Transcript The circular flow of income and the Keynesian multiplier

The circular flow of
income and the
Keynesian multiplier
Equilibrium in the goods market
Equilibrium in the goods market

The analysis of the goods market
equilibrium is the starting point of
Macroeconomic analysis (particularly from
the Keynesian point of view)
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All the goods and services are aggregated
into a single market ⇒ 1 equation
The purpose is to find the equilibrium level
of output Y* on this market ⇒ 1 unknown
A second issue is to describe how Y* varies
as a function of other macroeconomic
variables
Equilibrium in the goods market
The circular flow of income
Aggregate demand and output
The multiplier and role of savings
The circular flow of income
Income €
Labour + Capital
Households
Firms
Goods
Expenditure €
The circular flow of income
Real flows
Labour + Capital
Households
Firms
Goods
The circular flow of income
Monetary flows
Income €
Households
Firms
Expenditure €
The circular flow of income
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The circular flow of income is what guarantees
the existence of the central accounting identities
Remember: Three definitions of GDP (output)

Sum of the expenditures Z

Sum of the value added produced Q

Sum of the incomes distributed Y
Accounting identities
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Production = Aggregate expenditure (Q = Z )
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Production = Incomes of factors of production (Q = Y )
Equilibrium in the goods market
The circular flow of income
Aggregate demand and output
The multiplier and role of savings
Aggregate demand and output

In the Keynesian model, the aggregate demand
(also called planned expenditure) in a closed
economy with no government is:
Z=C+I
with
Z : Aggregate Demand
C : Consumption of households
I : Investment of firms
Aggregate demand and output
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Consumption C is not fixed. Its level depends on
the level of income Y, and is given by the
consumption function.
C = C0 + cY
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Where
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C0 is the autonomous level of consumption, i.e. the
level of consumption that does not depend on income
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c is the marginal propensity to consume (mpc) : the
amount spent out of an extra unit of income.
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The converse is the marginal propensity to save (mps)
s, such that :
c+s=1
Aggregate demand and output
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For the moment, investment I is considered to
be exogenous.
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Its level is pre-determined and does not depend
on output
This is a simplifying assumption that will be
relaxed later on (when interest rates are
introduced)
Aggregate demand Z is therefore a function of
output Y, of the marginal propensity to consume
c and of the exogenous level of investment I.
Z = C0 + cY + I
Aggregate demand and output
Aggregate demand as a function of income
Aggregate
Demand Z
Aggregate Demand (planned
expenditure)
Z = C0 + cY + I
mpc: 0<c<1
Autonomous demand (not a function of Y)
C0 + I
Income, output Y
Aggregate demand and output
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Effective demand and equilibrium
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For any level of planned expenditure Z (with a
slope < 1), There is only a single point for which
the planned expenditure is equal to the level of
income Y
This gives the equilibrium condition on the
goods market: Y = Z
Warning: There is no guarantee that this point is
a full employment equilibrium !!
 This will be examined later.
Aggregate demand and output
Equilibrium on the goods market
Aggregate
Demand Z
Effective expenditure
Y=Z
Aggregate Demand (planned
expenditure)
Z = C0 + cY + I
Keynesian
Equilibrium Output
45°
Y*
Income, output Y
Aggregate demand and output
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For each aggregate demand curve Z there is
only a single point for which the planned
expenditure is equal to the level of income Y
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But Z is determined by the plans of agents!
What happens if the level of planned
expenditure Z is not equal to Y ?
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The goods market is not in equilibrium !!
Output will adjust so that the equilibrium is
reached
Aggregate demand and output
Disequilibrium with Z > Y
Aggregate
Demand Z
Effective expenditure
Aggregate Demand (planned
expenditure)
Unplanned reduction in
inventories
Z
The firms are selling more than
they are producing. They have to
increase production in order to
meet the aggregate demand,
which brings the goods market
back to Y*
Y
45°
Y
Y*
Income, output Y
Aggregate demand and output
Disequilibrium with Z < Y
Aggregate
Demand Z
Effective expenditure
Y
Aggregate Demand (planned
expenditure)
Z
Unplanned increase in
inventories .
Firms are selling less than
they are producing. They
reduce output which brings
the goods market back to Y*
45°
Y*
Y
Income, output Y
Equilibrium in the goods market
The circular flow of income
Aggregate demand and output
The multiplier and role of savings
The multiplier and the role of savings
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So aggregate demand is given by
Z=C+I
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And the equilibrium condition is
Y=Z
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So what happens to output Y if investment I
increases by an amount ΔI ?
In fact, ΔY > ΔI !!
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Why is that?
The multiplier and the role of savings
Multiplier effect on the goods market
Aggregate
Demand Z
Y=Z
Z2 = C0 + cY + I2
Z1 = C0 + cY + I1
1. An increase in planned
investment…
ΔI
2. …leads to a more than
proportional increase in income
ΔY
45°
Y1
Y2
Income, output Y
The multiplier and the role of savings
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So aggregate demand is given by : Z = C0 + cY + I
And Y = Z
Solving for the equilibrium level of output gives us :
Y  C0  cY  I
Multiplier
Y
1

I 1  c 

Y 1  c   C0  I
1
C0  I 
Y
1  c 
Autonomous
demand
(exogenous)
There are 2 equivalent interpretations to this result
The multiplier and the role of savings
Why do we observe ΔY > ΔI ?

First interpretation: a multiplier effect due
to the circular flow of income
Increase in savings
Increase in planned
investment
ΔI
ΔY × mps
Increase in income
ΔY
Increase in
consumption
ΔY × mpc
The multiplier and the role of savings
Why do we observe ΔY > ΔI ?
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Step 1 : output increases by ΔI
Step 2 : output increases by c × ΔI
Step 3 : output increases by c2 × ΔI
Step 4 : output increases by c3 × ΔI
..... This continues forever ! The closer c is to 1, i.e.
the less people save, the larger the effect. (why ?)
The aggregate size of the increase is equal to:
1
1  c  c  c  c  ... 
1 c
2
3
4
The multiplier and the role of savings
Why do we observe ΔY > ΔI ?
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Second interpretation: The economy is
increasing output in order to balance
investments and savings
This is because the equilibrium condition Y =Z is
equivalent to I =S (planned investment = savings)
These two equilibrium conditions are equivalent !
The multiplier and the role of savings
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Aggregate demand can be decomposed into
consumption and investment
Z=C+I
Income can be decomposed into
consumption and savings
Y = Y (c+s) = C + S
So one can see that setting Y =Z is
equivalent to setting I =S !
Y Z I S
The multiplier and the role of savings
Why do we observe ΔY > ΔI ?
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Starting from equilibrium, if investment increases
by ΔI, then we are no longer in equilibrium:
I + ΔI > S
To get back to equilibrium, we need savings to
increase by the same amount (ΔS = ΔI ).
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Given the savings function, S  s  Y
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Y 1
⇒

S s
So we have
Y
1
Y 1


⇒
I 1  c
I s
The multiplier and the role of savings
Why do we observe ΔY > ΔI ?
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Both explanations (spending multiplier or
savings/investment balancing) are equally
valid.
The spending multiplier is usually easier to
understand, and is found in most manuals
The savings/investment balance, however,
often brings more interesting explanations
of the real-life economic phenomena.