The Keynesian Cross and IS Model Flashcards
What are the SR assumptions made when considering the Keynesian approach?
- Prices are fixed to avoid Menu Costs
- Firms will stick to original prices, regardless of market pressures
- Output is determined by AD (LR would be impacted by AS)
- Total Savings = Total Investment
What is the GDP equation? What does each facet mean?
- GDP = C + I + G + (X-M)
- As it is a closed economy, we only account for C, I and G
- C: Consumption (Demand for goods by households)
- I: Investment (Demand for physical capital by households and firms)
- G: Government Spending (Demand for goods by Public Sector)
What is Consumption? Give the function and relate this to MPC
- Consumption Function: C=C(Y-T), where Y-T denotes Disposable Income
- Marginal Propensity to Consume (MPC) measures the change in C when DI increases by £1
- MPC = ΔC / ΔY - ΔT
- Private savings = (Y-T) - C
- If DI = 0, C > 0 via the autonomous consumption component
What is Investment? Give the Function
- Investment Function: I=I(r), where r denotes the Real Interest Rate
- The Real Interest Rate is the Cost of Borrowing or the Opportunity Cost of Investing
- I depends negatively on r (as r increases, savings increase)
What is Government Spending? Give the formula for Public Saving and refer to the Fiscal Position
- If T>G, Budget Surplus and Public savings>0
- If T=G, Budget Surplus and Public savings = 0
- If T<G, Budget Surplus and Public savings<0
- Variations in G&T are denoted by different fiscal stances
- High G and Low T is Expansionary
- Low G and High T is Contractionary
What is the Keynesian Cross Model? What Question does it aim to answer
- A model that looks at the difference between planned and unplanned expenditure
- This is Unplanned Investment
- Due to rigid prices, changes in C, I or G change the level of output
What are some assumptions of the Keynesian Cross Model?
- Closed economy
- AD affects SR output
- Equilibrium condition: Y=PE
What are the variables in the equations PE? Which ones are Exogenous?
- PE = Planned Expenditure = C + I + G
- I = Planned Investment
- Y = RGDP = Actual Expenditure
- Consumption Function: C=C(Y-T)
- Exogenous variables: G, T, I
- Hence, PE = C(Y-T) + I + G where G, T, I are fixed
Explain an increase in Government spending on Planned Expenditure
- Higher G shifts PE outwards (PE = C + I + G)
- DI would increase, C would increase and output would increase
- This would create a Multiplier Effect, until the point where Y=PE
What is the formula for Government Purchases Multiplier? Show the Proof
- Y = C + I + G
- ΔY = ΔC + ΔI + ΔG
- ΔI and ΔT are 0 as I and T are fixed
- MPC = ΔC / ΔY - ΔT; So, ΔC = MPC x ΔY
- And, ΔY = (MPC X ΔY) + ΔG
- Therefore, ΔY = ΔG / (1-MPC)
Explain why the MPC increases the Multiplier
- The first time, ΔY = ΔG
- Increases in Y increases C, which increases Output (Y)
- Hence, a Virtuous Cycle is formed, and the final impact on Y is much greater than ΔG
Explain a decrease in Taxation on Planned Expenditure
- Lower T shifts PE outwards (PE = C + I + G)
- DI would increase, C would increase and output would increase
- This would create a Multiplier Effect, until the point where Y=PE
What is the formula for Tax Multiplier? Show the Proof
- Y = C + I + G
- ΔY = ΔC + ΔI + ΔG
- ΔI and ΔG are 0 as I and G are fixed
- MPC = ΔC / ΔY - ΔT;
- And, ΔY = (MPC X ΔY) - (MPC X ΔT)
- Therefore, ΔY = -MPC / (1-MPC) X ΔT
What are some properties of the Tax Multiplier
- Negative, due to the relationship between tax rates and consumption
- Greater than 1 if MPC > 0.5, causing a Multiplier Effect
- Smaller than the Government Spending Multiplier, as consumers save (1-MPC) of a Tax cut, hence the boost is smaller
What is the Equation for the IS curve?
- Y = C(Y-T) + I(r) + G, where T and G are fixed
