Chapter 2 The Basic Model: (three sector model)

Consumers, Producers and Government

Introducing the Consumer, Producer and Government

The basic Keynesian model is an Expenditure or Demand determined model Expenditure induces and determines production Changes in the equilibrium level of income are caused by changes in total expenditure

Assumptions of Keynesian Model

Expenditure model (Demand side model) (Chapter 2) Supply adjusts passively to demand changes (Chapter 6) Financial sector less important: Interest rates exogenous (Chapter 3) Closed economy : Foreign sector exogenous (Chapter 4) Price level unchanged (Chapter 6) No supply constraints ito labour, wages etc (Chapter 6)

Chapter 2: The basic model I: consumers, producers and government

How does it happen?

Complete Chain Reaction p 43:

Total expenditure increases, Expenditure bigger than production Stocks become depleted, Decision to adjust production upwards, Increase in Employment, Increase in Income, Increase in spending, And so Real GDP and Real Income (Y) increases. See cursive printed on p 43

The entire Keynesian approach is supported by this fundamental chain reaction

Now draw it

The shows the equilibrium between total expenditure and total production 45o line Point R shows the equilibrium. Y0 is where macroeconomic equilibrium is satisfied

E R AE

45o Y
0

Total Expenditure = Total Production

Right here!

Income, Production Y

Causes of fluctuations

Changes in trends and fluctuations in expenditure

Disturbances and shocks in the economy:

Changes in interest rates Money supply Taxation Gold price Exchange rate Balance of Payments Politics Business confidence International environment

Remember the Keynesian model framework

Consumption expenditure (C)

Capital formation (I) A model of C+I

Government expenditure (G)

Foreign expenditure (X-Z)

A model of C+I+G

A model of C+I+G+(X-Z)

Begin with Consumption expenditure

Consumption pertain to expenditure by households on consumable items and services. In this model expenditure on imported items is included in total consumption expenditure C=f(Yd, Wealth, expectations, habit, demographic factors) Why?

 The most important factor according to Keynes is Yd (Y-T)

( disposable income)

C= a + bYd

dC b = dYd

is MPC (marginal propensity to consume)

0<b<1 (Slope) If Yd=0 C= a : this is called autonomous consumption expenditure

The Keynesian Consumption function

The positive slope indicates the positive relationship between consumption and real income
a = autonomous consumption expenditure b = slope = MPC

C
c1 a 45o Y1
Income Y

C= a +bY

So . C= a + bYd

 For Duesenberry, consumption is not much determined by the absolute level of income, but also by the income of individual or households relative to that of friends or neighbors, or relative to higher level of their own income in a earlier period. (Behavioral)
For Friedman, households consumption depend less on the current income of a household at a certain time than on the level of income that this household expect to earn normally (permanent income). According to the life cycle income theory, households and individuals plan their expenditure given an expected pattern of income over their entire life time. C=f(Yd, Ye, Asset): Young people borrow more.

Introducing Investment
It is the purchase of productive or capital goods.
It is made of fixed investments and inventory (stock).

Investment = f (interest rates, expectations, business confidence, regulations)

Investment and interest rates have negative relationship. Why? This is because the interest rate is the opportunity cost of capital formation.

Investment function

Investment and interest rate have a negative relationship

i
io i1 Io I1 Investment (I)

interest rate is the opportunity cost of capital formation

Planned Capital Formation

Note:
Higher interest rate Higher costs Lower planned capital formation

i
1 5 10 5 Capital formation curve

2000

4500 6000

So we can now move along the I-curve

i (%)
Only when there is a i
i then I
i then I

i1 i2
0

I1

I2

Graph on page 55

E
C+ I C

i0 I
0

I Y
0 Income (Y)

I
0

Investment (I)

Changes in equilibrium: The Multiplier

Suppose interest rate falls E Decreases opportunity cost of I Investment will be encouraged Therefore total expenditureand sales increase Decline in inventories Decision to increase production to match higher expenditure The change in expenditure leads to a change in equilibrium income and production Economy in an upswing

C+I1 C+I0

I1
45o Y0 Y1 Income Y I0

Graph on page 56

E
C + I1 C + I0

i0 i1 I0 I1

I1 I0
Investment (I)

I1 I0 Y0 Y1
Income (Y)

Multiplier concept

Y multiplier Exp

The multiplier is I = 150 calculated as follows:

1/ (1-MPC)

= 1/(1-b)

Example: MPC = 0.8 1/(1-0.8) = 1/0.2 = 5

150 Production 120

120 150 Income

1 K Leakage

Spend 120 96

Save 30 24

Government Expenditure (G) & Taxation (t) Government expenditure concerns the purchase of goods and services by the general government.
Exhaustive expenditure and transfers In national accounts data, only the consumption expenditure by the general government is indicated separately. Government investment is included in the gross capital formation (investment) figure. Total government expenditure (G) sums both.

Fiscal policy, why worry?

Graph on page 61

E
C + I0 + G0 C + I0 C

i0
G0 G0 I0

I0 I0
Investment (I)

Y0

Income (Y)

Tax Multiplier (Autonomous Tax)

Taxation has an indirect effect on equilibrium income,

via its impact on disposable income and therefore, on consumption.

The tax multiplier (KT ) is smaller than the expenditure multiplier by a factor equal to the marginal propensity to consume (MPC).
This means that a R1million increase in government expenditure, for example, will not have the same impact on equilibrium income Y as a R1million reduction in total taxation.

Remember: An increase in G and reduction in T are both example of expansionary fiscal policy. But why would you use it?

Give us Proof

Y=C+I+G But C = a + bYd

Y = a + bYd + I + G and Yd = Y T

Y= a+ b(Y-T) + I + G and T = tY

Y + a + b (Y tY) + I + G Y = a + b (1-t) Y + I + G

Graphically

Effect of G Autonomous

demand increases (curve E shifts up)

C+I+G C+I

Effect of T:

600

Changes the slope (curve swivels down ) 250 0 b (1-t)

Yd

All together Now

E=Y
Equilibrium:

E C+I+G C+I C

Y = Spending Y=E Y=C+I+G Where C + I + G cuts the 45o line Ye = Multi x Auto E But the multiplier changes now

Y1

Y2

Y3

Yd