INTRODUCTORY

MACROECONOMICS
ECON10003
LECTURE 6: THE KEYNESIAN MODEL OF THE ECONOMY I

DR. JONATHAN THONG

MR. DANIEL MINUTILLO
THIS LECTURE
• Keynesian macroeconomics, part one

• Determinants of aggregate expenditure

• Role of government expenditure

• Keynesian cross diagram

• BOFAH chapter 7
RECALL THE BIG DEBATE
• Classical (pre-1930s) business cycle theory - key idea: ‘supply creates its own demand ’

• not possible to have economy-wide lack of demand as prices will adjust quickly to clear the
market.
• business cycles driven by fluctuations in aggregate supply (e.g., productivity shocks such as
technological advances)
• key policy conclusion: markets operate well, interventions counter-productive

• Keynesian business cycle theory – key idea: market clearing need not prevail at macro level

• can have economy-wide market failure due to lack of demand as prices do not adjust quickly.
• business cycles driven by fluctuations in aggregate demand (e.g., confidence, ‘animal spirits ’ of
investors)
• key policy conclusion: interventions can stabilise business cycle fluctuations by stabilising
aggregate demand
KEYNESIAN THEORY: MAIN ELEMENTS
• Key assumptions

– prices and wages do not fully adjust in short run (‘sticky prices ’)

• Key contributions

– output can be demand-determined

– importance of expectations, confidence, ‘animal spirits ’

• Key implications

– recessions can be fought by policies that stimulate demand

KEYNESIAN THEORY: QUESTIONS
• Why don’t prices and wages adjust to clear markets?

– are prices really more difficult to adjust than quantities?

• What determines expectations? Why are expectations so volatile?

• What policy settings best manage fluctuations in demand?

– fiscal policy? monetary policy?

– automatic stabilisers vs discretionary stimulus?
– decision lags vs implementation lags?
KEYNESIAN MODEL OF AGGREGATE
EXPENDITURE
• Simple closed economy version

• Let 𝑃𝐴𝐸 denote planned aggregate expenditure

𝑃𝐴𝐸 = 𝐶 + 𝐼 + 𝐺

• We can think of 𝑃𝐴𝐸 as the value of all goods and services created for
sale at a given interval of time (i.e., a quarter, or a year).
PLANNED CONSUMPTION
• Key building block of Keynesian model

• Planned consumption is a linear function of disposable income

𝐶 = 𝐶̅ + 𝑐 𝑌 − 𝑇 , 0<𝑐<1
• Where
𝐶̅ = 𝑎𝑢𝑡𝑜𝑛𝑜𝑚𝑜𝑢𝑠 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛
𝑐 = 𝑚𝑎𝑟𝑔𝑖𝑛𝑎𝑙 𝑝𝑟𝑜𝑝𝑒𝑛𝑠𝑖𝑡𝑦 𝑡𝑜 𝑐𝑜𝑛𝑠𝑢𝑚𝑒
𝑌 = 𝑎𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑖𝑛𝑐𝑜𝑚𝑒
𝑇 = 𝑎𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑡𝑎𝑥𝑒𝑠

• Planned consumption increases with disposable income, but less than one-for-one.
PLANNED CONSUMPTION
INVESTMENT
• Planned investment is assumed to be exogenous

𝐼 = 𝐼̅

• We assume this for now to keep things simple

• Key is that there is some component of investment that is independent of income 𝑌,

independent of interest rates, etc.

• We can think of exogenous changes in consumption and investment as ‘animal spirits’

(i.e., changes in mood, sentiment or confidence can induce firms and households to
change their consumption and investment expenditures regardless of what is happening
to their income)
GOVERNMENT
• Government purchases and taxa2on is also assumed to be exogenous

𝐺 = 𝐺̅

𝑇 = 𝑇%

• Government runs a surplus if 𝐺̅ < 𝑇%

• Government runs a deficit if 𝐺̅ > 𝑇%

• For now, we will ignore interest payments on pre-exis2ng debt.

KEYNESIAN EQUILIBRIUM CONDITION
• We now look for an equilibrium where planned aggregate expenditure 𝑃𝐴𝐸
equals actual aggregate expenditure (𝐴𝐸)

𝑃𝐴𝐸 = 𝐴𝐸 = 𝑌
• This will determine a parNcular level of 𝑌 that we refer to as the Keynesian
equilibrium level of 𝑌

- 𝑷𝑨𝑬 < 𝑨𝑬, surprisingly low demand, unplanned inventory accumulaNon.

- 𝑷𝑨𝑬 > 𝑨𝑬, surprisingly high demand, unplanned inventory draw down.

• When 𝑃𝐴𝐸 = 𝐴𝐸, planned and actual expenditure are consistent.

KEYNESIAN EQUILIBRIUM
• To find this Keynesian equilibrium level of 𝑌, we use the equilibrium
condition 𝑃𝐴𝐸 = 𝐴𝐸 = 𝑌 to write

𝐶̅ + 𝑐 𝑌 − 𝑇- + 𝐼 ̅ + 𝐺̅ = 𝑌

• This is a one equation to be solved for one unknown, 𝑌.

• We can depict the solution visually using what is known as the

Keynesian cross.
KEYNESIAN EQUILIBRIUM

The 45-degree line

represents the condition
When planned expenditures
exceed aggregate output, that 𝐴𝐸 = 𝑌
firms will be induced to
produce more.

When aggregate output

exceed planned
expenditures, firms will
experience an increase in
inventories and will respond
by producing less.
KEYNESIAN EQUILIBRIUM
• Key idea here is that economy can get stuck at an equilibrium level of output below
potenGal output

– hence stuck with high unemployment, via Okun’s Law

• In this equilibrium, planned and actual expenditure consistent

– no self-correcGng tendency for output to change

• Keynes viewed this as an explanaGon for persistently high unemployment during the
Great Depression
 KEYNESIAN EQUILIBRIUM
In 1929, the US stock market crashed
(“The Great Crash, Black Tuesday”),
leading to a collapse in consumer and
business confidence.

Households and firms sharply

curtailed their planned consumption
and investment expenditures leading
to a large downward shift in the PAE
curve.

Unemployment rose dramatically and

prices fell, creating a contractionary
spiral.
WHAT CAN BE DONE?
• How can we bring output back to potential? Having a lot of people
unemployed is really bad!

• One idea is to use fiscal policy (e.g., increasing 𝐺̅ or decreasing 𝑇)

-

• Need to solve for the equilibrium 𝑌, and see how 𝑌 depends on 𝐺̅ and
𝑇-
SOLVE FOR 𝑌
• Write 𝑃𝐴𝐸 = 𝐴𝐸 condiXon in terms of 𝑌

𝑌 = 𝐶̅ + 𝑐 𝑌 − 𝑇+ + 𝐼 ̅ + 𝐺̅

• Bring 𝑐𝑌 to the LHS of the equaXon and collect terms

1 − 𝑐 𝑌 = 𝐶̅ − 𝑐 𝑇+ + 𝐼 ̅ + 𝐺̅

• Divide both side by 1 − 𝑐 to obtain

1
𝑌= 𝐶̅ − 𝑐 𝑇+ + 𝐼 ̅ + 𝐺̅
1−𝑐

• Can now see how 𝑌 depends on 𝐺̅ and 𝑇+

HOW 𝑌 DEPENDS ON 𝐺̅ and 𝑇$
• Fiscal policy effects

– increase in autonomous government spending 𝐺̅ increases 𝑌

– increase in autonomous taxaGon 𝑇> decreases 𝑌

• Other shiOs in demand

– increase in autonomous consumpGon C ̄ increases Y

– increase in autonomous investment I ̄ increases Y

• What are the sizes of these effects?

THE GOVERNMENT SPENDING MULTIPLIER
• Take the derivative of 𝑌 with respect to 𝐺̅

𝑑𝑌 1
= >1 𝑠𝑖𝑛𝑐𝑒 0 < 𝑐 < 1
̅
𝑑𝐺 1 − 𝑐

• An increase in 𝐺̅ increases 𝑌 by more than one for one.

• This is known as the multiplier effect.

• Therefore, if 𝑐 = 0.2 and 𝐺̅ increases by $20 billion, then 𝑌 increases by

1 1
𝑑𝑌 = ̅
𝑑𝐺 = ×$20𝑏 = 1.25×$20𝑏 = $25𝑏
1−𝑐 1 − 0.2
INCREASES IN GOVERNMENT SPENDING
GOVERNMENT SPENDING MULTIPLIER
• Intuition for multiplier effect:

• Increase in government expenditure has direct effect on income.

• Part of this increase in income is itself consumed, which leads to further

indirect effect on income

• Total effect is greater than direct effect. How much more depends on how
much of income is consumed.
GOVERNMENT SPENDING MULTIPLIER
• Mathematically:

• $1 increase in 𝐺̅ has a $1 direct effect on 𝑌

• This $1 increase in 𝑌 increases consumption 𝐶 by $𝑐 which adds further to the increase in 𝑌

• That $𝑐 increase in 𝑌 further increases consumption 𝐶 by $𝑐×𝑐 which adds further to the
increase in 𝑌

• The direct effect plus all the indirect effects amounts to a geometric sum,

1
1+𝑐+ 𝑐! + 𝑐" +⋯=
1−𝑐
BALANCED-BUDGET MULTIPLIER
• Suppose we finance an increase in government spending 𝐺̅ with an increase in taxes 𝑇9 so as to
keep the budget deficit/surplus unchanged.

• Total effect on output

1 𝑐
𝑑𝑌 = ̅
𝑑𝐺 − 𝑑 𝑇9
1−𝑐 1−𝑐

• If new spending is fully paid for, 𝑑 𝐺̅ = 𝑑 𝑇9

1 𝑐
𝑑𝑌 = ̅
𝑑𝐺 − 𝑑 𝐺̅ = 𝑑 𝐺̅
1−𝑐 1−𝑐

• In this case, this will lead to a simple one for one increase in Y. This indirect effects will be undone
by the increase in taxation to fund increase in spending.
NEXT LECTURE

• Keynesian macroeconomics, part two

– savings and investment

– paradox of thrift

– more on taxes

• BOFAH chapter 7