lectures 8 - 10 revised

7/31/2019 Lectures 8 - 10 Revised

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Pearson Education 2008

In the Short Run:The Keynesian Model

CHAPTER

25


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After studying this chapter you will be able to:

Explain how expenditure plans are determined whenthe price level is fixed

Explain how equilibrium real GDP is determined when

the price level is fixed Explain the expenditure multiplier when the price level

is fixed

Explain the relationship between aggregateexpenditure and aggregate demand and explain the

multiplier when the price level changes



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Fixed Prices and Expenditure Plans

Keynesian model describes the economy in the very short

run when prices are fixed.

Fixed prices have two implications for the economy as a

whole:

1 Because each firms price is fixed, the price levelisfixed.

2 Because demand determines the quantities that each

firm sells, aggregate demanddetermines the aggregatequantity of goods and services sold, which equals real

GDP.



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Keynesian Model

The idea that aggregate demand determines real GDP is

the basis of the Keynesian model.

The Keynesian model is a model of the economy thatdetermines real GDP in the very short run, when the price

level is fixed.



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Expenditure Plans

The components of aggregate expenditure sum to realGDP (which is also equal to AD as we have seen).

That is,

Y= C+ I+ G+ X M

Aggregate planned expenditure is equal to planned

consumption expenditure plus planned investment plusplanned government expenditure plus planned exports

minus planned imports.



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Consumption Function and Saving Function

Consumption expenditure is influenced by many factors

but the most direct one is disposable income.

Disposable income is aggregate income or real GDP, Y,minus net taxes, T.

Call disposable income YD.

The equation for disposable income is

YD = Y T



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Disposable income is either spent on consumption goods

and services, C, or saved, S.

That is,

YD = C + S.

The relationship between consumption expenditure anddisposable income, other things remaining the same, is

the consumption function C = f(YD)

The relationship between saving and disposable income,other things remaining the same, is the

saving function S = f(YD)



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Fixed Prices and

Expenditure Plans

When consumption

expenditure exceeds

disposable income, there is

negative saving (dissaving).

When consumption

expenditure is less than

disposable income, there is

saving.


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Marginal Propensities to Consume and Save

The marginal propensity to consume (MPC) is thefraction of a change in disposable income spent onconsumption.

It is calculated as the change in consumption expenditure,C, divided by the change in disposable income, YD,that brought it about.

That is,

MPC= C YD



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Fixed Prices and

Expenditure Plans

MPCis the slope of the

consumption function.

Along this consumption

function, when disposable

income increases by200 billion, consumption

expenditure increases by

150 billion.

The MPCis 0.75.



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The marginal propensity to save (MPS) is the fraction ofa change in disposable income that is saved.

It is calculated as the change in saving, S, divided by the

change in disposable income, YD, that brought it about.

That is,

MPS= S YD



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Fixed Prices and

Expenditure Plans

MPSis the slope of thesaving function.

Along this saving function,

when disposable incomeincreases by 200 billion,saving increases by50 billion.

The MPSis 0.25.



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The MPCplus the MPSequals 1.

To see why, note that,

YD= C+ S(remember?). So,

C+ S= YD.

Divide this equation by YD to obtain,

C/YD + S/YD = YD/YD

MPC+ MPS= 1.



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Other Influences onConsumption and Saving

The other influences onconsumption expenditure and

saving are the real interest

rate, wealth, and expectedfuture income.

A fall in the real interest rate,

an increase in wealth or anincrease in expected future

income shifts the consumption

function upward and thesaving function downward.

Fixed Prices and

Expenditure Plans


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Consumption as a Function of Real GDP

C = f(YD), we learnt.

Y T = YD

Disposable income changes when either real GDP

changes or net taxes change.

If tax rates dont change, real GDP is the only influence on

disposable income.

So consumption expenditure is a function of real GDP.

We use this relationship to determine real GDP when the

price level is fixed.



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Import Function

The marginal propensity to import is the fraction of anincrease in real GDP spent on imports.

For example, if a 100 billion increase in real GDP

increases imports by 20 billion, then the marginal

propensity to import is 0.2.



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Real GDP with a Fixed Price Level

To understand how real GDP is determined when the

price level is fixed, we must understand how aggregatedemand is determined.

Aggregate demand is determined by aggregate

expenditure plans.

Aggregate planned expenditure is plannedconsumption

expenditure plus plannedinvestment plus plannedgovernment expenditure plus plannedexports minus

plannedimports.



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Weve seen that planned consumption expenditure and

planned imports are influenced by real GDP.

When real GDP increases, planned consumptionexpenditure and planned imports increase.

Planned investment plus planned government expenditure

plus planned exports are notinfluenced by real GDP.



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The relationship between aggregate planned expenditure

and real GDP can be described by an aggregate

expenditure schedule, which lists the level of aggregateexpenditure planned at each level of real GDP.



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Aggregate Planned

Expenditure andReal GDP

Figure 25.4 shows how

the aggregate

expenditure curve (AE)

is built from itscomponents.



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Consumption expenditure minus imports, which varieswith real GDP, is induced expenditure.

The sum of investment, government expenditure, and

exports, which does not vary with GDP, is autonomousexpenditure.

(Consumption expenditure and imports can have an

autonomous component.)



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Actual Expenditure, Planned Expenditure, andReal GDP

Actual aggregate expenditureis always equal to real GDP.

Aggregate planned expendituremay differ from actual

aggregate expenditure because firms can have unplannedchanges in inventories or stocks.

Equilibrium Expenditure

Equilibrium expenditure is the level of aggregateexpenditure that occurs when aggregate plannedexpenditure equals real GDP.



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Equilibrium occurs at thepoint at which the

aggregate expenditure

curve crosses the 45 linein part (a).

Equilibrium occurs when

there are no unplannedchanges in inventories or

stocks in part (b).

Real GDP with a

Fixed Price Level


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Convergence to Equilibrium

If aggregate plannedexpenditure exceeds realGDP (the AEcurve is abovethe 45 line), there is an

unplanned decrease instocks.

To restore stocks, firms hire

workers and increaseproduction.

Real GDP increases.

Real GDP with a

Fixed Price Level


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If aggregate planned

expenditure is less than

real GDP (the AEcurve isbelow the 45 line), there

is an unplanned increase

in stocks.

To reduce stocks, firms fire

workers and decrease

production.

Real GDP decreases.

Real GDP with a

Fixed Price Level


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If aggregate planned

expenditure equals realGDP (the AEcurveintersects the 45 line),there is no unplanned

change in stocks.

So firms maintain theircurrent production.

Real GDP remainsconstant.

Real GDP with a

Fixed Price Level


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The Multiplier

The multiplier is the amount by which a change inautonomous expenditure is magnified or multiplied to

determine the change in equilibrium expenditure and real

GDP.

Multiplier = change in real GDP (Y) change in

autonomous expenditure



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The Multiplier

The Basic Idea of the Multiplier

An increase in investment (or any other component of

autonomous expenditure) increases aggregate

expenditure and real GDP.

The increase in real GDP leads to an increase in inducedexpenditure.

The increase in induced expenditure leads to a further

increase in aggregate expenditure and real GDP.

So real GDP increases by more than the initial increase in

autonomous expenditure.



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The Multiplier

Figure 25.6 illustrates themultiplier.

An increase inautonomous expenditurebrings an unplanned

decrease in stocks.So firms increaseproduction and real GDP

increases to a newequilibrium.



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The Multiplier

Why Is the Multiplier Greater than 1?

The multiplier is greater than 1 because an increase in

autonomous expenditure induces further increases in

aggregate expenditure.

The Size of the Multiplier

The size of the multiplier is the change in equilibrium

expenditure divided by the change in autonomous

expenditure.

Multiplier= Y A



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The Multiplier

The Multiplier and the Slope of the AECurve

The slope of the AEcurve determines the magnitude ofthe multiplier:

Multiplier = 1 (1 Slope ofAEcurve)

If the change in real GDP is Y, the change inautonomous expenditure is A, and the change in

induced expenditure is N, then

Multiplier= Y A



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The Multiplier

To see why the multiplier = 1 (1 Slope ofAEcurve),begin with the fact that:

Y= N+ A

But

Slope ofAEcurve = N Yso,

N= (Slope ofAEcurve x Y)and

Y= (Slope ofAEcurve x Y) + A



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The Multiplier

Because

Y= (Slope ofAEcurve x Y) + Ayou can see that

Y- (Slope ofAEcurve x Y) = A

(1 Slope ofAEcurve) x Y= A

it follows then

Y= A (1 Slope ofAEcurve)



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The Multiplier

[Y= A (1 Slope ofAEcurve)]

But the multiplier is:

Y A

So, divide both sides of the above equation,

Y= A (1 Slope ofAEcurve)

by A to obtain

Y A = 1 (1 Slope ofAEcurve)



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The Multiplier

With the slope of the AEcurve is 0.75, the multiplier is

Y A = 1 (1 0.75) = 1 (0.25) = 4.When there are no income taxes and no imports, the

slope of the AEcurve equals the marginal propensity to

consume, so the multiplier is

Multiplier = 1 (1 MPC).

But 1 MPC= MPS, so the multiplier is also

Multiplier = 1 MPS.



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The Multiplier

Imports and IncomeTaxes

Both imports and income

taxes reduce the size of

the multiplier.

Figure 25.7 shows how.

In part (a) with no taxes or

imports, the slope of theAEcurve is 0.75 and themultiplier is 4.



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The Multiplier

In part (b), with taxes and

imports, the slope of the

AEcurve changes to 0.5

and the multiplier is: 2.

Say rate of tax is, 0.2 and

marginal propensity to

import is 0.05. Together it

comes to 0.25. Subtract

0.25 from 0.75 giving the

slope of the AE curve tobe 0.5 and the multiplier

becomes 2.


The Multiplier Maths


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The Multiplier Maths

Y= I+ bI+ b2I+ b3I+ b4I+ b5I+ . ....

(where b= slope ofAEcurve). Multiply by bto obtain

b

Y= b

I+ b2

I+ b3

I+ b4

I+ b5

I+ . ..bn (where n stands for any number) approaches zero(since b < 1) as nbecomes large (say, infinity) so b(n+ 1)

also approaches zero.

Subtract the second equation from the first to obtain

Y bY= I, or (1 b) Y= I, so,

Y= I (1 b).

Y= I1/(1 b) Y= I1/(1 MPC)

Y= IMultiplier Pearson Education 2008


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The Multiplier and the Price Level

Remember

Aggregate Expenditure and Aggregate Demand

The aggregate expenditure curve is the relationshipbetween aggregate planned expenditure and real GDP,

with all other influences on aggregate planned expenditure

remaining the same.

The aggregate demand curve is the relationship between

the quantity of real GDP demanded and the price level,with all other influences on aggregate demand remaining

the same.



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The Multiplier and the Price Level

Deriving the Aggregate Demand Curve

When the price level changes, a wealth effect andsubstitution effects change aggregate planned expenditure

and change the quantity of real GDP demanded.

Figure 25.9 on the next slide illustrates the effects of a

change in the price level on the AEcurve, equilibriumexpenditure, and the quantity of real GDP demanded.


The Multiplier and


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The Multiplier andthe Price Level

In Figure 25.9(a), a rise in

price level from 105 to 125

shifts the AEcurve from AE0downward to AE1 and

decreases the equilibrium

expenditure from1,300 billion to 1,200

billion.



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The Multiplier and


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In Figure 25.9(b), the same

rise in the price level that

lowers equilibrium

expenditure

brings a movement along

the ADcurve from point Bto point A.


The Multiplier and


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A fall in price level from105 to 85

shifts the AEcurve from

AE0 upward to AE2 and

increases equilibrium

expenditure from

1,300 billion to 1,400

billion.


The Multiplier and


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e u t p e a dthe Price Level

The same fall in the pricelevel that increases

equilibrium expenditure

brings a movement alongthe ADcurve to from pointBto point C.


The Multiplier and


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pthe Price Level

Points A, B, and Con theADcurve

correspond to the equilibrium

expenditure points A, B, andCat the intersection of theAEcurve and the 45 line.


The Multiplier and


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pthe Price Level

Changes in AggregateExpenditure and AggregateDemand

Figure 25.10 illustrates theeffects of an increase ininvestment.

The AEcurve shifts upward

and the ADcurve shifts rightward

by an amount equal to thechange in investment multiplied

by the multiplier.


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The Multiplier and


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pthe Price Level

The increase in investment

shifts the AEcurve upwardand shifts the ADcurverightward.

With no change in the price

level, real GDP would

increase to 1,500 billion at

point B.


The Multiplier and


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the Price Level

But the price level rises.

The AEcurve shiftsdownward.

Equilibrium expenditure

decreases to 1,430 billionAs the price level rises, real

GDP increases along the

SAScurve to 1,430 billion.The multiplier in the short run

is smaller than when the

price level is fixed.


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The Multiplier and


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the Price Level

Figure 25.12 illustrates the

long-run effects.

At point C, there is aninflationary gap.

The money wage ratestarts to rise and the SAScurve starts to shift

leftward.

The Multiplier and


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the Price Level

The money wage rate will

continue to rise and theSAScurve will continue toshift leftward, until real

GDP equals potential realGDP.

In the long run, the

multiplier is zero.

lectures 8 - 10 revised

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