The Expanded Model of Income Determination

Expanded model of income determination In chapter 14, a very basic Keynesian model of income determination was introduced This model serves as an introduction to income determination and capacity utilisation in the economy If is far to simple to be of any use in the real world, but it establishes some important points nevertheless

Keynes, John Maynard, 1st Baron Keynes of Tilton ( )

Expanded model of income determination Recall when Keynes was writing – mid thirties with massive unemployment Established theory until then had assumed that this would be a temporary phenomenon In a world with flexible prices, in the long run equilibrium will exist in all markets Keynes: In the long run, we are all dead

Expanded model of income determination Keynes gave politicians theoretically sound arguments for intervening in the economy Keynes in particular focused on how the authorities could affect aggregate demand through fiscal policy, i.e. government purchases of goods and services and taxes In chapter 15, this is incorporated into the basic model of income determination.

Expanded Model of Income Determination We introduce a public sector, with government purchases of goods and services G and taxes T. This model could be labelled a Keynes model for a closed economy with a public sector Later in the chapter, another sector is introduced – the foreign sector. Only goods transactions takes place, exports (X) and imports (Z) This chapter also provides a more satisfactory explanation of investment demand

Investment demand Demand for investment goods (I) very much depends on the outlook for the economy Profitability depends on: Investment outlay Increased income due to the investment Costs of financing the investment Increased income – cost of investment = MEI (marginal efficiency of investment) Cost of financing: R

Time value of money The investment outlay is paid for ”today” Income will accrue in the future, and value may be reduced due to: impatience and postponement of demand risk inflation Income must be discounted by an interest rate R

Net Present Value Example: Investment outlay = Income year 1: Income year 2: 2: Interest rate (R) = 5 % (0,05) What is the PV of the income?

Marginal Efficiency of Investment (MEI) Marginal efficiency ofinvestment Rate of return (R) R2R2 I2I2 R1R1 I1I1 I0I0

Expectations change Marginal efficiency ofinvestment Rate of return (R) I0I0 R0R0 I1I1 I2I2

The accelerator changes in national income and induced investment the accelerator coefficient the instability of investment The multiplier / accelerator interaction Keynesian business cycle

Fluctuations in UK real GDP and investment:

GDP

Fluctuations in UK real GDP and investment: GDP Investment

Accelerator in Norway

Accelerator theory capital output ratio = 2

Accelerator theory Investments are dependent on expected changes in GDP or I =   Y Accelerator – a small change in income gives a large change in induced investment This depends on the marginal ratio between capital and production In addition, we will have multiplier effects between I and Y

Introducing the public sector Taxes T represent a withdrawal from the economic circulation (like savings S) The Governments demand for goods and services G represent an injection (like investments I) Equilibrium when realised withdrawals = realised injections S + T = I + G

Keynes expanded model - 1 The public sectors demand for goods and services G is always exogenous Taxes (T) Version 1: Lump sum taxes T = T Version 2: Income taxes T = tY, where t is the (average) tax rate

The model version 1

Equilibrium

An example Assume we have the following: C = 0,8Yd I = 60 G = 50 T = 50

The multipliers

The model

Haavelmos theorem What happens if an increase in public spending is financed by an equivalent tax increase, i.e.  G=  T?

The Model Version 2

Equilibrium

The multipliers

The model

Built in stabilisers Governmentexpenditure and Taxes Yb G G T T

Introducing the foreign sector Imports: Z and Exports: X Equilibrium when leakages = injections S + T + Z = I + G + X It is assumed that imports are endogenous and dependent on income Exports are exogenous

Economic circulation

The model

The multipliers

The open economy model