1. Introduction to Macroeconomics
Chapter 22. Keynesian Macroeconomics

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. Graph Consumption Function Autonomous Consumption
Marginal Propensity to Consume
Savings
Marginal Propensity to Save
Average Propensity to Consume
Average Propensity to Save

9. 2. Consumption Consumption Function
C = C0 + b • Y
C = desired consumption
C0 = autonomous consumption
b = marginal propensity to consume
0 < b < 1
Y = income

10. 2. Consumption Graph Consumption Function
C = C0 + b • Y
Slope = b
Intercept = C0

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

12. 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)

13. 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

14. 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

15. 3. Simple Equilibrium Model Aggregate Expenditures
AE = C = C0 + MPC • Y
Slope = MPC
Intercept = C0

16. 3. Simple Equilibrium Model Equilibrium - the 45o Line
The 45o line: all points that represent potential equilibrium (aggregate expenditures = income)
45o

17. 3. Simple Equilibrium Model Aggregate Expenditures and the 45o LineAE
Equilibrium

18. 3. Simple Equilibrium Model Disequilibrium
Income > Spending
Undesired Inventory Build
45o Line AE
Income < Spending
Undesired Inventory Decline

19. 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

20. 3. Simple Equilibrium Model Shift in Autonomous Consumption
Slope = MPC = 0.67
dC0 = ± 5
dY = ± 15

21. 3. Simple Equilibrium Model Autonomous Consumption Multiplier
Spending = Income x Marginal Propensity to Consume

22. 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

23. 4. Add Investment to Model Aggregate Expenditures
AE = C + I = C0 + MPC • Y + I0
AE = C + I C
Slope = MPC
I0 = 10
C0 = 10

24. 4. Add Investment to Model Aggregate Expenditures and Equilibrium
45o Line
AE = C + I
Equilibrium C
I0 = 10
C0 = 10

25. 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

26. 5. Add Government Spending Aggregate Expenditures with Equilibrium
45o Line
Equilibrium
AE = C + I + G
C + I C
G0 = 10
I0 = 10
C0 = 10

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 7. Gaps Gaps and the Keynsian Cross
45o Line
Inflationary
Gap AE
Full-employment
Recessionary
Gap
Output
Output Gap
Output Gap

34. 8. Government Fiscal Policy
Lump Sum Tax
Lump Sum Tax Multiplier
Balanced Budget Multiplier

35. 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

36. 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

37. 8. Government Fiscal Policy Balanced Budget Multiplier