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Economics 405 Linda Kamas

Santa Clara University April 22, 24, 2014

NOTES ON THE SIMPLE KEYNESIAN MODEL

I. Aggregate Demand or Planned Expenditure (E
p
): E
p
= C + I
p
+ G + NX

Aggregate demand or planned expenditure determines the level of GDP.

Aggregate demand and planned expenditure are the same thing. We will call it
aggregate demand AD when we graph it with varying prices and aggregate
expenditure when we ignore price changes.

Firms respond to demand:

Decrease in Aggregate Expenditure: excess supply of goods; firms see sales
decline and inventories increase. They respond to undesired increase in inventories
by decreasing production. GDP declines, employment declines. and unemployment
rises. (Firms may also lower prices; we will cover this later.)

Increase in Aggregate Expenditure: excess demand for goods; causes an
undesired decline in inventories and firms respond by producing more and
GDP increases, employment increases, and unemployment falls.
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Simple Keynesian model: assume prices and interest rates are given at some
predetermined level.

Aggregate demand/expenditure consists of planned consumption, investment,
government spending and net exports. We assume consumers, the government and
foreigners spend what they plan, so actual and planned C, G, and NX are equal
therefore we do not use a subscript p. However, actual investment may or may not
equal planned investment because it includes changes in inventories or unsold goods.

Aggregate demand or planned expenditure is:

E
p
= C + I
p
+ G + NX


Type of Demand Economic actor
Consumption (and Saving) Households
Investment (new capital goods) Firms
Government Spending on Goods & Services Federal, state, & local govern.
Net Exports (exports-imports) Foreigners
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II. Components of Aggregate Demand or Planned Expenditure:

A. Consumption: Consumption spending depends on disposable income (after-tax
income). The greater disposable income, the greater consumption spending. (Other
factors that may affect consumption include: wealth and debt, interest rates,
consumer confidence and expectations about the future. For now, we will ignore
these. They will just be assumed to shift the consumption function up or down)

Consumption Function: C = C
a
+ c Y
D
numerical example: C = 75 + 0.5Y
D


C
a
(or 75) is autonomous consumption - spending that is not dependent on income.
If income were zero, consumption would be C
a
(or 75).

c (or 0.5) is the marginal propensity to consume: this is the fraction of an extra
dollar of disposable income that will be spent on consumer goods ( C/ Y
D
).
(There is also a marginal propensity to save s = S/ Y
D
= 1-c).

Disposable Income is national income minus taxes (Y
D
= Y T). Assume taxes are a
fixed amount, that is they do not depend on income so they are autonomous:

Taxes: T = T
a
T
a
= 100.

Consumption function is:
C = C
a
+ c(Y-T
a
) C = 75 + 0.5(Y - 100)
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2007 2008 2009
Income $100,000 $100,000 $100,000
Consumption $70,000 $85,000 $60,000
IncomeTaxes $20,000 $20,000 $20,000
Saving $10,000 - $5,000 $20,000
Wealth $300,000 $380,000 $230,000
House equity = value mortgage $200,000 $250,000 $150,000
Stock $80,000 $110,000 $60,000
Other assets (bonds, money, etc.) $20,000 $20,000 $20,000
B. Saving: Saving is defined to be that part of income that is not spent on
consumption or taxes:

S = Y C T

Note that this excludes capital gains since they are not included in GDP or
national income, so saving is not the same as the change in wealth:

Example:
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Saving from 2007 increases wealth (say it is put into the stock market so the
value of stock holdings increases $10,000 in 2008 due to new purchases and
another $20,000 due to rising stock prices, or capital gains.

But, capital gains may also increase wealth. Wealth increased by $80,000
while saving was only $10,000.

In 2008, if this person decides to spend more ($85,000 rather than $70,000)
due to his or her higher wealth) this will make the saving rate decline.
Previously, this person saved 10% of total income or 12.5% of disposable
income (income taxes). Now, he or she is saving a negative amount or
dissaving, yet he or she is far wealthier so it may not have seemed like a bad
idea at the time (consumption increased $15,000 while wealth increased
$80,000.

This works backwards as well large losses in wealth can lead to increased
saving in order to rebuild wealth (or fear of losing ones job).


Returns from Leverage: Housing Example

Buy house: $500,000
(1) Down Payment (20%): $100,000
Borrow (mortgage) $400,000 at 5% interest.

If house price rise 10% house is now
worth $550,000. Earn $50,000 on $100,000
for rate of return of 50%. ($50,000/$100,000)

But, if house price declines 10%, have
$50,000 loss or 50% (- $50,000/$100,000)

Leverage magnifies percentage gains or
losses.

(2) If down payment was only $25,000 and
house price rises 10%, earn $50,000 on
$25,000 or 200% return.

Problem with high leverage: if house price
falls 5% or more (below $475,000), the
homeowner will owe more than the house is
worth house is underwater. Housing
prices fell 20-30% or more in many cases.
Assets | Liabilities & Equity
$500,000 $400,000 Loan
$100,000 Equity
Assets | Liabilities & Equity
$550,000 $400,000 Loan
$150,000 Equity
Assets | Liabilities & Equity
$450,000 $400,000 Loan
$50,000 Equity
Assets | Liabilities & Equity
$500,000 $475,000 Loan
$25,000 Equity
Assets | Liabilities & Equity
$550,000 $475,000 Loan
$75,000 Equity
Assets | Liabilities & Equity
$450,000 $475,000 Loan
- $25,000 Equity
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Example including interest payment on mortgage:

(1) $100,000 down payment, $400,000 mortgage:

Sell house for $550,000 earn $50,000
Mortgage interest paid for year is $20,000 (.05 x $400,000)
Net earnings: $30,000 ($50,000 - $20,000)
Rate of return is 30% (100 x $30,000/$100,000)

(and is higher if include tax savings on mortgage interest paid; also live in the
house for a year)

(2) $25,000 down payment, $475,000 mortgage:

Sell house for $550,000 earn $50,000
Mortgage interest payment is $23,750 (.05 x $475,000)
Net earnings $26,250 ($50,000 - $23,750)
Rate of return is 105% (100 x $26,250/$25,000)

As long as interest rate paid on mortgage is less than the percentage increase
in the house price, leverage magnifies gains.

Investors (investment banks, hedge funds etc.)

Some leveraged more than 30 (even 50) times; even with small spreads between
earnings and cost of funds leads to huge profits:

Invest $3 million
Borrow $97 million at 4.5%
Buy $100 million risky securities
$100 million assets rise by 5% or $5 million
Interest costs .045 x $97 = $4.365 million
Dollar return = $5 $4.365 = $0.635 million
Rate of return = 100 x $0.635/$3 = 21.2%

Problem: If value of risky assets declines more than 3% wipes out total investment.
May be unable to continue getting loans and forced to sell assets. More
people/banks selling assets the more the asset prices decline (fire sales) further
worsening the situation.

Capital requirements or leverage ratio limits on banks or financial institutions
limit the percentage of assets that can be borrowed as opposed to equity financed.

Assets | Liabilities & Equity
$100 $97 Loans
$3 Equity
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C. Planned Investment:

Planned Investment is the desired purchase of capital goods by firms plus
planned change in inventories (say due to changed expectations of future
sales).

Investment depends on the expected profit of potential investment projects
and the cost of borrowing money, the interest rate. Higher interest rates
should reduce investment by raising the cost of funds. For now, we will
assume the interest rate is given. This implies investment is given at I
p
, for
example:


I
p
= 50


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Note on Inventories:

Unwanted changes in inventories ( I
u
) signal

the firms that they have over- or
under-produced and they respond by decreasing or increasing production.

Desired changes in inventories are included as part of planned investment and
are not a signal that firms have mistaken demand. An increased in planned
inventories may be a positive sign, since firms may be increasing inventories
because they are expecting sales to grow.

I
p
: Planned investment = purchases of capital goods and desired changes in
inventories

I: From GDP accounting, actual Investment = planned investment + unwanted
changes in inventories

I = I
p
+ I
u


Planned investment = actual investment when there are no undesired changes in
inventories. Firms have produced exactly what is demanded so there is no
reason for them to increase or decrease production

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D. Government Spending:

Government spending is set by the President and Congress, so we will
assume it is given at G, or


G = 150



E. Net Exports:

For simplicity, we take net exports NX as given; in practice they may
depend on the level of domestic income, foreign income, domestic and
foreign price levels, and the exchange rate


NX =25


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III. Equilibrium GDP:

GDP is at an equilibrium when there are no forces at work to make it change.
This occurs when firms' plans to sell goods and services are met - there are no
unwanted changes in inventories. Think of E
p
as demand and Y as production
or supply:


1. If E
p
< Y Aggregate demand or planned expenditure is less than
production (excess supply of goods), inventories rise
(I
u
>
.
0), firms reduce production, GDP declines.

2. If E
p
> Y Aggregate demand or planned expenditure is greater than
production (excess demand for goods), inventories decline
(I
u
<
.
0), firms increase production, GDP rises.

3. If E
p
= Y Aggregate demand or planned expenditure equals
production, there are no unwanted inventory changes (I
u
=0),
firms' expected sales and planned investment are met (I = I
p
),
there is no reason for them to change production. GDP is
constant. This is the equilibrium GDP.

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IV. Calculating Equilibrium GDP:

Demand or Planned Expenditure:

E
p
= C + I
p
+ G + NX E
p
= C + I
p
+ G + NX

E
p
= C
a
+ cY
D
+ I
p
+ G + N E
p
= 75 + 0.5Y
D
+ 50 + 150 + 25

E
p
= C
a
+ c (Y-T
a
) + I
p
+ G + NX E
p
= 75 + 0.5(Y - 100) + 50 + 150 + 25

E
p
= C
a
+ cY cT
a
+ I
p
+ G + NX E
p
= 75 + 0.5Y - (0.5x100) +50 + 150 + 25

let A
p
= C
a
cT
a
+ I
p
+ G + NX (A
p
is total autonomous planned spending or
spending that does not depend on Income:
A
p
= 250

[note that this has nothing to do with A in the growth model where A stands for
multifactor productivity its unfortunate your text uses A for both]

E
p
= A
p
+ cY E
p
= 250 + 0.5Y

This is the equation of the planned expenditure curve .
The intercept is A
p
= 250 and the slope is c = 0.5.

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There is only one level of GDP where the economy is at equilibrium:

production equals aggregate demand or expenditure Y = E
p
or unwanted
changes in inventories are zero I
u
= 0:


Y = E
p
Y = E
p


Y = A
p
+ cY Y = 250 + 0.5Y

Y(1- c) = A
p
Y(1-0.5) = 250

Y = (1/(1- c)) A
p
Y = (1/0.5)250 = 2 x 250 = 500

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Y
2
Y
45
0
Y
3
Y
1
E
p
2
3
1
500
Equilibrium
Unplanned
decrease in
inventories
E
p
= C+I
p
+G +NX
Y
E
p
250

A
p
Unplanned
increase in
inventories
Graphically: Equation of planned expenditure curve is: E
p
= 250 + 0.5Y
(250 is the intercept and 0.5 is the slope).

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Explanation of the 45 degree line:

Equation of 45 degree line: E
p
= Y (intercept is zero and slope is one)
whatever is measured on the vertical axis equals what is measured on
the horizontal axis (e.g. points (0,0), (100,100), (200,200), etc.).

Here, the point where the E
p
curve crosses the 45 degree line is where
E
p
= Y or it is equilibrium GDP.

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V. Changes in Aggregate Demand - the Multiplier

If there is an increase in any component of aggregate demand (C, I
p
, G or NX),
firms will respond to the higher demand by producing more. This raises
incomes of people working for the firms. They will spend part of this higher
income (the marginal propensity to consume times the change in income). This
creates further demand for goods and services, production rises, incomes rise
more, demand rises more, etc. The final increase in income and production is
larger than the initial increase in aggregate demand. This is called the
multiplier, since a given change in aggregate demand has a multiplied effect on
national output. (Note, the multiplier works downward as well as upward.
Decreases in aggregate demand cause larger declines in output.) The multiplier
helps explain some of the instability of GDP and business cycles.

For example: if G rises from 150 to
200:

E
p
= 75 + 0.5(Y - 100) + 50 + 200 + 25
E
p
= 300 + 0.5Y

At equilibrium: Y = E
p

Y = 300 + 0.5Y
Y = (1/0.5) 300 = 2(300) = 600.
E
p0

E
p1

1
250
300
Y
45
0
E
p
0
500 600
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The multiplier is the change in GDP for each $1 change in government spending:
Y/ G

GDP increased from $500 to $600 for a change of $100.
Government spending rose from $150 to $200 for a change of $50.

Therefore, the multiplier is $100/$50 = 2.

The coefficient on A
p
in the equilibrium equation above is the multiplier: 1/(1- c). This
is because a $1 increase in A
p
will cause GDP to increase by 1/(1- c). If c = 0.5 as in
our example above, the multiplier is 1/(1-0.5) = 1/0.5 = 2. This means that a $1
increase in A
p
will cause a $2 increase in equilibrium GDP. The larger the marginal
propensity to consume, the larger the multiplier, because if people spend more when
their incomes rise, aggregate demand will rise more and so will production. Since the
marginal propensity to save s = (1-c), the multiplier is also 1/s)

Note: the multiplier for changes in taxes is smaller than that for other components of
autonomous spending, such as G, because people do not spend every dollar of tax
cuts, some is saved. They spend the marginal propensity to consume times the tax
change. This implies that the tax multiplier is the marginal propensity to consume
times the government multiplier: - c (1/(1-c). Expenditures rise less for a tax cut than
for an increase in government spending, so GDP rises less.

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VI. Taxes Proportional to Income: T = tY A more realistic model takes taxes to be
proportional to income: T = tY (where T is dollar tax revenues and t is the tax rate) for
example: T = 0.2Y

General Case: Numerical Example:
C = C
a
+ cY
D
C = 75 + 0.5Y
D

Y
D
= Y - T = Y - tY Y
D
= Y - 0.2Y
I
p
, G, NX given I
p
= 50 G = 150 NX = 25

Aggregate demand or planned expenditure is: E
p
= C + I
p
+ G + NX

E
p
= C
a
+ c(Y - tY) + I
p
+ G + NX E
p
= 75 + 0.5(Y - 0.2Y) + 50 + 150 + 25

E
p
= C
a
+ c(1-t)Y + I
p
+ G + + NX

equation of E
p
curve, where autonomous spending A
p
= C
a
+ I
p
+ G + NX:

E
p
= A
p
+ c(1-t)Y E
p
= 300 + 0.4Y

Graphically (intercept of E
p
is A
p
= 300 and slope is c(1-t) = 0.4). The slope is smaller
because when households get $1 more income, they pay $0.20 as taxes, disposable
income is up $0.80 and they spend 0.5 (= mpc) of that or 0.4.

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Y 45
0
E
p

Slope
c (1-t) = 0.4
E
p

0
500
E
p
= 300 + 0.4Y

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Equilibrium: Y = E
p


Y = A
p
+ c(1-t)Y Y = 300 + 0.4Y

Y - c(1-t)Y = A
p
Y - 0.4Y = 300

Y(1 - c(1-t)) = A
p
Y(1 - 0.4) = 300

Y = 1 A
p
Y = (1/0.6)300 = 1.67(300) = 500
1 - c(1-t)

The new multiplier is the coefficient on A
p
: = 1 = 1.67.
1 - c(1-t)

The multiplier is smaller with proportional taxes because taxes reduce disposable
income at each stage of the multiplier process, so the increase in consumption
spending is less than it would have been without proportional taxes. Similarly,
when aggregate demand falls, the decline in disposable income is less than the
decline in total income (since when total income falls by $1, taxes fall by $0.20 and
disposable income declines $.80). Consumption declines less, so the multiplier is
smaller.

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Taxes act as an automatic stabilizer when GDP declines, the decline in tax
collections reduces the decline in expenditure so GDP falls less than it would
otherwise; when GDP rises, the increase in taxes reduces the increase in
expenditure so GDP rises less than it would otherwise.

A change in the tax rate will change the slope of the aggregate demand curve.
The slope is c(1 - t). Therefore, an increase in the tax rate will make the slope
flatter and reduce the equilibrium level of GDP. A higher tax rate will also reduce
the multiplier because people will have less disposable income to spend at each
stage of the multiplier process.

The Keynesian model can be made more and more complex by including other
variables in the equations. For example, the consumption function may depend
on interest rates and wealth, the investment demand may depend on interest
rates and expected sales (proxied by GDP growth), and net exports may be
affected by domestic income, foreign income, prices and the exchange rate. In
addition, we may distinguish between different types of consumption (non-
durables, durables or services) and different types of investment (plant and
equipment or residential) and have a separate equation for each one. The basic
structures of the models are the same but the equations are more complicated.
Some macro models have more than 200 equations.

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SUMMARY OF MULIPLIERS

Multiplier of Change in: Fixed Tax Model
(T = T
a
or T

= 100)
Proportional Tax Model
(T = tY or T = 0.2Y)

Consumption Y/C
Investment Y/I
Government Spending Y/G
Net Exports Y/NX


Tax Y/T




not required
1
1 - c(1-t)
1
1 - c
_ c
s
1
s
_ c
1 - c
or
or