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Lesson 26 KEYNESIAN THEORY OF INCOME & EMPLOYMENT
In long run, Prices flexible Output determined by factors of production & technology Unemployment equals its natural rate In short run, Prices fixed Output determined by aggregate demand Unemployment is negatively related to output
THE KEYNESIAN CROSS
It is the simple closed economy model in which income is determined by expenditure. This model is presented by J.M. Keynes. Notations: I = planned investment E = C + I + G = planned expenditure Y = real GDP = actual expenditure
Actual expenditure is the amount that households, firms and the government spend on goods and services; it equals the economy’s gross domestic product (GDP). Planned expenditure is the amount households, firms and the government would like to spend on goods and services.
ELEMENTS OF THE KEYNESIAN CROSS
Consumption function:
Govt policy variables:
For now, investment is exogenous:
Planned expenditure:
Equilibrium condition:
GRAPHING PLANNED EXPENDITURE
Income, output, Y
E Planned Expenditure E =C +I +G
MPC 1
C C Y ( T)
G G , T T
I I
Actual expenditure Planned expenditure
Y E
E C Y ( T ) I G
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GRAPHING THE EQUILIBRIUM CONDITION
THE EQUILIBRIUM VALUE OF INCOME
AN INCREASE IN GOVERNMENT PURCHASES
At Y 1, there is now an unplanned drop in inventory, so firms increase output, and income rises toward a new equilibrium
Income, output, Y
E Planned Expendit
E =Y
E =C +I +G
Equilibrium income
Income, output, Y
E Planned Expenditure
E =Y
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Y
E
E =Y
E =C +I +G (^1)
E 1 = Y 1
E = C + I + G (^2)
Y E 2 = Y 2
G
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Solving for Y :
Final result:
THE TAX MULTIPLIER
The change in income resulting from a $1 increase in T is known as tax multiplier.
If MPC = 0.8, then the tax multiplier equals
PROPERTIES OF TAX MULTIPLIER
Tax multiplier is negative: A tax hike reduces consumer spending, which reduces income. Tax multiplier is greater than one (in absolute value): A change in taxes has a multiplier effect on income. Tax multiplier is smaller than the govt. spending multiplier: Consumers save the fraction (1-MPC) of a tax cut, so the initial boost in spending from a tax cut is smaller than from an equal increase in G.
IS CURVE A graph of all combinations of r and Y that result in goods market equilibrium is called IS curve i.e. Actual expenditure (output) = planned expenditure. The equation for the IS curve is:
DERIVING THE IS CURVE
r I E Y
Y 1 Y 2
Y 1 Y 2 Y
E
r
Y
E = C + I ( r 1 )+ G
E = C + I ( r 2 )+ G
r 1
r (^2)
E = Y
IS
I
( 1 M P C ) Y M P C T
M P C 1 M P C
Y T
Y C (Y T ) I ( r ) G
M P C 1 M P C
Y T
(^)
(^0 8 0 8 ) 1 0 8 0 2
.. ..
Y T
(^) (^)
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