Keynesianism

Say’s Law says that producing goods
generates an amount of income equal to the
value of the goods produced

Great Depression

Keynes theorizes that not all income is spent
leaving surpluses
◦ In other words, the economy is not self-adjusting
and that external forces not always the cause of
recession, there are also internal forces caused by
failure of certain fundamental economic decisions
(savings and investing)

Income after taxes or net income

2 Choices with disposable income

Average Propensity to Consume

Average Propensity to Save

APC + APS = 1
◦ DI=Gross Income – Taxes
◦ Consume or Save
◦ APC = consumption/income
◦ APS = saving/income
 The
fraction of any change in
disposable income that is
consumed.
 MPC=
Change in Consumption
Change in Disposable Income
 MPC = ΔC/ΔDI
 The
fraction of any change in
disposable income that is saved.
 MPS=
Change in Savings
Change in Disposable Income
 MPS
=
ΔS/
ΔDI
 MPC
+ MPS = 1
◦ .: MPC = 1 – MPS
◦ .: MPS = 1 – MPC
 Remember,
people do two
things with their disposable
income, consume it or save it!
 An
initial change in spending (C,
IG, G, XN) causes a larger change in
aggregate spending, or
Aggregate Demand (AD).
 Multiplier
= Change in AD
Change in Spending
 Multiplier = Δ AD/Δ C, I, G, or X
Why
does this happen?
◦Expenditures and income flow
continuously which sets off a
spending increase in the
economy.
 The
Spending Multiplier can be
calculated from the MPC or the
MPS.
1
1
 Multiplier = /1-MPC or
/MPS
 Multipliers
are (+) when there is
an increase in spending and (–)
when there is a decrease

Ex. Assume U.S. citizens spend 90¢ for every extra $1
they earn. Further assume that the real interest rate (r%)
decreases, causing a $50 billion increase in gross private
investment. Calculate the effect of a $50 billion increase
in IG on U.S. Aggregate Demand (AD).
◦ Step 1: Calculate the MPC and MPS
 MPC = ΔC/ΔDI = .9/1 = .9
 MPS = 1 – MPC = .10
◦ Step 2: Determine which multiplier to use, and whether it’s + or  The problem mentions an increase in Δ IG .: use a (+) spending
multiplier
◦ Step 3: Calculate the Spending and/or Tax Multiplier
 1/MPS = 1/.10 = 10
◦ Step 4: Calculate the Change in AD
 (Δ C, IG, G, or XN) * Spending Multiplier
 ($50 billion Δ IG) * (10) = $500 billion ΔAD
When the government taxes, the multiplier
works in reverse
 Why?

◦ Because now money is leaving the circular flow


Tax Multiplier (note: it’s negative)
 = -MPC/1-MPC
or
-MPC/
MPS
If there is a tax-CUT, then the multiplier is
+, because there is now more money in the
circular flow

Ex. Assume U.S. citizens spend 90¢ for every extra $1
they earn. Further assume that the real interest rate (r%)
decreases, causing a $50 billion increase in gross private
investment. Calculate the effect of a $50 billion increase
in IG on U.S. Aggregate Demand (AD).
◦ Step 1: Calculate the MPC and MPS
 MPC = ΔC/ΔDI = .9/1 = .9
 MPS = 1 – MPC = .10
◦ Step 2: Determine which multiplier to use, and whether it’s + or  The problem mentions an increase in Δ IG .: use a (+) spending
multiplier
◦ Step 3: Calculate the Spending and/or Tax Multiplier
 1/MPS = 1/.10 = 10
◦ Step 4: Calculate the Change in AD
 (Δ C, IG, G, or XN) * Spending Multiplier
 ($50 billion Δ IG) * (10) = $500 billion ΔAD

Ex. Assume Germany raises taxes on its citizens by €200
billion . Furthermore, assume that Germans save 25% of
the change in their disposable income. Calculate the
effect the €200 billion change in taxes on the German
economy.
◦ Step 1: Calculate the MPC and MPS
 MPS = 25%(given in the problem) = .25
 MPC = 1 – MPS = 1 - .25 = .75
◦ Step 2: Determine which multiplier to use, and whether it’s + or  The problem mentions an increase in T .: use (-) tax multiplier
◦ Step 3: Calculate the Spending and/or Tax Multiplier
 -MPC/MPS = -.75/.25 = -3
◦ Step 4: Calculate the Change in AD
 (Δ Tax) * Tax Multiplier
 (€200 billion Δ T) * (-3) = -€600 billion Δ in AD

Ex. Assume the Japanese spend 4/5 of their disposable income.
Furthermore, assume that the Japanese government increases its
spending by ¥50 trillion and in order to maintain a balanced budget
simultaneously increases taxes by ¥50 trillion. Calculate the effect
the ¥50 trillion change in government spending and ¥50 trillion
change in taxes on Japanese Aggregate Demand.
◦ Step 1: Calculate the MPC and MPS
 MPC = 4/5 (given in the problem) = .80
 MPS = 1 – MPC = 1 - .80 = .20
◦ Step 2: Determine which multiplier to use, and whether it’s + or  The problem mentions an increase in G and an increase in T .: combine a
(+) spending with a (–) tax multiplier
◦ Step 3: Calculate the Spending and Tax Multipliers
 Spending Multiplier = 1/MPS = 1/.20 = 5
 Tax Multiplier = -MPC/MPS = -.80/.20 = -4
◦ Step 4: Calculate the Change in AD
 [ Δ G * Spending Multiplier] + [ Δ T * Tax Multiplier]
 [(¥50 trillion Δ G) * 5] + [(¥50 trillion Δ T) * -4]
 [
¥250 trillion
]+[
- ¥200 trillion
] = ¥50 trillion Δ AD
 Money
spent or
expenditures on:
◦ New plants (factories)
◦ Capital equipment (machinery)
◦ Technology (hardware & software)
◦ New Homes
◦ Inventories (goods sold by producers)

How does business make investment decisions?
◦ Cost / Benefit Analysis

How does business determine the benefits?
◦ Expected rate of return

How does business count the cost?
◦ Interest costs

How does business determine the amount of
investment they undertake?
◦ Compare expected rate of return to interest cost
 If expected return > interest cost, then invest
 If expected return < interest cost, then do not invest

What’s the difference?
◦ Nominal is the observable rate of interest.
Real subtracts out inflation (π%)and is only
known ex post facto.
How do you compute the real interest
rate (r%)?
r% = i% - π%
 What then, determines the cost of an
investment decision?

◦ The real interest rate (r%)
What is the shape of the Investment demand
curve?

◦
Downward sloping
Why?

◦
◦
When interest rates are high, fewer investments are
profitable; when interest rates are low, more
investments are profitable
Conversely, there are few investments that yield high
rates of return, and many that yield low rates of return
The Investment Demand Curve
Changes in r% cause
changes in IG. Factors
other than r% may shift
the entire ID curve
r%
5%

3%
ID

$2
trillion
$3
trillion
IG
◦ Cost of Production
 Lower costs shift ID 
 Higher costs shift ID 
◦ Business Taxes
 Lower business taxes shift ID 
 Higher business taxes shift ID 
◦ Technological Change
 New technology shifts ID 
 Lack of technological change shifts ID 
◦ Stock of Capital
 If an economy is low on capital, then ID 
 If an economy has much capital, then ID 
◦ Expectations
 Positive expectations shift ID 
 Negative expectations shift ID 
Shifts in Investment Demand
r%
When investment demand shifts, different
levels of gross private investment occur
even while r% remains constant

4%
ID1
ID
$2.5
trillion
$3.25
trillion
IG
 Durability
◦ Capital has a long life-span, therefore once it is built
there is no immediate need for further investment
 Irregularity of Innovation
◦ Innovation does not proceed in a smooth linear fashion,
instead there are bursts of innovation followed by
periods of relative stability
 Variability of Profits
◦ Profitability is subject to the forces of competition,
cyclical changes in the economy, and human
management decisions
 Variability of Expectations
◦ Political, social and natural phenomenon shape our
positive and negative expectations of the future

Many economists believe that investment instability
is the chief cause of the business cycle.



The market where savers and borrowers
exchange funds (QLF) at the real rate of interest
(r%).
The demand for loanable funds, or borrowing
comes from households, firms, government and
the foreign sector. The demand for loanable
funds is in fact the supply of bonds.
The supply of loanable funds, or savings comes
from households, firms, government and the
foreign sector. The supply of loanable funds is
also the demand for bonds.
Loanable Funds Market in
Equilibrium
r%
SLF & DBonds
r
DLF & SBonds
q
QLF




Remember that demand for loanable funds =
borrowing (i.e. supplying bonds)
More borrowing = more demand for loanable
funds ()
Less borrowing = less demand for loanable
funds ()
Examples
◦ Government deficit spending = more borrowing
= more demand for loanable funds
.: DLF  .: r%↑
◦ Less investment demand = less borrowing
= less demand for loanable funds
.: DLF .: r%↓
Increase in the Demand
for
Loanable
Funds
r%
SLF
r1
r
DLF
q
q1
DLF  .: r% ↑ & QLF ↑
QLF
DLF 1
Decrease in the Demand
for
Loanable
Funds
r%
SLF
r
r1
DLF 1
q1 q
DLF  .: r% ↓ & QLF ↓
QLF
DLF




Remember that supply of loanable funds =
saving (i.e. demand for bonds)
More saving = more supply of loanable funds()
Less saving = less supply of loanable funds ()
Examples
◦ Government budget surplus = more saving
= more supply of loanable funds
.: SLF  .: r%↓
◦ Decrease in consumers’ MPS = less saving
= less supply of loanable funds
.: SLF .: r%↑
Increase in the Supply
of
Loanable
Funds
r%
SLF
SLF 1
r
r1
DLF
q
q1
SLF  .: r% ↓ & QLF ↑
QLF
Decrease in the Supply of
Loanable
Funds
S
r%
LF 1
SLF
r1
r
DLF
q1
q
SLF  .: r% ↑ & QLF ↓
QLF





Loanable funds market determines the real
interest rate (r%).
Loanable funds market relates saving and
borrowing.
Changes in saving and borrowing create changes
in loanable funds and therefore the r% changes.
When government does fiscal policy it will affect
the loanable funds market.
Changes in the real interest rate (r%) will affect
Gross Private Investment
Effect of Expansionary Fiscal Policy
on Loanable Funds & Investment
SLF
r%
r%
r1
r
DLF 1
ID
DLF
q
q1
QLF
I1
I
G↑ and/or T↓ .: Government deficit spends .: DLF  .: r%↑ .: IG↓
(Crowding-Out Effect)
IG