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**Introduction to Macroeconomics**

Chapter 22. Keynesian Macroeconomics

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**Chapter 22. Keynesian Macroeconomics**

1. John Maynard Keynes 2. Consumption 3. Simple Equilibrium Model 4. Add Investment to the Model 5. Add Government Spending to the Model 6. Autonomous Spending Multiplier 7. Recessionary, Inflationary, and Output Gaps 8. Government Fiscal Policy

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**Objections to Classical Model **

1. John Maynard Keynes General Theory… (1936) Objections to Classical Model Equilibrium with Unemployment because of inadequate demand Advocated Activist Government Fiscal Policy Short-run model of aggregate demand only

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**1. John Maynard Keynes Objections to Classical Model**

Interest rates, prices, and wages are rigid (“sticky”) Savings (consumption) is a function of income, not interest rate. Supply doesn’t create its own demand, it responds to changes in demand

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**1. John Maynard Keynes Equilibrium with Unemployment**

Full-employment output Horizontal Aggregate Supply Curve Sticky prices Interest rates have only a long run effect Long-run growth factors can be ignored in short-run model AS Equilibrium AD

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**1. John Maynard Keynes Keynesian Activist Fiscal Policy**

Equilibrium Output less than full-employment output increase government spending reduce taxes Aggregate Demand (AD) shifts to right Full-employment output AS AD

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**1. John Maynard Keynes Short-Run Model of Aggregate Demand Only**

Changes in Aggregate Supply have no effect on spending (contrary to Say’s Law) Aggregate Supply responds to changes in demand Economy can be modeled by looking at Aggregate Demand only

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**Graph Consumption Function Autonomous Consumption **

Marginal Propensity to Consume Savings Marginal Propensity to Save Average Propensity to Consume Average Propensity to Save

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**2. Consumption Consumption Function**

C = C0 + b • Y C = desired consumption C0 = autonomous consumption b = marginal propensity to consume 0 < b < 1 Y = income

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**2. Consumption Graph Consumption Function**

C = C0 + b • Y Slope = b Intercept = C0

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**2. Consumptioon Autonomous Consumption**

Autonomous consumption = C0 Level of consumption at zero income Consumption independent of the level of income “Subsistence” level of income

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**2. Consumption Marginal Propensity to Consume (MPC)**

The change in consumption that results from a $1 change in income MPC = dC / dY Slope of the consumption function (b)

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**2. Consumption Marginal Propensity to Consume (MPC)**

MPC = dC / dY = 10 / 15 = 0.667 dC = 10 dY = 15 dC = 10 dY = 15 dC = 10 dY = 15 dC = 10 dY = 15

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**3. Simple Equilibrium Model**

Aggregate Expenditures: AE = C + I + G + NX Assume: No government, G = 0 No investment, I = 0 No international trade, NX = 0 AE = C

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**3. Simple Equilibrium Model Aggregate Expenditures**

AE = C = C0 + MPC • Y Slope = MPC Intercept = C0

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**3. Simple Equilibrium Model Equilibrium - the 45o Line**

The 45o line: all points that represent potential equilibrium (aggregate expenditures = income) 45o

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**3. Simple Equilibrium Model Aggregate Expenditures and the 45o Line**

AE Equilibrium

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**3. Simple Equilibrium Model Disequilibrium**

Income > Spending Undesired Inventory Build 45o Line AE Income < Spending Undesired Inventory Decline

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**3. Simple Equilibrium Model Autonomous Consumption Multiplier**

Shift in AE - if autonomous consumption increases by $1, how much does national income increase by? National income increases by the Multiplier times the change in autonomous consumption

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**3. Simple Equilibrium Model Shift in Autonomous Consumption**

Slope = MPC = 0.67 dC0 = ± 5 dY = ± 15

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**3. Simple Equilibrium Model Autonomous Consumption Multiplier**

Spending = Income x Marginal Propensity to Consume

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**4. Add Investment to Model**

I = I0 = Autonomous Investment Investment independent of the level of income AE = Consumption + Investment = C + I = C0 + MPC • Y + I0

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**4. Add Investment to Model Aggregate Expenditures**

AE = C + I = C0 + MPC • Y + I0 AE = C + I C Slope = MPC I0 = 10 C0 = 10

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**4. Add Investment to Model Aggregate Expenditures and Equilibrium**

45o Line AE = C + I Equilibrium C I0 = 10 C0 = 10

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**5. Add Government Spending to Model**

G = G0 = Autonomous Government Spending Spending independent of the level of income AE = C + I + G = C0 + MPC • Y + I0 + G0

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**5. Add Government Spending Aggregate Expenditures with Equilibrium**

45o Line Equilibrium AE = C + I + G C + I C G0 = 10 I0 = 10 C0 = 10

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**6. Autonomous Spending Multiplier**

Autonomous Spending: Spending that is independent of any other variable (e.g., income, prices, interest rate) C0 = Autonomous Consumption I0 = Autonomous Investment G0 = Autonomous Government Spending Autonomous (adj.) - self-governing

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**6. Autonomous Spending Multiplier The Multiplier**

1 - MPC If MPC = 0.9, Multiplier = 10 A $1 increase in autonomous spending leads to a $10 increase in national income If MPC = 0.8, Multiplier = 5 A $1 increase in autonomous spending leads to a $5 increase in national income

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**6. Autonomous Spending Multiplier Change in Autonomous Spending**

45o Line AE1 C AE0 D A B Change in Automous Spending = CD Change in National Income = AB Marginal Propensity to Consume = Slope = BD / AB

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**6. Autonomous Spending Multiplier Graphical Derivation of Spending Multiplier**

Multiplier = Change in National Income___ Change in Autonomous Spending = AB / CD = AB / (BC - BD) = AB / (AB - BD) where BC = AB for 45o triangle = (AB / AB)______ (AB / AB) - (BD / AB) = _____ 1 - (BD / AB) where MPC = BD / AB Multiplier = _ __ 1 - MPC

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**6. Autonomous Spending Multiplier Algebraic Derivation of Spending Multiplier**

AE = C + I + G = C0 + MPC • Y + I0 + G0 In equilibrium: Y = AE Y = C0 + MPC • Y + I0 + G0 Y - MPC • Y = C0 + I0 + G0 (1 - MPC) • Y = C0 + I0 + G0 Y = ___1___ • (C0 + I0 + G0) 1 - MPC

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**Recessionary Gap Inflationary Gap Output Gap 7. Gaps**

output in equilibrium less than full-employment output Inflationary Gap output in equilibrium greater than full-employment output Output Gap difference between actual output and full-employment output

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**7. Gaps Gaps and the Keynsian Cross**

45o Line Inflationary Gap AE Full-employment Recessionary Gap Output Output Gap Output Gap

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**8. Government Fiscal Policy**

Lump Sum Tax Lump Sum Tax Multiplier Balanced Budget Multiplier

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**8. Government Fiscal Policy Lump Sum Tax**

Consumption = C0 + MPC • Yd Yd = disposable income = total income (Y) - lump sum tax (T0) Consumption = C0 + MPC • (Y - T0) = C0 + MPC • Y - MPC • T0 Multiplier = - MPC_ 1 - MPC

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**8. Government Fiscal Policy Derivation of Lump Sum Tax Multiplier**

AE = C + I + G + NX AE = C0 + MPC • Y - MPC • T0 + I0 + G0 In equilibrium: Y = AE Therefore: Y = C0 + MPC • Y - MPC • T0 + I0 + G0 Y - MPC • Y = C0 - MPC • T0 + I0 + G0 (1 - MPC) • Y = (C0+ I0 + G0) - MPC • T0 Y = ___ • (C0+ I0 + G0) MPC_ • T0 1 - MPC MPC

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**8. Government Fiscal Policy Balanced Budget Multiplier**

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