Macroeconomic Theory and
Policy
Lecture 3
Keynesian Theory of Aggregate Demand for
the Short Run: Goods Market Equilibrium
1
Keynesian theory of aggregate demand
• Components of aggregate demand:
–
–
–
–
Consumption
Investment
Government expenditure, (Revenue)
Exports, (imports, trade balance)
• Determination of national income
– Keynesian cross,
– Saving and investment identity
• Derivation of the IS curve
• Factors that shift this curve
2
Consumption Function
C
C = a0 +a1*(Y-T)
a0 > 0: Autonomous Consumption
a1 >0: Marginal Propensity to Consumer
Y
3
Numerical Example
Y
Consumption Function
C
0 200
100 260
Consumption
1000
200 320
MPC 0.5
800
300 380
600
C =200 +0.5*Y
400
400 440
500 500
200
600 560
0
0
500
1000
Income
1500
700 620
800 680
900 740
1000 800
1100 4860
1200 920
Consumption and Saving in the Keynesian Model (MPC
= 0.6)
1000
C
Saving
Y
500
Income
12
00
10
00
80
0
60
0
40
0
-500
20
0
0
0
C and S
1500
Savin
g
C
0
-200
200
100
-160
260
200
-120
320
300
-80
380
400
-40
440
500
0
500
600
40
560
700
80
620
800
120
680
900
160
740
1000
200
800
1100
240
860
1200
280
920
Y
5
Investment Function
r
I = I0 -d(r)
I
6
Interest Rate
Investment Function
Invest
0.6
0.5
0.4
0.3
0.2
0.1
0
1700
I = 2000 - 500(r)
1800
1900
2000
Mon
etarie
st
r
I1
Keyne
sian
0
2000
2000
2000
0.05
1975
1995
1800
0.1
1950
1990
1600
0.15
1925
1985
1400
0.2
1900
1980
1200
0.25
1875
1975
1000
0.3
1850
1970
800
0.35
1825
1965
600
0.4
1800
1960
400
0.45
1775
1955
200
0.5
1750
1950
0
0.55
1725
1945
-200
2100
Amount of Investment
7
Tax Revenue Function
80
Tax Revenue
60
T
40
T = -50 +0.1*Y
20
0
-20
0
500
1000
1500
-40
-60
Income
8
Imports Function
300
M
Imports
250
200
150
100
M = 50+0.2*Y
50
0
0
500
1000
1500
Y
M
0
50
100
70
200
90
300
110
400
130
500
150
600
170
700
190
800
210
900
230
1000
250
Income
9
Tax and government spending
and imports and exports
Tax and spending
Export and Imports
Tax and
Spending
Income
Government spending and taxes
Exports
Imports
Income
Trade (exports and imports)
10
Equilibrium National Income In the Keynesian Model
AD =Y
C+I+G+X-M
C+I+G
C+I
C
450
Y: Output
11
Goods Market Equilibrium in a Closed Economy
Saving = Investment
Derivation of the IS Curve in the Keynesian Model
r0
r1<r0
AD
I(r) =S(y)
r0
r1
y1
y2
IS
y1
y2
12
Why the IS Curve Represents a Good Market Equilibrium?
r
Excess Supply
Not enough demand
Excess Demand
IS (r,y)
Y
13
Keynesian Model of National Income
Determination: Review
IS-Curve-Goods Market Equilibrium
Determination of National Income
E
AD
AD4
AD3
AD2
Interest
Rate
Excess Supply
AD
Excess demand
Income/Output
Goods market equilibrium
Aggregate Output
14
A Simple Keynesian Model
MODEL
C = C 0 + a(Y − T )
I = b − dr
Z = mY
T=100 G =100 X =50
Y = C + I +G+ X −Z
Numerical Example
C = 200 + 0.8(Y − 100)
I = 100 − 200(0.05)
Z = 0.2Y
C 0 − aT + b − dr + G + X
Y=
1− a + m
200 − 0.8 *100 + 100 − 200 * 0.05 + 100 + 50
Y=
1 − 0 .8 + 0 .2
15
Model Solutions
•
•
•
•
•
•
•
•
Y = 900
C = 840
I = 90
T=G= 100;X=50
M = 180
X-M = -130
S=Y-T-C=-40
S-I=-40-90=-130
C = 200 + 0.8(Y − 100)
I = 100 − 200(0.05)
Z = 0.2Y
16
Keynesian Saving and Net Trade Balance Functions
Keynesian Saving Function
Savings
Keynesian Trade Balance Function
Trade ( +)
Balance
(+)
0
0
(-)
(-)
Income
Income
17
What are the factor that shift the IS curve?
•
•
•
•
•
•
•
•
Towards the right
1 More G
2 Less T
3 Devaluation More X
4 Less Z
5 High MPC
6 High MPM
7 High I0, C0
•
•
•
•
•
•
•
•
Towards the left
1
2
3
4
5
6
7
18
Illustration on How the Keynesian Model can
be used for Policy Analysis
• Behavioural factors
• Increase in
autonomous
consumption spending
• Decrease in MPC
• Increase in MPM
• Autonomous taxes
•
•
•
•
Policy induced factors
Tax cut
Increase in spending
Depreciation of
currency
• Increase in foreign
income
19
References
•
B&W 10,11, Bl 4, MS 5 MK 11
•
Hicks, J. R.(1937): Mr. Keynes and the
"Classics"; A Suggested Interpretation,
Econometrica 5: 1937.
Keynes (1936) The General Theory of
Employment, Income and Interest Rate,
Cambridge University Press.
•
20