Chapter 23 The Keynesian Framework Learning Objectives See the differences among saving, investment, desired saving, and desired investment and explain how these differences can generate short run fluctuations in real GDP Understand the Keynesian cross and determination of an equilibrium level of income Analyze autonomous changes in macroeconomic variables and their potential to cause economic fluctuations 23-2 Learning Objectives (Cont.) Define the liquidity preference theory and its role in determining interest rates Comprehend the Keynesian theory of monetary policy and its role in impacting the economy Understand the Keynesian version of aggregate demand/aggregate supply analysis 23-3 1
Introduction In 1936, John Maynard Keynes published The General Theory of Employment, Interest and Money Concerned with short-run as compared to the Classical Economists who focused on long-run Argued that free market forces could take considerable time to adjust In the short run there could be lengthy periods of underemployment 23-4 Introduction (Cont.) Preoccupied with what determined the level of real economic activity during long periods of recession or depression If economy were sufficiently depressed, could experience increases in real output without any increase in the price level Assumed that the price level is fixed Focused on aggregate demand and supply since full employment was irrelevant 23-5 When Saving Doesn t Equal Investment Classical economists stated that equilibrium existed when total saving desired by households equals total investment desired by firms However, Keynes asked what happens when desired savings exceeds desired investment and prices were not free to adjust Prices are sticky and will not decline as inventories build up 23-6 2
When Saving Doesn t Equal Investment (Cont.) Wages are resistant to decreases Since interest rates are determined in the money market, fluctuations will not necessarily equilibrate desired saving and desired investment Therefore, since prices will not fall, both real output and income will decline until desired savings equaled desired investment at a lower equilibrium GDP 23-7 Consumption and Simple GDP Determination Figure 23.1 represents the Keynesian cross diagram Real income and real output are measured in the horizontal axis (Income: Y) Different types of expenditures are measured on the vertical (Expenditure: E) A 45 degree line from origin traces the equilibrium condition where E = Y 23-8 FIGURE 23.1 Spending determines income. 23-9 3
Consumption and Simple GDP Determination (Cont.) Expenditure takes two forms consumption and investment Consumption Function (C) Consumption is a linear function of income (Y) C = a + by b is equal to the slope of the consumption line 23-10 Consumption and Simple GDP Determination (Cont.) Consumption Function (C) (Cont.) Marginal propensity to consume (MPC) The slope of the consumption functions (b) how much additional consumption would result from a $1 increase in income and is always less than 1 a of the consumption function represents consumption level if income were equal to zero The consumption function will shift up or down if the value lf a changes due to increased/decreased personal wealth 23-11 Consumption and Simple GDP Determination (Cont.) Investment (I) A relationship between the rate of interest on bonds and the level of investment spending by business firms A negative relationship when interest rates fall, investment spending will increase Entrepreneurs invest as long as the rate of return on investment exceeds the rate of interest If the rate of interest is given, the level of investment will be constant and not a function of income 23-12 4
Consumption and Simple GDP Determination (Cont.) Total expenditure is equal to the sum of consumption which varies with income and investment which is constant (E = C + I) At points along the 45 degree line, total expenditure (E) is equal to total income (Y) Since desired savings is equal to Y C and E = Y, it follows that along the 45 degree line desired savings is equal to desired investment (S = I) 23-13 Consumption and Simple GDP Determination (Cont.) Savings Function (Figure 23.2) The marginal propensity to save (MPS) is equal to 1 MPC and less than 1 This represents the slope of the savings function which graphs a linear relationship between savings and income S = -a + (1 - b)y 23-14 FIGURE 23.2 Saving and investment determine income. 23-15 5
Consumption and Simple GDP Determination (Cont.) Savings Function (Figure 23.2) (Cont.) The economy is in equilibrium at an income level where the savings function is equal to a fixed investment This level of income is identical to the level where the total expenditure function crosses the 45 degree line 23-16 Changes in GDP The equilibrium level of income will not change unless there is a change in the consumption or investment functions This equilibrium would be a desirable outcome if level of income (output) was at full employment level 23-17 Changes in GDP (Cont.) Keynes argued that since the level of investment is highly unstable, it is likely that the equilibrium output level will not equal the full employment level of output If entrepreneurs became uncertain about the future, investment spending would decline (total expenditure function would shift down) and equilibrium would be established at a lower level of GDP 23-18 6
Changes in GDP (Cont.) Multiplier actual decline in GDP will be a multiple of the reduction in investment spending When investment declines, income begins to decline This induces a reduction in consumer spending, further lowering the level of income 23-19 Changes in GDP (Cont.) Multiplier (Cont.) The total change in income is related to the initial decline in investment through the multiplier, which takes the following form Multiplier 1 = ( 1 b) Where: b = marginal propensity to spend 23-20 Changes in GDP (Cont.) Multiplier (Cont.) Therefore, the total change in income resulting from a change in investment is: 1 ΔY = ΔI 1 b 23-21 7
Autonomous versus Induced Changes in GDP Figures 23.3 and 23.4 suggest that anything that shifts the position of the total desired spending function will alter GDP Such shifts are produced by autonomous spending changes which are independent of GDP However, the multiplier was based on the idea that autonomous spending changes will induce further changes in spending 23-22 FIGURE 23.3 A decline in investment spending reduces Y by a multiple of the change in investment. 23-23 FIGURE 23.4 A decline in investment spending reduces Y by a multiple of the change in investment. 23-24 8
Autonomous versus Induced Changes in GDP (Cont.) The larger the marginal propensity to spend (b), the greater the induced change in spending Keynes argued that consumption spending is largely induced, while investment spending is largely autonomous dependent on expected rate of return on capital and rate of interest 23-25 Autonomous versus Induced Changes in GDP (Cont.) Exports and Imports The multiplier expression can be modified to take account of changes in other components of spending Exports add to aggregate demand and imports reduce aggregate demand and these changes are impacted by the multiplier 23-26 Government to the Rescue Keynes was concerned that changes in autonomous spending would cause wide fluctuations in economic activity Government spending was necessary to offset the changes in autonomous spending and restore the economy to full employment Therefore, total spending is the sum of consumer, investment, and government expenditures 23-27 9
Government to the Rescue (Cont.) Figure 23.5 demonstrated the effect of additional government spending to raise the income level of the economy, ideally to the full employment level Government spending (G) is added to C + I This increases spending in the economy to C + I + G Total impact of additional government spending is enhanced through the multiplier 23-28 FIGURE 23.5 Adding government spending raises income. 23-29 Government to the Rescue (Cont.) Figure 23.6 shows the effect of increasing taxes which lowers income Government usually finances spending by taxation Taxation will reduce disposable income which further reduces income through the multiplier 23-30 10
FIGURE 23.6 Introducing taxes lowers income. 23-31 Government to the Rescue (Cont.) Government spending and taxes can be changed by government policy to buffer the effects of changes in autonomous spending Fiscal policy deliberate manipulation of taxes or government spending to achieve a desired level of income consistent with full employment 23-32 Money and Rate of Interest Keynes stated that interest rates were determined by the supply of and demand for money rather than by savings and investment Money might affect the level of real economic activity, only to the extent that it influenced the rate of interest Changes in the interest would alter desired investment spending and thereby the change the level of GDP 23-33 11
Money and Rate of Interest (Cont.) The Keynesian system of income determination deals only with flows in the economy consumption, saving, investment and income over a period of time These flows deal in real goods and services and not financial transactions Keynes introduced the idea that money is a financial asset, held in an individual s portfolio and is part of an individual s wealth 23-34 Money and Rate of Interest (Cont.) Demand for Money (Figure 23.7) Public s portfolio consists of two types of assets money and all other assets (represented by bonds) Money is liquid risk free, but does not earn interest However, the price of bonds can vary in terms of money, so the owner can suffer capital losses or reap capital gains, depending on changes in interest rates 23-35 FIGURE 23.7 Keynesian interest theory. 23-36 12
Money and Rate of Interest (Cont.) Demand for Money (Figure 23.7) (Cont.) Money is a riskless asset, and bonds are risky assets Therefore, more bonds in a portfolio means more risk The decision regarding the composition of a portfolio between money and bonds will be determined by the overall expected return, the average interest rate, on bonds The demand for money, liquidity preference, is a function of the rate of interest 23-37 Money and Rate of Interest (Cont.) Demand for Money (Figure 23.7) (Cont.) The demand for money is negatively sloped with respect to interest Speculative demand for money individuals hold more money (fewer bonds) at low interest rates since they expect interest rates to rise in the future which will cause a capital loss on bond holdings At low rates of interest, individuals have a small opportunity cost of forgoing interest by holding money and prefer liquidity 23-38 Money and Rate of Interest (Cont.) Demand for Money (Figure 23.7) (Cont.) Individuals are risk averse hold bonds only if rate of interest is high enough to compensate for the risk of holding bonds The supply of money is assumed to be constant and does not vary with interest rates The equilibrium level of interest is the intersection of the supply and demand curves (Figure 23.7) 23-39 13
Monetary Policy Changes in the demand for or supply of money will cause a change in equilibrium rate of interest and impact investment spending Cost of Capital Effect (Figure 23.8) Demonstrates the effect of increasing the money supply relative to equilibrium interest rates Demand for money does not change, only the supply of money increases 23-40 FIGURE 23.8 Effect on the interest rate of changing the money supply. 23-41 Monetary Policy (Cont.) Cost of Capital Effect (Figure 23.8) (Cont.) Increased money supply indicates cash balances are too high so individuals purchase stocks which increases the price and lowers the interest rate A lower interest rate will stimulate investment spending and higher GDP via the multiplier Decrease in the money supply would have the opposite effect 23-42 14
Monetary Policy (Cont.) Negative relationship between the demand for money and the rate of interest provides a link between changes in the supply of money and level of economic activity Liquidity Trap (Figure 23.9) However, under certain economic conditions, increased supply of money will not lower the rate of interest At low rates of interest the demand for money becomes perfectly horizontal 23-43 FIGURE 23.9 Keynesian liquidity trap. 23-44 Monetary Policy (Cont.) Liquidity Trap (Figure 23.9) (Cont.) At these low rates, individuals expect interest rates to increase and consider holding bonds too risky Liquidity trap any increase in money supply will simply be held by the public (hoarding) and none of the increased liquidity would spill over to the bond market In this range of money demand, monetary policy is completely ineffective 23-45 15
Monetary Policy (Cont.) Wealth Effect It is possible that consumers may change their spending in response to variations in the interest rate Lowering of interest results in higher prices of bonds and consumers feel wealthier Based on this wealth effect, consumers will spend more, thereby causing the consumption function to shift upward 23-46 Monetary Policy (Cont.) Monetary Policy and International Trade (Exchange Rate Effect) Although exports and imports are small segments of U.S. economy, there is a large impact of monetary policy on GDP through net exports Effect of a change in money supply Decrease in money supply causes interest rates to rise This increase relative to interest rates in other countries will encourage foreigners to buy U.S. bonds to enjoy a higher return 23-47 Monetary Policy (Cont.) Monetary Policy and International Trade (Exchange Rate Effect) (Cont.) Effect of a change in money supply (Cont.) Purchase U.S. dollars with foreign exchange which drives up value of the dollar under a flexible exchange rate system A stronger dollar will discourage exports and encourage imports Net exports decline when domestic interest rates rise, driving down GDP This international exchange rate effect strengthens the efforts of the government to slow down economic activity 23-48 16
Monetary Policy (Cont.) Summary of the three effects Transmission mechanism of monetary policy Three components of monetary policy Cost of capital effect influences investment through the cost to businesses of raising capital Wealth effect operates through interest rates on consumer wealth which effects consumer spending Exchange rate effect operates through interest rates and foreign exchange rate to effect net exports 23-49 Monetary Policy (Cont.) Transactions Demand and Monetary Policy (Figure 23.10) Keynes raised the idea of a speculative demand for money that is related to the rate of interest Increase in GDP leads to an increase in amount of money demanded--people need additional cash to carry out a higher level of transactions Changes in the liquidity preference will cause equilibrium rate of interest to change increased liquidity would increase interest rates 23-50 FIGURE 23.10 A shift in the demand for money changes the interest rate. 23-51 17
Monetary Policy (Cont.) Transactions Demand and Monetary Policy (Figure 23.10) (Cont.) An increase in income This will cause a rightward shift of the demand curve Shift of money demand curve will increase interest rates However, actions by central bank to increase the supply of money might prevent an increase in interest rates A growing economy will need a balanced growth of money to prevent interest rates from rising 23-52 Monetary Policy (Cont.) Transactions Demand and Monetary Policy (Figure 23.10) (Cont.) The transaction demand for money is probably affected by the interest rate as well as by income higher interest rates will reduce the demand for transaction balances Greater use of credit cards reduces the demand for money, thereby lowering interest rates, permitting investment and GDP to increase 23-53 Monetary Policy (Cont.) Expectations and Monetary Policy It is generally assumed that expectations are exogenous determined outside the system Assuming the central bank makes changes in the money supply and these changes are totally unanticipated, monetary policy alters the interest rate according on the conditions just described 23-54 18
Monetary Policy (Cont.) Expectations and Monetary Policy (Cont.) However, if the actions of the Federal Reserve are completely anticipated, individuals will make portfolio adjustments before the Fed enacts the policy change The result is that the anticipated monetary policy change will alter interest rates before it is implemented 23-55 Aggregate Demand and Supply The Keynesian assumption of fixed prices changes the shape of the aggregate supply curve. Figure 23.11 displays the Keynesian aggregate supply curve which is different than that envisioned by the classical economists 23-56 FIGURE 23.11 Increase in aggregate demand raises real income or prices, depending on the shape of aggregate supply. 23-57 19
Aggregate Demand and Supply (Cont.) This aggregate supply curve is in two parts A horizontal segment which reflects the fact that prices do not increase when the economy is at less than full employment A vertical segment, which is the classical school s supply schedule, showing only prices increase after full employment output is reached If aggregate demand increases in the horizontal portion the result will be higher real output and lower unemployment at a constant price level 23-58 Aggregate Demand and Supply (Cont.) This was the range of the curve that Keynes was concerned with levels of employment well below the full employment level In this range, actions by the government to stimulate output will result in real changes to the economy If the economy is operating at or near full employment, actions by the government will result in upward pressure on prices inflation 23-59 Aggregate Demand and Supply (Cont.) Supply-side policies This is relevant in the full employment range of aggregate supply Since the productive capacity is determined by supply of labor, capital and technology, policies that increase these factors will increase potential real output 23-60 20
Aggregate Demand and Supply (Cont.) Supply-side policies (Cont.) The government does not directly control any of these, but tax policies can influence the willingness of households and business firms to supply labor and invest in capital According to supply-siders, the main consequence of reducing tax rates is increased production incentives which shifts the vertical portion of the aggregate supply curve to the right 23-61 21