An Abridged Roadmap from The Keynesian Cross to the AD Curve (a.k.a. topics from Chapters 10-11)

Transcription

1 An Abidged Roadmap fom The Keynesian Coss to the AD Cuve (a.k.a. topics fom Chaptes 10-11) 1 The Keynesian Coss The Keynesian coss compaes what we call planned expenditue and actual expenditue. Mathematically, planned expenditue is epesented as follows: = C( T ) + I + G whee baing indicates that the vaiable is somehow set (i.e. is a policy vaiable, etc). Basically, it s what eveyone in the economy expects will be supplied and demanded at a given time. Note that C and ae the only two vaiables that ae not baed. Gaphically, this tanslates to the slope of the cuve being the MPC. 1 The economy is consideed to be in equilibium when planned expenditue equals actual expenditue. This means when the cuve intesects the 45-degee line fom the oigin. Imagine we ween t in equilibium. If we e above =, actual expenditue is highe than planned and fims have excess inventoy, causing them to scale back poduction and fie wokes, diving down GDP until we e at equlibium again. If we e below =, fims have a shotage of inventoy, hie moe wokes to pick up the slack, and that dives up GDP until equilibium is eached again. Planned xpenditue Actual xpenditue Figue 1: The Keynesian coss. = = C + I + G Changes in I, G, and T can cause the cuve to shift up and down. The size of the shift and the gowth in output do not have a one-to-one elationship due to the multiplie effect. Both I and G have simila multiplies. 1 = G 1 = I 1 Why? As you move ight along the cuve, inceases by some facto of. As shown in the above equation, C is the only vaiable that will change due to. Thus the movement along the cuve is exactly the same as the incease in C due to inceases in, o the MPC. Note that this is talking about a movement ALONG the cuve, not a movement OF the cuve. Pepaed by Nick Sandes, UC Davis Gaduate Depatment of conomics 2008

2 The multiplie effect exists because an incease in I o G esults in an incease in, which in tun inceases C (by a function of the MPC), which again inceases, which again inceases C, and so on until the final effect is given by the above equations. 2 Thee is as simila effect fo changes in taxes = T MP C whee the seconday appeaance of the MPC is because pat of any change in taxes will patially affect savings. Planned xpenditue ' ΔG ΔG/(1-MPC) ' = To see this gaphically, imagine thee is a incease in gov t spending. The elationship between the upwad shift in the cuve and the outwad movement along the axis will be detemined by the size of the multiplie effect. The highe the slope of the cuve, the geate the change in fo any Actual xpenditue Figue 2: A change in govenment spending in the Keynesian coss. given incease in. Makes sense, since we just decided that the slope of the cuve is the MPC, and that the highe the MPC, the highe the effect of an incease in. ' 2 - The Keynesian coss assumes a fixed amount of investment at a given. Is that ealistic? Not eally... we ve talked at length about the fact that as the inteest ate changes, the demand fo investment changes. We need a way to tie investment back to the inteest ate, i.e. to be able to wite I() again. That s whee the cuve comes in. The cuve gaphs the elationship between the inteest ate and output that is bought about by the inteaction between I and the inteest ate. As is to be expected, thee is an invese elationship between and a decease in the inteest ate means an incease in I, and thus an incease in Inteest ate () ' ' Output () Figue 3: The cuve. 2 Thus a highe MPC means that the powe of changes in G and I is geate. Does that mean we want a wold with a eally high MPC? In some ways, yes. But ecall fom ou study of the Solow model that a high MPC means a lowe savings, which leads to lowe capital pe laboe, which leads to lowe... thee ae always tade-offs. Welcome to economics. 2

3 . If we wee looking at the Keynesian coss, the incease in I would esult in an upwad shift of the cuve, and an incease in, just like we see hee. So the Keynesian coss and the cuve ae petty closely elated. Can we assume that things that move the cuve move the cuve? es... most of the time. If it s a shift in due to a change in the inteest ate (and thus a change in I), then that is a movement along the cuve. Howeve, any othe change in is a shift of the cuve (e.g. fiscal policy, changes in consume confidence). So changes in G and T will shift the cuve inwad o outwad, just like they shift the Keynesian coss down o up. Changes in the demand fo investment at all inteest ates will also shift the cuve. The cuve is the next piece of this stoy. It elates the inteest ate to the level of income though the level of eal money balances in the economy. Remembe the old M V = P equation? It s back. The cuve is dawn fo a given fixed level of eal balances (M/P ). As output inceases, people need moe money to buy that output, and thee is an incease in demand fo eal money balances. But we ' just said the level of eal money balances was fixed, so an incease in demand with no change in supply must mean the pice of eal money balances goes up (and the pice is ). That means an incease in the demand fo money will only incease the inteest ' ate... which is just what the upwad sloping Output () cuve shows. Figue 4: The cuve. What shifts the cuve? It is dawn fo a given level of eal money balances, so any change in eal money balances will shift the cuve. What changes eal money balances? That would be changes in P o M. Inteest ate () 3 Scene 2: They Meet When two cuves that eally deseve each othe get togethe, it s a beautiful thing. When the - cuves get togethe, they tell us the shot-un equilibium level of income and the inteest ate fo a given level of eal money balances and an equilibium in the goods and sevices maket (see Figue 5). These two cuves will ALWAS be in equilibium. ALWAS. If it s a question on final Jeopady, wage eveything. Use it as a ba bet to win a fee dink off you less economicallyknowledgeable fiends. It tuns out once these two hang out, ou Keynesian coss multiplie stuff gets a little less cetain. Befoe, an incease in G shifted ou cuve out, esulting in a nice incease, and it still 3

4 does. But we now see that if we shift out the cuve, we also get a new highe inteest ate, which lowes I. So an incease in G will still bing about an incease in, but it will be patially offset by a decease in I. How much of a decease depends on the slope of the cuve, i.e. the sensitivity of the investment maket to the inteest ate. Simila effects will take place with any othe vaiables that shift the cuve. Inteest ate () Similaly, any shift in the cuve will esult in a change in both the inteest ate and income. Fo example, if the Fed inceases the money supply, the cuve will shift outwad, esulting in a highe Output () Figue 5: quilibium in the - model. and a lowe. O an incease in pices will decease eal money balances, shifting the cuve back, inceasing the inteest ate and deceasing output (which makes sense... highe means lowe I, which means lowe... lovely how this all woks out, isn t it? Just makes you want to give economics a big hug). Hee s a couple of examples. In the fist (Figue 6a), the gov t decides to buy a whole bunch of new F-14 Tomcats, esulting in a huge incease in G and an outwad shift of the cuve, which gives us a a highe and a highe. In the second example (Figue 6b), a negative oil supply shock inceases pices in the economy, deceasing eal money balances and shifting the cuve backwad, esulting in a lowe and a highe. ' Inteest ate () ' Inteest ate () ' ' ' Output () (a) An incease in G ' Output () (b) An advese oil shock Figue 6: Changes in the - model. 4

5 4 - and AD It tuns out these cuves have a highe meaning. vey intesection of the - model tells us a stoy about the AD cuve. Movements in - due to changes in pice ae movements along the AD cuve. Conside a decease in pices... it means highe eal money balances, deceasing the inteest ate, which inceases I and thus... anothe key as to why the AD cuve slopes downwad. A shift in eithe o due to anything othe than a pice change esults in a shift in the AD cuve. The position of the AD cuve is detemined by the intesection of the - cuves, and thus is detemined by eveything that makes up the - cuves... govenment spending, investment, consumption, money supply, you name it. Check out the table below fo some examples fo what changes in the - model will do to the AD cuve. Policy/Shock Cuve Cuve AD Cuve Incease in M Nothing Shifts outwad Shifts outwad Decease in P Nothing Shifts outwad Movement ight ALONG the cuve Decease in G Shifts inwad Nothing Shifts inwad Incease in MPC Shifts outwad Nothing Shifts outwad Afte eliminating all competitos and dominating the economy, Wal-Mat lets loose a mighty oa and cushes society below its all-poweful monopolistic feet by inceasing all pices to levels unseen since befoe the days of K-Mat blue light specials Nothing Shifts inwad Movement left ALONG the cuve Table 1: Some changes in the - model. Check out some pe-pepaed and wondeful looking gaphs in Mankiw, pages