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    Keynesian Macroeconomics: Aggregate Demand and The Multiplier Effect

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    intizarbukhari
    - Keynesian economics focuses on aggregate demand and the multiplier effect, where an initial change in spending such as an increase in investment or government spending can have a larger effect on overall GDP through subsequent rounds of re-spending. - The multiplier captures how an initial $1 increase in spending leads to more than $1 increase in GDP when factoring in additional induced consumption. For example, a multiplier of 5 means $1 of new spending increases GDP by $5 total. - According to the Keynesian model presented, a $500 increase in investment, government spending, or net exports each increase GDP by $2,500 due to a multiplier of 5, while a $500 tax

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    Keynesian Macroeconomics: Aggregate Demand and The Multiplier Effect

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    intizarbukhari
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    - Keynesian economics focuses on aggregate demand and the multiplier effect, where an initial change in spending such as an increase in investment or government spending can have a larger effect on overall GDP through subsequent rounds of re-spending. - The multiplier captures how an initial $1 increase in spending leads to more than $1 increase in GDP when factoring in additional induced consumption. For example, a multiplier of 5 means $1 of new spending increases GDP by $5 total. - According to the Keynesian model presented, a $500 increase in investment, government spending, or net exports each increase GDP by $2,500 due to a multiplier of 5, while a $500 tax

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    - Keynesian economics focuses on aggregate demand and the multiplier effect, where an initial change in spending such as an increase in investment or government spending can have a larger effect on overall GDP through subsequent rounds of re-spending. - The multiplier captures how an initial $1 increase in spending leads to more than $1 increase in GDP when factoring in additional induced consumption. For example, a multiplier of 5 means $1 of new spending increases GDP by $5 total. - According to the Keynesian model presented, a $500 increase in investment, government spending, or net exports each increase GDP by $2,500 due to a multiplier of 5, while a $500 tax

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    26 views11 pages

    Keynesian Macroeconomics: Aggregate Demand and The Multiplier Effect

    Uploaded by

    intizarbukhari
    - Keynesian economics focuses on aggregate demand and the multiplier effect, where an initial change in spending such as an increase in investment or government spending can have a larger effect on overall GDP through subsequent rounds of re-spending. - The multiplier captures how an initial $1 increase in spending leads to more than $1 increase in GDP when factoring in additional induced consumption. For example, a multiplier of 5 means $1 of new spending increases GDP by $5 total. - According to the Keynesian model presented, a $500 increase in investment, government spending, or net exports each increase GDP by $2,500 due to a multiplier of 5, while a $500 tax

    Copyright:

    Attribution Non-Commercial (BY-NC)
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    of 11

    Keynesian Macroeconomics: Aggregate Demand

    and the Multiplier Effect

    • John Maynard Keynes, The General Theory of Employment, Interest and


    Money (1936)

    • Great Depression (1929-1938) shows possibility of underemployment


    equilibrium -- actual GDP had not been equal to potential for
    years.

    • The Keynesian model distinguishes:


    – Actual GDP -- what GDP happens to be right now
    – Potential GDP -- full employment GDP
    – Equilibrium GDP -- a level of GDP at which there are no forces
    tending to change the level of GDP.
    John Maynard Keynes, 1919 and 1945
    The Keynesian system: Planned and actual investment
    Investment has three components:
    • Plant and equipment -- drill presses, factory buildings, etc.
    • Residential investment -- new housing construction
    • Inventory investment -- Change in Business Inventories

    The first two are consciously planned (although plans can change, and
    typically do during a recession);
    inventory investment can be unplanned -- if a store fails to sell what it
    had expected to, it winds up with more inventory than it had expected.
    Stores with unplanned inventory investment will cut back on orders --
    resulting in reduced production at the factory, layoffs and recession.
    The Consumption Function: the key to Keynes
    Consumption depends on the level of DISPOSABLE INCOME
    (disposable personal income = income - taxes = Y - T)
    Some consumption is autonomous (= “independent” of DPI):
    it may depend on other factors such as wealth or stock
    values. (even at zero income, Bill Gates would consume something)
    The consumption function proposed by Keynes is:

    C = C0 + Cy ( Y - T)
    C0 = Autonomous consumption
    Cy = Marginal propensity to consume
    The marginal propensity to consume plays a central role in
    the Keynesian system. Keep your eye on the MPC in the following
    slides.
    Income (DPI = Disposable Personal Income) and
    Consumption
    (PCE = Personal Consumption Expenditures)
    (U.S., 1960.Q1 to 2001.Q3, data from FRED:
    Federal Reserve Economic Data
    Regression line:
    PCE = - 71.23 + 0.93 DPI
    The Keynesian model: National income identity and equilibrium
    The National income identity is:
    Y = C + I + G + NX
    The Keynesian equilibrium equation is:

    Y = C0 + Cy ( Y - T) + Ip + G + NX

    Notice that C has been replaced by the consumption function, and


    investment by planned investment.

    Given values for autonomous consumption = 300


    for the marginal propensity to consume = 0.8
    for planned investment = 1500
    and finally for G = 1200, T = 1000, and NX = 500
    the equation can be solved for Y.
    Keynesian equilbrium: Solution procedure
    Start with the equation in general form:

    Y = C0 + Cy ( Y - T) + Ip + G + NX
    Substitute in the given numbers:
    Y = 300 + 0.8 ( Y - 1000) + 1500 + 1200 + 500
    Collect all the constant terms:
    Y = 3500 + 0.8Y - 800
    Y = 2700 + 0.8Y
    Subtract 0.8 Y from both sides of the equation:

    0.2 Y = 2700
    Finally, multiply both sides by 1 / 0.2 = 5

    Y = 5 (2700) = 13, 500


    The Multiplier
    Rerun the previous exercise, raising planned investment by 500.
    Y = 300 + 0.8 ( Y - 1000) + 2000 + 1200 + 500
    Collect all the constant terms:
    Y = 4000 + 0.8Y - 800
    Y = 3200 + 0.8Y
    Subtract 0.8 Y from both sides of the equation:

    0.2 Y = 3200
    Finally, multiply both sides by 1 / 0.2 = 5
    Y = 5 (3200) = 16, 000
    GDP is UP BY 2,500, NOT up by only 500.
    Investment spending has a MULTIPLIER EFFECT of 5
    The Multiplier: Government Spending and Net Exports
    Instead of raising planned investment by 500, as on the last slide:
    • Raise Government Spending by 500
    • Raise Net Exports by 500
    • Cut taxes by 500

    What happens in each case?


    You should find that the increases in government spending and
    in investment raise income by 2,000 -- that the multiplier for
    investment, government spending and net exports is exactly the
    same.
    Hence the major policy proposals made by Keynes:
    -- raise government spending to expand the economy.
    -- ensure stability in the world trading system (IMF, WTO)
    The Tax Multiplier
    Tax cuts have a multiplier effect, but not the same effect as direct
    government spending. Reason: part of any tax cut is saved, not
    spent.Consider the tax cut of 500:

    Y = 300 + 0.8 ( Y - 500) + 1500 + 1200 + 500


    Collect all the constant terms:

    Y = 3500 + 0.8Y - 400 or Y = 3100 + 0.8Y


    Subtract 0.8 Y from both sides of the equation:
    0.2 Y = 3100
    Finally, multiply both sides by 1 / 0.2 = 5

    Y = 5 (3100) = 15, 500


    GDP is UP BY 2,000, NOT up by 2,500 as with investment.
    Tax cut has a MULTIPLIER EFFECT of 4.0 ( not 5.0 )

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