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Unformatted text preview: CHAPTER 8 THE KEYNESIAN THE MODEL MODEL Spring, 2011 1 INTRODUCTION National income accounting vs. National National income theory Orientation—ex ante Purposes – predict & explain Historical overview Historical The Classical Model The The Keynesian Model The aggregate demand— aggregate supply model The monetarist model Expectations models: Adaptive expectations Rational expectations Real business cycle theory 2 CLASSICAL MACROECONOMIC THEORY Who were the “Classical” Who economists? What did they conclude? A market economy can be in market equilibrium only at full employment Why did they conclude this? Say’s Law Equality of Saving and Equality Investment (Downward) flexibility of wages (Downward) and prices and What does this imply? Laissez faire What Laissez 3 policy for government! policy CLASSICAL THEORY, PART CLASSICAL 1: Say’s Law Say’s Law in a barter economy Supply creates its own demand Say’s Law in a money-using Say’s economy economy See Basic Circular Flow graph Assumptions No government No foreign trade Only consumer goods No household saving Conclusion: Supply creates its Conclusion: own demand own 4 THE BASIC CIRCULAR FLOW MODEL, P. 125 MODEL, Figure 15.1 (Macro 5.1) CLASSICAL THEORY, PART CLASSICAL 2: Equality of Saving and Investment Saving Interest Rate Household Saving I(p) Dollars 6 CLASSICAL THEORY, PART CLASSICAL 3A: Downward Flexibility of Prices Prices Eliminates Surplus Goods P(x) Supply of X P1 P2 Demand for X Q(x) 7 CLASSICAL THEORY, PART CLASSICAL 3B:Downward Wage Flexibility to Eliminate Unemployment Unemployment Wage Rate Supply of Labor W1 W2 Demand for Labor Q(L) 8 THE KEYNESIAN ATTACK THE ON CLASSICAL THEORY ON • Households will choose to save a Households portion of their disposable income portion • So household savings will have to So be returned to the circular flow by investors. • BUT, savers and investors are two BUT, different groups with different motivations motivations 9 THE KEYNESIAN ATTACK THE ON CLASSICAL THEORY ON (continued) • AS A RESULT, KEYNES AS CONCLUDED THAT: • The interest rate will not The automatically adjust to ensure that business firms will choose to invest an amount equal to what households choose to save out of a full employment income level full • This is an important concept! 10 KEYNESIAN CRITICISM OF KEYNESIAN CLASSICAL THEORY (continued): Investment declines. Saving schedule shifts to the left as disposable income and GDP decline interest rate S1 S2 E1 E2 I(p)2 I(p) 1 Dollars 11 THE KEYNESIAN ATTACK THE ON CLASSICAL THEORY: Wage and Price Flexibility Wage • Falling wages and prices will not Falling restore resource and product markets to full employment • Falling wages will cause product Falling demand schedules to shift leftward so falling prices will not be sufficient to remove surplus goods. sufficient • Result is that markets will not clear 12 INTRODUCTION TO THE INTRODUCTION KEYNESIAN MODEL: THE CONSUMPTION EQUATION CONSUMPTION Determinants of consumption: Determinants Disposable income Wealth Expectations Expectations Price level Price Interest rate Interest Stock of durable goods Stock Keynes emphasized the relationship between DI and consumption. Expressed in a table Expressed in an equation Expressed in a graph Expressed 13 THE CONSUMPTION THE FUNCTION:P. 189 FUNCTION:P. • • • • • • • • • • • Expressed in a Table: Y(d) Consumption Sav. Y(d) Sav. 000 1.00 trillion -1.00 1.00 1.75 trillion -0.75 2.00 2.50 trillion -0.50 3.00 3.25 trillion -0.25 4.00 4.00 trillion 0.00 5.00 4.75 trillion +0.25 4.75 +0.25 6.00 5.50 trillion +0.50 7.00 6.25 trillion +0.75 8.00 7.00 trillion +1.00 What equation fits these data? 14 CONSUMPTION FUNCTION CONSUMPTION EQUATION: EQUATION • In equation form: In • C = 1.0 trillion + 0.75 Y(d) • S = -1.0 trillion + 0.25 Y(d) -1.0 • When Y(d) = 4.00, C = 4.00 When • When Y(d) = 4.00, S = 0.00 • What do the graphs of these What relationships look like? relationships 15 THE CONSUMPTION FUNTION, P. 190 FUNTION, Figure 18.1 (Macro 8.1) GRAPH OF THE SAVING -GRAPH DISPOSABLE INCOME RELATIONSHIP RELATIONSHIP Saving Savings + values Slope=1/4 Function 0 DI - values DI=$4.00 Trillion Saving = $-1.00Trillion Graph of S = - $1.00 + ¼ (DI) 17 CHARACTERISTICS OF CONSUMPTION AND CONSUMPTION SAVING FUNCTIONS: PP. 190-191 190-191 • Slope of Consumption line is equal Slope to the Marginal Propensity to Consume Consume • (MPC) = ∆C / ∆ Y(d) (MPC) • MPC constant if straight line • MPS = ∆ S / ∆ Y(d) MPS • MPC + MPS = 1 18 SHIFTS VS. MOVEMENTS SHIFTS ALONG THE CONSUMPTION FUNCTION FUNCTION • Movements along schedule can be Movements caused only by a change in Y(d) • Shifts of the schedule are caused Shifts by changes in non-Y(d) determinants of consumption, such as: as: • Interest rates • Wealth • Expectations • Stock of durable goods Stock • Expectations 19 MOVEMENTS ALONG VS. SHIFTS OF THE CONSUMPTION FUNCTION Exhibit 6, p. 206 Exhibit Figure 18.4 (Macro 8.4) EXHIBIT 5: U. S. Consumption and Disposable Income 1930-2003, Exhibit 5, p. 204 Source: Bureau of Economic Research, 21 THE CONCEPT OF MACRO THE EQUILIBRIUM: • Assumptions: Assumptions: • • • • • No government No foreign trade No investment C = 40 + 0.8 Y(d) Analysis: Analysis: • Equilibrium GDP is sustain-able Equilibrium by market forces alone. by • Business firms goals is to max. Business profits profits • Profit max. requires firms able to sell all they produce sell • Production decisions by business Production firms are interdependent interdependent 22 GRAPH OF MACROECONOMIC EQUILIBRIUM: Households EQUILIBRIUM: Only Buyers of GDP Only C = 40 + 0.8 Y(d) Consumption Expenditures 45 degree line C Slope = 0.8 40 Y=DI=GDP 0 200 Y(f)=500 NOTE: Y = GDP = DI 23 NEXT STEP: ADD GROSS NEXT INVESTMENT PURCHASES TO THE MODEL MODEL Purchases of investment Purchases (durable) goods are undertaken by business firms for the purpose of max. profits Determinants of Investment Determinants expend: expend: Interest rates Expectations Technological change Keynes hypothesized that Keynes Invest: Invest: 24 depends on the interest depends rate, all other things equal rate, KEYNESIAN THEORY OF KEYNESIAN INVESTMENT EXPENDITURES: INVESTMENT Investment Spending Depends on Investment the Rate of Interest the Investment Interest Rate Demand schedule 8% 6% I(p) GDP = DI $100 B $150 B 25 KEYNESIAN THEORY OF KEYNESIAN INVESTMENT EXPENDITURES: INVESTMENT Investment Spending is “Autonomous” Investment (Independent) of Current GDP (Independent) Investment Expenditures $150 B $100 B I(p) 2 I(p) 1 GDP = DI 26 EQUILIBRIUM IN THE KEYNESIAN MODEL EQUILIBRIUM GDP = C + I(p) GDP 45 DEGREE LIINE AE = C + I(p) C + I(P) C GDP = DI $200 B $450 27 THE AGGREGATE EXPENDITURES (AE) SCHEDULE ( P. 205) (AE) C + I(p) at each DI and GDP level, I(p) Exhibit 10, p. 214 Exhibit TWO VIEWS OF KEYNESIAN TWO EQUILIBRIUM: EQUILIBRIUM • Assumptions: Assumptions: • • • • • • • • • • • • No government No foreign trade No The AE approach:Y = C + I(p) The The S = I(p) approach: The Y = C + I(p) I(p) Y-C = I(p) Y-C Y-C = S Y-C S = I(p) Conclusion: Conclusion: When Y = C + I(p), then When S = I(p) Two approaches to predicting equilibrium GDP are identical! equilibrium 29 EQUILIBRIUM WITH THE SAVING EQUILIBRIUM =INVESTMENT APPROACH =INVESTMENT SAVING AND INVESTMENT SAVING I(p) 2 I(P) 1 GDP = DI 0 $200 B $450 B 30 END OF CH. 8 END LECTURE LECTURE QUESTIONS??? 31 31 ...
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