The Keynesian Model

1. The Keynesian Model the multiplier, the paradox of thrift, savings and investment, fiscal policy, and the tax multiplier

2. multiplier – algebra of the model A simple Keynesian model of the economy with no government or foreign trade can be represented as: Y = C + I (1) where Y is equilibrium output (income), C is aggregate consumption, and I is aggregate investment. Aggregate consumption, or total expenditure by households on final goods and services, is determined by autonomous consumption (a), or the rate of consumer expenditure independent of disposable income, and the marginal propensity to consume (b = mpc), which is the part of each additional dollar of disposable income that is spent on consumption. Thus, the consumption function is: C = a + bY (2)

3. No government, so Y = Yd • Note that since there is no government, taxes are zero, so Y = Yd, since: Yd = Y – T Yd = Y – 0 Yd = Y Thus while the consumption function is usually C = a + bYd, here it will simply be: C = a + bY

4. Investment • Investment is determined by a complex of factors such as expectations of investors and lending institutions, business confidence, political climate, and so on. For present purposes, what is important is that investment is autonomous—that is, independent—of income. It is also not a simple function of the rate of interest, as in neoclassical loanable funds theory.

5. solving the equation Y = C + I (1) C = a + bY (2) • Substituting equation (2) into equation (1), i.e., replace C with a + bY, we get: • Y = a + bY + I (3) • Subtracting bY from both sides: • Y - bY = a + I (4)

6. Solving for Y Y - bY = a + I (4) • Factoring out the Y from the left hand side of equation (4) • Y (1 - b) = a + I (5) • Dividing both sides by (1 - b): • Ye = 1 (a + I) (6) (1-b)

7. the multiplier Ye = 1 (a + I) (1-b) where 1/(1-b)—or 1 divided by the mps—is the multiplier, or the feedback mechanism that amplifies any initial increase (injection) or decrease (withdrawal) in aggregate demand. Therefore, Ye, the equilibrium level of output (income) is determined by the multiplier and total injections. The total injections in this simple model are a + I.

8. Keynesian model - numerical example Given: Y = C + I C = a + bY Where: a = 100 b = .75 I = 300

9. Solving for Ye • Y = 100 + .75Y + 300 • Y - .75Y = 100 + 300 • Y (1 - .75) = 100 + 300 • Y (.25) = 100 + 300 • Y = (1/.25) x 400 • Y = 4 x 400 • Ye = $1600 billion

10. solving for equilibrium consumption and savings • Once we have Ye, we can find Ce and Se: • Ce = a + bYe • Ce = 100 + .75 (1600) • Ce = 100 + 1200 = 1300 • Se = -a + (1 - b)Ye • Se = -100 + (1 - .75) 1600 • Se = -100 + .25 (1600) = 300

11. double-checking savings • Also: Ye = Ce + Se Ye – Ce = Se 1600 – 1300 = 300 • Also: Se = I (savings = investment at equilibrium) 300 = 300

12. Keynesian Model 45° Expenditure AS = C + I C = 100 + .75Y a + I S = - 100 + (1 – .75) Y a I = 300 I 0 Y Y1 Y* - a 1600 400

13. the recessionary gap • Assume that this economy, if producing at full employment, given resources and technology, could produce an aggregate output of $2000. • We can now calculate the values of consumption and savings at full employment, as well as aggregate spneding at full employment, and the recessionary gap.

14. full employment and the recessionary gap Cf = a + bYf = 100 + .75 (2000) = $1600 Sf = -a + (1 - b)Yf = -100 + .25 (2000) = 400 (double-check: Yf – Cf = Sf = 2000 – 1600 = 400) AS@Yf = Cf + I = 1600 + 300 = 1900 gap = Yf – AS@Yf = (2000 – 1900) = 100 = = (Sf – I) = (400 – 300) = = (Yf – Ye)/multiplier = (2000 – 1600)/4 = 100

15. Keynesian Model 45° Expenditure AS = C + I C = a + bY a + I S = - a + (1 – b) Y a I I 0 Y Y1 Y* Yf - a 1600 2000

16. the paradox of thrift • An attempt by the economy as a whole to increase aggregate savings not only will not succeed, but may lower aggregate output, income and employment. This is because increased savings at a given level of aggregate income will mean decreased consumption. Thus a smaller marginal propensity to consume will reduce the stimulative effects of investment and other spending.

17. paradox of thrift • For example, suppose an economy is characterized by a consumption function: • C = $100 + .8Yd • If autonomous investment is equal to $300 billion then the equilibrium level of output and income is • Ye = 5 (100 + 300) = $2000 billion • because the multiplier = 1/(1 – b) = 1/(1 - .8) = 5.

18. paradox of thrift • Aggregate consumption is: • C = $100 + .8 ($2000) = $1700 billion • and aggregate savings is: • S = -$100 + (1 - .8) ($2000) = $300 bil. • So aggregate savings equals aggregate investment ($300 billion).

19. paradox of thrift - example • Suppose some political and or business leaders come out and say we have to save more so the economy can grow. If people comply in such a way that the mps rises from .2 to .25, what will be the effect?

20. paradox of thrift The new consumption function will be: • C = $100 + .75Yd With $300 billion in investment, the new equilibrium will be: • Ye = 4 (100 + 300) = $1600 billion because the new multiplier = 1/(1 - .75) = 4. Aggregate consumption is now: • C = $100 + .75 ($1600) = $1300 billion and savings: • S = -$100 + (1 - .75) ($1600) = $300 billion

21. paradox of thrift • Thus, savings is still equal to investment at the same level of $300, but output and employment are much lower. • So the attempt by the economy as a whole to save more not only did not result in more savings, but actually lowered aggregate output and income by $400 billion.

22. paradox of thrift • This is the paradox of thrift, and is another example of the paradoxical nature of macroeconomics. It is rooted in the two-sided nature of spending and saving. When we just look at one individual firm or household in isolation, we don't see the impact that our actions have on other participants in the economy due to the interdependent nature of economic activity. So while for any one individual, it is wonderful to save more, for the economy as a whole, it could be a disaster.

23. paradox of thrift • If, however, the increased saving is the result of higher incomes, then that is a different story. If income goes up, consumption and saving both go up. But at a given level of income, increased aggregate savings can throw the economy into a recession. Therefore, a policy to increase growth by increasing savings has it backwards: savings will increase as a result of growth.

24. Keynes’s critique of the neoclassical theory of savings and investment 1. In Keynes, since consumption is a function of disposable income, and saving is income not spent, saving is also primarily a function of disposable income. S is a passive residual, determined by disposable income and the marginal propensity to consume. Keynes did not believe it was legitimate to hold income constant when analyzing aggregate saving, as in neoclassical theory. He also disagreed with the neoclassical belief that saving is primarily a function of the rate of interest.

25. Loanable Funds Market Interest Rate S (Savings) i* I (Investment) S, I 0 S = I

26. Keynes’s critique of the neoclassical theory of savings and investment 2. Historical experience of the Great Depression: • interest rates very low, no investment; • wages low, no labor demand; • how long is the long run?.

27. 3. S = I is the macroeconomic equilibrium condition in both Keynes and neoclassical, but in Keynes I => S through changes in Y and in neoclassical S => I through changes in i. In addition, in Keynes the two may be equal at a whole range of potential levels of output and income, only one of which is full employment, while in neoclassical the two may be equal only at full employment.

28. 4. Keynes did not believe it was legitimate to hold the state of investor expectations constant in analyzing aggregate investment, as in neoclassical theory. He also disagreed with the neoclassical view that investment is primarily a function of the rate of interest. Expected profitability of investors and lending institutions both required for investment to take place.

29. 5. Keynes distinguished between risk, which is calculable, and uncertainty, which is not conducive to statistical probability. He believed most important determinants of investment described by uncertainty, not risk. In neoclassical theory, uncertainty in this sense is not recognized. Also, even under risk, the confidence of whether one will ‘beat the odds’ is subject to unpredictable variation. Mass psychology subject to waves of optimism and pessimism.

30. 6. Business and political climate will influence investment decisions, as will many other factors, not all of which appear immediately relevant, at least on the surface.

31. 7. In a modern capitalist economy with high-tech financial institutions and advanced instruments of credit, a ‘pool’ of savings is not necessary to finance investment. Banks are private, profit-maximizing institutions and will not pass up the chance to make profits if they believe a loan will be profitable. They will always make a loan and worry about reserve requirements at the end of the day (often borrowing themselves to meet their requirements).

32. 8. In Keynes, the rate of interest is not determined by savings and investment, but by the supply and demand for money. This is Keynes’s liquidity preference theory (more on this later).

33. 9. Separation of ownership and management means those who own do not necessarily know the business well, and those who manage may have different interests and incentives than if they also owned. Makes investment more unstable.

34. 10. Speed of asset revaluation increasingly faster and faster. Assets are revalued within the space of seconds, and ability to react immediately, without having to wait to see if a change is a temporary deviation, creates instability. Self-fulfilling prophecies become a characteristic of the system (for example, people think an asset’s value is going to go down, so they sell and because people sell, the value goes down).

35. fiscal policy for full employment: eliminating a recessionary gap • Keynes’s demonstration of the possibility of the economy being in macroequilibrium, with S = I, below full employment provides a theoretical justification for more interventionist policies by the government. • Fiscal policy: the attempt to affect macroeconomic variables (such as C, I, Y) through government spending and tax policies.

36. Increasing G • If Yf = $2000 billion and Ye is $1600, how much does the government have to increase spending to push the economy to Yf?

37. Increasing G • If Yf = $2000 billion and Ye is $1600, how much does the government have to increase spending to push the economy to Yf? Not $400.

38. Increasing G • If Yf = $2000 billion and Ye is $1600, how much does the government have to increase spending to push the economy to Yf? Not $400. If G increased by $400 then: Y = C + I + G C = a + bY

39. Increasing G • If Yf = $2000 billion and Ye is $1600, how much does the government have to increase spending to push the economy to Yf? Not $400. If G increased by $400 then: Y = C + I + G C = a + bY Ye = 1/(1 - .75) * 100 + 300 + 400 = 4 (800) = $3200 Way past Yf—impossible, so inflation will occur. What happened?

40. closing the recessionary gap • The government spending of 400, like all other autonomous expenditures, had a multiplier effect, in this case of 4, and so increased total output and income not by 400 but by 1600. • How much do we need to increase G by to just get the economy to full employment? • By the size of the gap, or the amount we need to increase total spending (Yf – Ye) divided by 4. • gap = Yf – AS@Yf = Sf – I = (Yf – Ye)/mult. = 100

41. Keynesian Model 45° C + I + G Expenditure AS = C + I C a + I + G a + I S = - a + (1 – b) Y I + G I + G a I I 0 Y Y1 Y* Yf - a

42. full employment • Notice that at Yf, S = I + G; (I + G can be thought of as private and public investment) • Notice the aggregate spending function with government (still no foreign trade), or the C + I + G line: • has a y-intercept of (a + I + G); • has a slope = mpc; and • intersects the 45 degree line at Yf

43. Keynesian Model 45° C + I + G Expenditure AS = C + I C a + I + G a + I S = - a + (1 – b) Y I + G I + G a I I 0 Y Y1 Y* Yf - a

44. Multiplier with Taxes • Let's add taxes and government spending into the multiplier formula! First, we begin with: • Y = C + I + G (1)  Then we take our consumption function: • C = a + bYd (2)  Only now we have to account for the fact that Y and Yd are not equal • Yd = Y - T (3)

45. Multiplier with Taxes • Yd = Y - T (3) because disposable income is aggregate income less taxes. Since taxes can be determined by the tax rate times aggregate income: • T = tY (4) Then: • Yd = Y - tY (5)

46. Multiplier with Taxes Substituting equation (5) into the consumption function: • C = a + b(Y - tY) (6) And substituting equation (6) into equation (1): • Y = a + b(Y - tY) + I + G (7)

47. Y = a + b(Y - tY) + I + G (7) We then solve for Y:  • Y = a + bY - btY + I + G (8) • Y - bY + btY = a + I + G (9) • Y(1 - b + bt) = a + I + G (10)

48. Y(1 - b + bt) = a + I + G (10) • Y = 1 * (a + I + G) (11) 1- b + bt So the multiplier with taxes is: • 1/(1 - b + bt) (12)  And the multiplier times total injections (a + I + G) will give us the equilibrium level of output and income.

49. Multiplier with taxes – numerical example • Given: C = $100 + .8Yd I = $50 G = $350 t = .25 • Find: Ye, value of mult., T, Yd, C, & S Does S = I? Why or Why Not?

50. Multiplier with taxes – numerical example Ye = 1/(1-b+b[t]) (a + I + G ) = 1/.4 (100 + 50 + 350) = 2.5 (500) = 1250