S4M KeynesianTheory

1

The Keynesian Theory

Theory of Income (Y) or Output(Q), and Employment Determination

Q≡E ≡ YMacroeconomics in Short‐Run

Macroeconomics in the Short Run

Ford Rides The Business Cycle Rollercoaster

• Sales of Ford cars and trucks have fluctuated up and down with the phases of the business cycle.

• Sales rise in booms and fall in recessions.

• Cars are durable goods.

• Sales fell by more than 40% in each of the 1981‐1982 and 2007‐2009 recessions.

• In the first 2 years of the Great Depression (1929‐1931),

• Ford’s sales fell by almost 2/3rd, • GM sales fell by 1/2, and • U.S. Steel sales fell by 3/4.

2

• Real GDP declined by 27% between business cycle peak in 1929 and trough in 1933.

• Investment spending fell by 81%, and the S&P 500 stock index fell 85%.• Unemployment rose from under 3% in 1929 to over 20% in 1933.• Unemployment was above 11% in 1939, six years after trough.

• Business cycles were not emphasized in macroeconomics before the Great Depression.

• U.S. economy experienced business cycles as far back as the early 19th

century.

• These firms were cutting production and employment as a result of the sluggish growth of total spending, or aggregate expenditure.

• This section discusses how aggregate expenditure affects economy in the short run.• John Maynard Keynes developed an influential business cycle model in 1936.

Macroeconomics in the Short Run

Ford Rides The Business Cycle Rollercoaster

Classical and Keynesian Economics

Classical Economics • Classical economist assumes that

there is perfect competition in both labor and output markets .

• Says’ law i.e. supply creates it’s own demand, No fluctuations is output . AS=AD.

• Problem of AS• Labor is the only factor of

production

• Prices , wages and Interest Rate are flexible.

• Classical long run Analysis.• LRAS is Vertical• No Role of Govt.• No Role of Money

Keynesian Economics:• The perfect competition in both labor

and output markets is unrealistic. • The Postulates of Says’ law failed

during great depression. AS not equal to AD always. In fact fall in AD lead to Business cycle ( fluctuation in Output)

• Problem of AD• Apart from Labor other factor of

productions are also important.

• Prices, Wages & Interest Rates are Sticky.

• Everything is in short run.• SRAS is Upward sloping• Active Role of Govt.• Active Role of Money.

3

Keynesian Premises

J.M Keynes assumes that some Prices, Wages and Interest rates are fixed in theshort‐run. It implies that some markets need not clear.

1. Product (Goods & Service) Market: reacts somewhat more slowly to

information, but assume able to change production so it clears.

AD=AS determines Output and Price

2. Factor(Labor) Market: reacts most slowly to information. When

economy out of general equilibrium, assume labor supply not equal to labordemand. Rigid nominal wage W = wP. Employment determined by labordemand. May have excess supply of labor, hence unemployment.

Nd= Ns determines Wage rate

3. Financial (Money) Market: reacts quickly to information. Assume it

always clears.

Md=Ms determines interest rates

A. The Product Market Equilibrium

4

The Product Market Equilibrium

J M Keynes says, “the equilibrium level of national incomeand Prices is determined at the level where aggregatedemand (AD) for goods and services equals their aggregatesupply (AS)”.

Model Can be explained through

• Aggregate Supply(AS) Function

• Aggregate Demand (AD) Function

– Aggregate Consumption Function

– Aggregate Saving Function

– Investment Function

Equilibrium: AD=AS

a. Aggregate Supply Functions/Curve

Aggregate Supply is the total supply of goods and services in an economy whichthe economy produces by utilizing all its resources. It depends on productivity.

Production Function:

Where K is capital, fixed in short run

N is labor, variable in short run

),( NKfY

SRASC

LRASC

Output ( Real GDP)

Price Level

5

b. Aggregate Demand Curve

Aggregate Demand Curve is the total demand curve ( aggregate expenditure) of alleconomic agent. It is negatively related with the price level and hence slope downward from left to right.

AD=C+I+G+(X-M)

Thus Keynes tried to explain theeconomic equilibrium withTwo, Three & Four sector model

P1

P2

Y1 Y2

Aggregate demand is the total spending on goods and services in the economy.

LRASCPrice Level

SRASC

The Product Market Equilibrium: AD=AS

6

Fixed Prices Flexible Prices

The Product Market Equilibrium: AD=AS

with Fixed vs.Flexible Prices

Determination of Equilibrium Level of Income and Output: The AD Curve

7

Equilibrium level of Income and Output:The Circular Flow

LetY =AD= Aggregate (National)

Income

Z=AE = Aggregate Expenditures

Q=AS= Aggregate Output (Money Value)

AS=AD=AE always

Or Z=Y=Q

For Keynes P is fixed

Two Sector Model

8

Income and Output Determination: Two Sector Model

Assumption:

1. Only 2 sector in the economy: Households and Firms/Industry

1. Households: owner of factors of production, L, L, K, E

2. Firms/Industry: Hire factor of production and sale output to households

2. Absence of Government: No Tax, No Govt. Exp.

3. Business Sector:

a. No corporate saving

b. No retain earning

4. All Prices are Fixed in Short‐run: Sticky Price, Wage, and interest rate.

5. Supply of Capital and Technology given (constant).

Aggregate Supply Functions

Aggregate Supply means total supply of goods and services in aneconomy which depends on productivity.

Production Function:

Where K is capital fixed in short run

N is labor variable in short run

),( NKfY Keynes Says AD=AS of outputalways

AD=AE Y=E

E2

E1

Y1 Y2

(c) Aggregate demand ( or Expenditure)= Aggregate supply ( Income)

450

AS=AY

9

Aggregate Demand Functions

Aggregate Demand : AD =C + I

C = ConsumptionI = Private Domestic Investment

1. Aggregate Demand for Consumer goods (C) by Households2. Aggregate demand for Investment goods (I) by Firms

C

C+IAD=C+I

Y

I

Aggregate Demand Functions/Curve

1. Consumption Function (C): C = C0 + c * Y

Co = Autonomous consumptionc = Marginal propensity to consume

out of income (MPC)Y = Income

Keynesian Psychological law ofconsumption,' men or women aredisposed , as a rule and on average , toincrease their consumption as theirincome increases, but not as much as theincrease in their income”

0<MPC<1

2. Savings Functions: S = Y‐C

=Y‐C0‐c*Y

=‐C0+s*Y

S = ‐ C0 + s * Y

where s= 1‐c

‐Co = Autonomous Saving

s = Marginal propensity to save out of income (MPS)

S= Saving

Y=Income

C= Consumption

10

1. MPC=c slope of consumption function= dC/dY= 0.75

2. APC:C/Y


1. Consumptions Function: C = C0 + c * Y 2. Savings Functions: S = -Co+s*Y

1. MPS=s slope of Saving function= dS/dY= 0.25

2. APS:S/Y

APC, MPC, APS, MPS

1. There is a break even level of income at which

APC = 1 when C = Y

Below the break-even level of income

APC > 1 because C > Y

Above the break-even level of income

APC < 1 because C < Y

2. 0 < MPC < 1 for all level of income

Since Y = C + S ( 1 )

dividing both sides of equation (1) by Y, we get the following :

Y = C + S

Y Y Y

=> 1 = APC + APS

Since Y = C + S (1)

Δ Y = Δ C + Δ S (2)

Dividing both sides of equation (2) by Δ Y ,we get :

ΔY = Δ C + Δ S

ΔY ΔY ΔY

1 = MPC + MPS

=> 1= c +s

11

Aggregate Demand Functions/CurveAggregate Demand : AD= C +I0

so AD= C0 + c * Y + I0C= Consumption, I0 is Autonomous Investment

Equilibrium: Income and Output Determination

Equilibrium: AE=AD=>Y= C + I0

i.e. AE=Y

Substituting C,Y= C0+c*Y+I0

Or Y- c*Y= C0+I0

Or (1-c)*Y= C0+I0

Or

How to determine C???

C=C0+c*YOr C=C0+(c/1-c)*{C0+I0}

)I(*)1

1( 00

Cc

Y

Keynesian cross

12

Income and Output Determination : Savings and Investment Approach

Agg Demand: Y= C + I

=> Y-C= I

Agg Supply: Y=C+S………………. Savings function

=> Y-C= S

=> S=I

Thus Agg Demand= Agg Supply implies Equilibrium

C + I = C + S

Since I= I0 i.e. Investment is fixed

Substituting S, we get

S=-C0+(1-c)*Y

=> I0 =-C0+(1-c)*Y

=> Y=(1/1-c)*C0+I0

S=I0 exposed or realized Only

S≠I0 exante or planned

Consumption and Saving Schedules: A Hypothetical Case

Time ( Year)

Levels of GDP or Y C=200+cY S=Y‐C

APC=C/Y

APS=S/Y

MPC=dC/dY

MPS=1‐MPC

1990 100 275 ‐175 2.75 ‐1.75 0.75 0.25

1991 200 350 ‐150 1.75 ‐0.75 0.75 0.25

1992 300 425 ‐125 1.42 ‐0.42 0.75 0.25

1993 400 500 ‐100 1.25 ‐0.25 0.75 0.25

1994 500 575 ‐75 1.15 ‐0.15 0.75 0.25

1995 600 650 ‐50 1.08 ‐0.08 0.75 0.25

1996 700 725 ‐25 1.04 ‐0.04 0.75 0.25

1997 800 800 0 1.00 0.00 0.75 0.25

1998 900 875 25 0.97 0.03 0.75 0.25

1999 1000 950 50 0.95 0.05 0.75 0.25

2000 1100 1025 75 0.93 0.07 0.75 0.25

2001 1200 1100 100 0.92 0.08 0.75 0.25

2002 1300 1175 125 0.90 0.10 0.75 0.25

2003 1400 1250 150 0.89 0.11 0.75 0.25

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S=ILevels of GDP

(i.e. (Y)

Planned Consumption

( C)

Planned Saving:

Y‐C=S

Planned Investment

(I)

Level of GDP (Y)

AD= Planned Consumption ( C ) +

Investment (I) (Total Exp)

Resulting Tendency of Output

100 275 ‐175 100 100 < 375 Expansion

200 350 ‐150 100 200 < 450 Expansion

300 425 ‐125 100 300 < 525 Expansion

400 500 ‐100 100 400 < 600 Expansion

500 575 ‐75 100 500 < 675 Expansion

600 650 ‐50 100 600 < 750 Expansion

700 725 ‐25 100 700 < 825 Expansion

800 800 0 100 800 < 900 Expansion

900 875 25 100 900 < 975 Expansion

1000 950 50 100 1000 < 1050 Expansion

1100 1025 75 100 1100 < 1125 Expansion

1200 1100 100 100 1200 = 1200 Equilibrium

1300 1175 125 100 1300 > 1275 Contraction

1400 1250 150 100 1400 > 1350 Contraction

S=I0 exposed or realized OnlyS≠I0 exante or planned always. It’s equal only at the equilibrium level

Change/Shift in Aggregate Demand: The Multiplier

14

Change in Aggregate Demand: The Multiplier

• The shift in aggregate spending shift the aggregate demandcurve and so also aggregate national income.

• Multiplier explains the relationship between change inaggregate spending ( aggregate demand) and change innational income

1. Investment Multiplier

2. Govt Exp Multiplier

3. Tax Multiplier

4. Balanced Budget Multiplier

5. Export Multiplier

6. Import Multiplier


Shift in aggregate demand curve 1. Due to shift in C2. Due to Shift in ILet c=0.80 i.e. MPC, the multiplier

would be 5. Let initial investment is 100.

Round of Income Generation

Consumption

(C )

Income Generation

1st 100.00

2nd 80.00 80.00

3rd 64.00 64.00

4th 51.20 51.20

5th

…..

last

40.96…

…….

…..

40.96

….

0.00

Total Income

Total 500.00

15


Model: Y= C + I0

Let Investment Increase (Δ I0), then this increases Y, which induces to increase Consumption (Δ C0).

So, Y+ΔY=C + ΔC+ I0+ Δ I0

=>ΔY=ΔC+ ΔI0

We know C= C0+c*Y=> Δ C= C0+c* Δ Y

Substituting Δ C=> ΔY= C0+c* Δ Y + Δ I0

=>ΔY= C0*(1/1-c)+(1/1-c)* Δ I0

=>ΔY= C0*(1/1-c)+(1/1-c)* Δ I0

=>

is called as investment multiplier

cI

Y

1

1

c1

1

30

Uses and Limits of the Multiplier

Uses– The Multiplier process by indicating different phases of

trade cycles helps the business community to plan itstransactions accordingly.

– Multiplier analysis acts as an important tool for themodern governments in formulating economic policies.

– A government, through multiplier analysis, can know thequantity of investment that has to be made to reach fullemployment level.

– The Multiplier principle shows the importance of deficitbudgeting

16

31

Uses and Limits of the MultiplierLimitations

a. Multiplier process works only when there is adequate availability of consumer goods.

b. Full value of multiplier is achieved only when various increments in investments are repeated at regular intervals.

c. The full value of the multiplier can be achieved only when there is no change in the MPC during the process of income propagation.

d. Multiplier does not work well in case of leakages from MPCa. Payments of the past debtsb. Purchase of exiting wealthc. Import of goods and services

e. Does not work well in case of full employment of resources.

Applications

• Less application in case of Less developed countries due to high MPC.– Vast agricultural sector– Disguised unemployment– Low level of capital equipment, technology– Vast non-monetised sector– Producing for self consumption

Paradox of Thrift and Multiplier

“Savings is a virtue”

‘A Penny saved is a penny earned’.

Those who save become reach andprosperous.

Keynes criticized, the abovesentence may be true for anIndividual but not for the society

When all or most householdsbecome thrifty, they consume lessand save more, the level of Incomeand savings declines.

17

Three Sector Model

Income and Out Determination:Three Sector Model

Three Sector Economy:1. Households 2. Firms/Industry3. Govt.

Government can affect aggregate economic activities through– Fiscal Policy– Monetary policy and credit Policy– Industrial Policy– Labor Policy, Employment Policy, Wage Policy– Control and Regulation of Monopoly– Export and Import Policy– Environment Policy

18

Income and Out Determination:Three Sector Model

Government Activities:

1. Imposes only Direct Taxes (T) on Households

2. Spend money to buy goods and services from firms and factor services from households (G)

3. Make transfer payment (Tr) to households.

eg. Pensions, subsidies etc.

Aggregate Demand Functions/CurveGiven:

AE = C + I + GC = C0 + c * YI = I0G = G0

Step 1. Substitute into equation for aggregate expenditures:AE = C0 + c * Y + I0 + G0

Step 2. State the Equilibrium Condition:

Y = AE

Step 3. Substitute AE from Step 1 into step 2:

Y = C0 + c * Y + I0 + G0

orY = (C0 + I0 + G0) + c * Y

Step 4. Solve for National Income (Y)

Y = (C0 + I0 + G0) + c * Y

Y ‐ c * Y = C0 + I0 + G0

Y = 1 * (C0 + I0 + G0)1 – c

The Govt Expenditure Multiplier:

ΔY/ ΔG= 1/1‐c

19

Equilibrium: Income and Output Determination

ExpenditureC, I,G

Output(Real GDP --

trillions of Rs.)

45º

AE =AD

1600

C

C+I

1200

C+I+GAS

1600

1200

Aggregate Demand Functions/CurveA. Imposing Tax (T)

• Given: AE = C + I + GC = C0 + c * YI = I0G = G0

If Govt Imposes Income Tax, Then Yd=Y‐T,

Where, Yd = Disposable IncomeT=taxNow, C = C0 + c * Yd

C= C0 + c * (Y‐T)

Step 1. Substitute into equation for aggregate expenditures:AE = C0 + c * (Y‐T) + I0 + G0


Y = AE

Step 3. Substitute AE from Step 1 into Step 2:

Y = C0 + c * (Y‐T) + I0 + G0

Or Y = (C0 + I0 + G0) + c * Y ‐c * T


Y = (C0 + I0 + G0) + c * Y ‐ c * T

Y = 1 * (C0 + I0 + G0‐c * T )1 – c

The Tax Multiplier: ΔY/ ΔT= ‐c/1‐c

20

Equilibrium Income and Output:

A. Imposing Tax (T)


B. Including Transfer Payment(GTr)• Given: AE = C + I + G

C = C0 + c * YI = I0G = G0

a. If Govt Imposes Income Tax, Then Yd=Y‐T, Y= National IncomeYd = disposable IncomeT=tax

b. If Govt Including Transfer Payment, Then

C = C0 + c * (Yd +GTr)or C= C0 + c * (Y‐T+ GTr)

Step 1. Substitute into equation for aggregate expenditures:

AE = C0 + c * (Y‐T + GTr ) + I0 + G0

Step 2. State the Equilibrium Condition:Y = AE

Step 3. Substitute AE from Step 1 into Step 2:Y = C0 + c * (Y‐T +GTr ) + I0 + G0+GTr

Or Y = (C0 + I0 + G0) + c * Y ‐c * T + c * GTr


Y = (C0 + I0 + G0) + c * Y ‐ c * T + c * GTr

Y = 1 * (C0 + I0 + G0)‐c * T + c * GTr1 ‐ c

21

Aggregate Demand Functions/Curve:

Given: AE = C + I + GC = C0 + c * YI = I0G = G0

a. If Govt Imposes Income Tax, then Yd=Y‐T, Y= National IncomeYd = disposable IncomeT=taxC = C0 + c * Yd Or C = C0 + c * (Y‐T)

b. If Govt Including Transfer payment, then C = C0 + c * (Y‐T +GTr)

c. If Govt Including Taxation as a function of Income, then

T= T0+t*Y and C = C0 + c * (Y‐T0‐tY)( No Transfer payment)

Step 1. Substitute into equation for aggregate expenditures:AE = C0 + c * (Y‐T0 –t*Y ) + I0 + G0



Y = C0 + c * (Y‐T0 –t*Y ) + I0 + G0

=> Y = (C0 + I0 + G0) + c * Y ‐c * T –ct*Y

Step 4. Solve for National Income (Y)Y = (C0 + I0 + G0) + c * Y ‐ c * T ‐ ct *Y

=> Y = 1 * (C0 + I0+ G0‐c * T )1 – c+ct

Govt Income Tax Multiplier: ΔY/ ΔT=

C. Taxation As a Function of Income

ctc

c

1

Govt. Fiscal Policy : Tax Function, Govt Exp and Transfer PaymentGiven Equations:

AE = C + I + G

where, C = C0 + c * Y

I = I0, G = G0,

Now C = C0 + c * Yd with disposable income

where, Yd = Y ‐ t * Y ‐ T0 + GTr

So, C = C0 + c * (Y‐T0‐t*Y+GTr)

Yd = disposable income; t * Y = income tax revenues; T0 = lump sum taxGTR = gov’t transfer payments

Step 1: Restate aggregate expendituresAE = C + I + G

= C0 + c * Yd + I0 + G0= C0 + c * (Y ‐ t * Y ‐ T0 + GTr) + I0 + G0

= C0 + I0 + G0 + c * Y ‐ c * t * Y ‐ c * T0 + c * GTr


Y = AE



Y = C0 + I0 + G0 + c * Y - c * t * Y - c * T0 + c * GTr

Step 4. Solve for National Income (Y)=>Y = C0 + I0 + G0 + c * Y - c * t * Y - c * T0 + c * GTr

Y = 1 * [C0 + I0 + G0 + c *(GTr - T0)] [1 - c * (1 - t )]

22

The Multiplier

Change in Y = Multiplier * Change in C0, I0,or G0 or GTr

Equilibrium model solution:Y = 1 * (C0 + I0 + G0)

1 - c1. Autonomous Spending Multiplier: ΔY/ ΔI =

2. Govt Expenditure Multiplier: ΔY/ ΔG=

3. Govt Tax Multiplier : ΔY/ ΔT=

4. Govt Transfer Payment Multiplier: ΔY/ ΔGTr=

5. Govt Income Tax Multiplier: ΔY/ ΔT=

6. The Complete Fiscal policy Multiplier: ΔY/ ΔG=

If ΔY/ ΔG- ΔY/ ΔGTr=1, then So ΔY/ ΔG> ΔY/ ΔGTr

c1

1

c1

1

c

c

1

c

c

1

ctc

c

1

ctc 1

1

Government Fiscal Policy: Balanced Budget Multiplier

From Step 4 (assume t = 0):

Y = 1 * [C0 + I0 + G0 + c * (GTr ‐ T0)]1 ‐ c

Multiplier (assume ΔC0 = ΔI0= ΔGTr= 0):

ΔY = 1 * (Δ G0 ‐ c * Δ T0)1 ‐ c

Balanced Budget (Δ G0 = Δ T0):

Δ Y = 1 * (Δ G0 ‐ c * Δ G0)1 ‐ c

= 1 * ( 1 – c) * Δ G01 ‐ c

= 1 * Δ G0

Multiplier = 1

Ex. Rs.1 increase in government spending

exactly matched by Rs.1 increase in lump sum taxes

• Spending multiplier (assume no income tax)1

1 – c

• Lump Sum tax multiplier- c

1 - c

Balanced budget multiplier: ΔG= ΔT

• Spending multiplier + lump sum tax multiplier

1 + -c = 1 – c = 11 – c 1 – c 1 - c

23

Government Fiscal Policy: Multipliers

No Income

Tax (t = 0.0)

Income Tax (t = 0.3)

Autonomous Spending

1 = 5 1 - c

1 = 2.3 1 – c (1-t)

Transfer Payment

c = 4 1 - c

c = 1.8 1 – c (1-t)

Lump Sum Tax

- c = - 4 1 - c

- c = - 1.8 1 – c (1-t)

Assume c (marginal propensity to consume) = 0.80

Automatic Stabilizers

Economy Moves Into

Recession Inflation

Desired Policy Government 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 Decrease

TA – Lump Sum Tax n/c n/c

tY) - Income Tax Receipts Decrease Increase

Automatic stabilizers describes/refers on how modern government budget policies, particularly income taxes and welfare spending, act to dampen fluctuations in real GDP

24

Four Sector Model

Income and Out Determination:Four Sector Model

Four Sector Economy:

1.Households

2.Firms/Industry

3.Govt.

4.Foreign Sector: Export and Import

Foreign Transaction in two things

1. Commodity Flow

2. Financial Flow

25

Export, Import and Aggregate Demand

a. Export Function: determinant

• Prices of export in relation to those in importing countries

• Income of importing countries• Income elasticity of import• Tariff and trade policies: both the country• Exchange rate policies• Export policy• Export duties and subsidies• Availability of export surplus• Etc.


Given:AE = C + I + G+XC = C0 + c * YYd=Y-TI = I0,, T=T0, GTr=0 ,G = G0 ,, X=X0

Step 1. Substitute into equation for aggregate expenditures:AE = C0 + c * (Y –T)+ I0 + G0+X0


Y = AE

b. Aggregate Demand (Expenditures) with Exports: Step 3. Substitute AE from Step 1 into

Step 2:

Y = C0 + c * (Y-T) + I0 + G0+X0

or Y = (C0 + I0 + G0+X0) + c * Y - c * T


Y = (C0 + I0 + G0+X0) + c * Y- c * T

Y - c * Y = C0 + I0 + G0+X0- c * T

Y = 1 * (C0 + I0 + G0+X0) - c * T1 – c

Export Multiplier: ΔY/ ΔX= 1 1 – c

26

c. Import Function: determinant

• Prices of foreign goods in relation to domestic prices.

• Income of domestic countries

• Income elasticity of import

• Tariff and trade policies: both the country

• Exchange rate policies

• Import duties and subsidies

• Etc.


d. Aggregate Demand (Expenditures) with Exports:

Given:AE = C + I + G+X-MC = C0 + c * YYd=Y-TI = I0,, T=T0, GTr=0, G = G0 , X=X0, M =M0+ m*Y

Step 1. Substitute into equation for aggregate expenditures:AE = C0 + c * (Y –T)+ I0 + G0+X0- M0- m*Y



27


Y = C0 + c * (Y-T) + I0 + G0+X0- M0- m*Yor Y = (C0 + I0 + G0+X0) + c * Y - c * T - M0- m*Y


=>Y = (C0 + I0 + G0+X0) + c * Y- c * T- M0- m*Y

=> Y - c * Y + m*Y = C0 + I0 + G0+X0- c * T- M0

=> Y = 1 * (C0 + I0 + G0+X0-M0) - c * T1– c+m

Foreign Trade Multiplier: ΔY/ ΔX= ___1__ 1 – c+m


Equilibrium Income and Output with Export and Import

28

The Complete Four Sector Model: Aggregate Demand

Aggregate Demand : The Complete Four Sector Model

Aggregate Demand (Expenditures) with Import and Exports:

Given:AE = C + I + G+X-MC = C0 + c * YdYd=Y-TT=T0+t*YI = I0, G=G0 , GTr=GT0>0 , X=X0,

M =M0+ m*YNow C= C0 + c * (Y-T0-t*Y+GT0)

Step 1. Substitute into equation for aggregate expenditures:AE = C0 + c * (Y –T0-t*Y+GT0)+ I0 + G0+X0- M0- m*Y


29

Aggregate Demand : The Complete Four Sector Model


Y = C0 + c * (Y-T0-t*Y+GT0) + I0 + G0+X0- M0- m*YOr Y = C0 + I0 + G0+X0 + c * Y - c * T0 - c *tY+c * GT0- M0- m*Y


=> Y = C0 + I0 + G0+X0 + c * Y- c * T0 - c *tY+ c * GT0- M0- m*Y

=> Y - c * Y + m*Y + c *tY = C0 + I0 + G0+X0- c * T0 + c * GT0- M0

=>(1 – c+ct+m) * Y = C0 + I0 + G0+X0-M0- c * T0+ c * GT0

=> Y = 1 * (C0 + I0 + G0+X0-M0 - c * T0+ c * GT0)1– c+ct+m

Foreign Trade Multiplier: ΔY/ ΔX= ___1__ 1 – c+ct+m

B. The Factor (Labour) Market Equilibrium

30

Labor Market in the Keynesian Sticky Wage Model

Labor Market Equilibrium

Nd= f( real wage rate)They are negatively related

Ns= f( real wage rate)They are positively related

Nd is MRPL=w

Nd= Ns determines real wage rate,w

C. The Financial (Money) Market Equilibrium

Keynesian Financial Market

Money Or Cash

Bond

31

i2

i1

i

Md (Y2, i)

Md (Y1, i)

Ms

Ms, MdM

Financial(Money) Market Equilibrium:Md=Ms

• Demand for Money: Md= L(P,Y,i) or Md= P L(Y,i)

• Supply of Money : Ms is fixed ( by RBI)

Md positively related with incomeMd negatively related with interest rate

References

• 1. Ch 6,7, & 8 in Macroeconomic Theory and Policy by D N Dwivedi, 3ed

• 2. Ch3 & 4, Macroeconomics by Blanchard 4ed.

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