Lectures 8 - 10 Revised
Transcript of Lectures 8 - 10 Revised
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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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Fixed Prices and Expenditure Plans
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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Fixed Prices and Expenditure Plans
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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Fixed Prices and Expenditure Plans
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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Fixed Prices and Expenditure Plans
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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Fixed Prices and Expenditure Plans
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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Fixed Prices and Expenditure Plans
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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Fixed Prices and Expenditure Plans
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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Fixed Prices and Expenditure Plans
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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Fixed Prices and Expenditure Plans
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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Real GDP with a Fixed Price Level
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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Real GDP with a Fixed Price Level
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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Real GDP with a Fixed Price Level
Aggregate Planned
Expenditure andReal GDP
Figure 25.4 shows how
the aggregate
expenditure curve (AE)
is built from itscomponents.
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Real GDP with a Fixed Price Level
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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Real GDP with a Fixed Price Level
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.
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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.
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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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The Multiplier andthe Price Level
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.
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The Multiplier and
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The Multiplier andthe Price Level
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.
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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.
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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.
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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.
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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.
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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.