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Macroeconomics
© RAINER MAURER, Pforzheim
4. The Keynesian Model and its Policy Implications
Prof. Dr. Rainer Maurer
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© RAINER MAURER, Pforzheim
Macroeconomics
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
4.2. Demand-side Shocks
4.2.1. Reduction of the Propensity to Consume
4.2.2. Reduction of the Propensity to Invest
4.2.3. Consequences for the Labor Market
4.3. Fiscal and Monetary Policy in the Keynesian Model
4.3.1. Fiscal Policy
4.3.2. Monetary Policy
4.4. The Long-run Implications of the Keynesian Model
4.5. Policy Conclusions
4.5.1. Practical Problems of Anti-cyclical Policy
4.5.2. Case Study: Fiscal Policy in Germany
4.5.3. Limits of Government Debt
4.5.4. Case Study: Economic Policy in the Great Recession
4.6. Questions for Review
Prof. Dr. Rainer Maurer
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Macroeconomics
Literature:
© RAINER MAURER, Pforzheim
◆ Chapter 9, 10, 11, 13, 14 Mankiw, Gregory; Macroeconomics, Worth
Publishers.
◆ Kapitel 10, Baßeler, Ulrich et al.; Grundlagen u. Probleme der
Volkswirtschaft, Schäfer-Pöschel.
Prof. Dr. Rainer Maurer
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Macroeconomics
© RAINER MAURER, Pforzheim
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
➤ The Crisis of Neoclassical Theory
■
■
■
© RAINER MAURER, Pforzheim
■
Prof. Dr. Rainer Maurer
Until the world economic crisis of 1929, the neoclassical
model was the consensus model of market oriented
economists.
This appraisal of the neoclassical theory was altered by the
world economic crisis.
Such a sharp and lasting break of economic development
was inconsistent with the neoclassical hypothesis of the
immanent stability of market economies.
Rising unemployment, bankrupt companies and decreasing
incomes caused social problems that called for new
solutions.
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
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The Development of the Dow Jones Index
Quelle:
www.dowjones.com
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
The W orld Economic Crisis in the USA
Year
Unemployment Rate
Real GDP
%
Change
% Change
Level
© RAINER MAURER, Pforzheim
1929
3,2
1930 178,1%
8,9
1931
83,1%
16,3
1932
47,9%
24,1
1933
4,6%
25,2
1934 -12,7%
22,0
1935
-7,7%
20,3
1936 -16,3%
17,0
1937 -15,9%
14,3
1938
33,6%
19,1
1939
-9,9%
17,2
1940 -15,1%
14,6
Quelle: US Bureau of Census
Prof. Dr. Rainer Maurer
-9,9%
-7,6%
-14,9%
-1,9%
9,0%
9,9%
14,0%
5,2%
-5,1%
8,6%
8,5%
Consumption
%
Change
Investment
%
Change
Governm.
Consum.
%
Change
-6,6%
-3,3%
-9,0%
-1,7%
4,7%
6,3%
10,3%
3,4%
-2,0%
5,7%
5,1%
-32,2%
-38,7%
-72,0%
12,8%
77,4%
91,5%
33,3%
24,6%
-43,1%
45,3%
33,6%
10,5%
4,5%
-4,7%
-3,7%
14,2%
1,5%
17,8%
-3,1%
10,1%
3,8%
3,4%
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
The W orld Economic Crisis in the USA
© RAINER MAURER, Pforzheim
The analysis of demand shocks in
Realhas
GDP
theUnemployment
neoclassical Rate
model
Yearrevealed that a reduction of
%
Level
% Change
consumption
Change demand should lead
1929to an increase in
3,2savings, which
reduce the
rate
1930should
178,1%
8,9 interest-9,9%
that demand
1931such83,1%
16,3for investment
-7,6%
grows and
the
1932goods
47,9%
24,1 replace
-14,9%
(and
vice
1933reduction
4,6%in consumption
25,2
-1,9%
1934versa).
-12,7%
22,0
9,0%
mechanism 20,3
did not work 9,9%
in the
1935This-7,7%
economic crisis!
1936world
-16,3%
17,0
14,0%
1937 -15,9%
14,3
5,2%
1938
33,6%
19,1
-5,1%
1939
-9,9%
17,2
8,6%
1940 -15,1%
14,6
8,5%
Quelle: US Bureau of Census
Prof. Dr. Rainer Maurer
Consumption
%
Change
Investment
%
Change
Governm.
Consum.
%
Change
-6,6%
-3,3%
-9,0%
-1,7%
4,7%
6,3%
10,3%
3,4%
-2,0%
5,7%
5,1%
-32,2%
-38,7%
-72,0%
12,8%
77,4%
91,5%
33,3%
24,6%
-43,1%
45,3%
33,6%
10,5%
4,5%
-4,7%
-3,7%
14,2%
1,5%
17,8%
-3,1%
10,1%
3,8%
3,4%
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
➤ The Keynesian Theory
■
■
■
Under these historical circumstances John Maynard Keynes
developed his new macroeconomic theory, which was
intended to explain the consequences of the world economic
crisis and to deliver economic policy recommendations
appropriate to overcome such a crisis.
This theory was published in a book with the title “General
Theory of Employment, Interest and Money” (1936).
In this book, Keynes contested two basic assumptions of the
neoclassical theory by assuming that
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1. …in the short run, goods prices are fix, so that they cannot de-
Prof. Dr. Rainer Maurer
crease in case of a reduction of goods demand. As a consequence, he assumed that instead of goods prices the supply of goods
adjusts to changes in demand = “Keynesian Price Rigidity”.
2. …household consumption is only a positive function of household
income C(Y ↑)↑; the negative impact of the interest rate C(i↓)↑
can be neglected = “Keynesian Consumption Function”.
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
➤ The Keynesian consumption function C(Y↑)↑ corresponds
at first sight much better to empirical observations as the
neoclassical consumption function C(i↑)↓.
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➤ The empirical correlation between consumption and
income is in deed much stronger than the empirical
correlation between consumption and interest rates, as the
following graphs demonstrate:
Prof. Dr. Rainer Maurer
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© RAINER MAURER, Pforzheim
Consumption of Private Households (C),Bn. €
Correlation between Consumption of Private Households and Disposable
Income in Germany (Prices = 1995; 1980 - 2002)
1400
1200
1000
800
C(Y-T) = 0,89 *(Y-T)
600
= C(Y↑)↑
400
= Keynesian Consumption Function
200
0
700
800
900
Quelle: SVG (2003), eigene Berechnungen
Prof. Dr. Rainer Maurer
1000
1100
1200
1300
1400
Disposable Income (=Y-T) in Bn. €
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Consumption of Private Households (C),Bn. €
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Correlation between Consumption of Private Households and Interest in
Germany (Prices = 1995; 1980 - 2002)
1400
1200
1000
800
600
C(i) = 1022 - 2865 *(i)
400
= C(i↑)↓
200
Prof. Dr. Rainer Maurer
0
= Neoclassical Consumption Function
Quelle: SVG (2003), eigene Berechnungen
2%
3%
4%
5%
6%
7%
Real Interest Rate of Fixed Rate Securities in %
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
➤ The second basic difference between Keynesian and neoclassical theory is the so called “Keynesian Price Rigidity”:
■
In neoclassical theory, an increase of production output
causes an increase of marginal costs, so that firms increase
their prices (and vice versa).
◆
■
In Keynesian theory, firms do not immediately adjust their
prices to production output:
◆
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Consequently, an increase of the demand for goods causes an
increase of the prices of goods (and vice versa).
An increase (decrease) of the demand for goods causes a
corresponding increase (decrease) of the supply of goods. The
prices of goods stay however constant.
➤ Who is right – Keynes or the Neoclassics?
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
➤ An large-scale empirical study of the European Central Bank
has led to the following result:
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Percentage Distribution of Firms According Their Frequency of Price
Adjustments per Year
Survey Period 2003-2004; Sample Size 11000 Firms;
BE = Belgium, DE= Germany; FR=France, IT=Italy LU= Luxembourg,
NL=Netherlands, AT=Austria, PT=Portugal
Quelle: The Pricing Behavior of Firms in the Euro Area, EZB (2005)
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
➤ From these and similar studies follows:
■
■
Firms do not immediately adjust their prices to
changes in costs.
Instead, they keep their prices constant over a longer
period of time – just as assumed by Keynes.
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➤ If firms try to maximize their profits, they should in
principle change their prices when their costs change.
➤ Why then do firms not change their prices more often?
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
➤ Why do prices not change more often?
■ In reality, changing prices causes costs:
◆ Internal organizational costs: Information of staff members,
◆
◆
distribution chains, sales agents…
External communication costs: Explication and justification of
price changes to clients…
Technical costs: printing costs of pricelists, mailing expenses…
■ If the costs per price change are higher than the return of a
© RAINER MAURER, Pforzheim
price change, a continuous adjustment of prices is not profit
maximizing, as the following diagram shows:
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
€
The costs per price change
will typically be constant or
slightly increasing, if the
number of price changes
per year grows.
Costs per
Price Change
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3€
3€
Number of Price Changes per Year
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
4,5
5,0
5,5
6,0
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
€
The costs per price change
will typically be constant or
slightly increasing, if the
number of price changes
per year grows.
Costs per
Price Change
3€
© RAINER MAURER, Pforzheim
6€
Number of Price Changes per Year
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
4,5
5,0
5,5
6,0
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
€
The return per price
change will typically
decrease, if the number of
price changes per year
grows.
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The return of 1 price
change every 2 years
will normally be quite
high, since it is very
likely that significant
changes of
production costs and
demand strength will
occur within a time
span of 2 years.
The return of 4 price
changes per year will
normally be lower,
since it is not so likely
that significant changes of production
costs and demand
Return
per
strength will
occur
Price Change
every quarter…
Number of Price Changes per Year
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
4,5
5,0
5,5
6,0
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
€
© RAINER MAURER, Pforzheim
Return of an
additional
price change
higher than
costs
Costs per
Price Change
Return per
Price Change
More often price
changes profitable
Number of Price Changes per Year
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
4,5
5,0
5,5
6,0
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
€
Return of an
additional
price change
lower than
costs
Costs per
Price Change
© RAINER MAURER, Pforzheim
Return per
Price Change
Less often price
change profitable
Number of Price Changes per Year
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
4,5
5,0
5,5
6,0
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
€
=> Profit maximizing
number of price changes
per year = 2
Costs per
Price Change
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Return per
Price Change
Number of Price Changes per Year
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
4,5
5,0
5,5
6,0
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
€
Profit at 2 adjustments of
prices per year
=> Profit maximizing
number of price changes
per year = 2
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Costs per Price
Change
Return per Price
Change
Number of Price Changes per Year
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
4,5
5,0
5,5
6,0
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
€
=> The higher the costs per price
adjustment, the lower the number
of profit maximizing price
adjustments per year!
Costs per Price
Change2
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Costs per Price
Change1
Return per Price
Change
Number of Price Changes per Year
0,5
1,0
1,5
2,0
2,5
3,0
3,5
4,0
4,5
5,0
5,5
6,0
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
➤ As the diagrams show:
It is possible to explain, why firms on average do not change
their prices more often than one time per year with the
standard microeconomic profit-maximization behavior.
■
Depending on the relation between the costs and return of a
price change it can be profit-maximizing to hold prices on
average constant for a time span of a year or even longer.
■
Rigid price setting and profit maximization are compatible!
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■
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
© RAINER MAURER, Pforzheim
4.1. The Keynesian Theory
➤
The Keynesian theory assumes therefore that in the “shortrun” (= within a time span of one year) firms keep their prices
constant:
P = constant within one year
➤
If the demand for goods changes in the short-run, firms do
simply adjust their production instead of prices to the demand
for goods.
➤
Consequently, in the short-run firms' production of goods Y is
always equal to the sum of households consumption demand
C plus firms’ demand for investment goods I plus government
consumption demand G:
Y=C+I+G
Consequently, in the short-run demand for goods determines
supply of goods!
➤
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
➤ If we add now the Keynesian consumption function C(Y)
we receive the following relationship:
Y = C(Y) + I + G
➤
Obviously, this is a circular relationship:
■
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➤
Prof. Dr. Rainer Maurer
GDP Y depends on consumption C(Y) and
consumption C(Y) depends on GDP Y and so on…
As the following analysis will show, this circular relationship can
boost the effects of economic policy (but complicates a bit the
graphical analysis…).
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Macroeconomics
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.1.1. The "Keynesian Cross"
➤ Since prices are constant and supply always adjust to
demand the following equation always holds in the
Keynesian model:
GDP
 Demand for Goods

GDP

Y
 Consumptio n  Investment  Gov. Consumptio n

C (Y )

I

G
© RAINER MAURER, Pforzheim
➤ For simplicity we will first assume that I and G are
constant.
➤ What exactly means C(Y)?
➤
Example: Let the consumption rate be: c = 50% and Y = 100 :
C( Y )  c * Y  0,5 * 100  50  Consumptio n
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.1.1. The "Keynesian Cross"
➤
This means “Everything that increases demand increases GDP”:
Investment Multiplier :
1
1  c
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Government Consumptio n Multiplier :
➤
➤
Prof. Dr. Rainer Maurer
1
1  c
Restriction: This government consumption multiplier is only
valid, if government consumption is financed with credits.
As can be mathematically proven, financing government
consumption with taxes yields a multiplier of exactly 1 under
Keynesian assumptions.
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4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
Graphical exposition of these
considerations:
30
25
C(Y)= 0,5 * Y
20
15
© RAINER MAURER, Pforzheim
10
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
30
25
Consumption (C) dependent on
GDP (Y)
C(Y)= 0,5 * Y
20
15
© RAINER MAURER, Pforzheim
10
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
30
25
C(Y) + G = 0,5*Y+G
C(Y)= 0,5 * Y
20
Government
Consumption = G = 5
15
© RAINER MAURER, Pforzheim
10
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
30
YD = 0,5*Y+G+I
25
C(Y) + G = 0,5*Y+G
Investment = I = 5
C(Y)= 0,5 * Y
20
15
© RAINER MAURER, Pforzheim
10
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
40
35
30
4.1.1. The "Keynesian Cross"
Demand for Goods
At what level of income
(Y) does the total demand
for goods equal income?
YD = 0,5*Y+G+I
25
C(Y) + G = 0,5*Y+G
20
C(Y) = 0,5 * Y
15
At what level does income
generate a demand for
goods, which is again equal
to the level of income?
= Where does the equation
0,5*Y+G+I = Y hold?
© RAINER MAURER, Pforzheim
10
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
30
Every point on this
45°-line implies:
Demand for Goods
= Supply of Goods
25
20
15
© RAINER MAURER, Pforzheim
10
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
The 45°-line
reveals
30
the solution:
YD = 0,5*Y+G+I
25
C(Y) + G = 0,5*Y+G
20
C(Y)= 0,5 * Y
15
© RAINER MAURER, Pforzheim
10
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
30
YD = 0,5*Y+G+I
25
C(Y) + G = 0,5*Y+G
20
C(Y)= 0,5 * Y
Investment = 5
15
Gov. Consumption = 5
© RAINER MAURER, Pforzheim
10
Consumption = 0,5 * (20)
= 10
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
- 50 -
Digression:
3. Das
What happens, if supply of goods is larger than the
keynesianische
Modell der Volkswirtschaft
equilibrium value = if there is excess supply ?
3.1. Die Struktur des keynesianischen Modells
The following digression shows that in this case an adjustment process takes
place.
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Since supply of goods under Keynesian assumptions always adjusts to demand
for goods, supply falls until it equals demand:
F49-F66
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
© RAINER MAURER, Pforzheim
➤ What happens now, if the equilibrium on the market for
goods is disturbed by a sudden increase in investment
demand?
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
30
YD = 0,5*Y+G+I
25
C(Y) + G = 0,5*Y+G
20
C(Y)= 0,5 * Y
15
© RAINER MAURER, Pforzheim
10
How strong is GDP-growth,
if investment grows by 5 ?
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
YD= 0,5*Y+G+I+ΔI
30
YD = 0,5*Y+G+I
25
C(Y) + G = 0,5*Y+G
20
C(Y)= 0,5 * Y
© RAINER MAURER, Pforzheim
Increase
in Invest-15
ment by
10
5
How strong is GDP-growth,
if investment grows by 5 ?
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
- 71 -
4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
YD= 0,5*Y+G+I+ΔI
30
YD = 0,5*Y+G+I
25
C(Y) + G = 0,5*Y+G
20
C(Y)= 0,5 * Y
© RAINER MAURER, Pforzheim
Increase
in Invest-15
ment by
10
5
Prof. Dr. Rainer Maurer
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Increase in GDP by 10
Supply of Goods= Income = Y
= 5 * (1/(1-0,5))
- 72 -
4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
YD= 0,5*Y+G+I+ΔI
30
YD = 0,5*Y+G+I
25
Investment
C(Y)= +10G = 0,5*Y+G
20
C(Y)= 0,5 * Y
Gov. Consumption = 5
© RAINER MAURER, Pforzheim
Increase
in invest-15
ment by
10
5
5
Consumption = 0,5 * 30
= 15
Consumption
= 0,5*20 = 10
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
- 73 -
4. The Keynesian Model and its Policy Implications
40
35
4.1.1. The "Keynesian Cross"
Demand for
Goods
YD= 0,5*Y+G+I+ΔI
30
YD = 0,5*Y+G+I
25
C(Y) + G = 0,5*Y+G
*Y
As impliedC(Y)=
by the0,5
investment
multiplier 1/(1-c), a consumption
ratio of c = 50% together with an
increase in investment by 5
causes GDP to grow by
10 = 5 * (1/(1-0,5)) = 5 * 2.
20
© RAINER MAURER, Pforzheim
Increase
in Invest-15
ment by
10
5
5
0
-5 0
5
10
15
20
25
30
35
40
45
50
55
Supply of Goods= Income = Y
Prof. Dr. Rainer Maurer
- 74 -
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
© RAINER MAURER, Pforzheim
➤ The following diagram graphically illustrates the multiplier
effect:
Prof. Dr. Rainer Maurer
- 75 -
4. The Keynesian Model and its Policy Implications
4.1.1. The "Keynesian Cross"
35
YD= 0,5*Y+G+I+ΔI
Demand for
Goods
30
YD = 0,5*Y+G+I
25
1st: Increase in C(Y) + G = 0,5*Y+G
Demand by 5
20
C(Y)= 0,5 * Y
Increase
15
in Investment by
10
5
What causes the
multiplier effect?
© RAINER MAURER, Pforzheim
5
0
-5
Prof. Dr. Rainer Maurer
0
5
10
15
20
25
30
35
40
45
50
Supply of Goods= Income = Y
- 76 -
4. The Keynesian Model and its Policy Implications
4.1.1. The "Keynesian Cross"
35
YD= 0,5*Y+G+I+ΔI
Demand for
Goods
30
YD = 0,5*Y+G+I
25
C(Y) + G = 0,5*Y+G
2nd: Increase in Income
C(Y)= 0,5 * Y
by 5 = ΔY
20
Increase
15
in Investment by
10
5
What causes the
multiplier effect?
© RAINER MAURER, Pforzheim
5
0
-5
Prof. Dr. Rainer Maurer
0
5
10
15
20
25
30
35
40
45
50
Supply of Goods= Income = Y
- 77 -
4. The Keynesian Model and its Policy Implications
4.1.1. The "Keynesian Cross"
35
YD= 0,5*Y+G+I+ΔI
Demand for
Goods
30
YD = 0,5*Y+G+I
3rd: Increase in Consumption
by c*ΔY = 0,5 * 5 = 2,5
25
C(Y) + G = 0,5*Y+G
20
C(Y)= 0,5 * Y
Increase
15
in Investment by
10
5
What causes the
multiplier effect?
© RAINER MAURER, Pforzheim
5
0
-5
Prof. Dr. Rainer Maurer
0
5
10
15
20
25
30
35
40
45
50
Supply of Goods= Income = Y
- 78 -
4. The Keynesian Model and its Policy Implications
4.1.1. The "Keynesian Cross"
35
YD= 0,5*Y+G+I+ΔI
Demand for
Goods
30
YD = 0,5*Y+G+I
25
C
+ by
G
0,5*Y+G
4th: Increase C(Y)=
in (Y-T)
Income
ΔY = 2,5
20
C(Y)= 0,5 * Y
Increase
15
in Investment by
10
5
What causes the
multiplier effect?
© RAINER MAURER, Pforzheim
5
0
-5
Prof. Dr. Rainer Maurer
0
5
10
15
20
25
30
35
40
45
50
Supply of Goods= Income = Y
- 79 -
4. The Keynesian Model and its Policy Implications
4.1.1. The "Keynesian Cross"
35
YD= 0,5*Y+G+I+ΔI
Demand for
Goods
30
5th: Increase
in Consumption
YD = 0,5*Y+G+I
by c*ΔY = 0,5 * 2,5 = 1,25
25
C(Y) + G = 0,5*Y+G
20
C(Y)= 0,5 * Y
Increase
15
in Investment by
10
5
What causes the
multiplier effect?
© RAINER MAURER, Pforzheim
5
0
-5
Prof. Dr. Rainer Maurer
0
5
10
15
20
25
30
35
40
45
50
Supply of Goods= Income = Y
- 80 -
4. The Keynesian Model and its Policy Implications
4.1.1. The "Keynesian Cross"
35
YD= 0,5*Y+G+I+ΔI
Demand for
Goods
30
etc...
25
C(Y) + G = 0,5*Y+G
20
C(Y)= 0,5 * Y
Increase
15
in Investment by
10
5
=> The primary
increase in investment
demand by 5 is multiplied by the additional
increase in consumption demand by factor
2 = 1/ (1-0,5).
© RAINER MAURER, Pforzheim
5
0
-5
Prof. Dr. Rainer Maurer
YD = 0,5*Y+G+I
0
5
10
15
20
25
30
35
40
45
50
Supply of Goods= Income = Y
- 81 -
4. The Keynesian Model and its Policy Implications
4.1.1. The "Keynesian Cross"
➤
Verbal Description of the Multiplier Process:
■
■
■
■
■
■
© RAINER MAURER, Pforzheim
■
Prof. Dr. Rainer Maurer
■
■
An increase in investment demand by 5 causes an increase in
total supply (which does always adjust to total demand) by 5 .
This causes an increase in household income by 5 .
This increase in income by 5 and a consumption ratio of 50 %
causes an increase in consumption by 0,5 * 5 = 2,5 .
This increase in consumption demand by 2,5 causes an increase
in total supply by 2,5 .
This causes an increase in household income by 2,5 .
This increase in income by 2,5 and a consumption ratio of 50 %
causes an increase in consumption by 0,5 * 2,5 = 1,25 .
This increase in consumption demand by 1,25 causes in
increase in total supply by 1,25 .
This causes an increase in household income by 1,25 .
This increase in income by 1,25 and a consumption ratio of 50 %
causes an increase in consumption by 0,5 * 1,25 = 0,625 ,
and so on ...
- 82 -
Macroeconomics
© RAINER MAURER, Pforzheim
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
Prof. Dr. Rainer Maurer
- 86 -
4. The Keynesian Model and its Policy Implications
4.1.2. The Keynesian Model with Capital Market
➤ The Keynesian Model with Capital Market
■ The "Keynesian Cross" reveals the basic features of the
Keynesian Theory.
■ It suffers, however, from the shortcoming of constant investment.
■ Keynes assumed that firms' investment depends on two factors:
1. the capital market interest rate (i), which represents the costs of
© RAINER MAURER, Pforzheim
investment, and
2. the expected return on investment E(r), where the function “E(r)”
symbolizes the expectation value of the return on investment “r”.
■ Like the Neoclassics, Keynes assumed that a higher (lower)
interest rate reduces (increases) firm investment, since it
increases (lowers) investment costs.
■ Following Keynes, an increase (decrease) of the expected return
on investment, increases (decreases) firm investment, since
more investment projects become profitable at a higher return.
Prof. Dr. Rainer Maurer
- 87 -
4. The Keynesian Model and its Policy Implications
4.1.2. The Keynesian Model with Capital Market
Interest Rate
3,5
3
2,5
2
1,5
1
I(i, E(r1))
0,5
0
© RAINER MAURER, Pforzheim
-0,5
0
5
10
15
20
25
30
35
40
45
50
Investment
Investment demand I(i) negatively depends
on the interest rate i.
Prof. Dr. Rainer Maurer
- 89 -
4. The Keynesian Model and its Policy Implications
4.1.2. The Keynesian Model with Capital Market
Interest Rate
3,5
E(r1) < E(r2)
3
2,5
2
1,5
I(i, E(r2))
1
I(i, E(r1))
0,5
0
© RAINER MAURER, Pforzheim
-0,5
0
5
10
15
20
25
30
35
40
45
50
Investment
Investment demand of firms I(i) positively
depends on expected return E(r): If the
expected return increases, investment
demand increases too.
Prof. Dr. Rainer Maurer
- 90 -
4. The Keynesian Model and its Policy Implications
4.1.2. The Keynesian Model with Capital Market
Interest Rate
3,5
E(r1) > E(r2)
3
2,5
2
1,5
1
I(i, E(r1))
0,5
I(i, E(r2))
0
© RAINER MAURER, Pforzheim
-0,5
0
5
10
15
20
25
30
35
40
45
50
Investment
Investment demand of firms I(i) positively
depends on expected return E(r): If the
expected return decreases, investment
demand decreases too.
Prof. Dr. Rainer Maurer
- 91 -
4. The Keynesian Model and its Policy Implications
4.1.2. The Keynesian Model with Capital Market
Interest Rate
3,5
S(Y) = 0,5*Y
3
25
2
20
1,5
15
1
I(i, E(r1))
5
0
0
5
10
15
20
25
© RAINER MAURER, Pforzheim
S= 15 = 0,5*30
30
35
40
45
50
Investment
C(Y)= 0,5* Y
10
0,5
0
C(Y)+I(i, E(r1))
30
2,5
-0,5
Demand
35
-5
0
5
10
15
20
Y = 30
25
30
35
40
45
50
Income = Y
Since household consumption depends on household income C(Y),
household savings, which equal household income minus household
consumption, depends on income too: Y – C(Y) = S(Y). If for example
household income is Y = 30 and the consumption ratio is c = 50%
household savings equal S(Y) = Y – C(Y) = 30 – 0,5*30 = 15
Consequently, savings like consumption do not depend on the interest rate!
- 92 -
Prof. Dr. Rainer Maurer
4. The Keynesian Model and its Policy Implications
4.1.2. The Keynesian Model with Capital Market
Interest Rate
3,5
S(Y) = 0,5*Y
3
i1
25
2
20
1,5
15
I(i, E(r1))
1
I = 15
0,5
C(Y)= 0,5* Y
10
5
0
0
0
5
10
I1 = 15
© RAINER MAURER, Pforzheim
C(Y)+I(i, E(r1))
30
2,5
-0,5
Demand
35
15
20
25
30
35
40
45
50
Investment
-5
0
5
10
15
20
25
30
35
40
45
50
Income = Y
As the capital market diagram now shows, at the resulting interest rate i1
the demand for investment goods equals I1 = 15 too, so that the resulting
equilibrium income is indeed equal to Y=30. This somewhat astonishing
result is not due to chance but a consequence of a mathematical law
called “Walras’ Law”.
Prof. Dr. Rainer Maurer
- 93 -
Digression: Walras’ Law
4. The
andeconomist
its Policy
Implications
“Walras’
Law”Keynesian
was discovered Model
by the French
Léon Walras
and
4.1.“Éléments
The Keynesian
1874 published in his book
d’èconomie Theory
politique pure”. Is says:
“If the number of all markets in an economy is equal to N and N-1 markets are in
equilibrium (i.e. demand equals supply on N-1 markets) and all households keep
their budgets (i.e. spend not more and not less money for consumption and savings
than equals their income), then the Nth market will automatically be in equilibrium
too (i.e. demand equals supply on the Nth market too).”
© RAINER MAURER, Pforzheim
In the above version of a Keynesian model only two markets exist: The goods
market and the capital market. Hence N=2. Consequently, if the goods market is in
equilibrium such that
Y = C(Y) + I(i, E(r))
and the household keeps its budget constraint such that
Y = C(Y) + S(Y)
then, the capital market must necessarily be in equilibrium too, i.e. savings supply
S(Y) must be equal to investment demand I(i, E(r)) such that
S(Y)= I(i, E(r))
It is easy to see that this is actually true, if one subtracts the budget constraint from
the goods market equilibrium equation:
Y – [Y] = C(Y) + I(i, E(r)) – [C(Y) + S(Y)]
<=>
0 = I(i, E(r)) – S(Y)
<=>
S(Y) = I(i, E(r))
- 94 -
Prof. Dr. Rainer Maurer
Macroeconomics
© RAINER MAURER, Pforzheim
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
4.2. Demand-side Shocks
4.2.1. Reduction of the Propensity to Consume
Prof. Dr. Rainer Maurer
- 95 -
4. The Keynesian Model and its Policy Implications
4.2.1. Reduction of the Propensity to Consume
➤ Since under Keynesian assumptions, the supply of goods
does always adjust to the demand for goods, a reduction of
demand causes immediately a reduction of GDP:
■
© RAINER MAURER, Pforzheim
■
■
Prof. Dr. Rainer Maurer
If households expect a deterioration of the economic
development, so that they fear unemployment and increase
their savings to have a financial “safety cushion” in the case
they become unemployed, they reduce their consumption
demand.
Consequently, what they have expected, a deterioration of the
economic development, does actually occur.
Such a phenomenon is called “self-fulfilling expectations”:
What is expected does actually happen, because it is
expected.
- 96 -
4. The Keynesian Model and its Policy Implications
4.2.1. Reduction of the Propensity to Consume
Interest Rate
3,5
S(Y) = 0,5*Y
3
25
2
20
1,5
15
1
I(i, E(r1))
0,5
C(Y)= 0,5* Y
10
I1=15
5
0
0
0
5
10
S1= 15
© RAINER MAURER, Pforzheim
C(Y) + 15
30
i1 2,5
-0,5
Demand
35
15
20
25
30
35
40
45
50
Investment
-5
0
5
10
15
Y1
20
25
30
35
40
45
50
Income = Y
What happens, if households expect a deterioration of economic
development and do therefore increase their savings ratio from (1-c) =
50% to (1-c) = 75%?
Prof. Dr. Rainer Maurer
- 98 -
4. The Keynesian Model and its Policy Implications
4.2.1. Reduction of the Propensity to Consume
Interest Rate
3,5
S(Y) = 0,5*Y
3
25
2
20
1,5
15
1
I(i, E(r1))
0,5
C(Y)= 0,5* Y
10
I1=15
5
0
0
0
5
10
S1= 15
© RAINER MAURER, Pforzheim
C(Y) + 15
30
i1 2,5
-0,5
Demand
35
15
20
25
30
35
40
45
50
Investment
-5
0
5
10
15
Y1
20
25
30
35
40
45
50
Income = Y
What happens, if households expect a deterioration of economic
development and do therefore increase their savings ratio from (1-c) =
50% to (1-c) = 75%?
The consumption ratio decreases from c = 50% to c = 25%
Prof. Dr. Rainer Maurer
- 99 -
4. The Keynesian Model and its Policy Implications
4.2.1. Reduction of the Propensity to Consume
Interest Rate
3,5
S(Y) = 0,5*Y
3
0,5*Y + 15
30
i1 2,5
25
0,25*Y + 15
2
20
C(Y)= 0,5* Y
1,5
15
1
I(i, E(r1))
0,5
-0,5
10
I1=15
C(Y)= 0,25* Y
5
0
0
0
5
10
S1= 15
© RAINER MAURER, Pforzheim
Demand
35
15
20
25
30
35
40
45
50
Investment
-5
0
5
10
15
Y1
20
25
30
35
40
45
50
Income = Y
What happens, if households expect a deterioration of economic
development and do therefore increase their savings ratio from (1-c) =
50% to (1-c) = 75%?
The consumption ratio decreases from c = 50% to c = 25%
Prof. Dr. Rainer Maurer
- 100 -
4. The Keynesian Model and its Policy Implications
4.2.1. Reduction of the Propensity to Consume
Interest Rate
3,5
S(Y) = 0,75*Y
3
30
i1 2,5
25
2
20
1,5
15
1
I(i, E(r1))
0,5
0
5
10
S2= 15
© RAINER MAURER, Pforzheim
0,25*Y + 15
10
I1=15
C(Y)= 0,25* Y
5
0
0
-0,5
Demand
35
15
20
25
30
35
40
45
50
Investment
-5
0
5
10
Y2
15
20
25
30
35
40
45
50
Income = Y
The consumption ratio decreases from c = 50% to c = 25%
=> GDP decreases from Y1=15 * (1/(1-0,5) = 30 to Y2= 15 * (1/(1-0,25) = 20
Prof. Dr. Rainer Maurer
- 101 -
4. The Keynesian Model and its Policy Implications
4.2.1. Reduction of the Propensity to Consume
Interest Rate
3,5
S(Y) = 0,75*Y
3
30
i1 2,5
25
2
20
1,5
15
1
I(i, E(r1))
0,5
0
5
10
S2= 15
© RAINER MAURER, Pforzheim
0,25*Y + 15
10
I1=15
C(Y)= 0,25* Y
5
0
0
-0,5
Demand
35
15
20
25
30
35
40
45
50
Investment
-5
0
5
10
Y2
15
20
25
30
35
40
45
50
Income = Y
Savings and investment remain unchanged, since the increase in the
savings ratio 0,75 = (1-0,25) does exactly compensate for the decrease in
GDP to a level of 20:1)
S(Y1) = (1-0,5) * 30 = 0,5 * 30 = 15 = S(Y2)= (1 - 0,25) * 20 = 0,75 * 20
1) All
variables change simultaneously. Therefore savings must not be calculated based on starting income
(=30). The resulting income of a period is not given before the end of a period, which equals 20 in the
given example.
- 102 Prof. Dr. Rainer Maurer
Macroeconomics
© RAINER MAURER, Pforzheim
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
4.2. Demand-side Shocks
4.2.1. Reduction of the Propensity to Consume
4.2.2. Reduction of the Propensity to Invest
Prof. Dr. Rainer Maurer
- 105 -
4. The Keynesian Model and its Policy Implications
4.2.2. Reduction of the Propensity to Invest
➤ Since under Keynesian assumptions, supply of goods does
always adjust to demand for goods, a reduction of demand
causes immediately a reduction of GDP:
■
■
© RAINER MAURER, Pforzheim
■
Prof. Dr. Rainer Maurer
If firms expect a deterioration of economic development, so
that they fear a decrease in investment return, they reduce
their demand for investment goods so that their expectations
actually realize.
Consequently, what they have expected, a deterioration of the
economic development, does actually occur.
Consequently, firms too can cause “self-fulfilling expectations”:
What is expected does actually happen, because it is
expected.
- 106 -
4. The Keynesian Model and its Policy Implications
4.2.2. Reduction of the Propensity to Invest
Interest Rate
3,5
S(Y) = 0,5*Y
3
25
2
20
1,5
15
1
I(i, E(r1))
0,5
10
I1=15
5
0
0
0
5
10
S1= 15
© RAINER MAURER, Pforzheim
C(Y) + 15
30
i1 2,5
-0,5
Demand
35
15
20
25
30
35
40
45
50
Investment
-5
0
5
10
15
Y1
20
25
30
35
40
45
50
Income = Y
What happens, if firms expect a lower investment return r2 < r1 , because
of a deterioration of the economic development and lower their
investment from 15 to 5 ?
Prof. Dr. Rainer Maurer
- 107 -
4. The Keynesian Model and its Policy Implications
4.2.2. Reduction of the Propensity to Invest
Interest Rate
3,5
S(Y) = 0,5*Y
3
25
2
20
1,5
15
1
I(i, E(r1))
0,5
0
5
10
© RAINER MAURER, Pforzheim
S1= 15
15
20
25
30
35
40
45
50
Investment
C(Y) + 5
10
I(i, E(r2)) I2=5
0
C(Y) + 15
30
i1 2,5
-0,5
Demand
35
5
0
-5
0
5
10
15
Y1
20
25
30
35
40
45
50
Income = Y
The demand for investment goods and the demand for credits to finance
these investment goods decrease.1)
1) All
variables change simultaneously. Therefore, both demand curves must be shifted simultaneously. (If
only the credit demand curve were shifted, the decreasing interest rate would increase investment
demand to its starting level.)
Prof. Dr. Rainer Maurer
- 108 -
4. The Keynesian Model and its Policy Implications
4.2.2. Reduction of the Propensity to Invest
Interest Rate
S(Y) = 0,5*Y
3,5
3
30
i1 2,5
25
2
20
1,5
15
1
I(i, E(r1))
0,5
0
5
© RAINER MAURER, Pforzheim
S2= 5
10
15
20
25
30
35
40
45
50
Investment
C(Y) + 15
C(Y) + 5
10
I(i, E(r2)) I2=5
0
-0,5
Demand
35
5
0
-5
0
5
Y2
10
15
20
25
30
35
40
45
50
Income = Y
If investment equals 5 and the consumption ratio is 50%, the resulting
GDP equals Y = 5 * ( 1/(1-0,5) ) = 5 * 2 = 10
For an consumption ratio for c = 50% the savings ratio will equal (1-c) =
50%, so that at a GDP of 10, savings equal S(Y) = 0.5 * 10 = 5.
Prof. Dr. Rainer Maurer
- 109 -
4. The Keynesian Model and its Policy Implications
4.2.2. Reduction of the Propensity to Invest
Interest Rate
S(Y) = 0,5*Y
3,5
3
30
i1 2,5
25
2
20
1,5
15
1
10
0,5
I(i, E(r2)) I2=5
0
-0,5
0
5
© RAINER MAURER, Pforzheim
S2= 5
10
15
20
Demand
35
25
30
35
40
45
50
Investment
C(Y) + 5
5
0
-5
0
5
Y2
10
15
20
25
30
35
40
45
50
Income = Y
If investment equals 5 and the consumption ratio is 50%, the resulting
GDP equals Y = 5 * ( 1/(1-0,5) ) = 5 * 2 = 10
For a consumption ratio of c = 50% the savings ratio will equal (1-c) =
50%, so that at a GDP of 10 savings equal S(Y) = 0.5 * 10 = 5.
Prof. Dr. Rainer Maurer
- 110 -
Macroeconomics
© RAINER MAURER, Pforzheim
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
4.2. Demand-side Shocks
4.2.1. Reduction of the Propensity to Invest
4.2.2. Reduction of the Propensity to Consume
4.2.3. Consequences for the Labor Market
Prof. Dr. Rainer Maurer
- 115 -
4. The Keynesian Model and its Policy Implications
4.2.3. Consequences for the Labor Market
➤ As the preceding chapter has revealed, a deterioration of
consumer and/or investor expectations concerning the
economic development can actually cause a recession
– a reduction of GDP.
➤ A reduction of GDP means however that firms also reduce
their demand for production factors - notably their demand
for labor:
■
© RAINER MAURER, Pforzheim
■
■
■
Prof. Dr. Rainer Maurer
If wages are not flexible, but fixed by collective labor
agreements, labor supply stays unchanged.
If labor demand slumps while labor supply stays constant,
unemployment will emerge.
This kind of unemployment is ultimately caused by a reduction
in the demand for goods.
It is called “Keynesian unemployment”
- 116 -
Y
The Effect of the Demand for
Goods on the Labor Market
"Normal Capacity GDP" or
"Full Employment GDP"
Y(LD1,K1)
Y(L,K1)
Equilibrium
Labor Input
Labor Demand of the
Neoclassical Model
LD1(w1/P1,K1)
L
© RAINER MAURER, Pforzheim
LS(w/p)
Under the assumptions of the
neoclassical model (s.
chapter 2.1.) the supply of
goods depends on the
equilibrium labor input
LD(w1/P1,K1) and the given
capital stock K1.
The resulting level of GDP is
called "Normal Capacity
GDP” or (since there is no
unemployment) "Full
Employment GDP“.
w
_1
P1
LD (w/p,K1)
LD1(w1/P1,K1)
L
- 117 -
Y
The Effect of the Demand for
Goods on the Labor Market
"Normal Capacity GDP" or
"Full Employment GDP"
Y(LD1,K1)
Y(L,K1)
Equilibrium
Labor Input
Labor Demand of the
Neoclassical Model
LD1(w1/P1,K1)
L
© RAINER MAURER, Pforzheim
LS(w/p)
w
_1
P1
LD (w/p,K1)
LD1(w1/P1,K1)
L
Under the assumption of the
Keynesian model, firms
adjust in the short run their
production of goods to the
demand for goods. Therefore
they will also adjust their
labor demand to the demand
for goods in the short run!
Consequently, in the short
run, the labor demand of
firms is, under Keynesian
assumptions, not determined
by the real wage w/P and the
given capital stock K1, i.e. by
LD(w/P,K1), but by the
demand for goods YD.
The "short-run" demand for
labor therefore equals LD(YD)
- 118 -
Y
The Effect of the Demand for
Goods on the Labor Market
"Normal Capacity GDP" or
"Full Employment GDP"
Y(L,K1)
YD,1
Keynesian Labor
Demand
If the demand for goods
equals the full employment
GDP, i.e. YD= Y(LD1,K1),
Keynesian labor demand will
equal the equilibrium labor
input of the neoclassical
model: LD(YD) = LD(w1/P1,K1).
L
LD(YD,1)
© RAINER MAURER, Pforzheim
LS(w/p)
w
_1
P1
LD (w/p,K1)
LD1(w1/P1,K1)
L
- 119 -
Y
Decrease of GDP below its
Full Employment Level in a
Recession
YD,1
YD,2
The Effect of the Demand for
Goods on the Labor Market
If the demand for goods falls
(for one of the reasons
Y(L,K1) discussed in section 3.2.)
below the full employment
GDP, i.e. YD< Y(LD1,K1),
Keynesian labor demand will
be lower than the equilibrium
labor input of the neoclassical
L model: L (Y ) < L (w /P ,K ).
D
D
D
1 1 1
© RAINER MAURER, Pforzheim
Decrease of
L1
Keynesian LD(YD,2)
LD(YD,1)
Labor
Demand in a
Recession
Keynesian
LS(w/p)
Unemployment
w
_1
P1
LME
ECB
L1
L
If the real wage is downward
fixed by a collective bargaining
contract to the long-run market
equilibrium level of w1/P1, the
resulting unemployment is
called “Keynesian
unemployment”
- 120 -
Y
YD,2
Increase in GDP above its
Full Employment Level in a
Boom
Y(L,K1)
YD,1
Increase in Short-run
Labor Demand in a
Boom
L1
LD(YD,1) LD(YD,2)
w
_2
P1
© RAINER MAURER, Pforzheim
L
LS(w/p)
Keynesian
Overemployment
w
_1
P1
L1
L
The Effect of the Demand for
Goods on the Labor Market
We know from section 3.2.
that also the opposite can
happen: The demand for
goods can grow above full
employment GDP, i.e.
YD > Y(LD1,K1). Then
Keynesian labor demand will
be higher than the equilibrium
labor input of the neoclassical
model: LD(YD) > LD(w1/P1,K1).
Since collective bargaining
contracts typically allow an
increase of wages, wages will
grow (also due to overtime
premiums). The result is
called “Keynesian
overemployment”
- 121 -
Classification of Business Cycles Based on the Difference between
Actual GDP Growth and GDP Growth Trend (Prices = 2000)
Bn. €
4%
2400
Percentage Change Year over Year
3%
2200
2%
2000
1%
1800
0%
1600
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
-1%
© RAINER MAURER, Pforzheim
-2%
-3%
-4%
Source: EU-Ameco Database
Prof. Dr. Rainer Maurer
1400
1200
Classification of Business Cycles:
Actual GDP Growth > Growth Trend =Upswing
Actual GDP Growth < Growth Trend =Downswing
1000
GDP Growth Minus
7 Year
Growthdes
Trend
(left scale)
BIP-Wachstum
minus
Wachstum
7-jahres
Durchschnitts (linke Skala)
Gleitender
7-jahres
Durchschnitt
desscale)
BIPs (rechte Skala)
7 Year Moving
Average
GDP (right
BIP
Skala)
GDP(rechte
(right scale)
800
- 122 -
Classification of Business Cycles Based on the Difference between
Actual GDP Growth and GDP Growth Trend (Prices = 2000)
4%
3%
2%
1%
0%
U
P
S
W
I
N
G
D
O
W
N
S
W
I
N
G
U
P
S
W
I
N
G
D U D
O P O
W S W
N W N
S I S
W N W
I G I
N
N
G
G
U
P
S
W
I
N
G
D
O
W
N
S
W
I
N
G
U
P
S
W
I
N
G
D
O
W
N
S
W
I
N
G
U
P
S
W
I
N
G
D
O
W
N
S
W
I
N
G
U
P
S
W
I
N
G
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
-1%
Bn. €
Percentage Change Year over Year
© RAINER MAURER, Pforzheim
-2%
-3%
-4%
Source: EU-Ameco Database
Prof. Dr. Rainer Maurer
2400
2200
2000
1800
1600
1400
1200
Classification of Business Cycles:
Actual GDP Growth > Growth Trend =Upswing
1000
Actual GDP Growth < Growth Trend =Downswing
800
BIP-Wachstum
GDP Growth Minus
minus
7 Year
Wachstum
Growthdes
Trend
7-jahres
(left scale)
Durchschnitts (linke Skala)
7 Year Moving
Average
GDP (right
Gleitender
7-jahres
Durchschnitt
desscale)
BIPs (rechte Skala)
GDP(rechte
(right scale)
BIP
Skala)
- 123 -
Long-run Development of the German Unemployment Rate
14%
12%
10%
8%
6%
4%
© RAINER MAURER, Pforzheim
2%
0%
2012
2010
2008
2006
2004
2002
2000
Germany
1998
1996
1994
1992
West Germany
1990
1988
1986
1984
1982
1980
1978
1976
Prof. Dr. Rainer Maurer
1974
1972
1970
1968
1966
1964
1962
1960
Source: EU-AMECO Data Base
- 124 -
Macroeconomics
© RAINER MAURER, Pforzheim
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
4.2. Demand-side Shocks
4.2.1. Reduction of the Propensity to Invest
4.2.2. Reduction of the Propensity to Consume
4.2.3. Consequences for the Labor Market
4.3. Fiscal and Monetary Policy in the Keynesian Model
4.3.1. Fiscal Policy
Prof. Dr. Rainer Maurer
- 126 -
4. The Keynesian Model and its Policy Implications
4.3.1. Fiscal Policy
➤ As we have already seen, there are two types of fiscal
policy depending on their way of financing:
■ Debt Financed Fiscal Policy
■ Tax Financed Fiscal Policy
➤ If the government finances its consumption (G) by taxes
(T) and by debt (DG) the following budget constraint
results:
■ G = T + DG
© RAINER MAURER, Pforzheim
➤ To simplify the following analysis we will analyze only
debt financed fiscal policy:
■ G = DG
| Debt Financed Fiscal Policy
➤ Under Keynesian assumptions, tax financed fiscal policy
has the same results, yet the strength of the effect is
somewhat weaker, since it lacks a multiplier effect
(Haavelmo-Theorem).
- 127 -
Prof. Dr. Rainer Maurer
4. The Keynesian Model and its Policy Implications
4.3.1. Fiscal Policy
i
S(Y) = 0,5*Y
3,5
i#
3
30
2,5
25
2
20
1,5
15
1
10
C(Y) + I°
C(Y)
Full EmploymentYGDP
I(i, E(r°)) I° 5
I,S 0
0,5
0
-0,5
Y
35
0
5
10
I°
15
20
25
30
35
40
45
50
-5
0
5
10
15
20
25
30
35
40
45
50
Y°D Y#D
© RAINER MAURER, Pforzheim
Starting point is a situation, where a demand-side recession has caused GDP
to fall to a level of Y°D below its full employment level Y#D, so that Keynesian
unemployment has emerged.
What happens then, if the government rises its consumption from G=0 to G=5
and finances this expenditure with new debt of DG=G=5 via the credit market?
Prof. Dr. Rainer Maurer
- 128 -
4. The Keynesian Model and its Policy Implications
4.3.1. Fiscal Policy
i
S(Y) = 0,5*Y
3,5
i#
3
30
2,5
25
2
20
1,5
15
1
10
C(Y) + I° + G
C(Y) + I°
C(Y)
I(i, E(r°)) I° 5
I,S 0
0,5
0
-0,5
Y
35
0
5
10
I°
15
20
25
30
35
40
45
50
-5
Y
0
5
10
15
20
25
30
35
40
45
50
Y°D Y#D
© RAINER MAURER, Pforzheim
The rise of government consumption from G=0 to G=5 raises total demand for
goods by 5.
Prof. Dr. Rainer Maurer
- 129 -
4. The Keynesian Model and its Policy Implications
4.3.1. Fiscal Policy
i
S(Y) = 0,5*Y
3,5
i#
3
30
2,5
25
2
1,5
I(i, E(r°)) + DG15
1
10
C(Y) + I° + G
C(Y) + I°
20
C(Y)
I(i, E(r°)) I° 5
I,S 0
0,5
0
-0,5
Y
35
0
5
10
I°
15
20
25
30
35
40
45
50
-5
Y
0
5
10
15
20
25
30
35
40
45
50
Y°D Y#D
© RAINER MAURER, Pforzheim
The multiplier effect then causes total demand to grow by additional 5 units,
so that total GDP grows by 10.
To finance this additional government consumption, the credit demand grows
by the government demand for credits equal to G=DG=5.
Prof. Dr. Rainer Maurer
- 130 -
4. The Keynesian Model and its Policy Implications
4.3.1. Fiscal Policy
i
i#
Y
S(Y) = 0,5*Y
3,5
3
30
2,5
25
2
I(i, E(r°)) + DG20
1,5
C(Y)
15
1
10
0,5
I(i, E(r°)) I° 5
0
0
-0,5
C(Y) + I° + G
C(Y) + I°
35
I,S
0
5
10
I°
15
20
25
30
35
40
45
50
-5
Y
0
5
10
15
20
25
30
35
40
45
50
Y°D Y#D
© RAINER MAURER, Pforzheim
Since the increase in income by 10, increases, for a given savings ratio of
50%, the credit supply of households by 5, credit supply of households grows
by the same amount as government consumption.
Prof. Dr. Rainer Maurer
- 131 -
4. The Keynesian Model and its Policy Implications
4.3.1. Fiscal Policy
i
S(Y) = 0,5*Y
3,5
i#
3
30
2,5
25
2
1,5
I(i, E(r°)) + DG15
1
10
C(Y) + I° + G
C(Y) + I°
20
C(Y)
I(i, E(r°)) I° 5
I,S 0
0,5
0
-0,5
Y
35
0
5
10
I°
15
20
25
30
35
40
45
50
-5
Y
0
5
10
15
20
25
30
35
40
45
50
Y°D Y#D
© RAINER MAURER, Pforzheim
The rise of GDP to its full employment level Y#D, increases the demand for
labor to its full employment level LD(Y#D)=LD(w1/P1,K1), so that the Keynesian
unemployment disappears.
Prof. Dr. Rainer Maurer
- 132 -
4.3.1. Fiscal Policy
Y
Y(L,K1)
Y#D
Y°D
L1
LD(Y°D) LD(Y#D)
L
LS(w/p)
© RAINER MAURER, Pforzheim
LS(w/p)
Keynesian Unemployment
w
_1
P1
L1
L
The increase of GDP from Y°D
to Y#D caused by the increase
of government consumption
causes an increase of the
short-run demand for labor
from LD(Y°D) to LD(Y#D).
Consequently, the Keynesian
Unemployment caused by the
recession completely
disappears. If the increase of
government consumption
were lower that G=5,
Keynesian unemployment
would not completely
disappear. If the increase of
government consumption
were stronger than G=5, GDP
would grow stronger than Y#D.
This would cause an
"overheating" of the economy.
- 133 -
4.3.1. Fiscal Policy
Y
Y(L,K1)
Y#D
Y°D
L1
LD(Y°D) LD(Y#D)
L
LS(w/p)
© RAINER MAURER, Pforzheim
Disappearance
LSof
(w/p)
Keynesian Unemployment
w
_1
P1
L1
L
The increase of GDP from Y°D
to Y#D caused by the increase
of government consumption
causes an increase of the
short-run demand for labor
from LD(Y°D) to LD(Y#D).
Consequently, the Keynesian
Unemployment caused by the
recession completely
disappears. If the increase of
government consumption
were lower that G=5,
Keynesian unemployment
would not completely
disappear. If the increase of
government consumption
were stronger than G=5, GDP
would grow stronger than Y#D.
This would cause an
"overheating" of the economy.
- 134 -
4. The Keynesian Model and its Policy Implications
4.3.1. Fiscal Policy
➤ Why is fiscal policy able to cause an economic recovery
under Keynesian assumptions, but not under the
assumptions of the neoclassical model?
■ Under the assumption of the neoclassical model, the
supply of goods is fix. An increase in the demand for
goods cannot cause an increase in the supply of goods:
◆ The increase in government debt, causes an increase in the
demand for credits.
© RAINER MAURER, Pforzheim
◆ Since the supply of credits does, however, not grow, the
Prof. Dr. Rainer Maurer
resulting increase in the interest rate causes a reduction of
investment (I(i↑)↓) and a reduction of household consumption
(C(i↑)↓).
◆ This is the reason for the complete „Crowding-Out“ under
neoclassical assumptions.
- 137 -
4. The Keynesian Model and its Policy Implications
4.3.1. Fiscal Policy
➤ Why is fiscal policy able to cause an economic recovery
under Keynesian assumptions, but not under the assumptions of the neoclassical model?
■ Under the assumptions of the Keynesian model, the supply of
goods adjusts to the demand for goods, so that GDP and hence
household income grows.
© RAINER MAURER, Pforzheim
◆ The increase in government debt, causes an increase in the
Prof. Dr. Rainer Maurer
demand for credits.
◆ The increase in GDP causes at the same time an increase in
household savings, so that credit supply grows.
◆ The increase in household credit supply is sufficient to
compensate the effect of additional government credit demand
on the interest rate.
◆ Therefore, an increase in the interest rate does not take place!
◆ Therefore, investment demand for firms does not decrease.
◆ As a consequence, a debt-financed expansion of government
consumption does not result in a „Crowding-Out“ of private
demand!
Tax financed fiscal policy?
- 138 -
© RAINER MAURER, Pforzheim
Macroeconomics
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
4.2. Demand-side Shocks
4.2.1. Reduction of the Propensity to Consume
4.2.2. Reduction of the Propensity to Invest
4.2.3. Consequences for the Labor Market
4.3. Fiscal and Monetary Policy in the Keynesian Model
4.3.1. Fiscal Policy
4.3.2. Monetary Policy
Prof. Dr. Rainer Maurer
- 139 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
© RAINER MAURER, Pforzheim
➤ In the above analysis of fiscal policy the existence of money
supply and demand was neglected by assuming implicitly a
pure barter economy.
■ Under the existence of money, the effect of fiscal policy would
be somewhat dampened, because an increase in GDP
increases the demand for money and consequently the
interest rate, so that investment demand shrinks somewhat
and the net increase in GDP is correspondingly smaller.
■ Nevertheless, the net effect of fiscal policy on GDP is
significantly positive, even in a Keynesian model with money.
■ In this sense, the neglect of money is harmless.
➤ Of course, in the following analysis of monetary policy, we
cannot neglect the existence of money .
Prof. Dr. Rainer Maurer
- 140 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
➤ The Determinants of Money Supply:
© RAINER MAURER, Pforzheim
■ Just like in the neoclassical model, the central bank
determines money supply: MS
Prof. Dr. Rainer Maurer
■ As the discussion of monetary policy in Chapter 6 will
show, most central banks offer in various ways their
money as a credit on the capital market.
■ Therefore, we can simply add money supply of the central
bank to credit supply of households.
■ Consequently, total real credit supply equals the sum of
real savings of households plus the real value of money
supply by the central banks ( =nominal money supply (MS)
divided by the price level P:
Total Real Credit Supply = S(Y) + MS / P
- 141 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
➤ The Credit Market without Money Supply and Demand:
S(Y)
3,5
i# 3
2,5
2
1,5
1
I(i, E(r°))
© RAINER MAURER, Pforzheim
0,5
Prof. Dr. Rainer Maurer
0
-0,5
0
5
10
15
20
25
30
35
40
45
50
I°
- 142 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
➤ The Credit Market with Money Supply:
S(Y) S(Y) + MS / P
3,5
i# 3
2,5
2
1,5
1
MS/P
I(i, E(r°))
© RAINER MAURER, Pforzheim
0,5
Prof. Dr. Rainer Maurer
0
-0,5
0
5
20
10
15
I°
I° + RD°
25
30
35
40
45
50
- 143 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
➤ Determinants of Money Demand:
© RAINER MAURER, Pforzheim
■ Just like in the neoclassical model, firms demand money to
pay their production factors labor and capital.
Prof. Dr. Rainer Maurer
■ Consequently, the real demand for money depends on the
sum of real wage and real interest payments, which equal
real GDP: Y.
■ Additionally, the original Keynesian model accounts for the
fact, that households and firms care for the opportunity
costs of holding money (= interest costs = interest rate = i)
and do therefore demand less money if the interest rate is
high and vice versa. For simplicity we will neglect the
dependency of money demand on the interest rate in the
following exposition, since it has no significant effects on
the results.
- 144 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
➤ Determinants of Money Demand:
■ Consequently, real money demand depends like in the
neoclassical model positively on GDP (Y) :
Real Money Demand = RD(Y)
© RAINER MAURER, Pforzheim
■ Total real credit demand equals then credit demand for
the purchase of investment goods I(i, E(r)) plus money
demand:
Total Real Credit Demand = I(i, E(r)) + RD(Y)
Prof. Dr. Rainer Maurer
- 145 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
➤ The Credit Market with Money Supply:
S(Y) S(Y) + MS / P
3,5
i# 3
2,5
2
1,5
1
MS/P
I(i, E(r°))
© RAINER MAURER, Pforzheim
0,5
Prof. Dr. Rainer Maurer
0
-0,5
0
5
20
10
15
I°
I° + RD°
25
30
35
40
45
50
- 147 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
➤ The Credit Market with Money Supply and Money Demand:
S(Y) S(Y) + MS / P
3,5
i# 3
2,5
2
RD(Y)
1,5
1
MS/P
I(i, E(r°)) + RD(Y)
I(i, E(r°))
© RAINER MAURER, Pforzheim
0,5
Prof. Dr. Rainer Maurer
0
-0,5
0
5
20
10
15
I°
I° + RD°
25
30
35
40
45
50
- 148 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
➤ The Credit Market with Money Supply and Money Demand:
If money supply (MS/P)
equals money demand
(RD(Y)), the interest rate
equals the natural interest
rate, i.e. the interest rate that
would result without money.
S(Y) S(Y) + MS / P
3,5
i# 3
2,5
2
RD(Y)
1,5
1
MS/P
I(i, E(r°))+ RD(Y)
I(i, E(r°))
© RAINER MAURER, Pforzheim
0,5
Prof. Dr. Rainer Maurer
0
-0,5
0
5
20
10
15
I°
I° + RD°
25
30
35
40
45
50
- 149 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
© RAINER MAURER, Pforzheim
➤ The capital market with money supply and demand can
now be inserted into the Keynesian model:
Prof. Dr. Rainer Maurer
- 150 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
i
3,5
i°
S(Y°) S(Y°)+M/P
3
30
2,5
25
2
20
1,5
15
0,5
I(i)+RD(Y°) 10
I° 5
I(i)
0
0
1
-0,5
I,S
0
5
10
15
20
25
I° I°+RD°
30
35
40
Y
35
45
50
-5
C(Y)+I°
C(Y)
Full EmployY GDP
ment
0
5
10
15
20
25
Y°D
30
35
Y#
D
40
45
50
© RAINER MAURER, Pforzheim
Starting point is a situation, where a demand-side recession has caused GDP
to fall to a level of Y°D below its full employment level Y#D, so that Keynesian
unemployment has emerged.
Ex. 25, sl. 195
Prof. Dr. Rainer Maurer
- 151 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
i
S(Y°)+M/P+5
3,5
i°
3
30
2,5
25
2
20
I(i)+RD(Y°)
1,5
I(i)
0,5
I,S
0
© RAINER MAURER, Pforzheim
C(Y)+I°
C(Y)
15
10
1
-0,5
Y
35
0
5
10
15
20
25
I° I°+RD°
30
35
40
45
50
I° 5
Y
0
-5
0
5
10
15
20
25
Y°D
30
35
Y#
D
40
45
50
What happens now, if the central bank rises money supply and hence total
credit supply by ΔM /P= 5 ?
Prof. Dr. Rainer Maurer
- 152 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
i
S(Y°)+M/P+5
3,5
i°
i#
3
30
2,5
25
2
20
1,5
15
0,5
I(i)+RD(Y°) 10
I° 5
I(i)
0
0
1
-0,5
I,S
0
5
10
I°
15
I#
20
25
I#+R
30
D°
35
40
45
Y
35
50
-5
C(Y)+I°
C(Y)
Y
0
5
10
15
20
25
Y°D
30
35
Y#
D
40
45
50
© RAINER MAURER, Pforzheim
The raise of money supply causes a reduction of the interest rate from i° to i#.
This rises investment from I° to I#.
Prof. Dr. Rainer Maurer
- 153 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
i
S(Y°)+M/P+5
3,5
i°
i#
3
30
2,5
25
2
20
1,5
15
0,5
I(i)+RD(Y°) 10
#
I
I(i)
5
0
0
1
© RAINER MAURER, Pforzheim
-0,5
I,S
0
5
10
I°
15
I#
20
25
I#+R
30
D°
35
40
45
Y
35
50
-5
C(Y)+I#
C(Y)+I°
C(Y)
Y
0
5
10
15
20
25
Y°D
30
35
Y#
D
40
45
50
The rise of investment by 5 increases the demand for goods by 5. The multiplier
process causes a final increase in GDP by 10 units.
Prof. Dr. Rainer Maurer
- 154 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
i
S(Y°)+M/P+5
3,5
i°
i#
3
30
2,5
25
2
20
1,5
15
0,5
I(i)+RD(Y°) 10
#
I
I(i)
5
0
0
1
© RAINER MAURER, Pforzheim
-0,5
I,S
0
5
10
I°
15
I#
20
25
I#+R
30
D°
35
40
45
Y
35
50
-5
C(Y)+I#
C(Y)+I°
C(Y)
Y
0
5
10
15
20
25
Y°D
30
35
Y#
D
40
45
50
The growth of GDP causes a higher demand for labor, so that labor demand
grows and Keynesian unemployment disappears.
Prof. Dr. Rainer Maurer
- 155 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
S(Y°)+M/P+5
S(Y#)+M/P+5
i
3,5
i#
3
30
2,5
25
2
20
1,5
15
0,5
I(i)+RD(Y°) 10
#
I
I(i)
5
0
0
1
© RAINER MAURER, Pforzheim
-0,5
I,S
0
5
10
15
I#
20
25
I#+R
30
D°
35
40
45
50
Y
35
-5
C(Y)+I#
C(Y)+I°
C(Y)
Y
0
5
10
15
20
25
Y°D
30
35
Y#
D
40
45
50
Since GDP grows by 10, household savings grow by 10 times the savings
ratio: 10*(1-c) = 10*0,5 = 5. This causes credit supply to shift to the right by 5
units.
Prof. Dr. Rainer Maurer
- 156 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
i
S(Y#)+M/P
3,5
i#
3
30
2,5
25
I(i)+RD(Y#)
2
1,5
1
I#
I(i)
0,5
I,S
0
© RAINER MAURER, Pforzheim
-0,5
0
5
10
15
I#
20
25
I#+R
30
D°
35
40
45
Y
35
50
C(Y)+I#
C(Y)+I°
20
C(Y)
15
10
5
Y
0
-5
0
5
10
15
20
25
Y°D
30
35
Y#
D
40
45
50
This would cause a further decrease in the interest rate. However the
increase in GDP causes also an increase in money demand, so that the
RD(Y)-curve shifts to the right too.
Prof. Dr. Rainer Maurer
- 157 -
4. The Keynesian Model and its Policy Implications
4.3.2. Monetary Policy
i
S(Y#)
3,5
i#
S(Y#)+M/P
3
30
2,5
25
I(i)+RD(Y#)
2
1,5
1
I#
I(i)
0,5
I,S
0
© RAINER MAURER, Pforzheim
-0,5
0
5
10
15
I#
20
25
30
35
I#+RD#
40
45
Y
35
50
C(Y)+I#
20
C(Y)
15
10
5
Y
0
-5
0
5
10
15
20
25
Y°D
30
Y#
35
40
45
50
D
To simplify the analysis, we make the assumption that money demand RD(Y)
shifts to the right by the same amount as the savings supply, so that the interest
rate stays constant at the level caused by monetary policy i#. In this case the
adjustment process comes to an end. If the shift of money demand were smaller,
a further decrease of the interest rate would cause a further growth of GDP.
Prof. Dr. Rainer Maurer
- 158 -
© RAINER MAURER, Pforzheim
http://www.businessweek.com/articles/2014-10-30/why-john-maynardMacroeconomics
keyness-theories-can-fix-the-world-economy
Prof. Dr. Rainer Maurer
- 165 -
© RAINER MAURER, Pforzheim
Macroeconomics
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
4.2. Demand-side Shocks
4.2.1. Reduction of the Propensity to Consume
4.2.2. Reduction of the Propensity to Invest
4.2.3. Consequences for the Labor Market
4.3. Fiscal and Monetary Policy in the Keynesian Model
4.3.1. Fiscal Policy
4.3.2. Monetary Policy
4.4. The Long-run Implications of the Keynesian Model
Prof. Dr. Rainer Maurer
- 166 -
4. The Keynesian Model and its Policy Implications
4.4. The Long-run Implications of the Keynesian Model
➤ As section 3.1 has shown that in reality it takes one year until
firms start to adjust their prices.
■ When firms adjust their prices, they will do so according to the
current degree of their capacity utilization:
◆ When a rise in the demand for goods has caused a boom so that
© RAINER MAURER, Pforzheim
production lies above full employment GDP, firms will notice that
an increase in prices will help to increase their profits.
◆ When a decline in the demand for goods has caused a recession
so that production lies below full employment GDP, firms will
notice that a decrease in prices will help to increase their profits.
➤ In the following, we will therefore analyze what happens, if the
economy is in a recession (production below the full employment
level) and firms start to reduce their prices.
Prof. Dr. Rainer Maurer
- 167 -
4. The Keynesian Model and its Policy Implications
4.4. The Long-run Implications of the Keynesian Model
3
i°
i#
Y
P°> P#
S(Y°)+M/P°
S(Y°)+M/P#
3,5
2,5
35
25
2
20
I(i)+RD(Y°)
1,5
C(Y)
Full Employment GDP
15
1
10
I(i)
0,5
I,S
I°
5
Y
0
0
-0,5
C(Y)+I°
30
0
5
10
15
20
25
I° I°+RD°
30
35
40
45
50
-5
P
0
5
10
15
20
25
Y°
30
35
40
45
50
Y#
The resulting lower interest rate i# triggers the same adjustment process
as discussed in section “4.3.2. Monetary Policy”!
© RAINER MAURER, Pforzheim
When the price level of goods prices decreases from P° to P#, the real value
of the money offered by the central bank increases: (MD/P↓)↑ This causes an
increase in credit supply from S(Y°)+MD/P° to S(Y°)+MD/P#
Prof. Dr. Rainer Maurer
- 170 -
4. The Keynesian Model and its Policy Implications
4.4. The Long-run Implications of the Keynesian Model
i°
i#
Y
S(Y°)+M/P#
3,5
35
3
30
2,5
25
2
20
I(i)+RD(Y°)
1,5
C(Y)
15
1
10
I(i)
0,5
I,S
I°
5
Y
0
0
-0,5
C(Y)+I°
0
5
10
15
20
I°
I#
I#+R
25
30
D°
35
40
45
50
-5
0
5
10
15
20
25
Y°
30
35
40
45
50
Y#
© RAINER MAURER, Pforzheim
This increase in credit supply causes the interest rate to decrease from i° to i#.
The lower interest rate causes a rise of investment from I° to I#.
Prof. Dr. Rainer Maurer
- 171 -
4. The Keynesian Model and its Policy Implications
4.4. The Long-run Implications of the Keynesian Model
Y
S(Y°)+M/P#
3,5
3
30
i° 2,5
i# 2
25
20
I(i)+RD(Y°)
1,5
1
I(i)
0,5
I,S
© RAINER MAURER, Pforzheim
C(Y)
15
I#
10
5
Y
0
0
-0,5
C(Y)+I#
C(Y)+I°
35
0
5
10
15
20
I°
I#
I#+R
25
30
D°
35
40
45
50
-5
0
5
10
15
20
25
Y°
30
35
40
45
50
Y#
This increase in investment increases the demand for goods from Y°D to Y#D.
Since the supply of goods adjusts to the demand for goods, the demand for
labor grows to the full-employment level.
Prof. Dr. Rainer Maurer
- 172 -
4. The Keynesian Model and its Policy Implications
4.4. The Long-run Implications of the Keynesian Model
3
2
I(i)+RD(Y#)
1,5
1
I(i)+RD(Y°) I#
0,5
I,S
30
25
20
C(Y)
15
10
5
Y
0
0
-0,5
C(Y)+I#
35
S(Y#)+MD/P#
2,5
i#
Y
S(Y°)+M/P#
3,5
0
5
10
15
I#
20
25
30
35
I#+RD#
40
45
50
-5
0
5
10
15
20
25
Y°
30
35
40
45
50
Y#
© RAINER MAURER, Pforzheim
The resulting rise of GDP from Y°D to Y#D increases household savings from
S(Y°) to S(Y#) and money demand from RD(Y°) to RD(Y#). Under the
assumption that savings supply and money demand grow by the same margin
the interest rate i# stays constant.
Prof. Dr. Rainer Maurer
- 173 -
4. The Keynesian Model and its Policy Implications
4.4. The Long-run Implications of the Keynesian Model
Y
3,5
3
25
20
I(i)+RD(Y#)
1,5
1
I(i)
0,5
I,S
C(Y)
15
I#
10
5
Y
0
0
© RAINER MAURER, Pforzheim
30
S(Y#)+M/P#
i° 2,5
i# 2
-0,5
C(Y)+I#
35
0
5
10
15
I#
20
25
30
35
I#+RD#
40
45
50
-5
0
5
10
15
20
25
Y°
30
35
40
45
50
Y#
Consequently, the decrease in prices by firms causes a decrease in the
interest rate, which causes an increase in investment. This increase in
investment causes an increase in the demand for goods, which leads
ultimately to an increase in the demand for labor.
(->Exercise 27)
Prof. Dr. Rainer Maurer
- 174 -
© RAINER MAURER, Pforzheim
Macroeconomics
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
4.2. Demand-side Shocks
4.2.1. Reduction of the Propensity to Consume
4.2.2. Reduction of the Propensity to Invest
4.2.3. Consequences for the Labor Market
4.3. Fiscal and Monetary Policy in the Keynesian Model
4.3.1. Fiscal Policy
4.3.2. Monetary Policy
4.4. The Long-run Implications of the Keynesian Model
4.5. Policy Conclusions
4.5.1. Practical Problems of Anti-cyclical Policy
Prof. Dr. Rainer Maurer
- 180 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
➤ As the above analysis has shown, “in the long run” (=when prices
start to adjust) the economy is able to find its way out of recession
without any help by the government.
➤ In other words, in the long run the “self-healing capacities” of the
market work – even under the assumptions of the Keynesian
model.
➤ This however means, that the Keynesian theory does not imply the
necessity of government anti-cyclical policy.
© RAINER MAURER, Pforzheim
➤ The Keynesian theory implies however that government business
cycle policy makes sense, if it allows to accelerate the process of
economic recovery.
➤ Such an acceleration of economic recovery is, however, only
possible if the government (or the central bank) is able to react in
face of a recession before firms start lowering their prices (and
cause a recovery in this way).
Prof. Dr. Rainer Maurer
- 181 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
➤ Consequently, the time-frame for government business cycle policy
corresponds to the span of time until firms start adjusting their prices
(about 1 year).
➤ Only if the government (and/or the central bank) is able to increase the
demand for goods before firms start adjusting their prices, it is possible
to shorten the duration of the autonomous adjustment process of the
economy.
© RAINER MAURER, Pforzheim
➤ If fiscal and monetary policy come to late, i.e. when firms have already
reduced their prices, this may cause an excess demand for goods that
can lead to an overheating of the economy:
➤ The following graphs illustrate this problem:
Prof. Dr. Rainer Maurer
- 182 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
Ideal Case: No Implementation Lag => No Danger of Overheating:
Implementation Lag of Fiscal Policy = 0 Year
© RAINER MAURER, Pforzheim
Fiscal Policy
becomes
effective: G↑
Start of
Recession:
YD↓
=>
Increase in
Demand
for Goods:
YD↑
0,5 Year
=>
Overcoming
of Recession
before 1 year
is over!
1 Year
1,5 Year
No reason for
price adjustment,
since the
recession is
already overcome!
No
Overheating,
since no
price
adjustment
takes place!
Start of Price Adjustment by Firms = 1 Year
Prof. Dr. Rainer Maurer
- 183 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
Realistic Case: Implementation Lag => Danger of Overheating:
Implementation Lag of Fiscal Policy = 1 Year
Fiscal Policy
becomes
effective: G↑
0,5 Year
© RAINER MAURER, Pforzheim
Start of Recession:
YD↓
=>
1 Year
Firms
decrease
Prices: P↓
=> i↓=>I(i)↑
Increase in
Demand
for Goods:
YD↑
1,5 Year
=>
Increase in
Demand
for Goods:
YD↑
Twofold
Demand
Effect :
YD↑+YD↑
=> Overheating
of the
Economy
Start of Price Adjustment by Firms = 1 Year
Prof. Dr. Rainer Maurer
- 184 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
➤ As a consequence, the resulting excess demand for goods
causes in the long run (when firms start to adjust their prices) an
increase in prices, which will finally cause a recession (exercise
27).
■ In this case, fiscal or monetary policy would not dampen but
boost business cycle fluctuations.
© RAINER MAURER, Pforzheim
➤ These dangers lead to the question, whether the government (or
the central bank) is able to react fast enough to reduce the
duration of the recovery process and avoid an overheating of the
economy.
➤ This question will be discussed in the following.
Prof. Dr. Rainer Maurer
- 186 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
➤
Practical experience with anti-cyclical fiscal policy has shown
that there are several reasons for lags in the implementation of
such policies. These lags can be classified according to the
following scheme:
© RAINER MAURER, Pforzheim
Total Implementation Lag
Prof. Dr. Rainer Maurer
Inside Lag
Outside Lag
Time between a shock
to the economy and
the policy action
responding to that
shock.
Time between the
policy action and its
influence on the
economy.
- 187 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
➤ The inside lag of fiscal policy has two sources:
1. The government needs time to analyze the causes of a
recession (“diagnosis lag”): Only in case of a reduction of the
demand for goods caused by a deterioration of the expectations of firms and households (= demand side shock)
Keynesian government spending policies will work. If the
recession is caused e.g. by a shock in the prices of raw
materials (= supply side shock), Keynesian spending policies
will not work.
2. The government needs time to change its budgeting:
© RAINER MAURER, Pforzheim
■ On the expenditure side laws must be changed in order to
Prof. Dr. Rainer Maurer
■
increase government spending for goods and services.
On the revenue side laws must be changed in order to
finance the additional government spending: Taxes and/or
borrowing must be increased.
Changing laws takes time (weeks if not months) in a
parliamentary system (“reaction lag”)
- 188 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
➤ The outside lag of fiscal policy:
■
Once the fiscal policy measures of the government are
implemented, some time is needed until they unfold their
full influence on the economy:
◆ In our textbook version of the Keynesian model a primary
© RAINER MAURER, Pforzheim
◆
Prof. Dr. Rainer Maurer
◆
increase in the demand for goods immediately causes an
increase in income and the increase in income causes
immediately an additional increase in household consumption
demand via the multiplier effect.
In reality, a couple of time is needed until households realize
the increase in their income (and/or lower risk of getting
unemployed) and react on this with a rise of their demand for
goods.
Therefore, in reality the multiplier effect needs much more
time to get started than in the simple Keynesian textbook
model.
- 189 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
➤
Taken together, the implementation lags of fiscal policy may
delay its effect on the real economy for a span of time, which
is likely between half a year and one year. Hence the
implementation lag comes close to the one-year lag with which
firms adjust their prices!
© RAINER MAURER, Pforzheim
Total Implementation Lag
Prof. Dr. Rainer Maurer
Inside Lag
Outside Lag
Time between a shock
to the economy and
the policy action
responding to that
shock.
Time between the
policy action and its
influence on the
economy.
- 190 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
➤ The Forecast Problem:
■
■
■
■
© RAINER MAURER, Pforzheim
■
Prof. Dr. Rainer Maurer
■
In principle, business cycle forecasts could be one way to
circumvent the problem of implementation lags.
Such forecasts could help to start the implementation of
fiscal policy measures in advance, so that the effects of
fiscal policy already start working at the beginning of a
recession.
However this approach works only, if the forecasts are
sufficiently reliable.
Experience has however shown, that forecasts of economic
developments are exposed to a high degree of uncertainty.
Forecasts of economic phenomena are forecasts of a
complex system and are such as difficult as forecast of
meteorological or ecological phenomena.
The following graph gives an example how difficult
economic forecasting can be.
- 191 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
Blue lines: Forecasts of the
US-unemployment rate
(average value of 20 US
forecast institutes)
© RAINER MAURER, Pforzheim
Red Line: Actual USunemployment rate.
Quelle: Mankiw, Gregory; Macroeconomics, Worth Publishers, S. 384
Prof. Dr. Rainer Maurer
- 192 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
© RAINER MAURER, Pforzheim
➤ The Policy Problem:
Prof. Dr. Rainer Maurer
■
Critics of the concept of anti-cyclical fiscal policy argue that
governments are not altruistic and benevolent agents
committed to the public welfare only, but strive – like
households or firms – to maximize their individual welfare.
■
If this hypothesis were right, it would be unlikely that
governments would actually try to reduce business cycle
fluctuations.
■
Instead they would use their economic policy instruments
to increase the probability of being reelected.
- 193 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
■
Therefore, these critics of fiscal policy argue that if
governments were given access to a lot of fiscal policy
instruments, they would not stabilize the economy but
destabilize it with a “political business cycle” of the following
kind:
◆ A couple of time before an election, the government increases
◆
© RAINER MAURER, Pforzheim
◆
Prof. Dr. Rainer Maurer
◆
government consumption, in order to rise the growth of income
and reduce unemployment.
This resulting improvement of economic conditions induces the
electors to vote for the government.
Once the government has won the elections, it will immediately
reduce government consumption, in order the keep the
government deficit in check – and be able to rise again
government consumption before the next elections.
This reduction of government consumption will cause a
recession after the election.
- 194 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
➤ To sum up:
➤ The practical implementation of fiscal policy is subject to
a couple of problems that do not appear in the Keynesian
textbook model:
1. The implementation lag
© RAINER MAURER, Pforzheim
2. The Forecast Problem
Prof. Dr. Rainer Maurer
3. The Policy Problem
- 195 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
➤ Anti-cyclical monetary policy too can be subject to
implementation lags:
■
■
The inside lag of economic policy is, however, typically
much shorter than the inside lag of fiscal policy, since the
central bank can change its money supply immediately
without changes of laws that must be approved by the
parliament (see chapter 6 “Monetary Theory and Policy”).
Nevertheless the outside lag of monetary policy can be quite
important:
© RAINER MAURER, Pforzheim
◆ Even though the effect of a change of monetary policy on
Prof. Dr. Rainer Maurer
interest rates is quite direct and fast in reality (see the next
diagram), a decrease in interest rates does not immediately
cause an increase in firms’ demand for investment goods.
◆ This is the case, because investment plans of firms are made in
advance and it takes up to six months until firms actually
demand more investment goods and hence increase economic
demand.
- 196 -
4. The Keynesian Model and its Policy Implications
4.5.1. Practical Problems of Anti-cyclical Policy
➤ The forecast problem is of course the same for monetary
and fiscal policy.
© RAINER MAURER, Pforzheim
➤ However, for an independent central bank, the policy
problem of monetary policy is of less importance as for
fiscal policy.
➤ Since the inside implementation lag and policy problem is
of less importance, monetary anti-cyclical policy has much
more proponents than fiscal policy.
Prof. Dr. Rainer Maurer
- 199 -
© RAINER MAURER, Pforzheim
Macroeconomics
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
4.2. Demand-side Shocks
4.2.1. Reduction of the Propensity to Consume
4.2.2. Reduction of the Propensity to Inves
4.2.3. Consequences for the Labor Markett
4.3. Fiscal and Monetary Policy in the Keynesian Model
4.3.1. Fiscal Policy
4.3.2. Monetary Policy
4.4. The Long-run Implications of the Keynesian Model
4.5. Policy Conclusions
4.5.1. Practical Problems of Anti-cyclical Policy
4.5.2. Case Study: Fiscal Policy in Germany
Prof. Dr. Rainer Maurer
- 200 -
4. The Keynesian Model and its Policy Implications
4.5.2. Case Study: Fiscal Policy in Germany
➤ The concept of anti-cyclical fiscal policy implies:
■
© RAINER MAURER, Pforzheim
■
Increase of credit financed government consumption in
recessions and, consequently, government budget deficits
in recessions: T-G < 0
Dampening of economic activity in booms by a reduction
of government demand and, consequently, government
budget surpluses in booms : T-G > 0
➤ If periods of budget deficits and budget surpluses set
off each other, the total amount of accumulated
government debt should stay constant.
➤ This idea is displayed by the following graph:
Prof. Dr. Rainer Maurer
- 201 -
The Theory of Anti-Cyclical Fiscal Policy
GDP-Level
UPSWING
DOWNSWING
UPSWING
GDP with perfect
anti-cyclical fiscal
policy
Actual GDP
without
anti-cyclical
fiscal policy
Budget Surplus
© RAINER MAURER, Pforzheim
Time
+
Budget Surplus = T-G > 0
0
figProf. Dr. Rainer Maurer
−
Budget Deficit = T-G < 0
- 202 -
Budget Surplus of Total Government and Business Cycles in Germany
40,0
20,0
0,0
-40,0
-60,0
-80,0
U D U
P O P
S W S
W N WI
I S N
N W G
G I
N
G
D U D UMTS-Auction
U D U D U
O P O P O P O P
W S W S W S W S
N W N W NW N W
S I S I S I S I
W N W N W N WI N
I G I G I G N G
N
N
N
G
G
G
G
-120,0
© RAINER MAURER, Pforzheim
Acceptance of the TreuhandDebt by the Government
-160,0
-180,0
Source: SVR (2004)
Prof. Dr. Rainer Maurer
D
O
W
N
S
WI
N
G
U D
P O
S W
W N
I S
N WI
G N
G
2400
2200
2000
1800
1600
1400
-100,0
-140,0
Bn. €
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
-20,0
(Prices = 2000)
Bn. €
1200
1000
Realer
Haushaltsüberschuss
insgesamt
Real Budget
Surplus
Gleitender
7-jahresAverage
Durchschnitt
des (right
BIPs (rechte
7-years Moving
of GDP
scale) Skala)
BIP
(rechte
GDP
(rightSkala)
scale)
800
205 --- 205
4. The Keynesian Model and its Policy Implications
4.5.2. Case Study: Fiscal Policy in Germany
➤
➤
© RAINER MAURER, Pforzheim
➤
As these charts show, there is no strong evidence that German
governments since 1970 have followed the theory of anti-cyclical
fiscal policy.
If we add up the yearly budget deficits of the last chart (= DG,t)
over the past, we receive the level of accumulated government
debt:
LADG,t = DG,t + DG,t-1 + DG,t-2 + DG,t-3 +…
If we divide the level of accumulated government debt up to a
certain year t by the GDP level of this year, we receive the
debt-GDP ratio:
LADG,t / GDPt
➤
If the growth rate of accumulated government debt is stronger
than the growth rate of GDP, the debt-GDP ratio is growing.
➤
After the acceptance of the Treuhand-Debt by the government in
1996 the debt-GDP ratio reached for the first time the 60% limit
according to the definition of the Maastricht Treaty.
Prof. Dr. Rainer Maurer
- 206 -
Development of the Debt-GDP Ratio and the Change of Governments
80%
% of GDP
70%
Angela Merkel
2010
2005
2000
1995
1990
1985
1980
1975
1970
1965
1960
1955
Source: SVR (2004)
Prof. Dr. Rainer Maurer
Gerhard Schröder
0%
1950
© RAINER MAURER, Pforzheim
10%
Helmut Kohl
20%
Helmut Schmidt
30%
Willi Brandt
40%
Georg Kiesinger
50%
Ludwig Erhard
Konrad Adenauer
60%
Schuldenstandsquote
Debt-GDP Ratio
(Gesamtverschuldung des Staates in % des BIP) - 207 -
4. The Keynesian Model and its Policy Implications
4.5.2. Case Study: Fiscal Policy in Germany
➤
➤
To fight the steadily increase of public debt, the German parliament
has implemented a so called “debt brake” in the German
constitution (Article 115) by May 2009.
According to this debt brake,
■
■
➤
There are however exceptions:
■
© RAINER MAURER, Pforzheim
the federal government must run a balanced government budget, i.e.
G = T, starting with the year 2016.
the federal states must run a balanced government budget starting with
the year 2020.
■
In a recession, debt financed government expenditure is allowed, if the
debts are reduced again in an upswing = anticyclical fiscal policy is
allowed.
In case of “natural disasters” or “extraordinary emergencies” debt
financed government expenditures are allowed, if it is ensured that the
resulting debt is paid back afterwards.
What will the long-run consequences of the „debt brake“ be?
Does this make sense?
Prof. Dr. Rainer Maurer
- 210 -
© RAINER MAURER, Pforzheim
Macroeconomics
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
4.2. Demand-side Shocks
4.2.1. Reduction of the Propensity to Consume
4.2.2. Reduction of the Propensity to Inves
4.2.3. Consequences for the Labor Markett
4.3. Fiscal and Monetary Policy in the Keynesian Model
4.3.1. Fiscal Policy
4.3.2. Monetary Policy
4.4. The Long-run Implications of the Keynesian Model
4.5. Policy Conclusions
4.5.1. Practical Problems of Anti-cyclical Policy
4.5.2. Case Study: Fiscal Policy in Germany
4.5.3. Limits of Government Debt
Prof. Dr. Rainer Maurer
- 211 -
4. The Keynesian Model and its Policy Implications
4.5.3. Limits of Government Debt
➤
Is there an economic limit for government debt?
■ Arithmetically the upper limit is the present value of maximal tax
payments, which depend on the politically maximal possible tax rate
and GDP (τmax * Yt):
This equation
 T  i t LAD t 
E t  0
t 


1

i
t


© RAINER MAURER, Pforzheim
Present value of
future interest
payments
■
Prof. Dr. Rainer Maurer

 T   max
Yt 
t
E  t  0
t 


1

i
t


≤
Present value of
future tax payments
shows that the
“debt-to-GDP
ratio” LADt / Yt
is a reasonable
empirical
measure
for
sustainability
of government
debt.
If the present value of all future interest payments on government debt
becomes larger than the present value of the maximal possible future
tax payments, the government is not able to serve its debt and has to
declare bankruptcy.
- 212 -
4. The Keynesian Model and its Policy Implications
4.5.3. Limits of Government Debt
Is there an economic limit for government debt?
■
Of course, governments will try to reduce their debt repayments
before this upper limit is reached – they will “restructure” their debt:
“debt restructuring” = “partial bankruptcy”
■
Since this is a risk for the creditors of government debts, financial
markets will typically react long before the upper limit is reached and
demand a risk premium (= higher interest rate).
■
In reality, the reputation of governments seems to play an important
role for the level of such risk premiums, as the following diagrams
show:
© RAINER MAURER, Pforzheim
➤
Prof. Dr. Rainer Maurer
- 213 -
Debt-to-GDP Ratio and 10 yr. Government Bond Interest Rate
Germany
90%
Debt in % of GDP
Interest Rate
10%
80%
9%
70%
8%
7%
60%
6%
50%
5%
40%
4%
30%
3%
German Interest Rate (right scale)
Source: Eurostat
Prof. Dr. Rainer Maurer
2013Q1
2012Q3
2012Q1
2011Q3
2011Q1
2010Q3
2010Q1
2009Q3
2009Q1
2008Q3
2008Q1
2007Q3
2007Q1
2006Q3
2006Q1
2005Q3
2005Q1
2004Q3
2004Q1
2003Q3
2003Q1
2002Q3
2002Q1
2001Q3
0%
2001Q1
1%
2000Q3
10%
2000Q1
2%
© RAINER MAURER, Pforzheim
20%
0%
German Debt-to-GDP Ratio
- 214 -
Debt-to-GDP Ratio and 10 yr. Government Bond Interest Rate
Greece vs. Germany
180%
Interest Rate
Debt in % of GDP
30%
160%
25%
140%
120%
20%
100%
15%
80%
60%
10%
40%
5%
Greek Interest Rate Spread vs. Germany (right scale)
German Interest Rate (right scale)
Greek Debt-to-GDP Ratio
German Debt-to-GDP Ratio
Source: Eurostat
Prof. Dr. Rainer Maurer
2013Q1
2012Q3
2012Q1
2011Q3
2011Q1
2010Q3
2010Q1
2009Q3
2009Q1
2008Q3
2008Q1
2007Q3
2007Q1
2006Q3
2006Q1
2005Q3
2005Q1
2004Q3
2004Q1
2003Q3
2003Q1
2002Q3
2002Q1
2001Q3
2001Q1
2000Q3
0%
2000Q1
© RAINER MAURER, Pforzheim
20%
0%
- 215 -
Debt-to-GDP Ratio and 10 yr. Government Bond Interest Rate
Japan
250%
Interest Rate
Debt in % of GDP
10,0%
9,0%
200%
8,0%
7,0%
150%
6,0%
5,0%
100%
4,0%
3,0%
50%
2,0%
Japanese Interest Rate (right scale)
Source: Eurostat
Prof. Dr. Rainer Maurer
2013Q1
2012Q3
2012Q1
2011Q3
2011Q1
2010Q3
2010Q1
2009Q3
2009Q1
2008Q3
2008Q1
2007Q3
2007Q1
2006Q3
2006Q1
2005Q3
2005Q1
2004Q3
2004Q1
2003Q3
2003Q1
2002Q3
2002Q1
2001Q3
2001Q1
2000Q3
0%
2000Q1
© RAINER MAURER, Pforzheim
1,0%
0,0%
Japanese Debt-to-GDP Ratio
- 216 -
4. The Keynesian Model and its Policy Implications
4.5.3. Limits of Government Debt
© RAINER MAURER, Pforzheim
➤
Why does the Japanese debt-to-GDP ratio not lead to higher risk
premiums?
■
The creditors of Japanese government debt expect that the
japanese government is able and willing to serve its debt in the
future.
■
The expectations of financial markets play a crucial role in
respect to the upper limit of government debt.
■
It is even possible that the phenomenon of self-fulfilling
expectations appears, as the following scheme displays:
Prof. Dr. Rainer Maurer
- 217 -
4. The Keynesian Model and its Policy Implications
4.5.3. Limits of Government Debt
➤ Self-fulfilling expectations of government bankruptcy:
Sales lead to fall
in market prices
of government
bonds
© RAINER MAURER, Pforzheim
Doubts come
up concerning
the ability of a
government to
repay all debt.
Prof. Dr. Rainer Maure
Ability of
government to
repay debt falls.
Fall in market
price = Increase
of effective
interest rate
Higher interest
rates increase
costs of revolving
government debt.
- 218 -
Total Public Debt in Percent of GDP
United Kingdom 1900 - 2010
250%
Percent of GDP
It is possible to reduce the debtto-GDP ratio without reducing the
debt level…
200%
150%
100%
© RAINER MAURER, Pforzheim
50%
0%
1900
1910
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
Public Net Debt-total in Percent of GDP (left scale)
Source: www.ukpublicspending.co.uk
Prof. Dr. Rainer Maurer
- 221 -
Total Public Debt in Percent of GDP
250%
Percent of GDP
United Kingdom 1900 - 2010
Yearly Growth Rate
Nominal GDP must grow faster as
the debt level!
200%
40%
35%
30%
25%
150%
20%
15%
100%
10%
5%
50%
0%
© RAINER MAURER, Pforzheim
-5%
0%
-10%
1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000 2010
GDP Growth Rate (right scale)
Public Net Debt-total Growth Rate (right scale)
Public Net Debt-total in Percent of GDP (left scale)
- 222 Source: www.ukpublicspending.co.uk
Prof. Dr. Rainer Maurer
4. The Keynesian Model and its Policy Implications
4.5.3. Limits of Government Debt
➤ Is there a “moral” limit for government debt?
1. Not future generations, but future tax payers pay for today debt:
◆
◆
Interest for government debt accumulated by current generations,
will not be paid by future generations, but by future tax payers to
future owners of government bonds.
Therefore, the money stays „within the generation“.
2. Every generation does not only inherit debt,
◆
© RAINER MAURER, Pforzheim
◆
Prof. Dr. Rainer Maurer
◆
…but also net wealth like infrastructure, physical capital (machines,
buildings…), technical knowledge, institutions, human capital…
The yearly monetary and non-monetary return, of this net wealth,
is opposed to the interest payments, which have to be paid to the
owners of government bonds.
Is this return equal to the costs of interest payments, future tax
payers suffer no net loss!
- 226 -
© RAINER MAURER, Pforzheim
Macroeconomics
4. The Keynesian Model and its Policy Implications
4.1. The Keynesian Theory
4.1.1. The "Keynesian Cross"
4.1.2. The Keynesian Model with Capital Market
4.2. Demand-side Shocks
4.2.1. Reduction of the Propensity to Consume
4.2.2. Reduction of the Propensity to Invest
4.2.3. Consequences for the Labor Market
4.3. Fiscal and Monetary Policy in the Keynesian Model
4.3.1. Fiscal Policy
4.3.2. Monetary Policy
4.4. The Long-run Implications of the Keynesian Model
4.5. Policy Conclusions
4.5.1. Practical Problems of Anti-cyclical Policy
4.5.2. Case Study: Fiscal Policy in Germany
4.5.3. Limits of Government Debt
4.5.4. Case Study: Economic Policy in the Great Recession
Prof. Dr. Rainer Maurer
- 227 -
4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
Business Cycle Germany
(Real GDP based on Chained Volumes, Reference Year = 2000, Trend = Hodrick-Prescott-Filter)
580
1,0%
Bn. €
560
0,5%
540
0,0%
520
-0,5%
500
480
-1,0%
460
-1,5%
440
-2,0%
1990Q01
1990Q03
1991Q01
1991Q03
1992Q01
1992Q03
1993Q01
1993Q03
1994Q01
1994Q03
1995Q01
1995Q03
1996Q01
1996Q03
1997Q01
1997Q03
1998Q01
1998Q03
1999Q01
1999Q03
2000Q01
2000Q03
2001Q01
2001Q03
2002Q01
2002Q03
2003Q01
2003Q03
2004Q01
2004Q03
2005Q01
2005Q03
2006Q01
2006Q03
2007Q01
2007Q03
2008Q01
2008Q03
2009Q01
2009Q03
© RAINER MAURER, Pforzheim
420
Actual GDP growth minus trend growth (right scale)
Prof. Dr. RainerEurostat,
Maurer
Source:
Own Calculations
Actual GDP
Trend GDP
- 228 -
www.rainer-maurer.com
4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
Unemployment and Business Cycle Germany
(Real GDP based on Chained Volumes, Reference Year = 2000, Trend = Hodrick-Prescott-Filter)
10%
0,5%
8%
0,0%
6%
-0,5%
4%
-1,0%
2%
-1,5%
0%
-2,0%
1990Q01
1990Q03
1991Q01
1991Q03
1992Q01
1992Q03
1993Q01
1993Q03
1994Q01
1994Q03
1995Q01
1995Q03
1996Q01
1996Q03
1997Q01
1997Q03
1998Q01
1998Q03
1999Q01
1999Q03
2000Q01
2000Q03
2001Q01
2001Q03
2002Q01
2002Q03
2003Q01
2003Q03
2004Q01
2004Q03
2005Q01
2005Q03
2006Q01
2006Q03
2007Q01
2007Q03
2008Q01
2008Q03
2009Q01
2009Q03
1,0%
© RAINER MAURER, Pforzheim
12%
Actual GDP growth minus trend growth (right scale)
Unemployment Rate (left scale)
Source:
Own Calculations
Prof. Dr. RainerEurostat,
Maurer
- 229 -
www.rainer-maurer.com
4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
© RAINER MAURER, Pforzheim
Private Consumption in Current Prices, Billion Euro
Quelle: Statistisches Bundesamt
Prof. Dr. Rainer Maurer
- 230 -
4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
© RAINER MAURER, Pforzheim
Gross Investment in Current Prices, Billion Euro
Quelle: Statistisches Bundesamt
Prof. Dr. Rainer Maurer
- 231 -
4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
➤ The expenditure account of GDP show the components of
the demand for domestic goods:
© RAINER MAURER, Pforzheim
Y = C + I + G + EX – IM
<=> BIP = Consumption
+ Gross Investment
+ Government Consumption
+ Exports
“Net Exports”
- Imports
Prof. Dr. Rainer Maurer
- 232 -
4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
© RAINER MAURER, Pforzheim
Exports ./. Imports in Current Prices, Billion Euro
Quelle: Statistisches Bundesamt
Prof. Dr. Rainer Maurer
- 233 -
4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
© RAINER MAURER, Pforzheim
Production in Manufacturing, 2005 = 100
Quelle: Statistisches Bundesamt
Prof. Dr. Rainer Maurer
As postulated by the Keynesian
model firms adjust their
production in the short-run to the
demand for goods.
- 234 -
4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
© RAINER MAURER, Pforzheim
➤ As the data reveal, the current recession was mainly
caused by a reduction of investment and export demand.
➤ The reason for the reduction of investment and export
demand was the bursting of a speculative bubble on the US
real estate market.
➤ The causal chain behind the development is relatively
complex, as the following chart shows:
Prof. Dr. Rainer Maurer
- 235 -
4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
USA
Decrease in Real
Estate Prices
Net Wealth Loss of
Households
Loss of Credit
Receivables of
US Banks
Germany
Loss of Credit
Receivables of
Ger. Banks
Reduction in
Credit Supply
by US Banks
Reduction in
Credit Supply
by Ger. Banks
© RAINER MAURER, Pforzheim
Reduction in Consumption Demand
Reduction in
Investment Demand
Reduction in Demand for
Consumption and Investment
Goods from Germany
Prof. Dr. Rainer Maurer
German
Consumption
Relatively Stable
Reduction in
Investment Demand
Reduction of Export
Demand
Reduction of
Production in
Germany
- 236 -
4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
➤ Fiscal Policy Measures in Germany:
➤ “Konjunkturpaket I” of November 2008 with a total volume
of about 100 Bn. €:
◆ Subsidization of building investment: energy saving investments
◆ Subsidization of investment in equipment: extension of write-off
© RAINER MAURER, Pforzheim
possibilities
◆ Extension of child allowances and other family support benefits
◆ Increase of credit supply for midsize companies:
Sonderprogramm KfW – Bank
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
➤ Fiscal Policy Measures in Germany:
➤ “Konjunkturpaket II” of January 2009 with a total volume of
about 50 Bn. €:
Reduction of income tax
Reduction of health insurance allowances
Additional Extension of child allowances
Subsidization of private demand for cars (“Cash for clunkers”)
Municipal investment program: Improvement of infrastructure
© RAINER MAURER, Pforzheim
◆
◆
◆
◆
◆
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
© RAINER MAURER, Pforzheim
4.5.4. Case Study: Economic Policy in the Great Recession
➤ Monetary Policy Measures:
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
4.5.4. Case Study: Economic Policy in the Great Recession
➤ Geldpolitische Maßnahmen:
The Impact of the ECB on Credit Interest Rates
of Commercial Banks
9%
8%
7%
Mortgage Loans
1)
Consumer Credits1)
6%
2)
5%
Corporate Credits
4%
3%
Main Refinancing Rate
© RAINER MAURER, Pforzheim
2%
1%
0%
Jan 99 Jan 00 Jan 01 Jan 02 Jan 03 Jan 04 Jan 05 Jan 06 Jan 07 Jan 08 Jan 09 Jan 10
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
© RAINER MAURER, Pforzheim
4.5.4. Case Study: Economic Policy in the Great Recession
Prof. Dr. Rainer Maurer
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4. The Keynesian Model and its Policy Implications
© RAINER MAURER, Pforzheim
4.5.4. Case Study: Economic Policy in the Great Recession
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
© RAINER MAURER, Pforzheim
➤ You should be able to answer the following questions
at the end of this chapter. All of the questions can be
answered with the help of the lecture notes. If you have
difficulties in answering a question, discuss this
question with me at the end of the lecture, attend my
colloquium or send me an E-Mail.
Prof. Dr. Rainer Maurer
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© RAINER MAURER, Pforzheim
4.6. Questions for Review
1.
What empirical developments in the course of the world economic
crisis contradict neoclassical theory?
2.
What are the two main differences between Keynesian and
neoclassical theory.
3.
What is the difference between the Keynesian and neoclassical
consumption function and what implications does this have for the
savings decision of households.
4.
What is the economic explanation for the observed lagged price
adjustment of firms?
5.
Why do firms adjust their supply of goods to the household demand
for goods in the Keynesian model?
6.
What value has the Keynesian investment multiplier for a
consumption ratio of 80%?
7.
What is the increase in GDP under the assumption of the
“Keynesian Cross”, if the consumption ratio is 75% and investment
grows by 1 Bn. ?
8.
Give a verbal explanation of the multiplier process.
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
9.
Plot the following consumption function in this diagram:
C(Y) = 0,8 * Y. How does this function change, if the consumption
ratio decreases to 40%?
C, I, G 30
25
20
15
© RAINER MAURER, Pforzheim
10
5
Y
0
0
Prof. Dr. Rainer Maurer
5
10
15
20
25
30
35
40
45
50
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4.6. Questions for Review
10. Determine (given the assumptions of the Keynesian Cross) GDP, if
investment demand equals 5, government consumption equals 5 and
the consumption function equals C(Y) = (1/3)*Y. How does GDP
change, if government consumption grows by 10?
C, I, G
30
25
20
15
© RAINER MAURER, Pforzheim
10
5
Y
0
0
Prof. Dr. Rainer Maurer
-5
5
10
15
20
25
30
35
40
45
50
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4.6. Questions for Review
11. Why does an increase in the demand for investment goods leads to
an increase in GDP that is larger than the increase in the demand
for investment goods under the assumption of the “Keynesian
Cross”?
12. What possibilities does a government have under the assumptions
of the “Keynesian Cross” to increase GDP?
© RAINER MAURER, Pforzheim
13. Discuss the difference between the neoclassical and the Keynesian
consumption function on the background of your own consumption
behavior: Do you have a Keynesian or a neoclassical consumption
function?
14. How does the “Keynesian Cross” have to be modified, if the capital
market is taken into account?
15. What factors affect money demand of households and firms under
the assumptions of the Keynesian model and what is their
economic explanation?
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
Interest Rate
S(Y1) = (1/3) * 30
3,5
3
30
2,5
25
i1
2
20
1,5
15
1
10
0,5
I(i, E(r1))
0
-0,5
0
5
10
© RAINER MAURER, Pforzheim
I1
15
20
25
30
Demand
35
35
40
45
50
Investment
C(Y) + I(i)
C(Y)= (2/3)* Y
5
0
-5
0
5
10
15
20
25
30
Y1
35
40
45
50
Income
16. Caused by a deterioration of expectations, households lower their
consumption ratio from 2/3 to 1/3 of their income. How does this
reduction affect GDP in the above diagram?
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
Interest Rate
S(Y1)= (2/3) * 15
3,5
3
30
2,5
25
i1
2
20
1,5
15
C(Y) + I(i)
1
10
C(Y)= (1/3)* Y
0,5
I(i, E(r1))
0
-0,5
0
5
10
I1
© RAINER MAURER, Pforzheim
Demand
35
15
20
25
30
35
40
45
50
Investment
5
0
-5
0
5
10
15
20
25
30
Y1
35
40
45
50
Income
17. Caused by a better economic outlook, households increase their
consumption ratio from 1/3 to 1/2 of their income. How does this
increase affect GDP in the above diagram?
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
Interest Rate
S(Y1)
3,5
3
30
2,5
25
i1
2
20
1,5
15
I(i, E(r1))
1
5
0
0
0
5
10
© RAINER MAURER, Pforzheim
I1
15
20
25
30
35
40
45
50
Investment
C(Y) + I(i)
C(Y)= (2/3)* Y
10
0,5
-0,5
Demand
35
-5
0
5
10
15
20
25
30
Y1
35
40
45
50
Income
18. Firms expect a decrease in investment returns and do therefore
reduce their demand for investment goods by 5 units. How does
this reduction affect GDP in the above diagram?
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
Interest Rate
S(Y1)
C(Y) + I(i)
i1
C(Y)= (1/3)* Y
I(i, E(r1))
© RAINER MAURER, Pforzheim
I1
Investment
Y1
Income
19. Caused by a better economic outlook, firms expect a higher return
on investment and increase their demand for investment goods by
10 units. How does this behaviour affect GDP in the above
diagram?
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
Interest Rate
S(Y1)
3,5
3
30
i1 2,5
25
2
20
1,5
15
1
10
0,5
I(i, E(r1))
0
5
I1
© RAINER MAURER, Pforzheim
C(Y) + I(i)
C(Y)= 0,5* Y
5
0
0
-0,5
Demand
35
10
15
20
25
30
35
40
45
50
Investment
-5
0
5
10
Y1
15
20
25
30
Y#
35
40
45
50
Income
20. The above economy is in a recession with Keynesian unemployment. To reestablish full employment, GDP must reach a level of
Y# = 30 . Present government consumption is G = 0. What increase
in government consumption is necessary to reestablish full
employment, if government consumption is completely financed
with credits?
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
3,5
Interest Rate
S(Y1) S(Y1) + M/P
Demand
35
3
30
2,5
25
2
20
i1
1,5
I(i)+ RD(Y)
1
0,5
C(Y)= 0,5* Y
15
10
5
I(i)
0
0
-0,5
C(Y) + I(i)
0
5
I1
10
15
20
25
30
35
40
45
50
Investment
-5
0
5
10
Y1
15
20
Y#
25
30
35
40
45
50
Income
© RAINER MAURER, Pforzheim
21. The above economy is in a recession with Keynesian unemployment. To
reestablish full employment, GDP must reach a level of Y# = 20 . What
increase in money supply MS/P is necessary to reestablish full
employment? (Assume that the effect of an increase in savings is always
absorbed by a corresponding increase in money demand).
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
22. Explain how a recession can be overcome with the help of fiscal
and monetary policy under the assumptions of the Keynesian
model.
23. Explain the practical problems of fiscal and monetary policy in
realtiy.
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24. Explain the mechanism that help to overcome a recession under
the assumptions of the Keynesian model of the long run.
Prof. Dr. Rainer Maurer
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3,5
Interest Rate
S(Y1) S(Y1) + M1/P
Demand
35
3
30
2,5
25
i1
2
I(i, E(r1))+ RD(Y1)
1,5
20
C(Y)= 0,5* Y
15
10
1
0,5
I(i, E(r1))
0
0
5
I1
10
15
20
25
30
35
40
45
50
Investment
5
I1
0
-5
0
5
10
Y1
15
20
25
30
35
40
45
50
Income
© RAINER MAURER, Pforzheim
-0,5
C(Y) + I(i1)
25. How does an increase in money supply from M1/P by 5 units to M2/P =
M1/P+5 affect the economy?
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
Interest Rate
S(Y1)
3,5
3
30
i1 2,5
25
2
20
1,5
15
1
10
0,5
I(i, E(r1))
0
5
I1
© RAINER MAURER, Pforzheim
C(Y) + I(i)
C(Y)= 0,5* Y
5
0
0
-0,5
Demand
35
10
15
20
25
30
35
40
45
50
Investment
-5
0
5
10
Y1
15
20
25
30
35
40
45
50
Income
26. How does an increase in government consumption from G1=0 to
G2=10 affect the economy, if this increase is financed by credits.
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
3,5
Real Interest
S(Y1) S(Y1) + M1/P1
Demand
35
30
3
2,5
i1
I(i, E(r1))+ RD(Y1)
25
2
20
1,5
15
I(i, E(r1))
1
5
0
0
0
5
10
15
25
30
35
40
45
50
Investment
-5
0
5
10
15
20
Y#
25
30
Y1
35
40
45
50
Income
© RAINER MAURER, Pforzheim
I1
20
C(Y)= 0,5* Y
10
0,5
-0,5
C(Y) + I(i1)
27. This economy is in a boom, where the current GDP Y1 lies above full
employment GDP Y#. Analyze what happens in the long-run, if firms begin
to adjust their prices.
Prof. Dr. Rainer Maurer
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4.6. Questions for Review
Interest Rate
S(Y1)
3,5
3
30
2,5
25
i1
2
20
1,5
15
1
10
0,5
I(i, E(r1))
0
-0,5
0
5
10
© RAINER MAURER, Pforzheim
I1
15
20
Demand
35
25
30
35
40
45
50
Investment
C(Y) + I(i)
C(Y)= (1/3)* Y
5
0
-5
0
5
10
15
20 25
Y#
30
35
40
45
50
Income
28. The above economy is in a recession with Keynesian unemployment. To reestablish full employment, GDP must reach a level of
Y# = 20 . Present government consumption is G = 0. What increase
in government consumption is necessary to reestablish full
employment, if government consumption is completely financed
with taxes levied upon household income?
Prof. Dr. Rainer Maurer
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