Post on 04-Apr-2018
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The circular flow ofincome and the
Keynesian multiplier
Equilibrium in the goods market
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Equilibrium in the goods market
The circular flow of income
Aggregate demand and output
The multiplier and role of savings
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The circular flow of income
Households Firms
Labour
Income
Goods
Expenditure
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The circular flow of income
Households Firms
Labour
Goods
Real flows
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The circular flow of income
The circular flow of income is what guaranteesthe central accounting identities
Three definitions of GDP (output)
Sum of the expenditures Z
Sum of the value added produced Q
Sum of the incomes distributed Y
Accounting identities
Production = Aggregate demand / expenditure
Q = Z
Production = Incomes of factors of production
Q = Y
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Equilibrium in the goods market
The circular flow of income
Aggregate demand and output
The multiplier and role of savings
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Aggregate demand and output
In the Keynesian model, the aggregate demand(also called planned expenditure) in a closed
economy with no government is:
Z = C + I
with Z : Aggregate Demand
C : Consumption of householdsI : Investment of firms
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Aggregate demand and output
Consumption C is not fixed. Its level depends onthe level of income Y, and is given by the
consumption function.
C = C0 + cY
Where
C0is the autonomous level of consumption, i.e. the
level of consumption that does not depend on income
c is the marginal propensity to consume (mpc) : the
amount spent out of an extra unit of income.
The converse is the marginal propensity to save (mps)
s, such that
c + s = 1
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Aggregate demand and output
For the moment, investment I is considered tobe exogenous.
Its level is pre-determined and does not depend
on output
This is a simplifying assumption that will berelaxed later on (when interest rates are
introduced)
Aggregate demand Z is therefore a function of
output Y, of the marginal propensity to consumec and of the exogenous level of investment I.
Z = C0 + cY + I
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Aggregate demand and output
Effective demand and equilibrium For any level of planned expenditure Z (with a
slope < 1), There is only a single point for whichthe planned expenditure is equal to the level of
income Y This gives the equilibrium condition on the
goods market: Y = Z
There is no guarantee that this point is a fullemployment equilibrium !!
This will be examined later.
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Aggregate demand and output
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Effective expenditure
Y = Z
KeynesianEquilibrium Output
Y* Income, output Y
Aggregate Demand (planned
expenditure)
Z = C0 + cY + I
Equilibrium on the goods marketAggregateDemand Z
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Aggregate demand and output
For each aggregate demand curve Z there isonly a single point for which the plannedexpenditure is equal to the level of income Y
But Z is determined by the plansof agents!
What happens if the level of plannedexpenditure Z is not equal to Y ?
The goods market is not in equilibrium !! Output will adjust so that the equilibrium is
reached
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Aggregate demand and output
Effective expenditure
Y* Income, output Y
Aggregate Demand (planned
expenditure)
Disequilibrium with Z > Y
Z
Y
Unplanned reduction ininventories
The firms are selling more thanthey are producing. They have toincrease production in order tomeet the aggregate demand,which brings the goods marketback to Y*
Y
AggregateDemand Z
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Y
Z
Aggregate demand and output
Effective expenditure
Y* Income, output Y
Aggregate Demand (planned
expenditure)
Disequilibrium with Z < Y
Y
Unplanned increase ininventories .
Firms are selling less thanthey are producing. Theyreduce output which bringsthe goods market back to Y*
AggregateDemand Z
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Equilibrium in the goods market
The circular flow of income
Aggregate demand and output
The multiplier and role of savings
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The multiplier and the role of savings
So aggregate demand is given by
Z = C + I
And the equilibrium condition is
Y = Z
So what happens to output Y if investment I
increases by an amount I ? In fact, Y > I !!
Why is that?
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The multiplier and the role of savings
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Y = Z
Y1 Income, output Y
Z1 = C0 + cY + I1
Multiplier effect on the goods marketAggregateDemand Z
Z2 = C0 + cY + I2
Y
Y2
I
1. An increase in plannedinvestment
2. leads to a more thanproportional increase in income
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The multiplier and the role of savings
Aggregate demand is given by : Z = C0 + cY + I And Y = Z
Solving for the equilibrium level of output gives us :
There are 2 equivalent interpretations to this result
IC
c
Y
ICcY
IcYCY
0
0
0
1
1
1
cI
Y
1
1
MultiplierAutonomous
demand
(exogenous)
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The multiplier and the role of savings
Why do we observe Y > I ?
Increase in plannedinvestment
I
Increase in income
Y
Increase in savings
Y mps
Increase inconsumption
Y mpc
First interpretation: a multiplier effect dueto the circular flow of income
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The multiplier and the role of savings
Why do we observe Y > I ?
Step 1 : output increases by I
Step 2 : output increases by c I
Step 3 : output increases by c2 I Step 4 : output increases by c3 I
..... This continues forever ! The closer c is to 1, i.e.the less people save, the larger the effect. (why ?)
The aggregate size of the increase is equal to:
ccccc
1
1...1
432
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The multiplier and the role of savings
Why do we observe Y > I ?
Second interpretation: The economy isincreasing output in order to balance
investments and savings
This is because the equilibrium condition Y=Z isequivalent to I=S (planned investment = savings)
These two equilibrium conditions are equivalent !
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The multiplier and the role of savings
Aggregate demand can be decomposed intoconsumption and investment
Z = C + I
Income can be decomposed intoconsumption and savings
Y = Y(c+s) = C + S
So one can see that setting Y=Z isequivalent to setting I=S !
SIZY
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The multiplier and the role of savings
Why do we observe Y > I ?
Starting from equilibrium, if investment increasesby I, then we are no longer in equilibrium:
I + I > S To get back to equilibrium, we need savings to
increase by the same amount (S = I).
Given the savings function,
So we have
YsS
sS
Y 1
sI
Y 1
cI
Y
1
1
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The multiplier and the role of savings
Why do we observe Y > I ?
Both explanations (spending multiplier orsavings/investment balancing) are equally
valid. The spending multiplier is usually easier to
understand, and is found in most manuals
The savings/investment balance, however,often brings more interesting explanationsof the real-life economic phenomena.