Chapter Three: Simple Keynesian Multiplier

Aggregate Demand = total amount of goods demanded

Output is said to be in equilibrium when output produced (Y) = output demanded
(AD)
AD = C+I+G+NX
Difference between Y & AD is unplanned investment

Consumption and AD
Out of the determinants of demand consumption has a clear relation with income
and also is a major component of AD. The relation of consumption and income is
consumption function. C = C + cY where C > 0 & 0< c <1

C is autonomous consumption
c is marginal propensity to consume which shows rise in consumption with every Re.
1 rise in income.
Since MPC is less than 1, we can say that all income is not consumed, so part is saved,
We can have a saving function:
Y = C+S
S = Y-C
S = Y - C + cY
S = -C + (1-c) Y which shows that savings has a positive relation with income.
Point E in the above is ‘break-even’ income where consumption = income.

In the presence of the Government sector, Consumption is out of Yd = Disposable

income which is income earned including transfers from government and payment of
taxes to the Government.
Yd = Y +TR – TA
C = C + c(Y +TR – TA)

Now let’s see the effect of consumption on demand

AD = C + c(Y +TR – TA) +I+G+NX
AD = A + cY where A = C +c (TR – TA) +I+G+NX
The objective of this exercise is to find the equilibrium level of output and income

Equilibrium output = Y = AD
Y = A + cY
Y = 1/1-c * A
It is understood that equilibrium output is higher, larger the MPC or larger the
autonomous spending.
Another way to understand equilibrium income equation is: ∆ Y = 1/1-c * ∆A.
If MPC is 0.9 making 1/1-c i.e. the multiplier = 10 and additional spending is Rs.1lakh
then change in Y will be to the tune of Rs.10 lakhs.

Savings & Investment: Alternative formula for equilibrium output is when S = I

Savings is difference between Y and C so vertical distance between consumption
function curve and 45◦ line.
I is the vertical distance between consumption curve and AD in a simple economy,
no G & NX.
Y = C+S Income / Output
Y = C+I AD
So S = I
If we add the other components:
S = I + ( G deficit) + CA

Multiplier:
By how much should autonomous increase to raise equilibrium income.
At equilibrium AD = Y
∆ AD = 1/1-c *∆A = ∆ Y
Therefore ∆ Y = 1/1-c *∆A

Multiplier is the amount by which equilibrium output changes when autonomous

spending rises by 1 unit. Larger c or higher ∆A leads to larger output.

Government sector:
G can affect AD in two ways, either increase G or change tax rates or change TR.
YD = Y +TR – TA
TA = t Y
AD = C + c(Y +TR – tY) +I+G+NX
AD = C + cTR +I+G+NX + c(1-t)Y
AD = A + c(1-t)Y
Equilibrium income when government is included:
Y = A + c(1-t)Y
Y = 1/1-c(1-t) * A Tax lowers multiplier if MPC = .8 Multiplier is 5
When there is t = 0.25, then Multiplier is 2.5.

Effects of fiscal policy: We want to know by how much will the equilibrium income
increase with increase in government expenditure of amount G. ∆ Y = ∆G + c(1-t)Y.
Hence change in equilibrium income ∆ Y = 1/1-c(1-t) *∆G.
The government expenditure multiplier = 1/1-c(1-t).
The Budget: BS = TA –TR – G
BS = tY –TR – G
Budget will be in deficit if G & TR are in excess of tax collections.
Budget deficit does not depend only on tax and G but on anything that will shift the
level of income. So we generally see budget deficits in times of recessions, when tax
receipts are low.

Effects of G & change in TA on budget surplus: Increased G will lead to a reduced

budget surplus or higher budget deficit and not higher budget surplus on account of
tax collections from higher income as tax is only a fraction of the income. In the same
manner if G remains constant and tax rates increase we will see increase in budget
surplus.

Full employment budget surplus: Increases in taxes add to BS and increase in G

reduces BS. Increase in tax reduces income whereas increase in G& TR increase
income. If the budget is in deficit we can say that it is expansionary, tending to
increase GDP.
We have a measure called BS* : full employment BS measures surplus at full
employment level of income or at potential output.

BS* = t Y* - TR – G
BS* - BS = t (Y* - Y) the only difference is tax collection.
If output is below full employment, surplus exceeds actual surplus conversely if
actual output exceeds potential output, potential surplus is less than actual surplus.
The difference between actual and potential output is called output gap.

Balanced Budget Multiplier:

The balanced-budget multiplier comprises the expenditures multiplier and tax
multiplier.
The balanced-budget multiplier based on the combination of the simple expenditure
multiplier and the simple tax multiplier.

1 - MPC 1- MPC MPS

Balanced Budget Multiplier = + = = =1
MPS MPS MPS MPS
Where MPC is the marginal propensity to consume and MPS is the marginal
propensity to save.

Multiplier in the presence of open economy

AD = C + I + G + X – M where Imports are related to disposable income by the import

function: M = MPI × Yd where MPI is the marginal propensity to import; exports are
exogenous and are thus assumed to remain fixed.

Hence, AD is:
AD = a + b Y (1 – t) + I + G + X – MPI (1 – t) Y
Since AD equal income, in equilibrium, we have:
Y = a + I + G + X /1 – (1 – t) (b – MPI)
So, the multiplier is:
1/1 – (1 – t) (b – MPI)
If t = 0.25, b = 0.8, MPI = 0.1, then the multiplier is
1/1 – 0.75 (0.80 – 0.1) = 2.1 which is much smaller than in the absence of foreign trade.

Numericals:
C = 85 + 0.5Yd
I = 85
G = 60
Net taxes = N = -40 + 0.25Y
Find Equilibrium output and how much is the government deficit / surplus at
equilibrium?
If the economy is opened, Exports = 200 and Imports = 0.1Y, find the impact of
increase in investment by 15.

C = 85 +0.5(Y + 40 – 0.25Y) = 105 + 0.375Y

Y = 105 + 0.375Y +85 + 60 = 250 + 0.375Y
Y = 250/0.625 = 400
Deficit = 60 +40 -0.25(400) = 100 – 100 = 0
Multiplier in open economy is dy/dg = 1/1-0.5(1-0.25) +0.1= 40/29 = 1.379
If investment goes up by 15 Y will go up by 15*1.379 = 20.68

From the following information, find Budget Deficit at equilibrium:

Savings Function -8+0.15Yd
Tax Function 0.2Y
Import Function 0.1Y
Investment 20
Government Expenditure 10
Transfer Payments 5
Exports 10

AD = C + I + G + X – M
AD = 8+0.85Yd +20+10+10-0.10Y
AD = 8+0.85(Y – 0.2Y +5) +20+10+10-0.10Y
AD = 8+0.85(Y – 0.2Y +5) +20+10+10-0.10Y
AD = 8+0.85(0.8Y +5) +20+10+10-0.10Y
At Equilibrium AD= Y
Y = 52.25 -0.58Y
Y = 124.40 Taxes = 124.40 * 0.2 = 24.88
Budget deficit = 24.88 – (10+5) = 9.88