are small segments of U.S. economy, there is a large impact of monetary policy on GDP through net exports – Effect of a change in money supply • Decrease in money supply causes interest rates to rise • This increase relative to interest rates in other countries will encourage foreigners to buy U.S. bonds to enjoy a higher return Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-47 Monetary Policy (Cont.) • Monetary Policy and International Trade (Exchange Rate Effect) (Cont.) – Effect of a change in money supply (Cont.) • Purchase U.S. dollars with foreign exchange which drives up value of the dollar under a flexible exchange rate system • A stronger dollar will discourage exports and encourage imports • Net exports decline when domestic interest rates rise, driving down GDP • This international exchange rate effect strengthens the efforts of the government to slow down economic activity Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-48 Monetary Policy (Cont.) • Summary of the three effects – Transmission mechanism of monetary policy— Three components of monetary policy • Cost of capital effect—influences investment through the cost to businesses of raising capital • Wealth effect—operates through interest rates on consumer wealth which effects consumer spending • Exchange rate effect—operates through interest rates and foreign exchange rate to effect net exports Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-49 Monetary Policy (Cont.) • Transactions Demand and Monetary Policy (Figure 23.10) – Keynes raised the idea of a speculative demand for money that is related to the rate of interest – Increase in GDP leads to an increase in amount of money demanded--people need additional cash to carry out a higher level of transactions – Changes in the liquidity preference will cause equilibrium rate of interest to change—increased liquidity would increase interest rates Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-50 FIGURE 23.10 A shift in the demand for money changes the interest rate. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-51 Monetary Policy (Cont.) • Transactions Demand and Monetary Policy (Figure 23.10) (Cont.) – An increase in income • This will cause a rightward shift of the demand curve • Shift of money demand curve will increase interest rates • However, actions by central bank to increase the supply of money might prevent an increase in interest rates • A growing economy will need a balanced growth of money to prevent interest rates from rising Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-52 Monetary Policy (Cont.) • Transactions Demand and Monetary Policy (Figure 23.10) (Cont.) – The transaction demand for money is probably affected by the interest rate as well as by income— higher interest rates will reduce the demand for transaction balances – Greater use of credit cards reduces the demand for money, thereby lowering interest rates, permitting investment and GDP to increase Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-53 Monetary Policy (Cont.) • Expectations and Monetary Policy – It is generally assumed that expectations are exogenous—determined outside the system – Assuming the central bank makes changes in the money supply and these changes are totally unanticipated, monetary policy alters the interest rate according on the conditions just described Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-54 Monetary Policy (Cont.) • Expectations and Monetary Policy (Cont.) – However, if the actions of the Federal Reserve are completely anticipated, individuals will make portfolio adjustments before the Fed enacts the policy change – The result is that the anticipated monetary policy change will alter interest rates before it is implemented Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-55 Aggregate Demand and Supply • The Keynesian assumption of fixed prices changes the shape of the aggregate supply curve. • Figure 23.11 displays the Keynesian aggregate supply curve which is different than that envisioned by the classical economists Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-56 FIGURE 23.11 Increase in aggregate demand raises real income or prices, depending on the shape of aggregate supply. Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-57 Aggregate Demand and Supply (Cont.) • This aggregate supply curve is in two parts – A horizontal segment which reflects the fact that prices do not increase when the economy is at less than full employment – A vertical segment, which is the classical school’s supply schedule, showing only prices increase after full employment output is reached • If aggregate demand increases in the horizontal portion the result will be higher real output and lower unemployment at a constant price level Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-58 Aggregate Demand and Supply (Cont.) • This was the range of the curve that Keynes was concerned with—levels of employment well below the full employment level • In this range, actions by the government to stimulate output will result in real changes to the economy • If the economy is operating at or near full employment, actions by the government will result in upward pressure on prices—inflation Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-59 Aggregate Demand and Supply (Cont.) • Supply-side policies – This is relevant in the full employment range of aggregate supply – Since the productive capacity is determined by supply of labor, capital and technology, policies that increase these factors will increase potential real output Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-60 Aggregate Demand and Supply (Cont.) • Supply-side policies (Cont.) – The government does not directly control any of these, but tax policies can influence the willingness of households and business firms to supply labor and invest in capital – According to supply-siders, the main consequence of reducing tax rates is increased production incentives which shifts the vertical portion of the aggregate supply curve to the right Copyright © 2009 Pearson Addison-Wesley. All rights reserved. 23-61