Chapter 8(Keynesian model of national income).

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Keynesian model of national incom

Keynesian model of national incom

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  • 1. Chapter 8: KEYNESIAN EMPLOYMENT THEORY The purpose of this topic is to analyze how aggregate expenditure and aggregate output can be represented, establish why equilibrium may be present below full employment, and identify the process of the multiplier. KEYNESIAN EMPLOYMENT THEORY The purpose of Keynesian employment theory is to offer a solution to periods of excessive unemployment (i.e. recession). This solution is tied to the idea that employment depends on what firms need to produce, and their production level, in turn, depends on what individuals and firms plan to buy: this is what Keynes calls aggregate expenditure. During the great depression, people were afraid to spend. Businesses were reluctant to hire workers because they could not expect any pick up in sales. This was especially true for key sectors of the economy such as automobile purchases. AGGREGATE EXPENDITURE Aggregate expenditure (in the opinion of Keynes) is the key to economic activity. That is, what households, businesses and government plan to buy will be the determinant of what firms will eventually produce. In the first step of the analysis, a simplified model excludes government, assumes that no foreign sector is present, and the level of real income (not prices) is the major determinant of aggregate expenditure. When a family is planning to buy a car or put new appliances in the house, that would be a carefully thought out decision which considers the long term situation of the family. Such purchases are key items of aggregate expenditure. AGGREGATE EXPENDITURE COMPONENTS Aggregate expenditure AE is the sum of what households plan to buy (or consumption C), and what businesses plan to buy in terms of capital (or investment I): AE=C+I Later, the model will also include government purchases (G). Purchases from all sources should be included in aggregate expenditure: both foreign and domestic, public and private. For instance, what foreign consumers could buy from American computer manufacturers next year, would be an important element. However, government and foreign purchases are affected by other than purely domestic economic conditions.
  • 2. CONSUMPTION Consumption is what individuals (or households) want to (or plan to) buy. Their ability to consume is entirely dependent on their income. What is not consumed (in income) is set aside for future consumption: this is saving. What is of interest is not the physical consumption, such as the use of a car, but the time pattern of purchases. If members of a family need to drive to work, they will have to have a car whether it is brand new or very old. The purchase of the car can be postponed. What prompts a family to buy a car now is a great interest to economists: such purchase is consumption. CONSUMPTION DETERMINANTS The major determinant of consumption is the willingness or propensity to use the real income to buy goods and services. Thus consumption and income are directly related. Other determinants of consumption are the price level, wealth, stock of durables, level of indebtedness and expectations about the future. The perception of a family's income is what allows it to be confident that it will be able to make the necessary payments or to afford to take out the savings, to buy a car. If it does not feel confident about its level of current and future income, it may want to use the car one more year. CONSUMPTION STABILITY The pattern of consumption tends to be quite stable. Consumption shifts upward through time: the proportion of consumption out of income remains about the same. Statistics show that consumption, i.e. purchases of households, is the most stable component of aggregate expenditure. AVERAGE PROPENSITY TO CONSUME The willingness to use a proportion of income (Y) for consumption (C) is known as average propensity to consume (APC): APC=C/Y As income increases, the average propensity to consume decreases. This is indeed observable in the fact that wealthy individuals consume a smaller proportion of their income than to poorer people who may in fact be force to receive money from others. If the income of a family is $50,000 and that family spends $45,000 per year, the average propensity to consume is APC = 45,000/50,000 = .9 or 90%. MARGINAL PROPENSITY TO CONSUME The marginal propensity to consume (MPC) is the proportion of additional consumption (dC) which will be taking place out of an increase in income (dY):
  • 3. MPC=dC/dY MPC is the slope of the consumption line. It is constant throughout reflecting a stable pattern of consumption in our society. If the income of the family increases by $1,000 and the family decides to buy an additional television worth $600 with that new income, the marginal propensity to consume is MPC = 600/1000 = .6 or 60%. SAVING Saving is what is left from income after consumption is taken out. Saving is primarily determined by the level of real income. The higher the income, the more individuals are willing and able to save. Saving is what will permit consumption in the future. In today's society, a lot of saving is institutional. For instance, social security contributions and pension plan deductions are a form of saving. AVERAGE PROPENSITY TO SAVE The willingness of individuals to save (S) a proportion of their income is called average propensity to save (APS): APS=S/Y. If a family earns $50,000 and saves $5,000 each year, the average propensity to save is APS = 5,000/50,000 = .1 or 10%. MARGINAL PROPENSITY TO SAVE The marginal propensity to save (MPS) is the proportion of additional saving (dS) out of an additional income (dY): MPS=dS/dY The marginal propensity to save is the slope of the savings line. Since income can only be consumed or saved, the sum of the marginal propensities to consume and to save is one: MPC+MPS=1. If a family has an increase in income of $1,000 and decides to save $400 of that increase, the marginal propensity to save is MPS = 400/1,000 = 0.4 or 40%. INVESTMENT DETERMINANTS Investment is determined by the rate of return from various possible projects and the cost of borrowing (or interest rate). The pattern of rate of return gives the demand for investment (also known of the marginal efficiency of investment): it is inversely related with interest rates. The cost of borrowing or interest rate is determined in the money market and is essentially the product of monetary policy. Most companies determine their current investment plans with the help of long range planning and capital budgeting. Forecasts of future sales are the major determinants in these calculations.
  • 4. INVESTMENT INSTABILITY In addition to the rate of return, investment demand is determined by state of technology, maintenance and level of existing capital, as well as expectations about future sales. Some of these components are highly unstable, such as new inventions and innovations and changes in future sales expectations. Thus, it is not entirely useful to model investment with other elements than investment demand and the given interest rate. Historically, the investment component of aggregate expenditure and of gross national product has been the most erratic of all. In periods of economic slow down, it is often negative. It jumps back up as soon as expectations of future sales look brighter. AGGREGATE OUTPUT Real aggregate output (or net national product NNP) is the 45 degree line in the Keynesian model because total income is equal to total output since taxes and transfer payments are omitted, and total output can be shown vertically as the 45 degree line. Graph G-MAC8.1 Aggregate output is very closely correlated to national income; in fact, if there were no government, it would be almost identical. KEYNESIAN EQUILIBRIUM The equilibrium occurs where aggregate expenditure (AE) is equal to aggregate real output (NNP):
  • 5. AE=NNP. Should firm produce more, they will be forced to cut back production because of excess inventories. Should they produce less, they will have to increase production because their inventories will be depleted. The equilibrium may very well occur below the full employment level of output. Graph G-MAC8.2 Businesses adjust their production to sales by observing their inventories. If the inventories are insufficient, production is increased. If the inventories are excessive, production is cut back. LEAKAGE Saving can be viewed as a leakage of funds out of the circular flow model. (Taxes are also a form of leakage, so are imports). If the economy is looked upon as a circular flow of funds similar to an engine with the funds as fuel, a loss of funds to saving would slow down the economy just as a loss of fuel would slow down the engine. INJECTION Investment can be viewed as a form of injection of funds in the circular flow model. (Exports would also be an injection). In the circular funds and engine comparison, a new input of funds speed up the economy just as an additional fuel injection into the motor.
  • 6. LEAKAGE-INJECTION EQUILIBRIUM The equilibrium in the leakage-injection graph is where saving is equal to investment: I=S. Should firms produce more an unintended saving would be present in the form of inventory accumulation. Should firms produce less, dissaving would occur in the form of inventory depletion. Graph G-MAC8.3 Many modern automobiles are equipped with vapor recirculation devices: what is lost to gasoline evaporation in the tank and carburetor is returned to the engine with that device so that the motor does not lose power. A similarity can be established with the circular fund flow model. MULTIPLIER EFFECT The multiplier effect comes from the fact that a positive change in planned expenditure by households or businesses will require a change in production putting new employees to work. This will result in new income that will cause a second round of increased aggregate demand. Successive rounds will add up so that a small change in aggregate demand (dAE) causes a multiple (M) change in real output (dNNP) M=dNNP/dAE. Just think about how many hands the money one has in one's wallet, has gone through! A payment for one additional purchase will not stop there, but will create income for several successive persons. That is the multiplier effect.
  • 7. MULTIPLIER The value of the multiplier is equal to the inverse of the marginal propensity to save or M=1/MPS=1/(1-MPC) If the marginal propensity to save is .4, the multiplier is M = 1/MPS = 1/0.4 = 2.5. COMPLEX MULTIPLIER Empirical estimates of the multiplier when all other forms of leakage are included, such as taxes, exports as well as saving, give a value of the complex multiplier of close to 2. All forms of funds usage other than spending reduce the multiplier. Taxes and import are two such diversions. PARADOX OF THRIFT If a society attempts to save more, its aggregate expenditure will decrease causing the equilibrium and real output to also decrease. As real output and income have shrunk, the society will not be able to save more, but only the same amount (or may be even less). The great depression is a vivid and regrettable example of the paradox of thrift. People tried to put more money aside because they were afraid. But, their very reluctance to spend caused income to decrease. RECESSIONARY GAP The extent to which the aggregate expenditure falls short of the full employment level of aggregate expenditure is called the recessionary gap. This is also the amount by which aggregate expenditure should be increased to achieve full employment. The administration calculates the potential GNP or full-employment income, which is presented in the Economic Report of the President. INFLATIONARY GAP The extent to which the actual aggregate expenditure exceeds the full employment level of aggregate expenditure is called the inflationary gap because such excess demand can only cause inflation as businesses already are producing at full capacity. . The SIMPLE KEYNESIAN MODEL OF INCOME DETERMINATION 2. Session Outline Consumption and savings function Investment function Multiplier analysis (incl. Multiplier process) Acceleration principle 06/07/09
  • 8. 3. Consumption and Savings Function The level of private disposable income is the chief determinant of private consumption and saving , which, in the absence of government is equal to total income. i.e., at higher levels of income the private sectors will both consume more and save more and vice versa. But, consumption and saving are determined by many factors in addition to the level of disposable income. Other important factors that influence the consumption and savings function are: Stock of Wealth Expectations Taxation Policy Distribution of Income Age Composition 06/07/09 4. Investment Function Investment is the most volatile of all the major components of aggregate demand (output), because of the multiplier mechanism. Capital investments (new buildings, new machineries, inventory etc) are made either out of own resources or borrowings . If borrowing is used, interest has to be paid on the sum borrowed. This is called `Debt financing‟. That does not mean that in the case of self- financing, own resources, come free of cost. With `self financing‟ the investor sacrifices the interest that he could otherwise have earned. 06/07/09 5. Investment Function…. Investments are made with an objective to earn profit. Interest is the price , profit is the reward for investment. The expected rate of profit from investment is called „marginal efficiency of capital‟ or „marginal productivity of investment‟. A rational investor will compare the profits earned with the rate of interest to be paid on the funds borrowed. The investor would decide to invest only if the expected profit from investment (marginal efficiency of capital) is higher than the rate of interest to be paid. 06/07/09 6. Investment Function… We conclude that the volume of investment in an economy mainly depends on two important factors: Marginal efficiency of capital Interest rates Of the two factors , MEC has a greater influence on the volume of investment 06/07/09 7. Other Factors Affecting Investment Demand Acquisition and operating cost The initial expenditure incurred on capital goods and the cost of maintenance of these goods, are important aspects for estimating the rate of net profitability of any investment. Such initial expenses increase the cost of installation , with limited return on investment. If these costs decline, the expected net profits go up. 06/07/09 8. Other Factors Affecting Investment Demand Operating costs are often company specific, while the company may not have any control on its initial expenses. Operating costs are driven by wage rates, which are influenced by the trade union policies of the company. Thus, an increase in the acquisition and operating cost reduces the expected net profitability, thereby reducing investment demand. 06/07/09 9. Other Factors Affecting Investment Demand Taxes Profits earned by a business after paying all the charges against Interest and Taxes, is the true yardstick for measuring prospective investment. Therefore, an increase in the rates of taxes would reduce the profitability of an investment, while a decrease would make the investment attractive 06/07/09
  • 9. 10. Other Factors Affecting Investment Demand Change in Technology Technological progress, process of development of new products, improvement in the quality of performance of the existing products and development of a new method of production- all these, act as a stimulant to the investment climate. Development of a new machine, for instance would help to reduce the cost of production, improve the quality of the product and increase the expected rate of profit earned from such an investment. In short, a rapid degree of technological innovation drives the demand for new investment in the economy. 06/07/09 11. Other Factors Affecting Investment Demand Stock of Capital Goods in Hand Stock of capital goods in hand influences the investment demand in just the same way as the stock of consumer goods in hand affects the household consumption-savings decision. To the extent that a given industry is well equipped with productive facilities and inventory of finished goods, money remains blocked in that industry, thus affecting return on investment. Any industry with such a kind of problem would be forced to accept lesser profits. With lower rates of return, incremental investments into the industry would also be less. Thus an excess or inadequate availability of stock of capital determines investment demand in the economy. 06/07/09 12. Other Factors Affecting Investment Demand Ratchet effect is the commonly observed phenomenon that some processes cannot go backwards once certain things have happened, by analogy with the mechanical ratchet that holds the spring tight as a clock is wound up. 06/07/09 13. Steady State Level of Consumption in the Long Run Consumption function, C t = a + bY d t + gC t -1 [Where Ct = Consumption expenditure for the current year; a = Autonomous consumption; b = Short run MPC; Y d t = Disposable personal income for the current year; g = Coefficient indicating the relation between current period consumption and previous period consumption ; C t-1 = Previous period consumption expenditure] Since C t = C t-1 Ct = a + bY d t + gC t Or, C t (1 – g) = a + bY d t Or, C t = [{a/(1-g)} + {b/(1-g). Y d t }] 06/07/09 14. Process of Multiplier How does the process of multiplier work beginning from the initial injection? Increase in autonomous spending adds to incomes, which in turn are spent partly on other goods and services, leading to increase in income. Part of this increased income is again spent on goods and services, causing further increase in income. This process continues uninterruptedly with a smaller sum of income passed on at each phase. The magnitude of this increase is determined by how much income is passed on at each phase. This in turn is dependent on the rise in consumption spending ( Δ C/ Δ Y) or the marginal propensity to consume for a unit rise in disposable income. 06/07/09 15. Process of Multiplier The change in total income ( Δ Y) = Change in autonomous expenditure ( Δ E) + the induced change in consumption ( Δ C). Symbolically, Δ Y = Δ E + Δ C We know that MPC = Or, Δ Y (1 06/07/09 = Δ C/ Δ Y Or, Δ C = MPC. Δ Y Thus, Δ Y = Δ E + Δ C = Δ E + ) = Δ E Or, k (multiplier) = Where, MPS = the marginal propensity to save .ΔY
  • 10. 16. Multiplier Analysis 06/07/09 Illustration: If consumption function is given by C = 50 + 0.5Y, what is the change in equilibrium income for an increase of Rs.100 crores in autonomous government expenditure? Solution: With the increase of autonomous government expenditure by Rs.100 crores, the demand income increases by Rs.100 crores in the first phase. This induces a demand of Rs.50 crores in the second phase due to consumption of 0.5 or 50% of increased income; Rs.25 crores in the third phase; Rs.12.5 in the fourth phase; Rs.6.25 in the fifth phase; 3.125 in the sixth phase; and so on. Thus, the total increase in equilibrium income ( Δ Y) = 100 + 50 + 25 + 12.5 + 6.25 + 3.125 + 1.5625 + 0.78125 + … = 200 Multiplier x Δ E = 17. Multiplier Process (For an Increase of Rs.100 in Autonomous Investment) 06/07/09 Stages MPC x Change in Income Rise in Income Total Income 1 100 100 100 2 0.5x 100 50 150 3 0.5x 50 25 175 4 0.5x 25 12.5 187.5 5 0.5x 12.5 6.25 193.75 6 0.5x 6.25 3.125 196.875 7 0.5x 3.125 1.5625 198.4375 8 0.5x 1.5625 0.78125 199.2188 9 0.5x 0.7815 0.39 199.6088 18. 06/07/09 19. Uses and Limits of the Multiplier Uses The Multiplier process by indicating different phases of trade cycles helps the business community to plan its transactions accordingly. Multiplier analysis acts as an important tool for the modern governments in formulating economic policies. A government, by multiplier analysis, can know the quantity of investment that has to be made to reach full employment level. The Multiplier principle shows the importance of deficit budgeting 06/07/09 20. Uses and Limits of the Multiplier Limitations Multiplier process works only when there is adequate availability of consumer goods. Full value of multiplier is achieved only when various increments in investments are repeated at regular intervals. The full value of the multiplier can be achieved only when there is no change in the MPC during the process of income propagation. While estimating the multiplier in a country, we assume that the country has no trade relations with others. If there are trade relations with other countries, then the multiplier estimated may be more or less than its real value. To realize the full value of multiplier, it is assumed that there are no time lags between the receipt of income and its spending. But, this is not possible in real life. 06/07/09 21. Acceleration Principle Acceleration principle is concerned with the changes in investment and its ultimate effect on gross product or income. Although J.M. Keynes discussed the principle of multiplier, he did not make any reference to acceleration principle in his General Theory. Acceleration principle (principle of magnified derived demand) is based on the induced investment; the principle states that the demand for durable goods (investment) is derived from the demand for final goods and services produced by them. For example, if demand for consumption goods increases, it induces an additional demand for capital goods. Thus the concept of acceleration shows the functional relationship between changes in demand for final goods (consumption goods) and the consequent changes in the demand for capital goods (capital goods – e.g. machines). 06/07/09
  • 11. 22. Acceleration Principle This functional relationship can be expressed as Acceleration principle = Δ K/ Δ Y (Change in Investment „divided by‟ Change in Income) The working of “ Acceleration Principle ” is similar to that of “ Multiplier Principle ”. 06/07/09