s4m keynesiantheory
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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.
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• 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.
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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
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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
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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
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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
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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
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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
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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
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1. MPC=c slope of consumption function= dC/dY= 0.75
2. APC:C/Y
Aggregate Demand Functions/Curve
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
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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
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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
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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
Change in Aggregate Demand: The 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
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Change in Aggregate Demand: The Multiplier
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
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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
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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.
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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
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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
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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
Step 2. State the Equilibrium Condition:
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
Step 4. Solve for National Income (Y)
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
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Equilibrium Income and Output:
A. Imposing Tax (T)
Aggregate Demand Functions/Curve
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
Step 4. Solve for National Income (Y)
Y = (C0 + I0 + G0) + c * Y ‐ c * T + c * GTr
Y = 1 * (C0 + I0 + G0)‐c * T + c * GTr1 ‐ c
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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
Step 2. State the Equilibrium Condition:Y = AE
Step 3. Substitute AE from Step 1 into Step 2:
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
Step 2. State the Equilibrium Condition:
Y = AE
Aggregate Demand Functions/Curve
Step 3. Substitute AE from Step 1 into Step 2:
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 )]
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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
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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
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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
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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.
Export, Import and Aggregate Demand
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
Step 2. State the Equilibrium Condition:
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
Step 4. Solve for National Income (Y)
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
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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.
Export, Import and Aggregate Demand
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
Step 2. State the Equilibrium Condition:Y = AE
Export, Import and Aggregate Demand
27
Step 3. Substitute AE from Step 1 into Step 2:
Y = C0 + c * (Y-T) + I0 + G0+X0- M0- m*Yor Y = (C0 + I0 + G0+X0) + c * Y - c * T - M0- m*Y
Step 4. Solve for National Income (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
Export, Import and Aggregate Demand
Equilibrium Income and Output with Export and Import
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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
Step 2. State the Equilibrium Condition:Y = AE
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Aggregate Demand : The Complete Four Sector Model
Step 3. Substitute AE from Step 1 into Step 2:
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
Step 4. Solve for National Income (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
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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
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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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Thank You All