Economic Analysis for Business

Economic Analysis for Business Chapter 12 The Basic Keynesian Macroeconomic Model

Aim in studying macroeconomics • what causes the level of output to deviate from its highest potential level • attempts to explain why unemployment exists • attempts to explain why inflation occurs • makes a stab at explaining economic growth

Keynesian theory – WARNING • Keynesian economic theory is bad for your economic health • Where applied, will lead to poor economic outcomes, low rates of economic growth, high rates of unemployment and a subdued standard of living which improves only slowly if it improves at all • There is no example in the history of economics where a Keynesian policy was applied that led to a successful return to full employment and strong rates of economic growth

Keynesian economics is modern macro • Keynesian economics is nevertheless the standard approach to macroeconomics found in virtually every introductory text in economics and is taught in virtually every introductory economic course • Even taught here, but in this course it also comes with a warning

Keynesian economics based on aggregate demand • Following Keynes, the single most important element in macroeconomic analysis is aggregate demand • In macroeconomics, the driving force behind the level of activity, and therefore the rate of unemployment, is the level of demand in an economy for everything that the economy produces

Classification of Aggregate Demand C = consumption – the purchasers of the end products of the production process I= investment – purchases of assets to be used in the production process G = governments – purchases made by the public sector X = exports – purchases made by buyers overseas From which is deducted: M = imports – local purchases of overseas produced goods and services

Macro’s fundamental equation • The total level of domestically produced goods and services: Y = C + I + G + (X – M)

Circular flow of income • to understand the nature of the relationship between the elements of an economy • it shows the flow of real factors of production in one direction and the flow of goods and services in the other • very abstract but gets to the core issues

$ $ (2) Users of Factors of Production (6) Inv $$$ $s (4) C $s (3) Factor payments – profit, rent, wages, interest Factors – entrepreneurs, land, labour, capital Financial Institutions (5) Sav $$$ (1) Owners of Factors of Production $ $ Diagram of circular flow Basic Keynesian Model of 1936

Interpreting the circular flow – the flow of G&S • Start with the “owners” of the factors of production 2) These factors of production are: entrepreneurial talent, land, labour and capital used to produce goods and services

Circular flow of income – the flow of money 3) in return for the use of the various factors, payments are made eg, profits, rent, wages and interest, etc 4) money spent on consumption goes straight back into the revenue stream of businesses 5) some of the money received, however, is saved and goes to financial institutions 6) money borrowed from financial institutions is used for investment purposes

The Keynesian issue • The level of investment spending leaving such financial institutions must be as large as the savings that have come in • If not, the level of business receipts, (4) plus (6), will be smaller than the level of incomes paid out (3)

Understanding Keynes • the circular flow diagram presents a simplified means of comparing Keynesian and the classical models • the Keynesian version is that there are serious impediments caused by the different saving and investment decisions that prevent the circle from being closed • in the classical model, this is never the problem when recessions occur

Core difference between Keynes and the classics • in the classical model, saving and investment would be equilibrated by adjustments to the rate of interest • interest rate determination was based on the supply and demand for saving • no financial institution could pay a positive interest rate return without lending those funds to others at an even higher rate of return • there was therefore a certainty that all savings would be put to work and none would remain uninvested

Rate of Interest S i D Q (saving) Q Supply and demand for savings Savings never go to waste in the classical model

The central difference • Where does the adjustment occur? • in the classical model, interest rates would adjust until S=I • in the Keynesian model, the entire economy (Y) would adjust until S=I

Demand deficiency • in the classical model there would therefore be no unemployment due to demand deficiency while in the Keynesian model there often was • in the classical model there were a large number of reasons that an economy might go into unemployment, but demand deficiency was never one of them • in the Keynesian model, all other reasons for recession were ignored, with only demand deficiency being admitted as a cause

Bringing in government • to the previous circular flow diagram is now added the government sector which involves • taxes (T) on the revenue side • and government spending (G) on the outlays side

$ $ Users of Factors of Production I G $s C $s Factor payments – profit, rent, wages, interest Factors – entrepreneurs, land, labour,capital Financial Institution& Markets Government S T Owners of Factors of Production $ $ Circular flow with government Adding G and T

Government spending • incomes received spent on consumption goods (C), used as savings (S) or paid to governments as taxes (T) • for businesses, revenues can now come as spending on consumer goods and services (C), investment (I) or as government spending (G) • in the Keynesian framework, the answer to oversaving is to increase public spending to make up the difference • In equilibrium: I+G = S+T

International trade – imports • final addition required is the introduction of the international sector • not all income earned flows back into domestic firms • imports (M) disappear from the domestic spending stream • total use of the funds received: C+S+T+M

International trade – exports • some of the demand for domestic production comes from the international sector • exports (X) add to domestic aggregate demand • AD now totals: C+I+G+X

$ $ Users of Factors of Production $s C $s I G X Factor payments – profit, rent, wages, interest Factors – entrepreneurs, land, labour,capital Financial Institutions & Markets ons Government International S T M Owners of Factors of Production $ $ Circular flow with international sector The full model

Equilibrium • total spending in equilibrium, C+I+G+X is equal to total uses made of incomes, C+S+T+M • if one drops C from both sides, it can be seen that the equilibrium condition is where injections equal leakages: I + G + X = S + T + M • the top half of the flow on the diagram equals the bottom half

Leakages always equal to injections • what happens when the two sides of the leakages-injections equation are not equal? • in fact, they are always equal

Inventory adjusts to maintain equality • the level of investment is divided into intended and unintended investment • unsold goods remain as part of inventories • classified as unintended inventory accumulation • equilibrium occurs when the actual level of investment at the end of a period is equal to the investment that had been intended when the period began RMIT University

The basic Keynesian equation • Start with a cut down version of an economy where there are only consumers and investors, C and I • Aggregate demand for GDP (Y) is the total of consumer and investment demand Y = C + I

Income and saving • GDP, which is also national income, can either be used for consumption (C) or saving (S) • So we have another basic equation: Y = C + S

Saving equals investment • In equilibrium: I = S • the economy comes to its resting point when the level of investment equals the level of saving • importantly, the labour market has no influence on the level of economic activity • Saving and investment come to an equilibrium and the unemployment rate is whatever it is

Basic Keynesian diagram • assumes • investment is a particular amount at all levels of income • the level of saving rises with the level of income • investment could rise with income but does not affect the basic point of the analysis

I, S S I 0 Y Ye Equilibrium occurs where saving and investment are equal At equilibrium I = S

Basic framework • income is shown on the horizontal axis and the level of saving and investment are shown in the vertical axis • investment is constant at all levels of income • saving increases as income increases • equilibrium occurs where investment and saving are equal

Movement to equilibrium • if Y is below Ye, and investment is greater than saving, then the economy will expand up to Ye • if saving is greater than investment, so that not everything produced gets bought, the economy contracts until it reaches Ye • once at Ye, nothing shifts

45-degree line • same sort of equilibrium can be shown from the expenditure side although it is slightly more complicated to understand • basis of the diagram is the 45-degree line which comes half way between the vertical and horizontal axis • notable about the 45-degree line is that everywhere along the 45-degree line, everything on the vertical axis is equal to whatever is on the horizontal axis

On 45º line AD = Y

Income and expenditure model • on the horizontal axis in the diagram below, is the level of output • on the vertical axis is the level of aggregate demand • in this simple example aggregate demand is comprised of Consumption and Investment

On the 45-degree line • along the 45-degree line the level of aggregate demand – made up of Consumption and Investment – is equal to the level of production • equilibrium occurs where aggregate demand is equal to the level of production which occurs somewhere along the 45-degree line

C, I C + I C + I C I 45° Y Ye Equilibrium where C and I equal Y Keynesian Cross Diagram

Consumption • C line shows the level of Consumption as income rises • upwards slope shows that as income goes up, the level of consumer demand goes up • Read vertically – if this is the level of national income, then this will be the level of consumption

Investment • I line shows the level of investment at each level of income • perfectly horizontal slope indicates that the level of investment does not change as income goes up • level of I is added to the level of C to find the total level of aggregate demand • this is shown by the C+I line

Equilibrium • where C+I crosses the 45-degree line the level of aggregate demand is equal to the level of production • if C+I is lower than Y, demand is lower than production • production must contract since not everything being produced is being bought • if, on the other hand, the level of aggregate demand is above the level of production, then the economy will expand until production and demand are the same • equilibrium occurs at Ye where the level of demand, represented here by C and I, is equal to the level of production

Essence of the Keynesian model • this is the essence of the Keynesian model as it was first formulated in the 1930s • the diagram not first drawn by Keynes, but by another very famous economist, Paul Samuelson • diagram first used in 1939, only three years after the General Theory was published

Employment Output Y2 Y1 Employment N1 N2 Production function Relationship between output and employment

Both diagrams together • the two graphical forms of equilibrium determination can be shown together • the equilibrium in the top diagram occurs where Y=C+I • in the bottom diagram equilibrium occurs where S=I • the two diagrams show exactly the same set of relationships but in different ways

Equilibrium Income Determination C, I C+I C Level of Investment I Y 0 S, I S I 0 Y Ye Yf Equilibrium Y= C+I I=S

Full employment and GDP • full employment level of output is the level of production that would employ all those who seek work • shown in the diagram at Yf • level of output required to reach full employment is higher than the equilibrium level of output • unless something can be done to raise output levels, the consequence will be a prolonged period of unemployment

Economic policy • economic policy, based on this model, has subsequently revolved around activities that will raise the level of output • In a Keynesian model this has meant raising the level of aggregate demand • counter-cyclical policy in recessions is based on raising aggregate demand

Saving in classical analysis • classical economists had argued that saving drives an economy forward • since it is saving that finances investment and therefore growth, an economy could not have too much saving • the greater the level of saving the faster the economy would expand

Saving in modern economic analysis • in modern economic theory demand rather than production is seen as the prime impetus for economic activity • saving, rather than being the feedstock for capital investment is instead a withdrawal from the spending stream • saving is seen to lower growth rather than increase it

Modern Example – RMIT edition of The Principles of Macroeconomics “The classical economists argued that saving was a national virtue. More saving would lead via lower interest rates to more investment and faster growth. Keynes was at pains to show the opposite. Saving, far from being a national virtue, could be a national vice…. “As people save more, they will spend less. Firms will thus produce less. There will thus be a multiplied fall in income…. “But this is not all. Far from the extra saving encouraging more investment, the lower consumption will discourage firms from investing. If investment falls, the aggregate expenditure line will shift downwards. There will then be a further multiplied fall in national income…. “[This phenomenon] had been recognised before Keynes…. But despite these early recognitions of the dangers of underconsumption, the belief that saving would increase the prosperity of the nation was central to classical economic thought.”

Economic Analysis for Business