Basic Keynesian Model Keynesian Cross Diagram

Measuring the macroeconomy Pág.2 GNPpm = GDP – factor incomes from abroad + factor incomes of foreigners NetNPpm = GNPpm - Depreciation NNP at factor costs = Net National Product – Net indirect taxes + Subsidies (NNP=net national product at factor costs) NI (National Income) = NNPcf Personal Dispousable Income (PDI = Family income = NI – Direct taxes + Transfers - Profits + Undistributed profits Personal Disposable Income (PDI = Family income )= Consumption Spending + Savings Consumer price index: the CPI measures the price increase of a merket basket fo goods representative of the purchases of a typical household The Unemployment rate: The unemployed are people who want to work and are actively looking for jobs but have not yet found one. The unemployment rate is equal to the number of unemployed people divided by the total labor force.

Macroeconomic model Pág.3 SectorsMarketsFunctions Endogenous variables Policies Households Firms Government Foreign Sector Goods and Services Financial wealth: − Money. − Bonds. Trabajo C, I, G, X,Q, T,S. L, M/P. Ls, Ld. Y (GDP) P (CPI) U (Unemployment) er (Exchange rates) r (Interest rates) Demand side − Fiscal. − Monetary. − Trade and Exchange rates policies. Supply side: − Incomes. − Structural.

Key concepts Pág.4 GDP composition The demand of goods and services The equilibrium

Intended expenditure or aggregate demand components Pág.5 CCCCpriv + I + Cpub + G + Ipriv = Internal+ X+ Ipub + X = Final+ X - Q GDP mp

The circular flow of economic activity Pág.6 INCOMES –WAGES ((FLOW OF INCOMES) MONETARY FLOW REAL FLOW HOUSEHOLDS (CONSUMPTION) FIRMS (PRODUCTION ) EXPENDITURE (FLOW OF EXPENDITURE) MARKET GOODS & SERVICES MERCADO DE FACTORES DE PRODUCCION FACTORS GOODS AND SERVICES Demand varies, production Production varies, income varies Income varies, demand varies

National income identity Pág.7 Production is equal to income. Then: This last equation states that savings should be sufficient for financing the investment spending, the budget deficit and the trade deficit. In other words, increases in budget or trade deficits unless accompanied by an equal increase in savings will lead to the crowding out of investment

Short-run macroeconomic models Pág.8 Keynesian model (Endogenous variable: Income) Fixed prices Pure exchange economy. No money IS-LM Model (Endogenous variables: income-interest rate) Fixed prices Monetary economy Open economy without capital flows IS-LM with capital mobility (Mundell-Fleming) (Endogenous variables: Income-interest rates) Fixed prices Monetary economy Open economy with capital flows Aggregate supply and demand model (Endogenous variables: Prices- Income). AS-AD diagram Sticky prices Monetary economy Dynamic AS-AD model (endogenous variables: inflation rates and income)

Keynesian model: assumptions Pág.9 Government sector: (0<t<1) Budget deficit (BS) is defined by the difference between taxes and the sum of government purchases (G) and transfers (TR). Open Economy: net export is a decreasing function of national income. The coefficient m, is the marginal propensity to import. No money Fixed prices: no inflation nor deflation

Keynesian model Pág.10 In this model a macroeconomic equilibrium is reached when actual ouput Y, is equal to intended spending. Hence, the level of the aggregate demand determines the income level. AD Components Consumption spending (C), Investment spending (I), Government purchases, G, Investment spending, I. Therefore Y+Q-X is equal to: and Being X and Q, export and import, respectively.

Keynesian model Pág.11 Equations: Susbtracting (7) - (8), s:

Keynesian model Pág.12 Ecuaciones del modelo: Substituting (4) in (3)

Simple keynesian model Pág.13 Substituting (5), (6), (9) y (10) in (2)

Keynesian model Pág.14 Equations are now: Substituting (11) into (1) :

Keynesian model Pág.15 In compact form: ¿Qué dice aquí? The equilibrium level of income is determined by the multiplier and by the autonomous expenditure component. Any increase in autonomous spending or any increase in the multiplier will change national income. Proof:

Keynesian model Pág.16 dAo: Interpretation Any change in autonomous consumption spending, autonomous investment spending, marginal propensity to consume out of disposable personal income, ttransfers, government purchases or autonomous net export will increase autonomous spending. On the other hand, any change in t, m or c will change the multiplier value

Check Pág.17 By using the last equation we can check that

Pág.18 Exogenous variables in the model can be splitted into two groups: a) variables depending on the individual’s decisions: (c, I, m); variables determined by authorities (Government or Central Bank):G, TR, XN, t. Changes in G, TR, XN and t are fiscal and trade policy variables. Changes in this variables are policy shocks. Since changes in G, TR y t, will lead changes in budget surplus, they are defined as fiscal policy instruments. Changes in tariffs or in the exchange rate in order to change NXo, are trade policy instruments. Types of changes in the exogenous variables

Expansionary vs. Contractionary policies Pág.19 If as a result of any kind of policy shock income increases, this policy is expansionary. The so-called contractionary policies lead income decreases. For instance, Increase in G : Fiscal policy expansionary A tax cut: Fiscal policy expansionary Decrease in TR: Fiscal policy contractionary A cut in tariffs: Trade policy contractionary A decreaase in the marginal propensity to consume (NO policy)

The model Pág.20 Renta,Y Demand (AD), Production (Y) HORIZONTAL AXIS: INCOME (Y) VERTICAL AXIS: DEMAND(AD)

45º LINE: EQUILIBRIUM CONDITION Y=DA Pág.21 INCOME,Y 45 o LINE Y=AD SLOPE= 1 Y1Y1 Y1Y1 Demand (AD), Production (Y)

THE INTENDED EXPENDITURE OR AD Pág.22 Y AD 45 o LINE AD SLOPE AD=c(1-t)-m Ao

THE EQUILIBRIUM Pág.23 Y AD 45 o LINE AD AUTONOMOUS SPENDING EQUILIBRIUM: Y = DA E

¿HOW AN INCREASE IN NET EXPORT WOULD AFFECT THE EQUILIBRIUM INCOME? Pág.24 45º AD 1 =A 1 +(c(1-t)-m)Y INCOME,Y Y=AD YoYo E YoYo Y1Y1 Y1Y1 E’ AD AD o =A o +(c(1-t)-m)Y A1A1 AoAo

HIGHLIGHTS Pág.25 C and I will decrease in recessions Howver, Government could increase G (government purchases): Government intervention vs. laissez faire-laissez-passer. Key argument: multiplier effect. From this model, what are the recipes for the crisis

Multiplier effect Pág.26 For simplicity suppose that we are in a closed economy, and suppose that Government increases the government purchases. The increase in government purchases by 1 euro changes intended spending by 1 euro and income in 1 euro. After tax, 1-t euros will be disposable for consumption. Therefore, the consumption spending will increase in c(1-t) euros, so the intended spending goes up and income will also increase in c(1-t). This new increase in income, will lead a new increase in consumption spending of …. The sum of the initial effects and the rest of induced effects determines that the multiplier will be higher than 1.

Fiscal policy and Budget surplus Pág.27 How an increase in G would affect the budget deficit?

Pág.28 Taking differences The increase in income from the increase in government purchases is, dY= αdG then: How an increase in G would affect the budget deficit?

Extensions

An increase in the Government purchases Pág.30 45º AD 1 =A 1 +(c(1-t)-m)Y Income,Y Y=AD YoYo E YoYo Y1Y1 Y1Y1 E’ AD AD o =A o +(c(1-t)-m)Y A o =C 0 +I 0 +G 0 +cTR o +NX o A 1 =C 0 +I 0 +G 1 +cTR o +NX o

An Increase in the Transfers Pág.31 45º AD 1 =A 1 +(c(1-t)-m)Y INCOME,Y Y=AD YoYo E YoYo Y1Y1 Y1Y1 E’ AD AD o =A o +(c(1-t)-m)Y A o =C 0 +I 0 +G 0 +cTR o +NX o A 1 =C 0 +I 0 +G 0 +cTR 1 +NX o

An increase in the tax rate Pág.32 45º AD 0 =A o +(c(1-t)-m)Y Income,Y Y=AD YoYo E’ Y1Y1 Y1Y1 YoYo E AD AD 1 =A o +(c(1-t 1 )-m)Y A o =C 0 +I 0 +G 0 +cTR o +NX o