Micro / Macro Economics. Module 7. Classical Keynesian Economics. Classical Keynesian Economics. Aggregate Expenditure The same as Aggregate Demand

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1 Micro / Macro Economics Module 7 Classical Keynesian Economics EM1 1 Classical Keynesian Economics Aggregate Expenditure The same as Aggregate Demand Components of AE include: Consumption 55% Investment 20% Government Spending 22% Net Exports 3% EM1 2 Classical Keynesian Economics Consumption has two components Autonomous Not dependent on income Subsistence living The amount of spending if your income is zero Induced determined by Based on Disposable income, Expected future income, age and Interest rate 3 1

2 45 degree line Spending Disposable Income Assumptions: The total of what an economy earns = its total spending. We can go into debt in the short run but not the long run. The 45 degree line shows combinations where income = spending Consumption Function 160 Autonomous consumption = 160 Disposable Income Induced consumption is represented by the slope of the consumption function (MPC) If the MPC = 0.80, then for every dollar we earn, we spend $ degree line Consumption Function Equilibrium C = Y Disposable Income The horizontal axis is Disposable Income and the vertical axis is expenditures The consumption function is the sum of autonomous and planned consumption The slope of C = Marginal Propensity to Consume (MPC), and is less than 1 6 2

3 45 degree line Y > C Consumption Function Equilibrium C = Y C > Y Disposable Income At any level of income below equilibrium, there is negative savings At income levels above equilibrium there is unplanned savings MPC + MPSave = 1 EM1 7 C1 C A change in disposable income Causes a movement along the C function A change in interest rates, future Expectations, world economies etc causes a shift of C to C1 8 Disposable Income = Income Taxes Y d = (1- t) * Y t = tax rate Marginal Propensity to consume out of real GDP = (1- t) * MPC Marginal Propensity to Spend = (1- t) * MPC MPImport EM1 9 3

4 Calculation t = 0.3 MPI = 0.2 MPC = 0.8 If $100 falls from the sky and into the economy then Y d will increase by (1-0.3) * 100 = $70 Consumption Spending will increase by $70 * 0.8 = $56 Domestic Spending will increase by $56 20 = $36 ***(Slope of C) *** Verification: Domestic Spending 36 Taxes 30 Imports 20 Savings (100 * (1- t) * (1-MPC)) 14 $100 EM1 10 Aggregate Expenditure C = f(real GDP) Since Aggregate Income = Y d + Taxes And GDP = Aggregate Income We can change the axis of our model as shown Consumption = function () 11 Investment = function (Interest rates, Expected inflation Expected Profits Depreciation) Investment includes business inventories and our purchases of durable goods (houses, cars etc.) Investment = f(interest rates) cp EM1 12 4

5 Investment = function (Interest rates, Expected inflation Expected Profits Depreciation) Investment includes business inventories and our purchases of durable goods (houses, cars etc.) Investment = f(interest rates) cp Investment is predominantly autonomous Investment decisions are made well before they are carried out Usually a result of long term strategy There is an induced component to Investment, but that is beyond the scope of this course EM1 13 Real Interest Rate Investment = Function (i) Real Investment As real interest rates change there is a movement along the Investment curve If profit expectations change there is a movement of the Investment curve, either to the left or to the right 14 Exports decisions from the rest of the world to buy Canadian products Exports = function (other countries GDP Canadian Prices Exchange rates) Imports decisions by Canadians to buy foreign products Imports = function (exchange rates Foreign Prices Canadian GDP) EM1 15 5

6 Imports Trade Surplus Trade Deficit Exports Exports are constant (determined by the economy of other countries) Imports are upwards sloping (determined by the Canadian economy) Trade surplus or deficit is the difference between imports from exports As Canadian GDP rises from 500 to 650, Canada goes from a trade surplus to a trade deficit (a paradox of wealth) 16 C + I + G + NX = AE Autonomous Consumption Slope = Marginal Propensity to Spend Domestically out of real Yd G is set by parliament and budgets and is considered autonomous Autonomous consumption is the consumption that an economy would spend if GDP or Yd is zero I + G + NX are considered autonomous Slope of the AE line = MPC * (1- t) MPIm 17 AE E The 45 degree line represents the points where Aggregate Expenditures = Aggregate Income At E there is balance in the economy and Y = GDP = AE EM1 18 6

7 AE E If GDP = 450, spending exceeds income and business inventories fall. As inventories fall, businesses increase output and GDP will rise to 500 EM1 19 AE 150 E At GDP = 650, income exceeds spending and there is unplanned savings. As businesses inventories start to build, businesses lay off employees and cut back production. GDP will fall to 500 EM1 20 The Multiplier page 555 Suppose that an element of AE increases by 10 The AE line will shift from AE1 To AE2 GDP will change also, but by more than 10 AE2 AE

8 Multiplier Illustration G increases by $10 MPC = 0.8 I spend $8.00 on goods and services. That $8.00 * 0.8 = $6.40 is spent on other goods and services Then 6.40 * 0.8 = 5.12 is spent Notice in these three rounds total spending = = $29.52 EM1 22 GDP will change by K * change in AE Where K is the multiplier K = 1 / (1 MPSpend) or K = 1 / (1 slope of AE) So if MPS = 0.8 then the multiplier = 1 / 0.2 = 5 page 556 A 10 dollar shift in AE will increase GDP by 10 * 5 = 50 dollars EM1 23 GDP will change by K * change in AE Where K is the multiplier K = 1 / (1 MPSpend) or K = 1 / (1 slope of AE) Calculating K: t = 0.20 MPI = 0.15 MPC =.80 K = 1 = 1 = (0.8 * ( )) 0.15)

9 Fiscal Policy If the economy needs a boost, Government can increase spending If G increase by 20 and K = 4, then GDP will rise by 80 As GDP rises Employment rises Tax collection rises EI payments drop EM1 25 Government can also change taxes As taxes decrease, Yd increases and Spending increases Because some taxes come from or go to savings, the tax multiplier is different Tax Multiplier = - MPC 1-slope of AE (***** if Imports = 0 then slope of AE = MPC *****) Government Spending Multiplier = 1 / (1 slope of AE) EM1 26 Tax Multiplier = - MPC 1-slope of AE Government Spending Multiplier = 1 / (1 slope of AE) If Government raised taxes and used the taxes to fund a project the net effect is the Balanced Budget Multiplier BBM = 1 / (1 slope of AE ) + - MPC / (1 slope of AE) BBM = 1- MPC 1 slope of AE EM1 27 9

10 Government Tax Cuts page 589 E1 SAS E AD As Government cuts taxes, Savings, Consumption and Investment increase Increased C causes a shift of the AD Initial equilibrium is at E1 Government Tax Cuts page 589 E1 SAS E E2 AD As Government cuts taxes, Savings, Consumption and Investment increase Increased S & I increase the Supply curve (right shift) Increased C causes a shift of the AD Initial equilibrium is at E1 but after the tax cut the equilibrium is E2 Deriving Aggregate Demand from Aggregate Expenditure page 560 AE if Price level is The top graph shows AE and the bottom graph shows AD EM

11 Deriving Aggregate Demand from Aggregate Expenditure AE if Price level is 80 AE if Price level is AS the Price level decreases, the AE shifts upwards, causing a corresponding point on the AD AD EM1 31 Deriving Aggregate Demand from Aggregate Expenditure AE if Price level is 80 AE if Price level is 100 AE if Price level is 120 Real GDP As the price level increases, AE shifts downwards causing another point on the AD EM1 32 Deriving Aggregate Demand from Aggregate Expenditure AE if Price level is 80 AE if Price level is 100 AE if Price level is Real GDP AD All we do now is connect the dots to form the AD line. EM

12 Calculating Equilibrium GDP (mathematical method) Autonomous Consumption 50 Investment 10 Government Spending 30 Exports 15 Marginal Propensity to Consume 0.80 Marginal Propensity to Import 0.20 Marginal Tax Rate 0.30 Calculate the Marginal Propensity to Spend Domestically ( ( 1 MTR ) * MPC) MPImport = ( ( ) * 0.80 ) 0.20 = 0.7 * = = 0.36 EM1 34 Calculate Equilibrium GDP AE = C + I + G + NX = ( (Y tax) ) (15 0.2Y) = ( Y 0.3Y) Y = Y Y = Y since AE = GDP then Y = Y Y Y = Y = 105 so Y = 105 / 0.64 Y = 164 EM1 35 SAS AD Typical Recession Scenario Notice the flat SAS As AD expands, real GDP increases but the price level stays the same Notice that the SAS eventually does rise (at full employment) EM

13 SAS AD Typical Boom Scenario As AD rises, real GDP rises but so do prices, as the economy reaches full employment EM1 37 Full Employment GDP AE 1 Full Empl. GDP Deflationary Gap AE 1 represents a recessionary scenario resulting in a deflationary gap The gap is measured as the distance between the 45-degree line and the AE line, at full employment EM1 38 Fiscal Policy Deflationary Gap multiplier = change in G required Potential GDP = 600 Actual GDP (using AE1) = 500 Multiplier = 5 Then government should increase spending by Or.. Decrease taxes using the tax multiplier -MPC 1 slope of AE Or.. Monetary Policy: decrease interest rates which increases spending and investment EM

14 Full Employment GDP AE 2 Full Empl. GDP Inflationary Gap 600 AE 2 shows an inflationary model as a result of a boom The gap is measured as the vertical distance between the 45-degree line and the AE line, at full employment Since GDP cannot increase, Price levels go up Inflation! EM1 40 Review Questions 1. Autonomous consumption is 200 while for every $1 increase in disposable income,.80 is spent on consumption. Taxes are a constant 25% and Govt spending is 300. Investment is 200. Exports are 100 and imports are 10% of real GDP. a. Calculate equilibrium real GDP. b. If the govt wants to increase GDP by 100, by how much must it increase its purchases? EM1 41 Review Questions 1. Autonomous consumption is 200 while for every $1 increase in disposable income,.80 is spent on consumption. Taxes are a constant 25% and Govt spending is 300. Investment is 200. Exports are 100 and imports are 10% of real GDP. a. real GDP = C + I + G + NE = (Y Y) ( Y) = Y 0.1Y Y = Y so... Y = Y or 0.5Y = 800 Y = 800 / 0.5 b. If the govt wants to increase GDP by 100, it increases its purchases by 100 / multiplier or 100 / 2 EM

15 2. An economy has the following data relating to its AE. C = Y = 0. If GDP rises by 100, C rises by 60. I = 50. G = 80. EX = 50 and the MP to import = 0.1. a. Complete the following table. Y C I G EX IM b. What is the equilibrium GDP? c. Calculate the MP to consume domestically out of real disposable income. d. Calculate the autonomous expenditure multiplier. 43 e. If Investment rises by 50, what is the new equilibrium GDP. 2. An economy has the following data relating to its AE. C = Y = 0. If GDP rises by 100, C rises by 60. I = 50. G = 80. EX = 50 and the MP to import = 0.1. Y C I G EX IM ***** b. What is the equilibrium GDP? c. MP to consume domestically = = 0.5 d. Expenditure multiplier = 1 / = 2 e. If Investment rises by 50, what is the new equilibrium GDP. GDP will increase by 50 *

13 EXPENDITURE MULTIPLIERS: THE KEYNESIAN MODEL* Chapter. Fixed Prices and Expenditure Plans. D) the aggregate price level is fixed and that aggregate

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