Basic Keynesian Model Keynesian Cross Diagram Measuring the macroeconomy GNPpm = GDP – factor incomes from abroad + factor incomes of Pág.2 foreigners NetNPpm = GNPpm - Depreciation NNP at factor costs = Net National Product – Net indirect taxes + Subsidies (NNP=net national product at factor costs) NI (National Income) = NNPcf Personal Dispousable Income (PDI = Family income = NI – Direct taxes + Transfers - Profits + Undistributed profits Personal Disposable Income (PDI = Family income )= Consumption Spending + Savings Consumer price index: the CPI measures the price increase of a merket basket fo goods representative of the purchases of a typical household The Unemployment rate: The unemployed are people who want to work and are actively looking for jobs but have not yet found one. The unemployment rate is equal to the number of unemployed people divided by the total labor force. Macroeconomic model Sectors Markets Functions Endogenous Policies variables • Demand side •Households •Goods and • C, I, G, X,Q, • Y (GDP) • Firms Services T,S. • P (CPI) • Government •Financial • Foreign Sector wealth: •L, M/P. − Money. − Bonds. •U (Unemployment) • er (Exchange rates) • r (Interest rates) •Trabajo Pág.3 • Ls, Ld. − Fiscal. − Monetary. − Trade and Exchange rates policies. • Supply side: − Incomes. − Structural. Key concepts GDP composition The demand of goods and services The equilibrium Pág.4 Intended expenditure or aggregate demand components Pág.5 C C C Cpriv +I +I +I + Cpub +G +G +G + Ipriv = Internal +X + Ipub +X +X = Final +X -Q GDP mp -Q GDP mp -Q GDP mp -Q GDP mp The circular flow of economic activity GOODS AND SERVICES EXPENDITURE (FLOW OF EXPENDITURE) MARKET GOODS & SERVICES HOUSEHOLDS (CONSUMPTION) MONETARY FLOW MERCADO DE FACTORES DE PRODUCCION REAL FLOW INCOMES –WAGES ((FLOW OF INCOMES) FACTORS Pág.6 Demand varies, production Production varies, income varies Income varies, demand varies FIRMS (PRODUCTION) National income identity Production is equal to income. Then: Y AD Y C I G X Q Y C I G NX S I G NX This last equation states that savings should be sufficient for financing the investment spending, the budget deficit and the trade deficit. In other words, increases in budget or trade deficits unless accompanied by an equal increase in savings will lead to the crowding out of investment Pág.7 Short-run macroeconomic models Keynesian model (Endogenous variable: Income) Fixed prices Pure exchange economy. No money IS-LM Model (Endogenous variables: income-interest rate) Fixed prices Monetary economy Open economy without capital flows IS-LM with capital mobility (Mundell-Fleming) (Endogenous variables: Income-interest rates) Fixed prices Monetary economy Open economy with capital flows Aggregate supply and demand model (Endogenous variables: Prices- Income). AS-AD diagram Sticky prices Monetary economy Pág.8 Dynamic AS-AD model (endogenous variables: inflation rates and income) Keynesian model: assumptions Government sector: Taxes tax rate· Income T t·Y (0<t<1) Budget deficit (BS) is defined by the difference between taxes and the sum of government purchases (G) and transfers (TR). BS t·Y - Go - TRo Open Economy: net export is a decreasing function of national income. The coefficient m, is the marginal propensity to import. o NX NX - m·Y No money Fixed prices: no inflation nor deflation Pág.9 Keynesian model In this model a macroeconomic equilibrium is reached when actual ouput Y, is equal to intended spending. Hence, the level of the aggregate demand determines the income level. Production Income Expenditure or Aggregate demand Y Yincome AD AD Components Consumption spending (C), Investment spending (I), Government purchases, G, Investment spending, I. Therefore Y+Q-X is equal to: and Y Q - X C I G Y C I G X -Q Being X and Q, export and import, respectively. Pág.10 Keynesian model Equations: (1) Y AD (2) AD C I G X - Q (3) C Co cYd (4) Yd Y - tY TRo (5) I Io (6) G Go (7) X Xo xY * (8) Q Qo mY Susbtracting (7) - (8), s: X Q Xo Qo xY * mY (9) NXo Pág.11 Keynesian model Ecuaciones del modelo: (1) Y AD (2) AD C I G X - Q (3) C Co cYd (4) Yd Y - tY TRo (5) I Io (6) G Go (7) X Xo xY * (8) Q Qo mY Substituting (4) in (3) C Co cY tY TRo Co c(1 t)Y cTRo (10) Pág.12 Simple keynesian model (1) Y DA (2) DA C I G X - Q (5) I Io (6) G Go (9) C Co c(1- t)Y cTRo (10) XN XNo - mY Substituting (5), (6), (9) y (10) in (2) DA Co c(1 t)Y cTRo Io Go XNo mY (11) Pág.13 Keynesian model Equations are now: (1) Y AD (11) AD Co c(1 t)Y cTRo I o Go NX o mY Substituting (11) into (1) : Y Co c(1 t)Y cTRo I o Go NX o mY Y c(1 t)Y mY Co cTRo I o Go NX 0 Y(1 c(1 t) m) Co cTRo I o Go NX 0 1 C cTR I G NX Y o o o o 0 1 c(1 t) m autonomousexpenditure component Pág.14 multiplier Keynesian model In compact form: 1 Y C cTR I Go XNo Y α·A0 o o o 1 c(1 t) m expenditure component autonomous multiplier A 0 ¿Qué dice aquí? The equilibrium level of income is determined by the multiplier and by the autonomous expenditure component. Any increase in autonomous spending or any increase in the multiplier will change national income. Proof: dY dα·A0 dA0· Pág.15 Keynesian model dAo: dAo dC dcTR dTRo c dI dGo dNX o o o o Interpretation Any change in autonomous consumption spending, autonomous investment spending, marginal propensity to consume out of disposable personal income , ttransfers, government purchases or autonomous net export will increase autonomous spending . On the other hand, any change in t, m or c will change the multiplier value d11 - c(1 - t) m d 1 - c(1 - t) m ·1 2 1 - c(1 - t) m d1 dc(1 t) d(1 t)c dm 2 1 - c(1 - t) m dc tdc d1 dtc dm (1 t)dc dtc dm 1 - c(1 - t) m 2 1 - c(1 - t) m 2 dα Pág.16 Check By using the last equation we can check that Co Go TRo A0 Y NXo I0 c c m Y t Pág.17 Types of changes in the exogenous variables Exogenous variables in the model can be splitted into two groups: a) variables depending on the individual’s decisions: (c, I, m); variables determined by authorities (Government or Central Bank):G, TR, XN, t. Changes in G, TR, XN and t are fiscal and trade policy variables. Changes in this variables are policy shocks. Since changes in G, TR y t, will lead changes in budget surplus, they are defined as fiscal policy instruments. Changes in tariffs or in the exchange rate in order to change NXo, are trade policy instruments. Pág.18 Expansionary vs. Contractionary policies If as a result of any kind of policy shock income increases, this policy is expansionary. The so-called contractionary policies lead income decreases. For instance, Increase in G : Fiscal policy expansionary A tax cut: Fiscal policy expansionary Decrease in TR: Fiscal policy contractionary A cut in tariffs:Trade policy contractionary A decreaase in the marginal propensity to consume (NO policy) Pág.19 Demand (AD), Production (Y) The model Pág.20 HORIZONTAL AXIS: INCOME (Y) VERTICAL AXIS: DEMAND(AD) Renta,Y 45º LINE: EQUILIBRIUM CONDITION Y=DA Demand (AD), Production (Y) 45o LINE Pág.21 Y=AD SLOPE= 1 Y1 Y1 INCOME,Y THE INTENDED EXPENDITURE OR AD DA Co c(1 t)Y cTRo I o Go NX o mY A0 (c(1 - t) - m)Y 45o LINE AD AD AD A0 (c(1 - t) - m)Y number SLOPE AD=c(1-t)-m Ao number dAD c(1 t) m 0 dY intercept : Si Y 0 AD Ao Pág.22 Y THE EQUILIBRIUM AD 45o LINE AD E EQUILIBRIUM: Y = DA AUTONOMOUS SPENDING Pág.23 Y ¿HOW AN INCREASE IN NET EXPORT WOULD AFFECT THE EQUILIBRIUM INCOME? AD Y=AD E’ AD1=A1+(c(1-t)-m)Y Y1 ADo=Ao+(c(1-t)-m)Y A1 E Yo Ao 45º Pág.24 Yo Y1 INCOME,Y HIGHLIGHTS From this model, what are the recipes for the crisis C and I will decrease in recessions Howver, Government could increase G (government purchases): Government intervention vs. laissez faire-laissez-passer. Key argument: multiplier effect. Pág.25 Multiplier effect For simplicity suppose that we are in a closed economy, and suppose that Government increases the government purchases. The increase in government purchases by 1 euro changes intended spending by 1 euro and income in 1 euro. After tax, 1-t euros will be disposable for consumption . Therefore, the consumption spending will increase in c(1-t) euros, so the intended spending goes up and income will also increase in c(1-t). This new increase in income, will lead a new increase in consumption spending of …. The sum of the initial effects and the rest of induced effects determines that the multiplier will be higher than 1. Pág.26 Fiscal policy and Budget surplus How an increase in G would affect the budget deficit? SP t·Y - Go - TRo Pág.27 How an increase in G would affect the budget deficit? BS t·Y - Go - TRo Taking differences dBS dt·Y dY·t - dGo - dTRo The increase in income from the increase in government purchases is , dY=αdG then: t dBS αdG·t - dG αt 1dG 1 dG 1 - c(1 - t) m t - 1 c(1 - t) m (c - 1)(1 - t) m dG dG 0 1 - c(1 - t) m 1 - c(1 - t) m Pág.28 Extensions An increase in the Government purchases AD Y=AD E’ AD1=A1+(c(1-t)-m)Y Y1 ADo=Ao+(c(1-t)-m)Y A1=C0+I0+G1+cTRo+NXo Yo Ao=C0+I0+G0+cTRo+NXo Pág.30 E 45º Yo Y1 Income,Y An Increase in the Transfers AD Y=AD E’ AD1=A1+(c(1-t)-m)Y Y1 ADo=Ao+(c(1-t)-m)Y A1=C0+I0+G0+cTR1+NXo Yo Ao=C0+I0+G0+cTRo+NXo Pág.31 E 45º Yo Y1 INCOME,Y An increase in the tax rate AD Y=AD E AD0=Ao+(c(1-t)-m)Y Yo AD1=Ao+(c(1-t1)-m)Y Y1 E’ Ao=C0+I0+G0+cTRo+NXo 45º Pág.32 Y1 Yo Income,Y