Basic Keynesian Model Keynesian Cross Diagram

1. Basic KeynesianModel Keynesian Cross Diagram

2. Measuring the macroeconomy • GNPpm = GDP – factor incomesfromabroad + factor incomes of foreigners • NetNPpm = GNPpm - Depreciation • NNP at factor costs = Net NationalProduct – Net indirecttaxes + Subsidies (NNP=net nationalproduct at factor costs) • NI (NationalIncome) = NNPcf • Personal DispousableIncome (PDI = Familyincome = NI – Directtaxes + Transfers - Profits + Undistributedprofits • Personal DisposableIncome (PDI = Familyincome )= ConsumptionSpending+ Savings • Consumerpriceindex: the CPI measuresthepriceincrease of a merketbasketfogoodsrepresentative of thepurchases of a typicalhousehold • TheUnemploymentrate: Theunemployed are peoplewhowanttowork and are activelylookingforjobsbuthavenotyetfoundone. Theunemploymentrateisequaltothenumber of unemployedpeopledividedbythe total labor force.

3. Macroeconomic model

4. Key concepts • GDP composition • The demand of goods and services • The equilibrium

5. Intendedexpenditureoraggregatedemandcomponents

6. EXPENDITURE (FLOW OF EXPENDITURE) MARKET GOODS & SERVICES MONETARY FLOW HOUSEHOLDS FIRMS (CONSUMPTION) (PRODUCTION) MERCADO DE FACTORES DE PRODUCCION INCOMES –WAGES ((FLOW OF INCOMES) REAL FLOW FACTORS The circular flow of economicactivity GOODS AND SERVICES Demand varies, production Production varies, income varies Income varies, demand varies

7. National income identity • Production is equal to income. Then: • 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

8. Short-run macroeconomic models • 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)

9. Keynesian model: assumptions • 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

10. Keynesian model • 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.

11. Keynesian model • Equations: • Susbtracting (7) - (8), s:

12. Keynesian model • Ecuaciones del modelo: • Substituting (4) in (3)

13. Modelo Keynesiano básico IV • 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)

14. Keynesian model • Equations are now: • Substituting (11) into (1) :

15. Keynesian model • 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:

16. Modelo Keynesiano básico VII • 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

17. Check • By using the last equation • we can check that

18. Types of changes in theexogenous variables • Exogenous variables in themodel can besplittedintotwogroups: a) variables dependingontheindividual’sdecisions: (c, I, m); variables determinedbyauthorities (Governmentor 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. • Sincechanges in G, TR y t, will lead changes in budget surplus, they are defined as fiscal policyinstruments. • Changes in tariffsor in theexchangerate in ordertochangeNXo, are tradepolicyinstruments.

19. Expansionary vs. Contractionarypolicies • 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 contractionary • A decreaase in the marginal propensity to consume (NO policy)

20. El modelo gráficamente (I) Eje de abscisas: mide la renta, (Y) Renta,Y

21. The model HORIZONTAL AXIS: INCOME (Y) VERTICAL AXIS: DEMAND(AD) Demand (AD), Production (Y) Renta,Y

22. 45º LINE: EQUILIBRIUM CONDITION Y=DA 45o LINE Y=AD Demand (AD), Production (Y) SLOPE= 1 Y1 INCOME,Y Y1

23. THE INTENDED EXPENDITURE OR AD 45o LINE AD AD SLOPE AD=c(1-t)-m Ao Y

24. THE EQUILIBRIUM AD 45o LINE AD E EQUILIBRIUM: Y = DA AUTONOMOUS SPENDING Y

25. AD1=A1+(c(1-t)-m)Y E’ Y1 E Yo 45º Yo Y1 ¿HOW AN INCREASE IN NET EXPORT WOULD AFFECT THE EQUILIBRIUM INCOME? AD Y=AD ADo=Ao+(c(1-t)-m)Y A1 Ao INCOME,Y

26. HIGHLIGHTS • C and I will decrease in recessions • Howver, 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 crisis

27. Multiplier effect • 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.

28. Fiscal policy and Budget surplus How an increase in G would affect the budget deficit?

29. How an increase in G would affect the budget deficit? • Taking differences • The increase in income from the increase in government purchases is , dY=αdG then:

30. Extensions

31. AD1=A1+(c(1-t)-m)Y E’ Y1 Yo E 45º Yo Y1 An increase in the Government purchases AD Y=AD ADo=Ao+(c(1-t)-m)Y A1=C0+I0+G1+cTRo+NXo Ao=C0+I0+G0+cTRo+NXo Income,Y

32. AD1=A1+(c(1-t)-m)Y E’ Y1 Yo E 45º Yo Y1 An Increase in the Transfers AD Y=AD ADo=Ao+(c(1-t)-m)Y A1=C0+I0+G0+cTR1+NXo Ao=C0+I0+G0+cTRo+NXo INCOME,Y

33. AD0=Ao+(c(1-t)-m)Y E Yo 45º Y1 An increase in the tax rate AD Y=AD AD1=Ao+(c(1-t1)-m)Y Y1 E’ Ao=C0+I0+G0+cTRo+NXo Income,Y Yo