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slide 1 Diploma Macro Paper 2 Monetary Macroeconomics Lecture 2 Aggregate demand: Consumption and the Keynesian Cross Mark Hayes

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slide 2 Outline Introduction Map of the AD-AS model

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Goods market KX and IS (Y, C, I) Money market (LM) (i, Y) IS-LM (i, Y, C, I) AD Labour market (P, Y) AS AD-AS (i, P, Y, C, I) Foreign exchange market (NX, e) AD*-AS (i, P, e, Y, C, I, NX) Phillips Curve (,u)

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slide 4 Short-run effects of an increase in demand Y P AD 1 In the short run when prices are sticky,… …causes output to rise. SRAS Y2Y2 Y1Y1 AD 2 …an increase in aggregate demand…

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slide 5 Outline Introduction Map of the AD-AS model This lecture, we begin explaining the AD curve Step 1: Equilibrium with variable income and consumption - the Keynesian Cross Various Multipliers

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slide 6 The Circular Flow I

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slide 7 The Circular Flow II

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slide 8 Income in Classical model Profit and Rent Wages Consumption Saving Investment Consumption

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slide 9 First step to AD - the Keynesian Cross A simple closed economy model (NX exogenous) in which private consumption (C ) is the only element of demand which varies Notation: I = expected investment E = C + I + G = expected expenditure Y = real GDP = value of output

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slide 10 Elements of the Keynesian Cross Consumption function: for now, investment is exogenous: Expected expenditure: equilibrium condition: Government consumption and tax: Value of output = expected expenditure

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slide 11 Plotting the equilibrium condition income, output, Y E expected expenditure E =Y 45 º

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slide 12 Plotting planned expenditure income, output, Y E expected expenditure E =C +I +G

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slide 13 The equilibrium value of income income, output, Y E expected expenditure E =Y E =C +I +G Equilibrium income c1c1 1

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slide 14 An increase in autonomous consumption Y E E =Y E =C +I +G 1 E 1 = Y 1 E =C +I +G 2 E 2 = Y 2 Y G

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slide 15 The spending multiplier Definition: the change in income resulting from a (small) change in autonomous expenditure such as G or I. (In the following slides MPC = c 1 )

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slide 16 The multiplier as a partial derivative equilibrium condition in changes because I exogenous because C = MPC Y Collect terms with Y on the left side of the equals sign: Solve for Y :

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slide 17 The spending multiplier In this model, the spending multiplier equals If MPC = 0.8 An increase in G causes income to increase 5 times as much!

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slide 18 Why the multiplier is greater than 1 An increase in G represents an equal increase in Y: Y = G. But Y C further Y further C further Y So the final impact on income is much bigger than the initial G. But not infinite, it converges.

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slide 19 Conventional explanation of convergence

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slide 20 The Phillips Machine, 1949 Invented by Bill Phillips at the LSE. A water- driven analogue computer used to demonstrate Keynesian economics The flaw is that he used water, taking us back to a Classical corn model

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slide 21 The Phillips Machine, 1949

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slide 22 The Phillips Machine, 1949

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slide 23 The Phillips Machine, 1949 www.sms.cam.ac.uk/media/1094078

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slide 24 An increase in taxes Y E E =C 2 +I +G E 2 = Y 2 E =C 1 +I +G E 1 = Y 1 Y C = MPC T The tax increase reduces consumption, and therefore E:

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slide 25 The tax multiplier Definition: the change in income resulting from a (small) change in T

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slide 26 The tax multiplier as a partial derivative equilibrium condition in changes I and G exogenous Solving for Y : Final result:

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slide 27 The tax multiplier If MPC = 0.8, then the tax multiplier equals

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slide 28 The tax multiplier …is negative: A tax increase reduces C, which reduces income. …is greater than one (in absolute value): A change in taxes has a multiplier effect on income. …is smaller than the spending multiplier: Consumers save the fraction (1 – MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.

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slide 29 The balanced budget multiplier

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slide 30 By definition: Equilibrium Condition: The balanced budget multiplier

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slide 31 Summary Keynesian cross: equilibrium income determined with income and consumption variable Shows how the direction of causation between saving and investment is reversed from the Classical model The multiplier as comparative statics – Spending, tax and balanced budget multipliers – Comparing two equilibrium positions does not explain the dynamic process linking them

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slide 32 Next time Step 2 of building the AD curve Finding equilibrium when income, consumption and investment can all move the IS-LM model

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