Chapter 11 Basic Keynesian Model Expenditure and Tax Multipliers This chapter presents the basic Keynesian model and explains: how aggregate expenditure (C,I,G,X and M) is determined when the price level is fixed how real GDP (Y) is determined when the price level is fixed multipliers - the expenditure and tax multiplier the relationship between aggregate expenditure and aggregate demand NOTE: Fixed price level is a key assumption of the basic Keynesian model. We consider variable price level in the aggregate demand/ aggregate supply model presented later. Short-run with Fixed Prices The Keynesian model describes the economy in the short run - when prices are fixed (rigid, sticky). Because the overall price level is fixed - Aggregate expenditure (demand) determines real GDP. Basic Keynesian model is called the Aggregate Expenditure model. 1
Short-run with Fixed Prices Recall: In the long run: K, L and technology determine full employment potential GDP Chapter 6. The basic Keynesian model explains why the economy may not be at full employment potential in the short-run. Short-run with Fixed Prices From the definition of real GDP, the components of aggregate expenditure [C, I, G (X-M)] sum to real GDP. Real GDP = C + I + G + X M (definition, Ch. 4) Real GDP = Y = Aggregate output(ch. 6) AE = C + I + G + X M (definition) At equilibrium: Aggregate output (Y) is equal to Aggregate Expenditure (AE): Y = AE. Y = C + I + G + X M Short-run with Fixed Prices In this basic model, two of the components of aggregate expenditure, household consumption (C) and imports (M), are influenced by Y (real GDP). 2
Household Consumption Plans Household Consumption and Saving Plans, i.e., what households plan to do. Household consumption expenditure is influenced by many factors but the most direct one is disposable income. Disposable income is aggregate income Y, minus net taxes, T. Net taxes = taxes + transfer payments We denote disposable income as YD. Disposable income is YD = Y T. Household Consumption Plans Disposable income, YD, is either spent on consumption C, or saved, S. That is, YD = C + S. Y T = C + S Y = C +S +T The relationship between consumption expenditure and disposable income, other things remaining the same, is the consumption function. The relationship between saving and disposable income, other things remaining the same, is the saving function. All points on the 45 0 line represent points where C = YD. When consumption expenditure exceeds disposable income, saving is negative (dissaving). When consumption expenditure is less than disposable income, there is saving. 3
Quarterly U.S. Consumption (C) and Disposable Income (Y-T), 2000 2014 11000.0 10500.0 C = 453.95 +0.8713(Y-T) C 10000.0 R² = 0.9783 9500.0 9000.0 8500.0 8000.0 8500.0 9000.0 9500.0 10000.0 10500.0 11000.0 11500.0 12000.0 (Y-T) 11 Marginal Propensity to Consume and Marginal Propensity to Save MPC Figure 11.2(a) shows that the MPC is the slope of the consumption function. When disposable income increases by $2 trillion, consumption expenditure increases by $1.5 trillion. The MPC is 0.75. Look at the Table on Figure 11.1. 4
MPS MPS Figure 11.2(b) shows that the MPS is the slope of the saving function. When disposable income increases by $2 trillion, saving increases by $0.5 trillion. The MPS is 0.25. MPC + MPS = 1 Fixed Prices and Expenditure Plans Consumption as a of Y Disposable income changes when either real GDP (Y) changes or net taxes (T) change. If T does not change, Y is the only influence on disposable income, so consumption expenditure is a function of Y (real GDP). We can put Y (not Y-T) on the horizontal axis, holding T fixed. 5
The Consumption with Y on the horizontal axis. Real Consumption Spending ($ Billions) 6,000 5,000 4,000 3,000 Consumption 2,000 1,000 800 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Y (Real income,$ billions) 19 A change in T will cause the Consumption to Shift. Real Consumption Spending ($ Billions) 6,000 5,000 Consumption function when net taxes drop 4,000 3,000 2,000 1,700 1,000 800 Consumption A decrease in T is caused by a reduction in taxes or an increase in transfer payments. 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real income ($ billions) 20 Other factors that Shift the Consumption Wealth (W), which is accumulated household savings and investments Interest rates (r), which is the cost to borrow. Expectations about the future 21 6
Other factors that Shift the Consumption an increase in household wealth (W) a decrease in interest rates (r) households become more optimistic about the future ( ) Shift the consumption function upward 22 Upward Shift in the Consumption Real Consumption Spending ($ Billions) 6,000 5,000 W, r, T, 4,000 3,000 Consumption 2,000 1,000 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real income ($ billions) 23 Shift in the Consumption a decrease in household wealth (W) an increase in interest rates (r) household became more pessimistic about the future ( ) Shift the consumption function downward 24 7
Downward Shift in the Consumption Real Consumption Spending ($ Billions) 6,000 5,000 4,000 3,000 Consumption W, r, T, 2,000 1,000 1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000 Real income ($ billions) 25 Movement Along Versus a Shift 26 Import In the short run, U.S. imports are influenced primarily by U.S. real GDP. The marginal propensity to import (MPM) is the fraction of an increase in real GDP spent on imports. If an increase in real GDP of $1 trillion increases imports by $0.25 trillion, the marginal propensity to import is 0.25. 8
Putting the Model Together Planned aggregate expenditure is planned consumption expenditure (C) plus planned investment (I) plus planned government expenditure (G) plus planned exports (X) minus planned imports (M). Planned consumption expenditure (C) and planned imports (M) are influenced by real GDP (Y). Short-run Model: Real GDP with a Fixed Price Level We assume in this simple short-run model planned investment (I) and planned government expenditure (G) and planned exports (X) are not influenced by real GDP (Y). I, G, and X are autonomous. But, in the loanable funds model I depends on? Planned Aggregate Expenditure Real GDP with a Fixed Price Level The relationship between aggregate planned expenditure and real GDP can be described by an aggregate expenditure schedule, which lists the level of aggregate expenditure planned at each level of real GDP. The relationship is also called the aggregate expenditure curve, which is a graph of the aggregate expenditure schedule. 9
Planned Aggregate Expenditure Schedule MPC = 0.7 and MPM = 0.2 Trillions of $ Real GDP (Y) C I G X M AE A 0 0 2.5 3.5 2.0 0 8 B 5 3.5 2.5 3.5 2.0 1 10.5 C 14 9.8 2.5 3.5 2.0 2.8 15.0 D 15 10.5 2.5 3.5 2.0 3.0 15.5 E 16 11.2 2.5 3.5 2.0 3.2 16.0 F 17 11.9 2.5 3.5 2.0 3.4 16.5 Amount produced ---------- Planned ( desired ) spending ---------------------- Short-run Model: Real GDP with a Fixed Price Level Figure 11.3 shows how the aggregate expenditure curve (AE) is built from its components. Short-run Model: Real GDP with a Fixed Price Level Consumption expenditure (C) and imports (M), which change as a result of a change in Y (real GDP), are called induced expenditure. Investment, government expenditure, and exports, which do not vary with GDP, are called autonomous expenditure. Consumption expenditure (C) and imports (M) can have an autonomous component constant term. Autonomous components for C are W, T, interest rate (r) and expectations. 10
Real GDP with a Fixed Price Level Actual Expenditure, Planned Expenditure, and Real GDP Planned aggregate expenditure may differ from actual aggregate expenditure because firms may experience unplanned changes in inventories which is included as part of actual expenditure. <= Important! Key concept here is unplanned changes in inventories. The 45 o Line A 45 line = translator line It allows us to measure any horizontal distance as a vertical distance instead Using a 45 Line to Translate Distances Dollars 1. Using a 45 line... A Consumption 3. into an equal vertical distance (BA). SLOPE = BA = 1 OB 45 0 2. we can translate any horizontal distance (such as 0B)... B Dollars 11
Equilibrium: Equilibrium expenditure is the level of aggregate expenditure that occurs when aggregate planned expenditure equals real GDP. Real GDP is what is produced. Its measured along the horizontal axis and the 45 0 line. Equilibrium occurs at the point at which the AE curve crosses the 45 line in the upper graph. Equilibrium occurs when there are no unplanned changes in business inventories in part (b). Real GDP with a Fixed Price Level Convergence to Equilibrium From Below Equilibrium If aggregate planned expenditure exceeds real GDP (point B), there is an unplanned decrease in inventories. To restore inventories, firms hire workers and increase production. Firms adjust production quantity not price. Real GDP increases. Real GDP with a Fixed Price Level From Above Equilibrium If real GDP exceeds aggregate planned expenditure (point F), there is an unplanned increase in inventories. To reduce inventories, firms lay off workers and decrease production. Firms don t have a sale and lower prices. The cut production and real GDP decreases. 12
Real GDP with a Fixed Price Level Equilibrium If aggregate planned expenditure equals real GDP (the AE curve intersects the 45 line), there is no unplanned change in inventories. And firms maintain their current production. Real GDP remains constant. Equilibrium GDP Trillions of $ Real GDP(Y) Planned Aggregate Expenditure (AE) Unplanned Inventory Change A 13 14.5-1.5 B 14 15.0-1.0 C 15 15.5-0.5 D 16 16.0 0 E 17 16.5 5 F 18 17.0 1.0 Equilibrium GDP Trillions of $ Real GDP(Y) Planned Aggregate Expenditure (AE) Unplanned Inventory Change A 13 14.5-1.5 B 14 15.0-1.0 C 15 15.5-0.5 D 16 16.0 0 E 17 16.5 5 F 18 17.0 1.0 13