Post on 06-Feb-2016
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The circular flow of income and the
Keynesian multiplier
Equilibrium in the goods market
Equilibrium in the goods market
The analysis of the goods market equilibrium is the starting point of Macroeconomic analysis (particularly from the Keynesian point of view)All the goods and services are aggregated
into a single market ⇒ 1 equationThe purpose is to find the equilibrium level
of output Y* on this market ⇒ 1 unknownA second issue is to describe how Y* varies
as a function of other macroeconomic variables
Equilibrium in the goods market
The circular flow of income
Aggregate demand and output
The multiplier and role of savings
The circular flow of income
Households Firms
Labour
Income €
Goods
Expenditure€
The circular flow of income
Households Firms
Labour
Goods
Real flows
The circular flow of income
Households Firms
Income €
Expenditure€
Monetary flows
The circular flow of income
The circular flow of income is what guarantees the central accounting identities
Three definitions of GDP (output) Sum of the expenditures Z Sum of the value added produced Q Sum of the incomes distributed Y
Accounting identities Production = Aggregate demand / expenditure
Q = Z Production = Incomes of factors of production
Q = Y
Equilibrium in the goods market
The circular flow of income
Aggregate demand and output
The multiplier and role of savings
Aggregate demand and output
In the Keynesian model, the aggregate demand (also called planned expenditure) in a closed economy with no government is:
Z = C + I
with Z : Aggregate Demand
C : Consumption of households
I : Investment of firms
Aggregate demand and output
Consumption C is not fixed. Its level depends on the level of income Y, and is given by the consumption function.
C = C0 + cY
Where C0 is the autonomous level of consumption, i.e. the level
of consumption that does not depend on income c is the marginal propensity to consume (mpc) : the
amount spent out of an extra unit of income. The converse is the marginal propensity to save (mps) s,
such that
c + s = 1
Aggregate demand and output
For the moment, investment I is considered to be exogenous.
Its level is pre-determined and does not depend on output
This is a simplifying assumption that will be relaxed later on (when interest rates are introduced)
Aggregate demand Z is therefore a function of output Y, of the marginal propensity to consume c and of the exogenous level of investment I.
Z = C0 + cY + I
Aggregate demand and output
Income, output Y
Aggregate Demand (planned expenditure)
Z = C0 + cY + I
mpc: 0<c<1
Aggregate demand as a function of income
Autonomous demand (not a function of Y)
C0 + I
Aggregate Demand Z
Aggregate demand and output
Effective demand and equilibrium For any level of planned expenditure Z (with a
slope < 1), There is only a single point for which the planned expenditure is equal to the level of income Y
This gives the equilibrium condition on the goods market: Y = Z
There is no guarantee that this point is a full employment equilibrium !!
This will be examined later.
Aggregate demand and output
45°
Effective expenditure
Y = Z
Keynesian Equilibrium Output
Y* Income, output Y
Aggregate Demand (planned expenditure)
Z = C0 + cY + I
Equilibrium on the goods market
Aggregate Demand Z
Aggregate demand and output
For each aggregate demand curve Z there is only a single point for which the planned expenditure is equal to the level of income Y But Z is determined by the plans of agents!
What happens if the level of planned expenditure Z is not equal to Y ? The goods market is not in equilibrium !! Output will adjust so that the equilibrium is
reached
Aggregate demand and output
Effective expenditure
Y* Income, output Y
Aggregate Demand (planned expenditure)
Disequilibrium with Z > Y
Z
Y
Unplanned reduction in inventories
The firms are selling more than they are producing. They have to increase production in order to meet the aggregate demand, which brings the goods market back to Y*
Y
Aggregate Demand Z
45°
Y
Z
Aggregate demand and output
Effective expenditure
Y* Income, output Y
Aggregate Demand (planned expenditure)
Disequilibrium with Z < Y
Y
Unplanned increase in inventories .
Firms are selling less than they are producing. They reduce output which brings the goods market back to Y*
Aggregate Demand Z
45°
Equilibrium in the goods market
The circular flow of income
Aggregate demand and output
The multiplier and role of savings
The multiplier and the role of savings
So aggregate demand is given by
Z = C + I
And the equilibrium condition is
Y = Z
So what happens to output Y if investment I increases by an amount ΔI ?
In fact, ΔY > ΔI !! Why is that?
The multiplier and the role of savings
45°
Y = Z
Y1Income, output Y
Z1 = C0 + cY + I1
Multiplier effect on the goods market
Aggregate Demand Z
Z2 = C0 + cY + I2
ΔY
Y2
ΔI
1. An increase in planned investment…
2. …leads to a more than proportional increase in income
The multiplier and the role of savings
Aggregate demand is given by : Z = C0 + cY + I And Y = Z Solving for the equilibrium level of output gives us
:
There are 2 equivalent interpretations to this result
ICc
Y
ICcY
IcYCY
0
0
0
1
1
1
cI
Y
1
1Multiplier
Autonomous demand
(exogenous)
The multiplier and the role of savings
Why do we observe ΔY > ΔI ?
Increase in planned investment
ΔI
Increase in income
ΔY
Increase in savings
ΔY × mps
Increase in consumption
ΔY × mpc
First interpretation: a multiplier effect due to the circular flow of income
The multiplier and the role of savings
Why do we observe ΔY > ΔI ?
Step 1 : output increases by ΔI Step 2 : output increases by c × ΔI Step 3 : output increases by c2 × ΔI Step 4 : output increases by c3 × ΔI ..... This continues forever ! The closer c is to 1,
i.e. the less people save, the larger the effect. (why ?)
The aggregate size of the increase is equal to:
ccccc
1
1...1 432
The multiplier and the role of savings
Why do we observe ΔY > ΔI ?
Second interpretation: The economy is increasing output in order to balance investments and savings
This is because the equilibrium condition Y=Z is equivalent to I=S (planned investment = savings)
These two equilibrium conditions are equivalent !
The multiplier and the role of savings
Aggregate demand can be decomposed into consumption and investment
Z = C + I Income can be decomposed into
consumption and savingsY = Y(c+s) = C + S
So one can see that setting Y=Z is equivalent to setting I=S !
SIZY
The multiplier and the role of savings
Why do we observe ΔY > ΔI ?
Starting from equilibrium, if investment increases by ΔI, then we are no longer in equilibrium:
I + ΔI > S To get back to equilibrium, we need savings to
increase by the same amount (ΔS = ΔI).
Given the savings function,
So we have
YsS
sS
Y 1
sI
Y 1
⇒ ⇒ cI
Y
1
1
The multiplier and the role of savings
Why do we observe ΔY > ΔI ?
Both explanations (spending multiplier or savings/investment balancing) are equally valid.
The spending multiplier is usually easier to understand, and is found in most manuals
The savings/investment balance, however, often brings more interesting explanations of the real-life economic phenomena.