1

Keynesian Model of Income Determination

E = C + I + G + NX
C = Ca + c(YT)

By Definition
Consumption Function

Note:
Ca = Autonomous Consumption (500)
c = Marginal propensity to consume (0.75)
c(YT) = Induced Consumption.
P = fixed, r = Fixed, T = Personal taxes (Fixed) &
(YT) = Personal disposable income.

45

)C = (Y-T

So, C = 500 + 0.75(YT)

At: (YT) = 8000 C = 6,500

S = (YT) C = Ca + (1-c)(YT)
Where: (1 c) (YT)

Ca

(Y-T)

is "Induced Saving"

So, S = 500 + 0.25(YT)

At: (YT) = 8000 S = 1,500

To Establish Equilibrium:

E Ep = 0
Since:

Y=E

Then:

Y Ep = 0 Y = Ep

Ca

(Y-T)

But: Ep = C + Ip + G + NX
Ep = Ca + c(YT) + Ip + G + NX
Ep = Ca cT + Ip + G + NX + cY
Rewrite as:
Where:

Ep = Ap + cY

Ap = Ca cT + Ip + G + NX

Autonomous Planned Spending

Note:

Ep
Y
Ap

45

Y = Ep

Ep
1

T = Ta

Let: Ca = 500, c = 0.75, Ip = 1200, NX = 200, G & T = 0

1

So, Ap = 500 0.75(0) + 1200 + 0 200 = 1,500

Ep = 1500 + 0.75Y
At Equilibrium:

Y = Ep

Or:

Y = Ap + cY

Income Produced must equal planned expenditures by sectors.

If:

Y > Ep

Then:

Iu > 0

There is: Unintended Inventory Accumulation

If:

Y < Ep

Then:

Iu < 0

At: Y = 6000 Ep = 1500 + 0.75(6000) = 6000

So, Y* = 6000 & Iu = 0
If:

Y = 8000 Ep = 1500 + 0.75(8000) = 7500

Then:

Iu = + 500

"Not at equilibrium"

Rewrite the Equilibrium Condition:

Y = Ap + cY

Or:

Y cY = Ap

(1 c)Y = Ap

Or:

s Y = Ap

Note:

Induced Saving = Autonomous Planned Spending

Induced Leakages = Injections

Since: Ap = 1500, Then: 0.25Y = 1500 Y* = 6,000
Rewriting:

Y* = Ap / s = k Ap

Where:

k - the multiplier

sY

Ap & sY

Ap1 = 2000

Suppose: Ip = 1000 Ap1 = 2000

Then:

Y1 = 2000 / 0.25 = 8,000

Recall: Ip = 500 Ap0 = 1500

Note:

Ap2 = 1500

6000

8000

Then: Y0 = 1500 / 0.25 = 6,000

Multiplier ( k ) = Y / Ap = 2000 / 500 = 4

Recall:

Ap = Ca cTa + Ip + G + NX

So:

Ap = Ca cTa + Ip + G + NX
2

Hence:

Multiplier for Ca , Ip , G & NX is: k = 1 / s = + 4

Multiplier for Ta is = c / s = 0.75 / 0.25 = 3

Government Surplus: T G = I + NX S
Alternatively: S +T = I + G + NX

Leakages = Injections

The General Case:

Introduce: Income Taxes & Endogenous NX
T = Ta + tY
Recall:

&

NX = NXa nxY

Ep = C + Ip + G + NX
Ep = Ca + c(Y Ta tY) + Ip + G + NXa nxY
Ep = Ca cTa + Ip + G + NXa + cY ctY nxY
Ep = Ap + c(1 t)Y nxY

At equilibrium:

Y = Ep

Y c(1 t)Y + nxY = Ap

[1 c(1 t)]Y + nxY = Ap
[s(1 t) + t + nx]Y = Ap

(Shift induced parts to left)

1 c(1 t) = (1 c) + ct
= s + (1 s)t
= s + t st
= s(1 t) + t

[MLR]Y = Ap
Ca cTa + Ip + G + NXa
Y* = Ap / MLR = --------------------------------s(1 t) + t + nx

Another proof for: [1 c(1 t)]Y = [s(1 t) + t]Y

Y = C + S + T Y = C + S + T
Y = c(1 t) Y + s(1 t) Y + t Y
1 = c(1 t) + s(1 t) + t

1 c(1 t) = s(1 t) + t

The IS - LM Model
(1) The IS Curve: Shows equilibrium in the real sector
3

Based on Rate-of-return analysis, we can show that:

Ip + Ca 1/r Ip + Ca = 2500 100 r

RoR & r
Int. Rate

10

(Higher r reduces both)

If r = 0 & r = 10

(Ip + Cp)

Then: Ip + Ca = 2500 & 1500

1500

2000

2500

Note: Optimism & Confidence shifts (Ip + Cp) Right.

r

The Ap Demand Schedule:

15

Since: Ap = (G cTa + NXa ) + (Ca+ Ip)

Ap Demand
Schedule

10

(G cTa + NXa ) is given &

A'p0

(Ca+ Ip) is related to r

1000 1500

2000

Ap

2500

If: G = Ta = NXa = 0
Then: Ap = 2500 100r
Ap = A'p0 br
At Equilibrium:

(A'p0 is Ap @ r = 0)

(MLR) Y

Ap

Y = k Ap

2000

The IS Curve

Y = k [A'p0 b r ]

Equation:

Y = 4 [2500 100 r]

1500

6000

Ap (r = 10)
8000

Y = 10,000 400 r
r

- What shifts the IS curve?

- What are the channels through

15

which interest rate influence

10

components of Ap?

IS(A'p0 = 2500, k = 4)
B
C

kA'p0

4,000

Ap (r = 5)

6,000

8,000

10,000

(2) The LM Curve: Shows equilibrium in the financial sector

(M/P)d = f(Y, r)

Or: (M/P)d = h Y f r

(M/P)d = 0.5Y 200r

Note: for every level of Y there is

(Ms/P) = 2000

a new money demand curve.

Example: For: Y = 8000

LM0 (Y=8000)

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Then: (M/P)d = 4000 200r

L1 (Y=6000)

For: Y = 6000

2000 3000 4000

Then: (M/P)d = 3000 200r

M/P

For Equilibrium in Money Market (LM Curve):

Ms /P = (M/P)d

Ms /P = h Y f r

LM Curve

- For a given Ms /P, Y & r positively related.

Ms /P = 0.5 Y 200 r

LM0 (Ms/P=2000)
LM1 (Ms/P=3000)

- If: Ms /P = 2000, then:

LM: 2000 = 0.5Y 200 r

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At: Y = 8000, r = 10 point F

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At: Y = 6000, r = 5

point G

F
G

- If Ms /P = 3000, then:

4,000 6,000 8,000

New LM: 3000 = 0.5Y 200 r

At: Y = 8000, r = 5

& At: Y = 6000, r = 0

Ms/P

LM
Points of LM

Falling Y shifts money demand left.

Changing r moves on money demand.

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The IS Meets The LM

IS0 (A'p0 = 2500, k = 4):

Y = k(A'p0 br)

LM0 (Ms /P = 2000):

Ms /P = hY fr
E0

(IS0)
4000 7000 10000 Y

2000 = 0.5Y 200r

Y = 4000 + 400 r

LM0

IS0

7.5

Y = 4(2500 100r)
Y = 10,000 400 r

(LMo)

Solving the two equations:

Both markets are

at equilibrium at
E0

4000 + 400 r = 10,000 400 r

800 r = 6000
Equilibrium r = 6000 / 800 = 7.5

LM0 LM
1

IS0

Equilibrium Y = 4000 + 400 (7.5) = 7,000

If: Ms /P = 3000, then

3000 = 0.5Y 200r

E0

7.5

Monetary Policy:

E1

LM curve
shifts right

4000

6000

7000

Y = 6000 + 400 r
Solve for Equilibrium again (E1)
6000 + 400 r = 10,000 400 r
800 r = 4000
New r = 4000 / 800 = 5
New Y = 6000 + 400(5) = 8000
Transmission Mechanism for Monetary Policy:
Ms/P Saving & Bonds r Ap Y*

10000
8000

Fiscal Policy:

Start with Original IS0 & LM0

IS0: Y = 4[2500 100 r] = 10000 400 r

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LM0: 2000 = 0.5Y 200r

7.5

Or:

E0

E2

Y = 4000 + 400r

If: G = 500, then Ap = 500

IS1:

E3

4000 7000 8000 9000 10000 12000

Y = 4[3000 100 r]
Y = 12000 400 r

New equilibrium:

IS1 & LM0 at E3

12000 400 r = 4000 + 400 r 800 r = 8000 r* = 10

Y* = 12000 400 (10) = 8000
Note: With simple multiplier income should rise by 2000 (at E2).
But: At E2 money market not in equilibrium (r must increase).
So:

Rise in r cuts the multiplier to 2 instead of 4.

Important: Even though income has increased, the composition

of spending is different at E3 compare to E2.
Recall: Y = Ap + c Y

& Ap = Ca + Ip + G + NX cTa

At E0 (r = 7.5): Ip + Ca = 2500 100 r = 1750

& G=0

etc.

Ap (at r = 7.5) = 1750 Y = 4 (1750) = 7000

Induced consumption = c Y = 5250 Y = 1750 + 5250 = 7000
At E3 (r = 10): Ip + Ca = 2500 100 r = 1500
Ap (at r = 10) = 2000

& G = 500

Y = 4(2000) = 8000

Induced consumption = c Y = 6000 Y = 2000 + 6000 = 8000

Hence: Autonomous private spending decreases from 1,750 to 1,500.
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Induced consumption spending increases from 5,250 to 6,000.

Can the crowding out be eliminated to get maximum

increase in Y?
Yes: Keep r fixed by shifting the LM to right.

Elementary Algebra of the IS-LM Model

Recall: Y = k Ap = k (A'p b r)

IS-Curve equation

And: Ms / P = (M / P)d = h Y f r
Y = 1/h (Ms / P) = (f / h) r

LM-Curve equation

To find the equilibrium:

Rewrite the LM equation as: r = (h/f)Y (1/f)(Ms /P)
Substitute in IS equation:
Y = k [A'p (b h / f)Y + b / f (Ms /P)]
Y + (k b h / f)Y = k A'p + k b / f (Ms /P)
[1 + k b h / f ]Y = k A'p + k b / f (Ms /P)
[1/k + b h / f ] Y = A'p + b / f (Ms /P)
Y = k1 A'p + k2 (Ms / P)
Where:

k1 = [1/k + b h / f ]-1
k2 = (b / f) [1/k + b h / f ]-1 = (b / f) k1

Given: k = 4, b = 100, h = 0.5, f = 200

k1 = 2.0 & k2 = 1.0
So:
At:

Y = 2 A'p + 1.0 (Ms /P)

A'p = 2500 & Ms /P = 2000 Y = 7,000