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Lecture 6
KEYNESIAN ECONOMICS &
FISCAL POLICY
AGGREGATE OUTPUT AND
INCOME - 1
• Each period (weeks, months, years,
etc), firms produce some aggregate
quantity of goods and services.
• We call this aggregate output (Y).
• We have seen that GDP (Y) can be
calculated in terms of either income or
expenditures.
AGGREGATE OUTPUT AND
INCOME - 2
• We will use the variable Y to refer to
both aggregate output and aggregate
income, because they are the same
seen from different points of view.
AGGREGATE OUTPUT AND
INCOME - 3
• What happens when output increases?
• What happens when output is cut?
• In any given period there is an exact
quality between aggregate output
(production) and aggregate income.
AGGREGATE OUTPUT AND
INCOME - 4
• Aggregate output can also be looked
on as the aggregate quantity supplied,
because that is the amount firms are
supplying (producing) during the
period.
AGGREGATE OUTPUT AND
INCOME - 5
• In the lectures which follow, we use
the phrase aggregate output (income),
rather
than
aggregate
quantity
supplied, but keep in mind that the two
are equivalent.
INCOME, CONSUMPTION AND
SAVING - 1
• In the analysis which follows, we are
initially going to assume a simple
world with no government and a
‘closed’ economy - i.e. no imports and
no exports.
• With their income, households can
either consume or save.
INCOME, CONSUMPTION AND
SAVING - 2
• Total household saving in the
economy (S) is by definition equal to
income (Y) minus consumption (C):
Saving
S
Income – Consumption
Y–C
INCOME, CONSUMPTION AND
SAVING - 3
• The triple equal sign means this is an
identity - something that is always
true.
• In our simple economy, in which there
is no government, there are two types
of spending behavior - spending by
households or consumption (C) and
spending by firms, or investment (I)
THE 450 LINE
• Divides the angle between the
two axes of a graph in half
• Has the important property that
from any point on it, the vertical
and
horizontal
distances
measured along the axes are
equal
THE 450 LINE
Demand
450
A
0
a
Output, y
Any point on the 450 line corresponds to the same vertical and
horizontal distances. The distance 0a equals the distance Aa.
THE SIMPLEST KEYNESIAN
CROSS
• Uses the 450 line
• A graph with the demand for goods and services
on the vertical axis and output ( y ) on the
horizontal axis
• The government and foreign sector are omitted
from this model
• Only consumers and firms can demand output
• Consumers demand consumption goods and
firms demand investment goods
• Assume initially that consumers and firms
demand a fixed amount of goods
CONSUMPTION AND
INVESTMENT DEMAND
•
•
•
•
•
•
Consumption demand is “C”
Investment demand is “I”
Total demand is “C + I”
In the short run, demand determines output
Output = demand
Output = demand = C + I
THE KEYNESIAN CROSS
Demand
450
E
C+I
0
y*
C+I
Demand
Output , y
At equilibrium output y*, total demand Ey* equals output 0y* .
THE SIMPLE KEYNESIAN
CROSS
• Superimpose the horizontal line – C + I (demand)
– on the 450 diagram
• Total demand is fixed at C + I and is independent
of the level of GDP
• Equilibrium output is at y*, the level of output at
which the demand line crosses the 450 line at
point E
• Output measured on the horizontal axis equals
demand by consumers and firms
• Since E is on the 450 line, the vertical distance Ey*
equals the horizontal distance 0y*
THE KEYNESIAN CROSS
Demand
450
E
C+I
0
y*
C+I
Demand
Output , y
At equilibrium output y*, total demand Ey* equals output 0y* .
IF ECONOMY PRODUCES AT A HIGHER
LEVEL OF OUTPUT THAN EQUILIBRIUM
• More goods and services are being
produced than are desired by consumers
and firms
• Extra goods will pile up as demand fell
short of production
• Firms will react by cutting back on
production
• The economy rapidly adjusts to reach the
equilibrium level of output
EQUILIBRIUM OUTPUT
Demand
450
E
C+I
0
y*
C+I
Demand
Output, y
Given total demand equilibrium output (y*) is determined at E, where
demand intersects the 450 line.
EQUILIBRIUM OUTPUT
Demand
450
E
C+I
Demand
C+I
0
y*
y1
Output, y
Given total demand equilibrium output (y*) is determined at E, where
demand intersects the 450 line. If output were higher (y1),
EQUILIBRIUM OUTPUT
Demand
450
E1
E
}
C+I
0
y*
y1
excess
production
C+I
Demand
Output, y
Given total demand equilibrium output (y*) is determined at E, where
demand intersects the 450 line. If output were higher (y1), it would
exceed demand and production would fall.
IF ECONOMY PRODUCES AT A LOWER
LEVEL OF OUTPUT THAN EQUILIBRIUM
• Demand would exceed total output
• Firms find that demand for consumption
and investment goods is greater that their
current production
• Inventories disappear and firms face
increasing backlogs
• Firms respond by stepping up production
• The economy rapidly adjusts to reach the
equilibrium level of output
EQUILIBRIUM OUTPUT
Demand
450
E1
E
}
C+I
0
y2
y*
y1
excess
production
C+I
Demand
Output, y
Given total demand equilibrium output (y*) is determined at E, where
demand intersects the 450 line. If output were higher (y1), it would
exceed demand and production would fall. If output were lower (y2),
EQUILIBRIUM OUTPUT
Demand
450
E1
E
C+I
insufficient
production
}
{
excess
production
C+I
Demand
E2
0
y2
y*
y1
Output, y
Given total demand equilibrium output (y*) is determined at E, where
demand intersects the 450 line. If output were higher (y1), it would
exceed demand and production would fall. If output were lower (y2),
it would fall short of demand and production would rise.
THE CONSUMPTION FUNCTION
• Describes the relationship between consumer
spending and income
C = Ca + by
• Consumption spending, C, has two parts:
– Ca = autonomous consumption is the part of total
consumption which is unaffected by the level of
income, i.e. it is constant at all levels of income.
– by = the product of a fraction, b, called the
marginal propensity to consume (MPC) and the level of
income, y
• The consumption function is a line that intersects
the vertical axis at Ca. It has a slope equal to b.
THE CONSUMPTION FUNCTION
Demand
Consumption
function (Ca + by)
0
Output, y
The consumption function relates consumer spending to
the level of income.
THE CONSUMPTION FUNCTION
Demand
Consumption
function (Ca + by)
Ca
0
Output, y
The consumption function relates consumer spending to
the level of income.
THE CONSUMPTION FUNCTION
Demand
Consumption
function (Ca + by)
Ca
autonomous
consumption
{
0
Output, y
The consumption function relates consumer spending to
the level of income.
THE CONSUMPTION FUNCTION
Demand
Consumption
function (Ca + by)
slope b
Ca
autonomous
consumption
{
0
Output, y
The consumption function relates consumer spending to
the level of income.
THE CONSUMPTION FUNCTION
• Although output is on the horizontal axis,
output and income in this simple economy
are identical
• Output generates income that is all received
by households
• As output rises by $1, consumption
increases by the marginal propensity to
consume (b) times $1
MARGINAL PROPENSITY TO CONSUME
(MPC)
• Is always less than 1
• If a consumer receives a dollar of income,
consumer will spend some of it and save the rest
• The fraction that the consumer spends is
determined by the MPC
• The fraction of income that the consumer saves is
determined by the marginal propensity to save
(MPS)
• The sum of the MPC and MPS is always 1
$$
$$
CHANGES IN THE CONSUMPTION
FUNCTION
• The level of autonomous consumption and
the MPC can change causing movements in
the consumption function
• If the level of autonomous consumption is
higher, it will shift the entire consumption
function.
• Changes in the marginal propensity to
consume will change the slope of the
consumption function.
AUTONOMOUS CONSUMPTION
CHANGES
• Increases in consumer wealth will cause an
increase in autonomous consumption
Consumer wealth consists of the value of
stocks, bonds and consumer durables
• Increases in consumer confidence will
increase autonomous consumption
Demand
MOVEMENTS OF THE CONSUMPTION FUNCTION
Ca0
Output, y
Demand
MOVEMENTS OF THE CONSUMPTION FUNCTION
Ca1
Ca0
Output, y
An increase in autonomous consumption from
Ca0 to Ca1 shifts the entire consumption function.
MARGINAL PROPENSITY TO
CONSUME CHANGES
• Consumers’ perceptions of changes in their
income affect their MPC
• If consumers believe that an increase in
their income is permanent, they will
consume a higher fraction of the increased
income than if the increase were believed to
be temporary
$$
Demand
MOVEMENTS OF THE CONSUMPTION FUNCTION
Slope b
Output, y
Demand
MOVEMENTS OF THE CONSUMPTION FUNCTION
Slope b1
Slope b
Output, y
An increase in MPC from b to b1 increases the slope
of the consumption function.
DETERMINING GDP
• Plot the consumption function
• Investment is constant at all levels of income
• Add the level of desired investment vertically to
the consumption function
• The C + I line is the total spending in the economy
• At any level of income, total spending is C + I
• The level of equilibrium income, y*, occurs where
the total spending ( C + I ) line crosses the 450 line
• At this level of output, total spending equals
output
Demand
DETERMINING GDP
Consumption Function
C
Ca
Output, y
Demand
DETERMINING GDP
C+I
Consumption Function
C
Ca + I
Ca
Output, y
DETERMINING GDP
Demand
450
C+I
Consumption Function
C
Ca + I
Ca
Output, y
DETERMINING GDP
Demand
450
C+I
Consumption Function
C
Ca + I
Ca
y*
Output, y
GDP is determined where the C + I line intersects the 450 line. At that
level of output, y * , desired spending equals output.
EQUILIBRIUM INCOME
= autonomous consumption / (1 - MPC)
Y * = (Ca + I) / (1 - b)
• Suppose : C = 100 + 0.6
Ca = 100
b = 0.6
I = 40
• Using the formula for equilibrium income:
Y * = (100 + 40) / (1 - 0.6)
Y * = 140 / 0.4
y * = 350
• In equilibrium, saving = investment
THE MULTIPLIER
The increase in output divided by an increase
investment
• An increase in investment spending shifts up the
C + I curve by I
• The intersection with the 450 line shifts from E0 to
E1
• GDP increases by y from y0 to y1
• The increase in GDP (y) is greater than the
increase in investment (I)
• Since output increases more than the initial
increase in investment, the multiplier is greater
than 1
THE MULTIPLIER
Demand
450
C+I0
y0
Ca + I 0
E0
}I
Consumption Function
C
0
Ca
y0
Output, y
THE MULTIPLIER
450
Demand
C+I1
I
y0
Ca + I 0
}
I0
}
C+I0
E0
I1
Consumption Function
C
Ca
y0
Output, y
THE MULTIPLIER
450
C+I1
Demand
y1
y
y0
Ca + I 0
I
C+I0
E0
}I
Consumption Function
C
0
Ca
y
y0
y1
Output, y
When investment increases by I from I0 to I1, equilibrium output
increases by y. The change in output (y) is greater than the change
in investment (I).
KEYNESIAN FISCAL POLICY
Using taxes and spending to
influence the level of GDP in
the short run
GDP
Taxes
&
Spending
GOVERNMENT SPENDING
• Government purchases of goods and
services ( G ) is a component of spending
• Total spending is C + I + G
• Increases of government purchases ( G )
shift up the C + I + G line just as increases
of investment spending or autonomous
consumption spending do
• The multiplier for government spending is
also the same as for changes in investment
or autonomous consumption
GOVERNMENT SPENDING
• Changes in government purchases have
exactly the same effects as changes in
investment spending or autonomous
consumption spending
• The multiplier for government spending is
also the same as for changes in investment
or autonomous consumption
Multiplier for government spending =
1 / (1-MPC)
DISPOSABLE PERSONAL
INCOME
The income that ultimately flows back to
households and consumers, after
subtracting any taxes that are paid and after
adding any transfer payments received by
households (such as social security,
unemployment insurance and welfare)
disposable Personal income =
(y-T)
where T is net taxes -- taxes minus transfer
payments
Demand
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
AND TAXES
450
C + I + G0
y
0
Output, y
Demand
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
AND TAXES
After Spending Increase
450
C + I + G1
C + I + G0
y
0
Output, y
Demand
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
AND TAXES
After Spending Increase
450
C + I + G1
C + I + G0
y
0
y1
Output, y
Demand
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
AND TAXES
After Spending Increase
450
C + I + G1
C + I + G0
y
y1 Output, y
0
An increase
in government
spending leads to an increase
in output.
After Spending Increase
Demand
Demand
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
AND TAXES
After Tax Increase
450
450
C + I + G1
C+I+G
C+I+G
C + I + G0
y
y1 Output, y
0
An increase
in government
spending leads to an increase
in output.
y1 y
0
Output, y
After Spending Increase
Demand
Demand
CONSUMPTION FUNCTION WITH GOVERNMENT SPENDING
AND TAXES
After Tax Increase
450
450
C + I + G1
C+I+G
C + I + G0
C+I+G
y
y1 Output, y
0
An increase
in government
spending leads to an increase
in output.
y1 y
Output, y
0
An increase in taxes
leads to an
decrease in output.
TAX MULTIPLIER
• Is negative because increases in taxes
decrease disposable income and lead to
reduction in consumption spending
• Is smaller (in absolute value) than the
government spending multiplier, because
an increase in taxes first reduces the
disposable income of households by the
amount of the tax
• tax multiplier = - b / (1 - b)
= - MPC / ( 1 - MPC )
BALANCED-BUDGET
MULTIPLIER
• The multiplier for equal increases
in government spending and taxes
• Equal increases in spending and
taxes will not unbalance the
budget
• Is always equal to “1”
EXPANSIONARY POLICIES
Government policies that increase
total demand and GDP.
• Tax cuts and spending increases
are examples of expansionary
policies
CONTRACTIONARY
POLICIES
Government policies that decrease
total demand and GDP.
• Tax increases and spending cuts
are examples of contractionary
policies.
BUDGET DEFICIT
Increases when government
increases spending or cuts
taxes to stimulate the
economy.
PERMANENT INCOME
Consumers often base
their spending on an
estimate of their long-run
average income.
AUTOMATIC STABILIZERS
Taxes and transfers which act
as economic institutions that
automatically reduce economic
fluctuations.
HOW AUTOMATIC STABILIZERS
WORK
• When income is high:
-- government collects more taxes and pays out
less transfer payments
-- since government is taking funds from
consumers, this tends to reduce consumer
spending
• When income is low (i.e., during recessions):
-- government collects less taxes and pays out
more transfer payments
-- tends to increase consumer spending, since the
government is putting funds into the hands of
consumers
AFTER A TAX INCREASE
• Consumption function depends on after-tax
income:
C = Ca + b ( 1 - t ) y
• Marginal propensity to consume is now
adjusted for taxes and becomes
b(1-t)
• Raising the tax rate therefore lowers the
MPC adjusted for taxes
AN INCREASE IN TAX RATES
450
Demand
C+I+G
y0
Output, y
AN INCREASE IN TAX RATES
450
Demand
C+I+G
C+I+G
after tax- rate increase
y0
Output, y
AN INCREASE IN TAX RATES
450
Demand
C+I+G
C+I+G
after tax- rate increase
y1
y0
Output, y
AN INCREASE IN TAX RATES
450
Demand
C+I+G
C+I+G
after tax- rate increase
y1
y0
Output, y
An increase in tax rates decreases the slope of the C + I + G
line. This lowers output and reduces the multiplier.
OTHER FACTORS CONTRIBUTING TO
STABILITY OF ECONOMY
• If households base their consumption
decisions partly on their permanent or longrun income, they will not be very sensitive to
changes in current income.
• If consumption doesn’t change much with
current income, the marginal propensity to
consume out of current income will be small,
which will make the multiplier small.
• When consumers base their decisions on
long-run factors, not just on their current level
of income, the economy tends to be stabilized.
MODIFYING THE MODEL FOR EXPORTS
AND IMPORTS
• Add exports, X, as another source of demand for US
goods and services
• Subtract imports, M, from the total spending by US
residents
• Consumers will import more goods as income rises:
imports = M = m*y
• m is the fraction known as the marginal propensity to
import
• Subtract this fraction from the overall marginal
propensity to consume ( b ) to obtain the MPC for
spending on domestic goods
DETERMINING OUTPUT IN AN OPEN ECONOMY
Demand
450
Demand
C a+ I + X
y0
Output, y
Output is determined where demand for domestic goods
equals output.
Demand
Demand
INCREASE IN EXPORTS AND IMPORTS
450
Ca + I + X
Ca + I + X
450
y
0
Output, y
y Output, y
0
Demand
Demand
INCREASE IN EXPORTS AND IMPORTS
450
Ca + I + X
Ca + I + X
450
X
y
0
Output, y
y Output, y
0
Demand
Demand
INCREASE IN EXPORTS AND IMPORTS
450
450
Increase in the
Marginal
Propensity to
Import
Ca + I + X
Ca + I + X
After the
increase
in exports
X
y
0
y1
Output, y
y1
y Output, y
0
Demand
Demand
INCREASE IN EXPORTS AND IMPORTS
450
450
X
Ca + I + X
Ca + I + X
After the
increase
in exports
Increase in the
Marginal
Propensity to
Import
y
y1
y Output, y
y1 Output, y
0
0
An increase
in exports will increase An increase in taxes leads
to an
the level of GDP
decrease in output.
ACTUAL VERSUS PLANNED - 1
• A firm may not always invest the exact amount
that it planned to.
• Why?
• Firms do not have complete control over their
investment decisions.
• This is not true of consumption, as households
have complete control over their consumption.
Planned consumption is always equal to actual
consumption.
ACTUAL VERSUS PLANNED - 2
• Firms can generally chose how much new plant
and equipment they wish to purchase in any given
period (e.g. McDonald’s buys an extra french-fry
machines, etc).
• However, firms have less control over inventory
investment.
• Remember, inventories are part of the capital
stock. Manufacturing firms have two kind of
inventories:
– Inputs (e.g. tyres, rolled steel, engine blocks, etc)
– Final production (finished automobiles awaiting
shipment)
ACTUAL VERSUS PLANNED - 3
• Consequently, one component of investment inventory change - is partly determined by how
much households decide to buy, which is not
under complete control of firms.
• If households do not buy as much as firms expect
them to, inventories will be higher than expected,
and firms will have made an inventory investment
that they did not plan to make.
ACTUAL VERSUS PLANNED - 4
• Because involuntary inventory adjustments are
neither desired nor planned, we need to
distinguish between actual investment and
desired , or planned investment.
• When we have been discussing I in this lecture,
we have used I to refer to desired or planned
investment only.
• So, we could have written:
Planned aggregate expenditure
AE
Consumption + Planned investment
C+I
EQUILBIRUM AGGREGATE
OUTPUT (INCOME) - 1
• In microeconomics we said that equilibrium is
said to exist in a particular market (e.g. the market
for bananas) at the price for which the quantity
demanded is equal to the quantity supplied.
• In macroeconomics, we define equilibrium in the
goods market as that point at which planned
aggregate expenditure is equal to aggregate
output.
EQUILBIRUM AGGREGATE
OUTPUT (INCOME) - 2
Aggregate output
Y
Planned aggregate expenditure
AE C + I
Equilibrium: Y = AE, or Y = C + I
• This definition of equilibrium can hold if, and only
if, planned investment and actual investment are
equal. To understand why, consider Y no equal to
AE. First let us suppose aggregate output is
greater than planned aggregate expenditure:
Y>C + I
Aggregate output> Planned aggregate expenditure
EQUILBIRUM AGGREGATE
OUTPUT (INCOME) - 3
• When output is greater than planned spending,
there is unplanned inventory investment. Firms
planned to sell more of their goods than they
sold, and the difference shows up as unplanned
increase in inventories.
• Suppose now that planned aggregate expenditure
is greater than aggregate output:
C+I>Y
Planned aggregate expenditure > Aggregate output
EQUILBIRUM AGGREGATE
OUTPUT (INCOME) - 4
• When planned spending exceeds output, firms
have sold more than they planned to. Inventory
investment is smaller than planned.
• Planned and actual investment are not equal. Only
when output is exactly matched by planned
spending will there be no unplanned inventory
investment.
• Equilibrium in the goods market is achieved only
when aggregate output (Y) and planned aggregate
expenditure (C+I) are equal, or when actual and
planned investment are equal.
SAVINGS AND INVESMENT
APPROACH - 1
• Because aggregate income must either be saved
or spent, by definition:
Y
C+S
THIS IS AN IDENTITY
• The equilibrium condition is:
Y=C+I
BUT THIS IS NOT AN IDENTITY, BECAUSE IT DOES
NOT HOLD WHEN WE ARE OUT OF EQUILIBRIUM.
IT WOULD BE AN IDENTITY IF I WERE ACTUAL
INVESTMENT RATHER THAN PLANNED
INVESTMENT
SAVINGS AND INVESMENT
APPROACH - 2
• Substituting C + S for Y in the equilibrium
condition, we can write:
Saving/investment approach to equilibrium: C + S = C + I
Because we can subtract C from both sides of this equation,
we are left with S = I.
Thus, only when planned investment equals saving will there
be equilibrium.
• Remember, saving is income that is not spent.
Because it is not spent, saving is like a leakage
out of the spending stream.
SAVINGS AND INVESMENT
APPROACH - 3
• Only if that leakage is counterbalanced by some
other component of planned spending can the
resulting planned aggregate expenditure equal
aggregate output. This other component is
planned investment (I).
• The leakage out of the spending stream - saving is matched by an equal injection of planned
investment spending into the spending stream.
• For this reason, the saving/investment approach
to equilibrium is also called the leakages/
injections approach to equilibrium.