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Macroeconomics Lecture 3 The Keynesian Cross Model Outline of this lecture • The national accounting identity. • Planned and unplanned expenditure. • Demand-side equilibrium in the Keynesian Cross model. • The Keynesian Multiplier. • How to pay for the War? DAD-SAS (R,,Y) Labour market (AS) Goods market AD-AS Keynesian (R,P,Y) Cross (IS) IS-LM (R, Y) AD Financial markets (LM) Foreign AD* exchange (R*,Y,e, CA) markets The national accounting identity Y C I G X Z Total income Total expenditure What guarantees this? Investments may include an undesired component. I I P U Planned Unplanned Example Suppose there is a boycott of exports. Before: Y AE0 Y AE0 0 After: gap Y AE1 X For unchanged spending plans and taxes, the gap is filled by firms being forced to invest in the form of unplanned inventory build-up Y AE1 I U Demand-side equilibrium An equilibrium is a situation in which no agent would want to change behavior and the behavior of all agents is consistent. The economy is at equilibrium when there are no unplanned expenditures (investments), that is when Planned expenditure = Actual expenditure = Income (output) Only holds in equilibrium! Actual Income Y = Planned expenditure expenditure = Output C C Consumption Consumption + Ip + Ip Planned investment Planned investment + IU Unplanned investment +G +G Government expenditure Government expenditure + X-Z + X-Z net exports net exports Income determination Assume that all prices (P, R, e) are fixed (and that P=e=P*=1). (1) Y C I G X Z (2) C c0 c1 (1 t )Y T (3) I P i0 i1 R Planned demand (4) Z z0 z1Y Behavioral relations (5) X 0 1Y f (6) G G, T T , 0 t 1 Government behavior Planned aggregate expenditure AE C I P G X Z c0 c1 (1 t )Y T i0 i1R G 0 1Y f z0 z1Y c1 (1 t ) z1 Y A A G i0 i1R 0 0Yf z0 c0 c1T AE c1 (1 t ) z1 Y A Planned expenditure, AE AE (1-t) c1(1-t) 1 z1 C Flat if • z1 large • c1 small c1 (1 t ) z1 • t large B slope less than 1 £1 A income output, Y AE Equilibrium: Y*=AE(Y*) Actual Expenditure=Y AEa Expenditure exceeds output AE AE 0 AE1 I 0 u AE 2 AE * Output exceeds expenditure A * income Y Y2 Y1 Y0 output, Y Equilibrating mechanism Actual demand > planned demand Unplanned inventory build up Firms want to change their production plans to avoid this Reduction in output and income (actual demand) Reduction in planned demand, but Gap between planned and actual reduced. Equilibrium Y AE c1 (1 t ) z1 Y A 1 Y * A 1 c1 (1 t ) z1 The Keynesian Autonomous multiplier expenditures The Keynesian Multiplier The effect on an endogenous variable of a one unit change in an exogenous variable CETERIS PARIBUS The change in equilibrium income (Y*) when autonomous expenditure (A) increases by £1 (keeping all prices fixed) Why is this important? • Determines the impact of economic policy • Determines the impact of shocks Import leakage Initial impact z1 Planned expenditure Y Large multiplier Tax if leakages are small t leakage C Yd c1 Savings leakage z1=0 A Yd C Y 1 1 1 2 1 t c1 (1 t ) c1 (1 t ) 3 c1 (1 t ) 2 c1 (1 t ) 2 2 c (1 t ) 2 1 2 4 c1 (1 t ) 3 2 c1 (1 t ) 3 c1 (1 t ) 3 3 3 Y i 1 i 1 c1 (1 t ) c1 (1 t ) 2 c1 (1 t ) 3 .... 2 3 1 1 for c1 (1 t ) 1 1 c1 (1 t ) AE Actual expenditure=Y AE1 A AE0 A 1 c1 (1 t ) z1 Y A1 A Y A0 Y0 Y2 income Y1 output, Y How large is it? 1 MP 1 c1 (1 t ) z1 “Back of the envelope” Empirical estimates z1=0.22 t=0.3 MP=2.7 MP=1.5-3 c1=0.8-0.9 How to Pay for the War? (Keynes, 1940) Question: How can Great Britain meet the economic efforts required by the Second World War without generating inflation? Y1938 £5520 Y £825 Y £6345 How much can government spending be raised? G £825???? G z1 0 c1 C 4380 0.79 Y Y 5520 1 c1 (1 t ) z1 tT Y 770 5520 0.14 G 825 G £265 1 0.79 (1 0.14 ) What is next? • Fiscal policy in the Keynesian model – The balanced budget – Automatic stabilisers • Comparison between Classical and Keynesian model • The IS curve Leakages Y Y T Y T S C CZ Taxes imports Savings Government Rest of the Income T S X sector world Expenditure G I Z Government Investments Exports expenditure C I G X Z CI X Z C X Z CZ Injections