Eco 

104:  
Introduction to 

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by
Parisa
Shakur
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Macro Economics 
Parisa
Shakur 


Lecture
–
12,13



 Keynes and his rejections 
• Bri;sh
economist,
John
Maynard
Keynes
wrote
right
aDer
the

Great
Depression
(1929‐38)
poin;ng
out
how
self‐regula;on

does
not
work
when
the
economy
is
in
recession.


• Keynes
challenged
all
four
of
the
beliefs
of
the
classical


Created
by
Parisa
Shakur
(PSk)

economists

1.  Say’s
law
hold
in
the
money
economy
so
insufficient
demand

cannot
exist

2.  Wages,
prices
and
interest
rates
are
fully
flexible

3.  The
economy
is
self‐regula;ng

4.  Laissez‐faire
is
the
right
economic
policy
to
implement

Exhibit 1 Keynes s View of Say s Law in a Money
Economy

Created
by
Parisa
Shakur
(PSk)

Say’s
law
and
the
Money
economy:
a
cri5cism




Savings
≠
Investment
through
interest
rate
flexibility



Savers
may
not
save
more
at
higher
interest
rate
or
save
less
at
lower
interest

rate.
If
savers
have
a
goal
in
mind,
then
higher
interest
rate
means
even
if
they

save
less,
they
will
reach
their
goal.



If
business
expecta;ons
are
low,
higher
interest
rate
will
not
equate
with

higher
investment


Created
by
Parisa
Shakur
(PSk)





Wage
rates
are
s5cky
downwards
due
to


•  Resistance
from
employees/workers

•  Resistance
from
labour
unions



New
Keynesians
explana;ons

•  Wage
rates
are
‘locked
in’
labour
contracts

•  Efficiency
wage
models


Prices
are
inflexible
due
to

•  Internal
structure
of
te
economy
is
an;‐compe;;ve
or
monopolis;c

Exhibit 2 The Economy Gets Stuck in a Recessionary
Gap

Created
by
Parisa
Shakur
(PSk)

Classical
economists:
adjustments
take
place

quickly
so
self‐regula;ng








Created
by
Parisa
Shakur
(PSk)

Keynesian
economists:
adjustments
take
too

long
to
say
it
is
self‐regula;ng
so
it
is
not
self‐
regula;ng

Exhibit 3 A Question of How Long It Takes for
Wage Rates and Prices to Fall

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Parisa
Shakur
(PSk)

Simple Keynesian Model and C 
• Assump;ons

1.  The
price
level
is
constant
un;l
economy
reaches
full

employment

2.  It
is
a
closed
economy
so
C,
I
and
G
only

3.  The
monetary
side
of
the
economy
is
excluded


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by
Parisa
Shakur
(PSk)

Consump;on
(C):
Keynes
was
mostly
concerned
about
C
as
it
is

the
largest
component
of
TE/AD/GDP

Three
basic
points
to
remember:

1.  C
depends
on
Yd

2.  C
and
Yd
move
in
the
same
direc;on

3.  When
Yd
changes,
C
changes
by
less

C continued…. 
• Consump;on
func;on:


 
C=Co+
(MPC
x
Yd)

C=
consump;on,
Co=
autonomous
consump;on,
MPC=

marginal
propensity
to
consume,
Yd=disposable
income




Created
by
Parisa
Shakur
(PSk)

• Autonomous
and
induced
consump;on


 
MPC=
change
in
C/
change
in
Yd

When
C
changes
from
800
to
900
and
Yd
changes
from

1000
to
1200,
what
does
MPC
equal
to?



• MPC
is
always
between
0
and
1

• C
depends
on
Co,
MPC
and
Yd

 Consumption and Saving 
•  Saving=
Disposable
income‐
Consump;on



=
Yd‐
(Co+(MPCxYd))

see
Table

•  MPS=
change
in
saving/change
in
disposable
income

•  MPS+
MPC=
1


Created
by
Parisa
Shakur
(PSk)

•  We
know,
if
Co
rises
then
C
rises,
so
for
400
increase
in
autonomous

consump;on,
consump;on
should
increase
by
400.
however,
according

to
Keynes,
for
400
increase
in
autonomous
consump;on,
consump;on

would
increase
by
more
than
400.

•  Mul5plier,
m=1/(1‐MPC)

•  If
MPC=0.8,
m=5,
Co=40,
calculate
increase
in
spending

• Just
as
C,
I
and
G
also
has
autonomous
spending
components

• Change
in
total
spending=
mul5plier
x
change
in
autonomous

spending

Exhibit 4 Consumption and Saving at Different Levels of
Disposable Income (in billions)

Created
by
Parisa
Shakur
(PSk)

The multiplier process 


•  Consider
a
Tk300
crore
increase
in
business
capital
investment
–
for

example
created
when
an
overseas
company
decides
to
build
a
new

produc;on
plant
in
the
Bangladesh.
This
will
set
off
a
chain
reac;on
of

increases
in
expenditures.
Firms
who
produce
the
capital
goods
that
are

purchased
will
experience
an
increase
in
their
incomes
and
profits.
If

they
in
turn,
collec;vely
spend
about
3/5
of
that
addi;onal
income,

then
Tk180
crore
will
be
added
to
the
incomes
of
others.


Created
by
Parisa
Shakur
(PSk)

•  At
this
point,
total
income
has
grown
by
(Tk300cr
+
(0.6
x
Tk300cr).

•  The
sum
will
con;nue
to
increase
as
the
producers
of
the
addi;onal

goods
and
services
realize
an
increase
in
their
incomes,
of
which
they
in

turn
spend
60%
on
even
more
goods
and
services.

•  The
increase
in
total
income
will
then
be
(Tk300cr
+
(0.6
x
tk300cr)
+
(0.6

x
Tk180cr).

•  The
process
can
con;nue
indefinitely.
But
each
;me,
the
addi;onal
rise

in
spending
and
income
is
a
frac;on
of
the
previous
addi;on
to
the

circular
flow.

•  Mul;plier
effects
can
be
seen
when
new
investment
and
jobs
are

amracted
into
a
par;cular
town,
city
or
region.
The
final
increase
in

output
and
employment
can
be
far
greater
than
the
ini;al
injec;on
of

demand
because
of
the
inter‐rela;onships
within
the
circular
flow

 the Multiplier
Exhibit 10 Autonomous Investment Spending and

Arnold Economics, 5e / Ch. 9

Economic Instability 13
©2001 South-Western College
Publishing
Multiplier: things to remember 
• In
simple
Keynesian
model,

• Change
in
total
spending
=
change
in
Real
GDP


(as
economy
is
at
a
recessionary
gap
and
price
level
is


considered
constant)


Created
by
Parisa
Shakur
(PSk)



Two
things
about
mul;plier,
m

1.  In
real
world,
m
takes
;me
to
have
an
effect

2.  For
total
spending
to
increase
real
GDP,
there
must
be
idle

resources
or
else
it
will
be
infla;onary.

Exhibit 5
The Derivation
of the Total
Expenditures
(TE) Curve

15
Exhibit 8 A Change in Autonomous Investment Spending
Relative to a Change in Real GDP

16
Exhibit 6 The Three States of the Economy

17
Exhibit 7 The Economy: In Equilibrium, and in a
Recessionary Gap, Too