Basic Keynesian Basic Keynesian ModelModel

Keynesian Cross Keynesian Cross DiagramDiagram

Measuring the macroeconomy

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GNPpm = GDP – factor incomes from abroad + factor incomes of foreigners

NetNPpm = GNPpm - DepreciationNNP at factor costs = Net National Product – Net

indirect taxes + Subsidies (NNP=net national product at factor costs)

NI (National Income) = NNPcfPersonal Dispousable Income (PDI = Family income

= NI – Direct taxes + Transfers - Profits + Undistributed profits

Personal Disposable Income (PDI = Family income )= Consumption Spending + Savings

Consumer price index: the CPI measures the price increase of a merket basket fo goods representative of the purchases of a typical household

The Unemployment rate: The unemployed are people who want to work and are actively looking for jobs but have not yet found one. The unemployment rate is equal to the number of unemployed people divided by the total labor force.

Macroeconomic model

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Sectors Markets Functions Endogenous

variables

Policies

•Households

• Firms

• Government

• Foreign Sector

•Goods and

Services

•Financial

wealth:− Money.− Bonds.

•Trabajo

• C, I, G, X,Q,

T,S.

•L, M/P.

• Ls, Ld.

• Y (GDP)

• P (CPI)

• U

(Unemployment)

• er (Exchange

rates)

• r (Interest

rates)

• Demand side− Fiscal.− Monetary.− Trade and Exchange rates policies.

• Supply side:− Incomes.− Structural.

Key concepts

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GDP compositionThe demand of goods and servicesThe equilibrium

Intended expenditure or aggregate demand components

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C C C Cpriv

+ I + I + I + Cpub

+ G + G + G + Ipriv

= Internal + X + Ipub

+ X + X = Final + X

- Q -Q - Q - Q

GDP mp GDP mp GDP mp GDP mp

The circular flow of economic activity

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INCOMES –WAGES ((FLOW OF INCOMES)

MONETARY FLOW

REAL FLOW

HOUSEHOLDS(CONSUMPTION)

FIRMS(PRODUCTION)

EXPENDITURE (FLOW OF EXPENDITURE)

MARKET

GOODS &

SERVICES

MERCADO DE

FACTORES DE

PRODUCCION

FACTORS

GOODS AND SERVICES

Demand varies, production

Production varies, income varies

Income varies, demand varies

National income identity

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Production is equal to income. Then:

XNGISXNGICY

QXGICY

DAY

This last equation states that savings should be sufficient for financing the investment spending, the budget deficit and the trade deficit. In other words, increases in budget or trade deficits unless accompanied by an equal increase in savings will lead to the crowding out of investment

Short-run macroeconomic models

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Keynesian model (Endogenous variable: Income) Fixed prices Pure exchange economy. No money

IS-LM Model (Endogenous variables: income-interest rate) Fixed prices Monetary economy Open economy without capital flows

IS-LM with capital mobility (Mundell-Fleming) (Endogenous variables: Income-interest rates) Fixed prices Monetary economy Open economy with capital flows

Aggregate supply and demand model (Endogenous variables: Prices-Income). AS-AD diagram Sticky prices Monetary economy

Dynamic AS-AD model (endogenous variables: inflation rates and income)

Keynesian model: assumptions

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Government sector:

(0<t<1) Budget deficit (BS) is defined by the difference between taxes and the

sum of government purchases (G) and transfers (TR).

Open Economy: net export is a decreasing function of national income. The coefficient m, is the marginal propensity to import.

No money Fixed prices: no inflation nor deflation

t·YT

Income rate· tax Taxes

oo TR-G-t·YBS

m·Y-NN oXX

Keynesian model

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In this model a macroeconomic equilibrium is reached when actual ouput Y, is equal to intended spending. Hence, the level of the aggregate demand determines the income level.

AD Components Consumption spending (C), Investment spending (I), Government purchases, G, Investment spending, I. Therefore Y+Q-X is equal to:

and

Being X and Q, export and import, respectively.

DAYY

demand Aggregate or eExpenditur Income Production

income

GICX-QY

Q-XGICY

Keynesian model

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Equations:

Susbtracting (7) - (8), s:

mYQ Q (8)

*xYXX (7)

GG (6)

II (5)

TRtY-YY (4)

cYdCC (3)

Q-XGICAD (2)

DAY (1)

o

o

o

o

od

o

(9)mY*xYQoXoQXNXo

Keynesian model

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Ecuaciones del modelo:

Substituting (4) in (3)

mYQ Q (8)

*xYXX (7)

GG (6)

II (5)

TRtY-YY (4)

cYCC (3)

Q-XGICAD (2)

DAY (1)

o

o

o

o

od

o d

(10)cTRt)Yc(1CTRtYYcCC oooo

Modelo Keynesiano básico IV

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Eliminando las ecuaciones (3), (4), (7) y (8), que son sustituidas por las ecuaciones (9) y (10), las Ecuaciones del modelo son ahora:

Sustituyamos las ecuaciones (5), (6), (9) y (10) en (2)

mY-XN XN (10)

cTRt)Y-c(1CoC (9)

GG (6)

II (5)

Q-XGICDA (2)

DAY (1)

o

o

o

o

(11)mYXNGIcTRt)Yc(1CDA ooooo

Keynesian model

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Equations are now:

Substituting (11) into (1) :

mYXNGIcTRt)Yc(1CAD (11)

ADY (1)

ooooo

component eexpenditur autonomous

0oooo

multiplier

0oooo

0oooo

ooooo

XNGIcTRCmt)c(11

1Y

XNGIcTRCm)t)c(1Y(1

XNGIcTRCmYt)Yc(1Y

mYXNGIcTRt)Yc(1CY

Keynesian model

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In compact form:

¿Qué dice aquí? The equilibrium level of income is determined by the multiplier and by the

autonomous expenditure component. Any increase in autonomous spending or any increase in the multiplier will

change national income. Proof:

0

0

oo α·AY

A

component eexpenditur autonomous

XNGo

Io

cTRo

C

multiplier

mt)c(11

1Y

·00 Aα·AdY dd

Modelo Keynesiano básico VII

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dAo:

Interpretation Any change in autonomous consumption spending, autonomous investment

spending, marginal propensity to consume out of disposable personal income , ttransfers, government purchases or autonomous net export will increase autonomous spending .

On the other hand, any change in t, m or c will change the multiplier value

oooo dNXdGo

dIcdTRo

dcTRo

dCdA

22

2

2

mt)-c(1-1

dmdtct)dc(1

mt)-c(1-1

dmdtcd1tdcdc

mt)-c(1-1

dmt)cd(1t)dc(1d1

mt)-c(1-1

·1mt)-c(1-1dmt)-c(1-1d1α

d

Check

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By using the last equation we can check that

Y

t

m

c

YA

c

I

NXo

TRo

Go

Co

0

0

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Exogenous variables in the model can be splitted into two groups: a) variables depending on the individual’s decisions: (c, I, m); variables determined by authorities (Government or Central Bank):G, TR, XN, t. Changes in G, TR, XN and t are fiscal and trade policy variables. Changes in this variables are policy shocks.

Since changes in G, TR y t, will lead changes in budget surplus, they are defined as fiscal policy instruments.

Changes in tariffs or in the exchange rate in order to change NXo, are trade policy instruments.

Types of changes in the exogenous variables

Expansionary vs. Contractionary policies

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If as a result of any kind of policy shock income increases, this policy is expansionary. The so-called contractionary policies lead income decreases.

For instance, Increase in G : Fiscal policy expansionary A tax cut: Fiscal policy expansionary Decrease in TR: Fiscal policy contractionary A cut in tariffs: Trade policy contractionaryA decreaase in the marginal propensity to

consume (NO policy)

El modelo gráficamente (I)

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Renta,Y

Eje de abscisas:mide la renta, (Y)

The model

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Renta,Y

Dem

and

(A

D),

Pro

du

ctio

n (

Y)

HORIZONTAL AXIS:INCOME (Y)

VERTICAL AXIS:DEMAND(AD)

45º LINE: EQUILIBRIUM CONDITION Y=DA

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INCOME,Y

45o LINE

Y=AD

SLOPE= 1

Y1

Y1

Dem

and

(A

D),

Pro

du

ctio

n (

Y)

THE INTENDED EXPENDITURE OR AD

Pág.23Y

AD 45o LINE

AD

SLOPE AD=c(1-t)-m

m)Y-t)-(c(1AmYXNGIcTRt)Yc(1CDA0ooooo

o

numbernumber

AAD0YSi

:intercept

0mt)c(1dY

dAD

Ym)-t)-(c(1ADA0

Ao

THE EQUILIBRIUM

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AD 45o LINE

AD

AUTONOMOUS SPENDING

EQUILIBRIUM:Y = DA

E

¿HOW AN INCREASE IN NET EXPORT WOULD AFFECT THE EQUILIBRIUM INCOME?

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45º

AD1=A1+(c(1-t)-m)Y

INCOME,Y

Y=AD

Yo

EYo

Y1

Y1

E’

AD

ADo=Ao+(c(1-t)-m)Y

A1

Ao

HIGHLIGHTS

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C and I will decrease in recessionsHowver, Government could increase G

(government purchases):Government intervention vs. laissez faire-

laissez-passer.Key argument: multiplier effect.

From this model, what are the recipes for the crisisFrom this model, what are the recipes for the crisis

Multiplier effect

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For simplicity suppose that we are in a closed economy, and suppose that Government increases the government purchases.

The increase in government purchases by 1 euro changes intended spending by 1 euro and income in 1 euro. After tax, 1-t euros will be disposable for consumption . Therefore, the consumption spending will increase in c(1-t) euros, so the intended spending goes up and income will also increase in c(1-t).

This new increase in income, will lead a new increase in consumption spending of ….

The sum of the initial effects and the rest of induced effects determines that the multiplier will be higher than 1.

Fiscal policy and Budget surplus

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How an increase in G would affect the budget deficit?How an increase in G would affect the budget deficit?

oo TR-G-t·YSP

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Taking differences

The increase in income from the increase in government purchases is , dY=αdG then:

How an increase in G would affect the budget deficit?How an increase in G would affect the budget deficit?

oo dTR-dG-dY·tt·YdBS d

oo TR-G-t·YB S

0dGmt)-c(1-1

mt)-1)(1-(cdG

mt)-c(1-1

mt)-c(11-t

dG1mt)-c(1-1

tdG1αtdG-αdG·tdBS

ExtensionsExtensions

An increase in the Government purchases

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45º

AD1=A1+(c(1-t)-m)Y

Income,Y

Y=AD

Yo

EYo

Y1

Y1

E’

AD

ADo=Ao+(c(1-t)-m)Y

Ao=C0+I0+G0+cTRo+NXo

A1=C0+I0+G1+cTRo+NXo

An Increase in the Transfers

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45º

AD1=A1+(c(1-t)-m)Y

INCOME,Y

Y=AD

Yo

EYo

Y1

Y1

E’

AD

ADo=Ao+(c(1-t)-m)Y

Ao=C0+I0+G0+cTRo+NXo

A1=C0+I0+G0+cTR1+NXo

An increase in the tax rate

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45º

AD0=Ao+(c(1-t)-m)Y

Income,Y

Y=AD

Yo

E’Y1

Y1

Yo

E

AD

AD1=Ao+(c(1-t1)-m)Y

Ao=C0+I0+G0+cTRo+NXo