Chapter 2 Economics (3)

7/29/2019 Chapter 2 Economics (3)

1/26

Chapter 2

The Basic Model:

(three sector model)

Consumers, Producers and Government


2/26

Introducing the Consumer,

Producer and Government

The basic Keynesian model is an Expenditure or

Demand determined model

Expenditure induces and determines production

Changes in the equilibrium level of income are

caused by changes in total expenditure


3/26

Assumptions of Keynesian Model

Expenditure model (Demand side model) (Chapter 2)

Supply adjusts passively to demand changes (Chapter 6)

Financial sector less important: Interest rates exogenous(Chapter 3)

Closed economy : Foreign sector exogenous (Chapter 4)

Price level unchanged (Chapter 6)

No supply constraints ito labour, wages etc (Chapter 6)


4/26

4

Chapter 2: The basic model I: consumers, producers and

government


5/26

Complete Chain Reaction p 43: Total expenditure increases,

Expenditure bigger than production

Stocks become depleted,

Decision to adjust production upwards, Increase in Employment,

Increase in Income,

Increase in spending,

And so Real GDP and

Real Income (Y) increases.

See cursive printed on p 43

The entire Keynesian approach is supported by this fundamentalchainreaction

How does it happen?


6/26

Now draw it

The 45o line shows the equilibriumbetween total expenditure and totalproduction

Point R shows the equilibrium.

Y0 is where macroeconomicequilibrium is satisfied

Total Expenditure = TotalProduction

Right here!

45o

Income, Production Y

E

AE

R

Y0


7/26

Causes of fluctuations

Changes in trends and

fluctuations in expenditure

Disturbances and shocks in the

economy:

Changes in interest rates

Money supply Taxation

Gold price

Exchange rate

Balance of Payments

Politics Business confidence

International environment


8/26

Capitalformation

(I)

Consumptionexpenditure

(C)

Governmentexpenditure

(G)

A modelofC+I

Foreignexpenditure

(X-Z)

A model ofC+I+G+(X-Z)

A modelofC+I+G

Remember the Keynesian model

framework


9/26

Begin with Consumption

expenditure

Consumption pertain to expenditure by households on

consumable items and services.

In this model expenditure on imported items is included intotal consumption expenditure

C=f(Yd, Wealth, expectations, habit, demographic

factors)

Why?


10/26

The most important factor according to Keynes is Yd (Y-T)( disposable income)

C= a + bYd

b = is MPC (marginal propensity to consume)

0


11/26

The Keynesian Consumption function

The positive slope indicates the

positive relationship between

consumption and real income

a = autonomous consumption

expenditure

b = slope = MPC

So . C= a + bYd

Income Y

45o

C

C= a +bYc1

Y1

a


12/26

ForDuesenberry, consumption is not much determined bythe absolute level of income, but also by the income ofindividual or households relative to that of friends or neighbors,or relative to higher level of their own income in a earlier

period. (Behavioral)

ForFriedman, households consumption depend less on thecurrent income of a household at a certain time than on thelevel of income that this household expect to earn normally(permanent income).

According to the life cycle income theory, householdsand individuals plan their expenditure given an expected

pattern of income over their entire life time. C=f(Yd, Ye, Asset):Young people borrow more.


13/26

Introducing Investment

It is the purchase of productive or capital goods.

It is made of fixed investments and inventory (stock).

Investment = f (interest rates, expectations,business confidence, regulations)

Investment and interest rates have negative relationship.

Why?

This is because the interest rate is the opportunitycost of capital formation.


14/26

Investment function

Investment and interest

rate have a negative

relationship

interest rate is the

opportunity cost of

capital formation

i

Investment(I)

Io I1

i1

io


15/26

5

10

i

I0

15

2000 4500

Planned Capital Formation

Note:

Higher interest rate

Higher costs

Lower planned capital

formation

6000

Capitalformationcurve


16/26

So we can now move along the

I-curve

Onlywhen there isai

i then I

i then I

i (%)

I0

i1

I1 I2

i2


17/26

Graph on page 55

Investment (I)

i

i0

I0

Y0

E

I

C

C +

I

I0

Income (Y)


18/26

Changes in equilibrium:

The Multiplier

Suppose interest rate falls

Decreases opportunity cost of I

Investment will be encouraged

Therefore total expenditure andsales increase

Decline in inventories

Decision to increase

production to match higher

expenditure

The change in expenditure

leads to a change in

equilibrium income and

production

Economy in an upswing

Income Y

45o

Y0

E

C+I0

C+I1

Y1

I0

I1


19/26

Graph on page 56

Investment (I)

i

i0

I0 Y0

E

C + I0

C + I1

I1

Income (Y)I1

I0

Y1

I0

I1

i1


20/26

Multiplier concept

The multiplier is

calculated as follows:

1/(1-MPC) =1/(1-b)

Example:MPC = 0.8

1/(1-0.8) =1/0.2 = 5

multiplierExp

Y

I = 150

Income150

Spend

120

Save

30

120120

2496

Production150

KLeakage

1


21/26

Government Expenditure (G) &

Taxation (t)

Government expenditure concerns thepurchase of goods and services by the generalgovernment.Exhaustive expenditure and transfers

In national accounts data, only the consumptionexpenditure by the general government is indicatedseparately.

Government investment is included in the grosscapital formation (investment) figure.

Total government expenditure (G) sums both.

Fiscal policy, why worry?


22/26

Graph on page 61

Investment (I)

i

i0

I0 Y0

E

I0

C

C + I0

I0

Income (Y)

G0

C + I0 + G0

G0


23/26

Tax Multiplier (Autonomous Tax)

Taxation has an indirect effect on equilibrium income, via its impact on disposable income and therefore,

on consumption.

The tax multiplier (KT ) is smaller than the expendituremultiplier by a factor equal to the marginal propensity toconsume (MPC). This means that a R1million increase in government expenditure,

for example, will not have the same impact on equilibrium incomeY as a R1million reduction in total taxation.

Remember: An increase in G and reduction in T are bothexample of expansionary fiscal policy. But why wouldyou use it?


24/26

Give us Proof

Y = C + I + G

But C = a + bYd

Y = a + bYd + I + G

and Yd = Y T

Y= a+ b(Y-T) + I + G

and T = tY

Y + a + b (Y tY) + I + G

Y = a + b (1-t) Y + I + G


25/26

Graphically

Effect of GAutonomousdemand increases (curveshifts up)

250

Yd

E

C+I

0

Effect of T:

Changes the slope

(curve swivels down )

b (1-t)

C+I+G

600


26/26

E=Y

All together Now

Equilibrium:Y = Spending

Y = E

Y = C + I + G

Where C + I + G cuts the 45o

lineYe = Multi x Auto E

But the multiplier changes nowC

Yd

E

0

C+I

Y1 Y2

C+I+G

Y3

Chapter 2 Economics (3)

Documents

Transcript of Chapter 2 Economics (3)