Economics for CED Spring 2004 Noémi Giszpenc Spring

Economics for CED Spring 2004 Noémi Giszpenc Spring 2004 Lecture 10: Macro: Keynesian Model of Aggregate Demand June 9, 2004 Economics for CED: Lecture 10, Noémi Giszpenc

Neoclassical economists assumed • That the employment of labor would be determined by the supply and demand for labor, along with the wage in purchasing power terms. • The employment of labor, together with the productivity of labor, would determine production as measured by RGDP. • Then the Great Crash/Depression of 1929 happened. Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 2

1883 -1946 Enter John Maynard Keynes • A theory of “equilibrium” unemployment • Right or wrong, now used to make economic policy and to forecast economic events • Key question: How are national income and expenditure determined? – Recall: components of expenditure are • • Spring 2004 C (Consumption) I (Investment) G (Government purchases) NX (Net Exports) Economics for CED: Lecture 10, Noémi Giszpenc 3

A picture of the economy Human Economy goods & services wages & dividends goods & services--Exports payment for purchases Energy payment for purchases labor & ingenuity Natural World Matter Households Business services & transfers taxes goods & services (labor & ingenuity) taxes goods & services--Imports services & transfers (wages) payment for purchases Government Heat Rest of World Spring 2004 Waste Economics for CED: Lecture 10, Noémi Giszpenc 4

Picture showing money flow Human Economy Output = Y Energy Net Taxes = T Exports = X Natural World Matter Disposable Income = Yd Households Business Private Savings = S Imports = M G = Public Consumption Government Rest of World Loan to Ro. W Spring 2004 Net Public Savings Private Consumption = C Investment = I Economics for CED: Lecture 10, Noémi Giszpenc Heat Waste Banks 5

Income and Consumption • Keynes theorized a “psychological law”: One more dollar of income would lead to more consumption, but only of part of the dollar: – Fraction spent = marginal propensity to consume (MPC) • A Simple Consumption Function: C = C 0 + b. Y – – Where C is Consumption b is MPC Y is income so what’s C 0? …Autonomous consumption: the portion of consumption expenditure that does not depend on income. • What you would want to spend even if you had no money. Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 6

A simple model – And assuming C 0 positive, I constant and G, NX 0 expenditure • Given C = C 0 + b. Y and Y = C + I + G +NX • Equilibrium is where expenditure = income (the 45 o line) I • Or, algebraically: Ye=(C 0+I) / (1 -MPC) C 0 • 1/(1 -MPC) is the “autonomous consumption multiplier” Since MPC < 1, multiplier is > 1 • each person's spending is someone else’s income Spring 2004 45 o C+I C Economics for CED: Lecture 10, Noémi Giszpenc Ye income/ production 7

How to move toward equilibrium? • Inventories: a kind of capital good. – An increase in inventories is an investment. – A decrease in inventories is a negative investment. • If businessmen do not sell as much as they expected, find themselves with more inventories than planned – These increases in inventories are "unintended investment. ” – Realized investment is sum of planned investment and unintended inventory increases – In model, I (of C+I) is planned investment. Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 8

What happens in disequilibrium? Spring 2004 expenditure • If production is greater than Ye, it exceeds planned expenditure. • So, inventories build up. • So, businesses cut back on orders, factories cut back on production, until production falls back to equilibrium level. • If production less, inventories drawn down further than expected, so businesses make extra orders, factories increase production… back to Ye. • A plan-fulfillment equilibrium. 45 o C+I C Economics for CED: Lecture 10, Noémi Giszpenc Ye income/ production 9

Lots of scope for unemployment • Equilibrium level of production in model depends on planned level of production. • What if producer fears that others will cut back on production? – Assumes spending will be less – Therefore plans to produce less to meet smaller demand – If everyone reasons this way, expectations are fulfilled: aggregate production is less, people have less income, and aggregate demand is smaller – If this happens, there is a recession, and it is a result of a coordination failure Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 10

What happens if spending drops? expenditure 45 o C+I C’+I • Say autonomous spending drops by a certain amount, X. • Equilibrium output drops by the amount X times the multiplier: – X/(1 -MPC) Spring 2004 Ye ’ Ye Economics for CED: Lecture 10, Noémi Giszpenc income/ production 11

Saving and Investment • Saving = Income – Consumption S = Y – C (or Y = C + S) – This is an identity (it’s how it’s defined) – For households, it’s disposable income (net of taxes): • Yd = Y – T; where T is taxes (minus transfers) • Substituting into equilibrium model: Y = C + I + G + NX = S + C + T; so by identity: S = C + I + G + NX – C – T = I + G + NX – T Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 12

Where does saving go? • S = I + G + NX – T (by identity) – If trade is balanced, NX = 0. – If the government budget is balanced, G = T. – This would lead to S = I: all household saving going into investment. – If NX > 0 (we export more than we import), some saving goes as a loan to the Rest of the World. • If NX < 0 (trade deficit) Ro. W loans to us. – If G < T (a government budget surplus), more saving is available to go to investment or as loan to Ro. W. • If G > T (budget deficit) some saving has to go as loan to government Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 13

How to increase saving? • Saving is defined as identity: income minus consumption, S = Y – C • Can reducing consumption lead to more saving? • Reduce autonomous consumption C 0 – Ye = (C 0+I 0)/(1 – MPC). Change to C 0 -x. – Ye’= Ye – x/(1 – MPC) = (C 0 -x)/(1 – MPC)+S’ – (after some algebra) S’ = Ye – C = S (no change) Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 14

There must be some way! • Let’s try this: decrease the marginal propensity to consume, MPC. – Once again Ye’ < Ye (equilibrium output down) and S’ = S (no change). No dice. • “The paradox of thrift” – In our simple model, saving (S) can’t be different from intended investment, I (in equilibrium). – Illustrates the “fallacy of composition. ” Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 15

Don’t save: spend and boom! • Increase in autonomous consumption has a multiplier effect (even keeping I constant). • Increase in MPC increases multiplier. • Woohoo! Party! Y is in the house! – Is there a downside? Yes: – Although I does not decrease, proportionally to RGDP, it does decrease. It doesn’t keep up with growth of economy. Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 16

Investment isn’t constant anyway • Imagine a business with a steady level of investment, I. (basically replacement) • Demand picks up: in order to meet expanded demand, increase to I*. (expansion) – Increase in I increases total demand by multiplier • Boom! • Say demand eventually steadies. I* falls back down a bit to I*’. (replacement of a bigger stock) – Decrease in I decreases total demand by multiplier • Bust! Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 17

Paul Samuelson b. 1915 1970 Nobel laureate, wrote most successful principles textbook ever Accelerator principle • Amount of investment depends on the rate of increase of production (not just amount) • When demand is increasing, investment has to increase a lot to keep up. – Growth leads to growth, for a while… • When production levels off, investment drops a lot (to replacement levels) – Slowdown leads to more slowing down… • This is where term “business cycles” comes from. Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 18

International Trade / “Contagion” • If NX rises, then ceteris paribus, Ye rises (by the multiplier). – So exports more politically popular than imports • But recall: if NX>0, some S has to go as loan to Ro. W • If a country’s Y increases, buys more of all goods--including imports • Its imports are other countries’ exports • This leads to greater Y in other countries – Busts can also spread from country to country • Especially important for small countries dependent on trade Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 19

How to keep track of trade? • • Current account measures trade in goods and services (credits increase balance) Capital account measures trade in investments (debits increase balance) – • Credits = LHS; Debits = RHS of accounts 4 Transactions (see next slide): 1. 2. 3. 4. Spring 2004 U. S. exports a Ford truck for $10 K U. S. purchases Japanese stocks of $5 K U. S. imports French wine for $2 K U. S. imports Brazilian beef for $12 K Economics for CED: Lecture 10, Noémi Giszpenc 20

Current Acct (CA) & Capital Acct (KA) Credit (Cr. ) & Debit (Dr. ) 1. U. S. exports a Ford truck for $10 K 1. Cr. CA $10 K (inc. NX) 2. Dr. KA $10 K (inc. in FX holdings) 2. U. S. purchases Japanese stocks of $5 K 1. Dr. KA $5 K (inc. in foreign assets) 2. Cr. KA $5 K (dec. in FX holdings) (stock cost us Yen) 3. U. S. imports French wine for $2 K 1. Dr. CA $2 K (dec. NX) 2. Cr. KA $2 K (dec. in FX holdings) Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 21

Another accounting detour Current Account (NX) (goods & services) Cr. Capital Account (FX) (foreign assets) Dr. Cr. 1) $10 K (1 b 2 b) $5 K $2 K (3 Spring 2004 4 b) $12 K $5 K (2 At this point, NX=$8 K, FX=$8 K 3 b) $2 K $12 K (4 ($4 K) Dr. Trade deficit (NX<0) Economics for CED: Lecture 10, Noémi Giszpenc Loan from Ro. W (net liability) ($4 K) 22

Government Fiscal Policy – Can increase G to combat unemployment – Can decrease G to combat inflation expenditure • “Fiscal policy” is when national government makes decisions on taxation and spending to influence the level of production and employment. • Increasing the autonomous spending, G, increases Ye by multiplier. G I C 0 • What about taxes? Spring 2004 45 o C+I+G C+I C Economics for CED: Lecture 10, Noémi Giszpenc Ye income/ production 23

Don’t forget taxes! • Consumption depends on disposable income Yd = Y - T – T is net taxes: sum of income taxes Yt and non-income taxes TX, minus transfers TR • T Yd C Ye – by a “tax multiplier”: MPC/(1 -MPC) – Cut in taxes and increase of transfers have same effect on equilibrium aggregate demand • But they have different effects in many other ways, and are likely to affect different people. • And have smaller (indirect) effect than changes in G. Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 24

Trygve Haavelmo (b. 1911), 1989 Nobel laureate Bonus: Balanced Budget multiplier • Suppose government increases G and T by same amount, B. – G Ye by B/(1 -MPC) – T Ye by B*MPC/(1 -MPC) – Net increase in Ye is B*(1 -MPC)/(1 -MPC) = B*1 = B • “balanced budget multiplier” is 1 • Probably the only realistic kind of balanced budget: “cyclically balanced budget” – government deficits in recession periods offset by government surpluses in boom periods. Spring 2004 Economics for CED: Lecture 10, Noémi Giszpenc 25