Download AE Y

Investment, again:
All spending by
firms for newly built
equipment and
durable structures
All changes in
business inventories
All spending by
households for newly
constructed
residential housing
The record shows that
I is volatile--showing
substantial variation
from month to month
or year to year.
 Investment is assumed to
be an autonomous variable
in our model. That is, I is
presumed to be determined
independent of current real
output and income. More
precisely, we can say that:
I function
shifts right
due to
increase in
, ceteris
paribus
r
12
9
I = f(r, ), where
• r is the interest rate; and
•  is expected profits from
spending for tangible, capital
goods
I0
0
I2
I1
50
75
I
Acquisition price of tractor trailer rig (known)
$100,000
Expected revenue per year from shipping goods
168,000
Expected running expenses per year
•Driver salary and benefits $54,000
•Diesel fuel
36,000
•Insurance
11,750
•Repairs, other
26,250
$128,000
Let
Ignoring taxes,
if the interest
rate is less than 40
percent, the investment
will be made
•R denote expected revenue per
year
•C is expected cost per year
•AC is the acquisition price of the
capital good.
•Thus we have:
R  C 168000  128000
40000



 .40
AC
100000
100000
As r falls,
firms can make
investments
with lesser
expected returns
Interest (%)
A
9
H
6.5
B
I1
0
60
85
I1 to I2:
rising
expected
profitability
of spending
for capital
I2 goods
Investment
I
Function could shift down due to:
•Increase in the interest rate, ceteris
paribus.
85
60
•Diminished confidence about the future
profitability of investment.
Ia2
Ia1
0
YD
Assume that r = 9% and the investment demand schedule is in
position I1
Income
YD
$0
Consumption Investment
C
I
$30
$60
Aggregate
Expenditure (AE)
$90
100
100
60
160
200
60
60
230
300
170
240
300
400
310
60
370
500
380
60
440
For a closed economy without a public sector:
YC+I
[1]
C =Ca + cYD
[2]
I = Ia
[3]
Since there is no public sector nor retained earnings,
we can say: Y = YD. Therefore, [2] can be rewritten as:
C = Ca + cY
[4]
Substitute [4] and [3] into [1]:
Y = Ca + cY + Ia
[5]
AE In equilibrium,
AE = Y and
unplanned inventory
investment is zero
AE = Y
AE = Ca + Ia + cY
C =Ca + cY
There is no
guarantee that
Y* will
correspond to
potential GDP
Ca + Ia
c
0
Y*
Y
YC+I
C = 30+ .70YD
I = 60
AE = Y
AE

C
300
Thus:
Y* =
AE
60 + 30
1 - .70
90
Y* = 90/.30 = 300
30
0
300
Y
Properties of Equilibrium in the Keynesian System



Planned spending (AE) is equal to real output (Y) so
that firms on average experience zero unplanned
inventory accumulation or de-accumulation.
Firms on average have no reason to expand or contract
their output level; nor do they have any incentive to offer
more or less employment.
Equilibrium GDP might be equal to potential or full
employment GDP (the “special” or “Classical” case], but
there is no guarantee (as is true for the Classical
model). The more likely outcome (or what Keynes
referred to as the “general case” ) is “underemployment
equilibrium.”
UI is unplanned inventory investment
AE = Y
AE
AE
When Y = $200
• AE > Y by $30
•UI = ($30)
UI
370
•Firms have an
incentive to expand
output and employment
230
When Y = $400
UI
•AE < Y by $30
•UI = $30
200
300
400
Y
•Firms have an incentive
to decrease output and
employment