Intro Macro, ECON10003

Lecture 7: Keynesian Model of the Economy

Nahid Khan and Lawrence Uren

University of Melbourne

14 August, 2018

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Introduction: Outline

Today’s lecture
I A simple Keynesian model
Reading:
I Chapter 5 of Bernanke, Olekalns and Frank
Reminder:
I Online quiz this Thursday-Friday (4pm close)

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Introduction: Some History

I A number of important assumptions in his work

1. Prices don’t adjust in the short run
2. Expenditure plans realised, except for firms’ investment
expenditure
I A number of important contributions in his work
1. Aggregate expenditure or demand may determine output
2. Importance of expectations
I And a key implication
1. Government policy can help stabilise the economy

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Theories of the Business Cycle

Key assumption underlying Keynesian model:

I Prices are unable to adjust in the short term - firms satisfy
level of demand at a predetermined (given) price
I Seemingly intuitive assumption
I Not without controversy - why are prices more difficult to
adjust than output?

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Keynesian Model of Aggregate Expenditure

Consider an open economy. Recall expenditure equals output so

AE = C + I + G + X − M

Make the simplifying assumption that all imports are for

consumption:
I Not substantive in impacting key results but makes our model
more tractable
Define C d consumption demand for domestic output then it
follows,

C = Cd + M
AE = C d + I + G + X

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Keynesian Model of Aggregate Expenditure

Introduce concept of Planned aggregate expenditure (PAE)

I Households, government and foreign sector can satisfy their
demand for output
I Desired capital investment and inventory accumulation of
firms is I p
I Depending upon sales relative to desired sales, inventory may
build up or decline over time
1. If firms sell more than expected, inventories increase by less
than planned (I < I p )
2. If firms sell less than expected, inventories increase by more
than planned (I > I p )

PAE = C d + I p + G + X

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Consumption

Keynesian consumption function

C d = C + c(Y − T )

Basic Keynesian assumption

I As after-tax income rises, consumption rises
I Marginal propensity to consume, 0 < c < 1
I C - autonomous (exogenous) income
I T is total tax
Alternatives: Friedman’s Permanent Income Hypothesis -
consumption choice depends upon income today and in the future

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Consumption

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200000
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150000

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Consumption

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100000

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50000

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0

0e+00 1e+05 2e+05 3e+05 4e+05

Output

Figure: The linear relationship between consumption and output

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Government Spending, Taxation and Exports

Government spending is exogenous:

I Provides a key comparative static exercise
I How does output vary as government spending changes?
Taxation:
I Set T = T̄ + tY
I Describe T̄ as a lump sum tax
I t is a marginal rate of tax on income
Exports: determined by world demand for domestic output which
we take as exogenous

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Investment

Planned investment is taken as exogenous

I Firms have some level of capital investment they would like to
achieve
I Firms have some level of inventories they would like to
maintain
I Independent from income
Depends upon
I the real interest rate
I animal spirits - beliefs about the future profitability of
investment

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Equilibrium

Why is Y = PAE a reasonable condition?

I If Y > PAE then actual investment exceeds desired
investment → buildup of inventories
I If Y < PAE then actual inventories less than desired →
inventories are run down
Firms adjust their output accordingly

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Equilibrium: A Diagrammatic Representation

Keynesian cross diagram

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Equilibrium: Algebraic Representation

Recall,
I C d = C̄ + c(Y − T )
I I P , G , X are exogenous
I Y = Cd + IP + G + X
I For illustrative purposes, set T = 0
Together imply,

Y = C̄ + cY + I p + G + X
(1 − c)Y = C̄ + I p + G + X
C̄ + I p + G + X
Y =
1−c

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Equilibrium: Algebraic Representation

Could repeat the same exercise with a non-trivial tax system:

Y = C̄ + c(Y − T ) + I p + G + X
T = T̄ + tY

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Comparative Statics: An Increase in Saving

Keynesian Cross Diagram with fall in C̄

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Final Words

Have examined most general setting which encompasses

alternatives:
I Two sector economy, households and firms

Y =C +I

I Three sector economy, households, firms and government

Y =C +I +G

I Four sector economy, as above plus exports less imports

Y =C +I +G +X −M

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