The Keynesian Modelthe multiplier, the paradox of thrift, savings andinvestment, fiscal policy, and the tax multiplier
multiplier – algebra of the modelA simple Keynesian model of the economy with no government or foreign trade can be represented as: Y=C+I (1)where Y is equilibrium output (income), C is aggregate consumption, and I is aggregate investment. Aggregate consumption, or total expenditure by households on final goods and services, is determined by autonomous consumption (a), or the rate of consumer expenditure independent of disposable income, and the marginal propensity to consume (b = mpc), which is the part of each additional dollar of disposable income that is spent on consumption. Thus, the consumption function is: C = a + bY (2)
No government, so Y = YdNote that since there is no government, taxes are zero, so Y = Yd, since: Yd = Y – T Yd = Y – 0 Yd = YThus while the consumption function is usually C = a + bYd, here it will simply be: C = a + bY
InvestmentInvestment is determined by a complex of factors such as expectations of investors and lending institutions, business confidence, political climate, and so on. For present purposes, what is important is that investment is autonomous —that is, independent—of income. It is also not a simple function of the rate of interest, as in neoclassical loanable funds theory.
solving the equation Y=C+I (1) C = a + bY (2)Substituting equation (2) into equation (1), i.e., replace C with a + bY, we get: Y = a + bY + I (3)Subtracting bY from both sides: Y - bY = a + I (4)
Solving for Y Y - bY = a + I (4)Factoring out the Y from the left hand side of equation (4) Y (1 - b) = a + I (5)Dividing both sides by (1 - b): Ye = 1 (a + I) (6) (1-b)
the multiplier Ye = 1 (a + I) (1-b)where 1/(1-b)—or 1 divided by the mps—is the multiplier, or the feedback mechanism that amplifies any initial increase (injection) or decrease (withdrawal) in aggregate demand. Therefore, Ye, the equilibrium level of output (income) is determined by the multiplier and total injections. The total injections in this simple model are a + I.
Keynesian model - numerical exampleGiven: Y=C+I C = a + bYWhere: a = 100 b = .75 I = 300
Solving for YeY = 100 + .75Y + 300 Y - .75Y = 100 + 300 Y (1 - .75) = 100 + 300 Y (.25) = 100 + 300 Y = (1/.25) x 400 Y = 4 x 400 Ye = $1600 billion
solving for equilibrium consumptionand savingsOnce we have Ye, we can find Ce and Se:Ce = a + bYeCe = 100 + .75 (1600)Ce = 100 + 1200 = 1300Se = -a + (1 - b)YeSe = -100 + (1 - .75) 1600Se = -100 + .25 (1600) = 300
double-checking savingsAlso: Ye = Ce + Se Ye – Ce = Se 1600 – 1300 = 300Also: Se = I (savings = investment at equilibrium) 300 = 300
Keynesian Model 45°Expenditure AS = C + I C = 100 + .75Y a+I S = - 100 + (1 – .75) Y a I = 300 I 0 Y1 Y* Y -a 400 1600
the recessionary gapAssume that this economy, if producing at full employment, given resources and technology, could produce an aggregate output of $2000.We can now calculate the values of consumption and savings at full employment, as well as aggregate spneding at full employment, and the recessionary gap.
Keynesian Model 45°Expenditure AS = C + I C = a + bY a+I S = - a + (1 – b) Y a I I 0 Y1 Y* Yf Y -a 1600 2000
the paradox of thriftAn attempt by the economy as a whole to increase aggregate savings not only will not succeed, but may lower aggregate output, income and employment. This is because increased savings at a given level of aggregate income will mean decreased consumption. Thus a smaller marginal propensity to consume will reduce the stimulative effects of investment and other spending.
paradox of thriftFor example, suppose an economy is characterized by a consumption function: C = $100 + .8YdIf autonomous investment is equal to $300 billion then the equilibrium level of output and income is Ye = 5 (100 + 300) = $2000 billionbecause the multiplier = 1/(1 – b) = 1/(1 - .8) = 5.
paradox of thrift - exampleSuppose some political and or business leaders come out and say we have to save more so the economy can grow. If people comply in such a way that the mps rises from .2 to . 25, what will be the effect?
paradox of thriftThe new consumption function will be: C = $100 + .75YdWith $300 billion in investment, the new equilibrium will be: Ye = 4 (100 + 300) = $1600 billionbecause the new multiplier = 1/(1 - .75) = 4. Aggregate consumption is now: C = $100 + .75 ($1600) = $1300 billionand savings: S = -$100 + (1 - .75) ($1600) = $300 billion
paradox of thriftThus, savings is still equal to investment at the same level of $300, but output and employment are much lower. So the attempt by the economy as a whole to save more not only did not result in more savings, but actually lowered aggregate output and income by $400 billion.
paradox of thrift This is the paradox of thrift, and is another example of theparadoxical nature of macroeconomics. It is rooted in the two-sidednature of spending and saving. When we just look at one individual firmor household in isolation, we dont see the impact that our actions haveon other participants in the economy due to the interdependent natureof economic activity. So while for any one individual, it is wonderful tosave more, for the economy as a whole, it could be a disaster.
paradox of thriftIf, however, the increased saving is the result of higher incomes, then that is a different story. If income goes up, consumption and saving both go up. But at a given level of income, increased aggregate savings can throw the economy into a recession. Therefore, a policy to increase growth by increasing savings has it backwards: savings will increase as a result of growth.
Keynes’s critique of the neoclassical theoryof savings and investment1. In Keynes, since consumption is a function of disposable income, and saving is income not spent, saving is also primarily a function of disposable income. S is a passive residual, determined by disposable income and the marginal propensity to consume. Keynes did not believe it was legitimate to hold income constant when analyzing aggregate saving, as in neoclassical theory. He also disagreed with the neoclassical belief that saving is primarily a function of the rate of interest.
Loanable Funds MarketInterest Rate S (Savings) i* I (Investment) 0 S=I S, I
Keynes’s critique of the neoclassical theoryof savings and investment 2. Historical experience of the Great Depression: interest rates very low, no investment; wages low, no labor demand; how long is the long run?.
3. S = I is the macroeconomic equilibrium condition in both Keynes and neoclassical, but in Keynes I => S through changes in Y and in neoclassical S => I through changes in i. In addition, in Keynes the two may be equal at a whole range of potential levels of output and income, only one of which is full employment, while in neoclassical the two may be equal only at full employment.
4. Keynes did not believe it was legitimate to hold the state of investor expectations constant in analyzing aggregate investment, as in neoclassical theory. He also disagreed with the neoclassical view that investment is primarily a function of the rate of interest. Expected profitability of investors and lending institutions both required for investment to take place.
5. Keynes distinguished between risk, which is calculable, and uncertainty, which is not conducive to statistical probability. He believed most important determinants of investment described by uncertainty, not risk. In neoclassical theory, uncertainty in this sense is not recognized. Also, even under risk, the confidence of whether one will ‘beat the odds’ is subject to unpredictable variation. Mass psychology subject to waves of optimism and pessimism.
6. Business and political climate will influence investment decisions, as will many other factors, not all of which appear immediately relevant, at least on the surface.
7. In a modern capitalist economy with high-tech financial institutions and advanced instruments of credit, a ‘pool’ of savings is not necessary to finance investment. Banks are private, profit-maximizing institutions and will not pass up the chance to make profits if they believe a loan will be profitable. They will always make a loan and worry about reserve requirements at the end of the day (often borrowing themselves to meet their requirements).
8. In Keynes, the rate of interest is not determined by savings and investment, but by the supply and demand for money. This is Keynes’s liquidity preference theory (more on this later).
9. Separation of ownership and management means those who own do not necessarily know the business well, and those who manage may have different interests and incentives than if they also owned. Makes investment more unstable.
10. Speed of asset revaluation increasingly faster and faster. Assets are revalued within the space of seconds, and ability to react immediately, without having to wait to see if a change is a temporary deviation, creates instability. Self-fulfilling prophecies become a characteristic of the system (for example, people think an asset’s value is going to go down, so they sell and because people sell, the value goes down).
fiscal policy for full employment:eliminating a recessionary gapKeynes’s demonstration of the possibility of the economy being in macroequilibrium, with S = I, below full employment provides a theoretical justification for more interventionist policies by the government.Fiscal policy: the attempt to affect macroeconomic variables (such as C, I, Y) through government spending and tax policies.
Increasing GIf Yf = $2000 billion and Ye is $1600, how much does the government have to increase spending to push the economy to Yf?
Increasing GIf Yf = $2000 billion and Ye is $1600, how much does the government have to increase spending to push the economy to Yf? Not $400.
Increasing GIf Yf = $2000 billion and Ye is $1600, how much does the government have to increase spending to push the economy to Yf? Not $400. If G increased by $400 then: Y=C+I+G C = a + bY
Increasing GIf Yf = $2000 billion and Ye is $1600, how much does the government have to increase spending to push the economy to Yf? Not $400. If G increased by $400 then: Y=C+I+G C = a + bYYe = 1/(1 - .75) * 100 + 300 + 400 = 4 (800) = $3200Way past Yf—impossible, so inflation will occur. What happened?
closing the recessionary gapThe government spending of 400, like all other autonomous expenditures, had a multiplier effect, in this case of 4, and so increased total output and income not by 400 but by 1600.How much do we need to increase G by to just get the economy to full employment?By the size of the gap, or the amount we need to increase total spending (Yf – Ye) divided by 4.gap = Yf – AS@Yf = Sf – I = (Yf – Ye)/mult. = 100
Keynesian Model 45° C+I+GExpenditure AS = C + I Ca+I+G a+I S = - a + (1 – b) Y I+G I+G a I I 0 Y1 Y* Yf Y -a
full employmentNotice that at Yf, S = I + G; (I + G can be thought of as private and public investment)Notice the aggregate spending function with government (still no foreign trade), or the C + I + G line:has a y-intercept of (a + I + G);has a slope = mpc; andintersects the 45 degree line at Yf
Keynesian Model 45° C+I+GExpenditure AS = C + I Ca+I+G a+I S = - a + (1 – b) Y I+G I+G a I I 0 Y1 Y* Yf Y -a
Multiplier with TaxesLets add taxes and government spending into the multiplier formula!First, we begin with:Y = C + I + G (1) Then we take our consumption function:C = a + bYd (2) Only now we have to account for the fact that Y and Yd are not equalYd = Y - T (3)
Multiplier with TaxesYd = Y - T (3)because disposable income is aggregate income less taxes.Since taxes can be determined by the tax rate times aggregate income:T = tY (4)Then:Yd = Y - tY (5)
Multiplier with TaxesSubstituting equation (5) into the consumption function:C = a + b(Y - tY) (6)And substituting equation (6) into equation (1):Y = a + b(Y - tY) + I + G (7)
Y = a + b(Y - tY) + I + G (7)We then solve for Y: Y = a + bY - btY + I + G (8)Y - bY + btY = a + I + G (9) Y(1 - b + bt) = a + I + G (10)
Y(1 - b + bt) = a + I + G (10)Y = 1 * (a + I + G) (11) 1- b + bt So the multiplier with taxes is:1/(1 - b + bt) (12) And the multiplier times total injections (a + I + G) will give us the equilibrium level of output and income.
Multiplier with taxes – numericalexampleGiven:C = $100 + .8YdI = $50G = $350t = .25Find: Ye, value of mult., T, Yd, C, & SDoes S = I? Why or Why Not?
Multiplier with taxes – numericalexampleYe = 1/(1-b+b[t]) (a + I + G ) = 1/.4 (100 + 50 + 350) = 2.5 (500) = 1250
Multiplier with taxes – numericalexampleValue of the multiplier= 1/(1-b+b[t])= 1/(1-.8+.8[.25])= 1/.4 = 2.5 [since (.8 x .25) =.2]
Multiplier with taxes – numericalexample T = .25 (1250) = 312.50 Yd = Y – T = 1250 – 312.50 = 937.50 C = a + bYd = 100 + .8(937.50) = 100 + 750 = 850 S = -a + (1-b)Yd = -100 + (1-.8)937.50 = -100 + 187.50 = 87.50
Multiplier with taxes – numericalexampleDoes S = I? Why or why not?
Multiplier with taxes – numericalexampleDoes S = I? Why or why not?No, total injections = total withdrawals I+G=S+T= 50 + 350 = 87.50 + 312.50 = 400 = 400
Multiplier with taxes – numericalexampleDoes S = I? Why or why not? I+G=S+T=50 + 350 = 87.50 + 312.50 = 400 = 400and the: public deficit = private sector surplusG – T = S – I = 350 – 312.50 = 87.50 – 50 = 37.50 = 37.50