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Intermediate Macroeconomics
The Keynesian Model
1. Simple Keynesian model2. Aggregate expenditures3. Equilibrium4. Consumption function5. Autonomous spending6. Autonomous spending multiplier7. Government fiscal policy8. Automatic stabilizers
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Intermediate Macroeconomics
1. Simple Keynesian Model
Macroeconomics in a recession: Classical macro theory:
Prices will fall thereby stimulating demand.
Interest rates will fall thereby stimulatinginvestment. Keynesian macro theory:
Prices, wages and interest rate are fixed.
Government fiscal policy stimulus needed.
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Intermediate Macroeconomics
2. Aggregate Expenditures
AE = C + I + G + NX
C = ConsumptionI = Private Domestic InvestmentG = Government SpendingNX = Net Exports (Exports - Imports)
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Intermediate Macroeconomics
3. Equilibrium
Y = AE
Undesired Inventory Build: Y > AE
Undesired Inventory Draw: Y < AE
where, Y = National Income AE = Aggregate Expenditures
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Intermediate Macroeconomics
4. Consumption Function
C = C 0 + c Y
Co = Autonomous consumptionc = Marginal propensity to consume
out of income (MPC)Y = Income
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Intermediate Macroeconomics
4. Consumption Function
0
1000
2000
3000
4000
5000
0 1000 2000 3000 4000 5000
Income
D e s
i r e
d C o n s
u m p
t i o
C 0 = 500
2500
c = MPC = slope of consumption function
= (2500 - 500) / (2500 - 0)= 0.8
Saving Dissaving
2500
C = C 0 + c
Y
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Intermediate Macroeconomics
5. Autonomous Spending
Spending that is independent of anyother variable (e.g., income, prices,interest rate)
C0 = Autonomous Consumption I0 = Autonomous Investment G
0 = Autonomous Government
Spending
Autonomous ( adj .) - self-governing
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Intermediate Macroeconomics
6. Autonomous Spending MultiplierEquilibrium model solution
Step 1. Restate aggregate expendituresStep 2. State the equilibrium condition
Step 3. Substitute aggregateexpenditures from Step 1 intoequilibrium condition in Step 2
Step 4. Solve for Y (national income)
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Intermediate Macroeconomics
6. Autonomous Spending MultiplierStep 1. Aggregate expenditures restated
Given: AE = C + I + G + NXC = C 0 + c Y
I = I0G = G 0 NX = 0
Step 1 . Substitute into equation for aggregateexpenditures:
AE = C 0 + c Y + I0 + G 0
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Intermediate Macroeconomics
6. Autonomous Spending Multiplier Aggregate expenditures curve
0
1000
2000
3000
4000
5000
6000
7000
0 1000 2000 3000 4000 5000 6000 7000
Income
E x p e n
d i t u r e s
5000
C0 + I 0 + G 0 + NX = 1000MPC = slope of consumption line
= slope aggregate expenditure line= (5000 - 1000) / (5000 - 0) = 0.8
5000
AE = (C 0 + I0 + G 0) + c
Y AE C
45 o Line (AE = Y)all possible equilibria
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Intermediate Macroeconomics
6. Autonomous spending multiplierSteps 2 and 3
Step 2 . State the Equilibrium Condition:Y = AE
Step 3 . Substitute AE from Step 1 intoStep 2:Y = C0 + c Y + I0 + G 0
orY = (C0 + I0 + G 0) + c Y
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Intermediate Macroeconomics
6. Autonomous spending multiplierStep 4. Solve for National Income (Y)
Y = (C 0 + I0 + G 0) + c Y
Y - c Y = C 0 + I0 + G 0
(1 - c) Y = C 0 + I0 + G 0
Y = 1 (C0 + I0 + G 0)1 - c
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Intermediate Macroeconomics
6. Autonomous Spending Multiplier
Change in Y = Multiplier Change in C 0, I0,orG0
Equilibrium model solution:
Y = 1 (C0 + I0 + G 0)1 - c
Autonomous Spending Multiplier:1 or 1
1 - c 1 - MPC
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Intermediate Macroeconomics
7. Government Fiscal Policy
Given Equations: AE = C + I + G + NXC = C 0 + c YD
I = I0, G = G 0, NX = 0YD = Y - t Y - T0 + TR
YD = disposable income
t Y = income tax revenuesT0 = lump sum taxTR = govt transfer payments
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Intermediate Macroeconomics
7. Government Fiscal PolicyStep 1. Restate aggregate expenditures
AE = C + I + G + NX
= C 0 + c YD + I0 + G 0
= C 0 + c (Y - t Y - T0 + TR) + I 0 +G0
= C 0 + I0 + G 0 + c Y - c t Y - c T0 + c
TR
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Intermediate Macroeconomics
7. Government Fiscal PolicySteps 2 and 3
Step 2 . State the Equilibrium Condition:Y = AE
Step 3 . Substitute AE from Step 1 intoStep 2:
Y = C0 + I0 + G 0+ c Y - c t Y - c T0 + c TR
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Intermediate Macroeconomics
7. Government Fiscal PolicyStep 4. Solve for National Income (Y)
Y = C 0 + I0 + G 0 + c Y - c t Y - c T0 + c TR
Y = C 0 + I0 + G 0 - c T0 + c TR + (c - c t) Y Y = C
0+ I
0 + G
0 - c T
0 + c TR + c (1 - t) Y
Y - c (1 - t ) Y = C 0 + I0 + G 0 + c (TR - T 0)
[1 - c (1 - t )] Y = C 0 + I0 + G 0 + c (TR - T 0)
Y = 1 [C0 + I0 + G 0 + c (TR - T 0)][1 - c (1 - t )]
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Intermediate Macroeconomics
7. Government Fiscal PolicyMultipliers
No IncomeTax
(t = 0.0)
Income Tax(t = 0.3)
AutonomousSpending
1 = 51 - c
1 = 2.31 c (1-t)
TransferPayment
c = 41 - c
c = 1.81 c (1-t)
Lump SumTax
- c = - 41 - c
- c = - 1.81 c (1-t)
Assume c (marginal propensity to consume) = 0.8
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Intermediate Macroeconomics
7. Government Fiscal PolicyBalanced budget multiplier
$1 increase in governmentspending
matched by
$1 increase in lump sum taxes
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Intermediate Macroeconomics
7. Government Fiscal PolicyBalanced budget multiplier
Spending multiplier (assume no income tax)1
1 c
Lump Sum tax multiplier- c 1 - c
Balanced budget multiplier:
spending multiplier lump sum tax multiplier1 - c = 1 c = 1
1 c 1 c 1 - c
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Intermediate Macroeconomics
7. Government Fiscal PolicyBalanced Budget Multiplier
From Step 4 (assume t = 0):Y = 1 [C0 + I0 + G 0 + c (TR - T 0)]1 - c
Multiplier (assume C0 = I0 = TR = 0):
Y = 1 ( G0 - c T0)1 - cBalanced Budget ( G0 = T0):
Y = 1 ( G0 - c G0)1 - c
= 1 ( 1 c) G0 1 - c
= 1 G0 Multiplier = 1
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Intermediate Macroeconomics
8. Automatic Stabilizers
Economy Moves IntoRecession Inflation
Desired PolicyGovernment Spending Increase Decrease
Taxes Decrease Increase
Actual Outcomes
G - Defense Spending n/c n/c
TR - Social Security Benefits n/c n/c
TR Unemployment Comp. Increase DecreaseTA Lump Sum Tax n/c n/c
t Y - Income Tax Receipts Decrease Increase