2014/6/17. Context. Context. Elements of the Keynesian Cross. The Keynesian Cross. Graphing the equilibrium condition. Graphing planned expenditure
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1 Context Long un pices flexible output detemined by factos of poduction & technology unemployment equals its natual ate Shot un pices fixed output detemined by aggegate demand unemployment negatively elated to output Context This chapte develops the -LM model, the basis of the aggegate demand cuve. We focus on the shot un and assume the pice level is fixed (so, SRAS cuve is hoizontal). This chapte (and chapte ) focus on the closed-economy case. Chapte 2 pesents the open-economy case. 0 The Keynesian Coss Elements of the Keynesian Coss A simple closed economy model in which income is detemined by expenditue. (due to J.M. Keynes) Notation: I = planned investment = C + I + G = planned expenditue = eal GD = actual expenditue Diffeence between actual & planned expenditue = unplanned inventoy investment consumption function: govt policy vaiables: fo now, planned investment is exogenous: planned expenditue: equilibium condition: C C( T ) G G, T T I I C ( T ) I G actual expenditue = planned expenditue 2 3 Gaphing planned expenditue Gaphing the equilibium condition planned expenditue =C +I +G planned expenditue = MC 45º income, output, income, output, 4 5
2 The equilibium value of income An incease in govenment puchases planned expenditue = =C +I +G At, thee is now an unplanned dop in inventoy =C +I +G 2 =C +I +G G Equilibium income income, output, so fims incease output, and income ises towad a new equilibium. = 2 = Solving fo C I G C I G C G MC G Collect tems with on the left side of the equals sign: ( MC) G equilibium condition in changes because I exogenous because C = MC Solve fo : G MC The govenment puchases multiplie Definition: the incease in income esulting fom a $ incease in G. In this model, the govt puchases multiplie equals G MC Example: If MC = 0.8, then G An incease in G causes income to incease 5 times as much! 8 9 Why the multiplie is geate than Initially, the incease in G causes an equal incease in : = G. But C futhe futhe C futhe So the final impact on income is much bigge than the initial G. An incease in taxes Initially, the tax incease educes consumption, and theefoe : C = MC T so fims educe output, and income falls towad a new equilibium =C +I +G =C 2 +I +G At, thee is now an unplanned inventoy buildup 2 = 2 = 0 2
3 Solving fo C I G C MC T eq m condition in changes I and G exogenous The tax multiplie def: the change in income esulting fom a $ incease in T : T MC MC Solving fo : Final esult: ( MC) MC T MC T MC If MC = 0.8, then the tax multiplie equals T The tax multiplie is negative: A tax incease educes C, which educes income. is geate than one (in absolute value): A change in taxes has a multiplie effect on income. is smalle than the govt spending multiplie: Consumes save the faction ( MC) of a tax cut, so the initial boost in spending fom a tax cut is smalle than fom an equal incease in G. NOW OU TR: actice with the Keynesian Coss Use a gaph of the Keynesian coss to show the effects of an incease in planned investment on the equilibium level of income/output. 4 The cuve Deiving the cuve def: a gaph of all combinations of and that esult in goods maket equilibium i.e. actual expenditue (output) = planned expenditue The equation fo the cuve is: I I = =C +I ( 2 )+G =C +I ( )+G 2 C ( T) I( ) G
4 Why the cuve is negatively sloped A fall in the inteest ate motivates fims to incease investment spending, which dives up total planned spending (). To estoe equilibium in the goods maket, output (a.k.a. ka actual expenditue, ) must incease. The cuve and the loanable funds model (a) The L.F. model (b) The cuve S 2 S 2 2 I ( ) S, I Fiscal olicy and the cuve We can use the -LM model to see how fiscal policy (G and T) affects aggegate demand and output. Let s stat by using the Keynesian coss to see how fiscal policy shifts the cuve Shifting the cuve: G At any value of, G so the cuve shifts to the ight. The hoizontal distance of the shift equals G MC = =C +I ( )+G =C +I ( )+G NOW OU TR: Shifting the cuve: T Use the diagam of the Keynesian coss o loanable funds model to show how an incease in taxes shifts the cuve. The Theoy of Liquidity efeence Due to John Maynad Keynes. A simple theoy in which the inteest ate is detemined by money supply and money demand. 23 4
5 Money supply Money demand The supply of eal money is fixed: s inteest ate s Demand fo eal money : d L ( ) inteest ate s L( ) eal money eal money Equilibium How the Fed aises the inteest ate The inteest ate adjusts to equate the supply and demand d fo money: inteest ate s To incease, Fed educes M inteest ate 2 L( ) L( ) L( ) eal money M 2 M eal money CASE STUD: Monetay Tightening & Inteest Rates Late 970s: > 0% Oct 979: Fed Chaiman aul Volcke announces that monetay policy would aim to educe inflation Aug 979-Apil 980: Fed educes 8.0% Jan 983: = 3.7% How do you think this policy change would affect nominal inteest ates? 28 Monetay Tightening & Inteest Rates, cont. model pices pediction actual outcome The effects of a monetay tightening on nominal inteest ates shot un Liquidity pefeence (Keynesian) sticky i > 0 8/979: i = 0.4% 4/980: i = 5.8% long un Quantity theoy, Fishe effect (Classical) flexible i < 0 8/979: i = 0.4% /983: i = 8.2% 5
6 The LM cuve Deiving the LM cuve Now let s put back into the money demand function: L(, ) d (a) The maket fo eal money (b) The LM cuve LM The LM cuve is a gaph of all combinations of and that equate the supply and demand fo eal money. The equation fo the LM cuve is: L(, ) 2 M L (, 2 ) L (, ) Why the LM cuve is upwad sloping How M shifts the LM cuve An incease in income aises money demand. Since the supply of eal is fixed, thee is now excess demand in the money maket at the initial inteest ate. (a) The maket fo eal money (b) The LM cuve LM 2 LM The inteest ate must ise to estoe equilibium in the money maket. 2 2 L (, ) M 2 M NOW OU TR: Shifting the LM cuve The shot-un equilibium Suppose a wave of cedit cad faud causes consumes to use cash moe fequently in tansactions. Use the liquidity pefeence model to show how these events shift the LM cuve. The shot-un equilibium is the combination of and that simultaneously satisfies the equilibium conditions in the goods & money makets: C ( T) I( ) G L(, ) Equilibium inteest ate LM Equilibium level of income 35 6
7 The Big ictue Keynesian Coss Theoy of Liquidity efeence cuve LM cuve -LM model Explanation of shot-un fluctuations Agg. demand cuve Agg. supply cuve Model of Agg. Demand and Agg. Supply 7
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