Lecture 7: Introduction to Economic Fluctuations, The Keynesian Cross

Macroeconomics 1 Lecture 7: Introduction to Economic Fluctuations, The Keynesian Cross Dr Gabriela Grotkowska Tomasz Gajderowicz Based on slides by Mankiw, Macoreconomcis, 5e

Key questions What determines the equlibrium? demand or supply? Is there a conflict between short- and long run policy? What about the log run Mr. Keynes?

The Big Picture Keynesian Cross Theory of Liquidity Preference IS curve LM curve IS-LM model Explanation of short-run fluctuations Agg. demand curve Agg. supply curve Model of Agg. Demand and Agg. Supply slide 3

Agenda for today Some facts about the business cycle How the short run differs from the long run An introduction to aggregate demand The Keynesian Cross Fiscal policy and its impact on the GDP

Facts about the business cycle GDP growth averages 2 3 percent per year over the long run with large fluctuations in the short run. Consumption and investment fluctuate with GDP, but consumption tends to be less volatile and investment more volatile than GDP. Unemployment rises during recessions and falls during expansions. Okun s Law: the negative relationship between GDP and unemployment.

Growth rates of real GDP, consumption Percent change from 4 quarters earlier 10 8 6 Real GDP growth rate Consumption growth rate Average growth rate 4 2 0-2 -4 1970 1975 1980 1985 1990 1995 2000 2005

Growth rates of real GDP, consumption, investment Percent change from 4 quarters earlier 40 30 20 10 Investment growth rate Real GDP growth rate 0-10 Consumption growth rate -20-30 1970 1975 1980 1985 1990 1995 2000 2005

Unemployment Percent of labor force 12 10 8 6 4 2 0 1970 1975 1980 1985 1990 1995 2000 2005

Okun s Law Percentage change in real GDP 10 8 6 1984 1951 1966 Y Y 2003 3.5 2u 4 2 1987 0 1975-2 2001 1991 1982-4 -3-2 -1 0 1 2 3 4 Change in unemployment rate

Is it possible to predict fluctuations?

Index of Leading Economic Indicators Published monthly by the Conference Board. Aims to forecast changes in economic activity 6-9 months into the future. Used in planning by businesses and goverment, despite not being a perfect predictor.

Components of the LEI index Average workweek in manufacturing Initial weekly claims for unemployment insurance New orders for consumer goods and materials New orders, nondefense capital goods New building permits issued Index of stock prices M2 Index of consumer expectations

1996 = 100 Index of Leading Economic Indicators 160 140 120 100 80 60 40 20 Source: Conference Board 0 1970 1975 1980 1985 1990 1995 2000 2005

We focus on the short run.. What does it mean?

Time horizons in macroeconomics Long run: Prices are flexible, respond to changes in supply or demand. Short run: Many prices are sticky at some predetermined level. The economy behaves much differently when prices are sticky.

When prices are sticky output and employment also depend on demand, which is affected by fiscal policy (G and T ) monetary policy (M ) other factors, like exogenous changes in C or I.

The model of aggregate demand and supply the paradigm most mainstream economists and policymakers use to think about economic fluctuations and policies to stabilize the economy shows how the price level and aggregate output are determined shows how the economy s behavior is different in the short run and long run

Short run and long run: role of use of production factors Price level AD 4 AD 5 AS Subject of our interest AD 3 AD 2 AD1 Y max Output

Keynes model assumptions Fixed prices (growth of demand does not cause prices to grow, so firms adjust their supply at fixed price level) Production factors availability (possibility to increase supply without increasing prices requires that there is spare capacity, that may be used without increased prices; it means that some of the fixed assets is unused and there is some level of the unemployed persons ready to undertake employment at current wage level) Constant productivity of production factors (independent of degree of use) As a consequence: lack of changes in the production costs caused by changes in the production quantity 27

Other simplifying assumptions We do not distinguish different categories of national accounts We say Y: income, output Consumption, saving, investment, exports, imports, government spending, personal income tax, benefits 2

What determines the level of production? According to the Keynesian model output depends on the size of the planned expenditure in the economy: companies produce as much as someone wants to buy from them Price level AS AD 1 AD 2 Output 29

The Keynesian Cross A simple closed economy model in which income is determined by expenditure. (due to J.M. Keynes) Notation: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure slide 30

Kenesian cross: two simple equations Y=AE AE=C+I+G+NX

Elements of the Keynesian Cross consumption function: govt policy variables: C C ( Y T ) G G, T T for now, planned investment is exogenous: I I planned expenditure: E C ( Y T ) I G Equilibrium condition: Actual expenditure Y Planned expenditure E slide 32

Consumption spending The biggest part of the GDP C C Where and: C c Y D - level of consumption C - autonomous consumption - marginal propensity to consume Y disposable income: d Y D Y T B t Y Y c 0 c 1 c (1 t) C Y D T B How C changes when Yd chages by 1 T lump sum taxes, B social benefits, t tax rate 33

Graphical representation of consumption function C Y D C c Y D Y T B t Y Y(1 t) C C cb ct ( 1t) cy C C tg c cy T Total consumption B C 1 c Disposable income 3

Saving function Since Y d C S S Y d C S S Y d C C Y T ty (1 c) B (1 B c) T C (1 cb ct c t ct) Y c(1 t) Y Without government : B = T = t = 0 Total saving S C ( 1c) Y C 1 s= (1-c) Income 3

Graphing planned expenditure E planned expenditure AE =C +I +G 1 MPC income, output, Y slide 36

Graphing the equilibrium condition E planned expenditure AE =Y 45º income, output, Y slide 37

The equilibrium value of income E planned expenditure AE =Y AE =C +I +G income, output, Y Equilibrium income slide 38

39 Equilibrium in algebraic form r b I I Y D c C C G G Y t c r b NB c G I C AE ) (1 ) ( ) ( ) 1 ( r b NB c G I C Y t c Y ) (1 1 1 ) ( t c NB c r b G I C Y Y AE Equilibrium condition Autonomous spending (not depending on Y) Multiplier Y t c r b NB c G I C Y ) (1 ) (

An increase in government purchases E At Y 1, there is now an unplanned drop in inventory AE =C +I +G 2 AE =C +I +G 1 G so firms increase output, and income rises toward a new equilibrium E 1 = Y 1 Y E 2 = Y 2 Y slide 40

The government purchases multiplier Definition: the increase in income resulting from a $1 increase in G. In this model, the govt purchases multiplier equals Y 1 G 1 MPC Example: If MPC = 0.8, then Y G 1 1 0.8 5 An increase in G causes income to increase by 5 times as much! slide 41

Why the multiplier is greater than 1 Initially, the increase in G causes an equal increase in Y: Y = G. But Y C further Y further C further Y So the final impact on income is much bigger than the initial G. slide 42

Full version of the model: open economy Y = C + I + G + NX C C c Y D gdzie I I br G G NX NX my Y D Y ty T B Y AE ( C I G NX cnb br) c (1 t) Y my

Example of full version of the model: open economy Y = C + I + G + NX C C c Y gdzie D I I br G G NX NX my nr Y D Y Autonomus ty T B Y dependent Y AE ( C I G NX cnb br) c (1 t) Y my

Full version of the model: open economy Y AE Y AE ( C I G NX cnb br) c (1 t) Y my Y c ( 1 t) Y my ( C I G NX cnb br) Y ( C I G NX cnb br) 1 1 c(1 t) m Keynesian multiplier

Full version of the model: open economy AE Linia 45 Y AE AE = C + I + G + NX C I G NX cnb br Y* Y

Thank you