04 the keynesian model

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Chapter 18 The Keynesian Model

• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2000 South-Western College Publishing

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In this chapter, you will learn to solve these economic puzzles:

Why did economists believe the Great Depression was

impossible?

What are the components of the Keynesian Cross?

Why did Keynes believe that “animal spirits” and government policy were

important to maintain full employment?

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Who were theClassical Economists?The Classical economists

believed that a continuing depression is impossible because markets will eliminate persistent shortages or surpluses

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When were the ideas of the Classical Economists

widely accepted?Prior to the Great

Depression of the 1930’s

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What is Say’s Law?The belief of the

Classical Economists that the economy was always tending toward full employment

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What doesSay’s Law say?Supply creates its

own demand

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Why is Say’s Law a Full Employment theory?

Generally speaking, producers produce goods that consumers want and consumers have the money to buy because of the wages they were paid

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Under Say’s Law, is Unemployment possible?Yes, but it is a short-lived

adjustment period in which wages and prices decline or people voluntarily choose not to work

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What changed people’s mind about Say’s Law?The Great Depression and

the publication of The General Theory of Employment, Interest, and Money published in 1936

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Why did Keynes’ believe that “supply did not

create its own demand”? Aggregate expenditures

(demand) can be forever inadequate for an economy to achieve full employment

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What is the main idea of this chapter?

Keynes’s theory for the determination of consumption and investment expenditures

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What determines your family’s Spending for Goods and Services?

Disposable income

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What is theConsumption Function?The graph that shows the

amount households spend for goods and services at different levels of disposable income

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What is Savings?Disposable income minus

consumption, the amount households do not spend for consumer goods and services

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What is Dissaving?The amount by which

personal consumption expenditures exceed disposable income

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How do people Dissave?Negative savings is

financed by by drawing down previously accumulated financial assets or by borrowing

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What is Autonomous Consumption?Consumption that

is independent of the level of disposable income

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What happens when Disposable Income is Zero?

Spending will equal autonomous consumption because households will dissave to satisfy basic consumption needs

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What is the Marginal Propensity to Consume?

The change in consumption resulting from a given change in real disposable income

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MPC = C Yd

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What is Marginal Propensity to Save?The change in saving

resulting from a given change in real disposable income

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MPS = S Yd

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MPC + MPS = 1

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4321

1 2 3 4

5678

5 6 7 8 9

The Consumption Function

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Dissaving

Saving

CR

eal C

onsu

mp

tion

Tri

llio

ns

of $

per

yea

r

Real Disposable IncomeTrillions of $ per year

C

Yd

C = Yd

45°

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What happens if Factors other than

Income change?There is a shift or

relocation in the consumption schedule

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4321

1 2 3 4

5678

5 6 7 8 9

The Consumption Function

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C1

Rea

l Con

sum

pti

onT

rill

ion

s of

$ p

er y

ear

Real Disposable IncomeTrillions of $ per year

C = Yd

45°

MPC = .50MPC = .75

C2

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4321

1 2 3 4

5678

5 6 7 8 9

The Consumption Function

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Rea

l Con

sum

pti

onT

rill

ion

s of

$ p

er y

ear

Real Disposable IncomeTrillions of $ per year

C1 = a1 + bYd

C2 = a2 + bYd

A

B

real consumption

nonincome determinant

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Why does the Consumption Function Shift?

• Expectations• Wealth• Price level• Interest rate• Stock of durable goods

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How do Expectations affect the Consumption Function?Consumers expectations of

things to happen in the future will affect their spending decisions today

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How does Wealth affect the Consumption Function?

Holding all other factors constant, the more wealth households accumulate, the more they spend at any current level of disposable income

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How does the Price Level affect the

Consumption Function?Any change in the general

price level shifts the consumption schedule by reducing or enlarging the consumers purchasing power

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How does the Interest Rate affect the

Consumption Function?A high interest rate will

discourage people from borrowing money and a low interest rate will encourage people to borrow money

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How does the Stock of Durable Goods affect the Consumption Function?

When durable goods are suppressed, like during WWII, afterwards there is an increase in the demand for goods not previously made available

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How does Consumption compare with Investment?Consumption is more stable

than investment

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According to the Classical Economists,

what determined the level of Investment?The interest rate

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According to Keynes, what determines the level

of Investment?Expectations of future

profits is the primary factor, the interest rate is the financing cost of any investment proposal

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What is the Investment Demand Curve?

The curve that shows the amount businesses spend for investment goods at different possible rates of interest

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16%

12%

8%

4%

5 10 15 20

Real investment

Inte

rest

rat

e

A

B

Investment Demand Curve

Movement along the firm’s investment demand curve

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16%

12%

8%

4%

5 10 15 20

Inte

rest

rat

e

C

B

Shift in the firm’s investment demand curve

I1

I2Real investment

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Why is Investment Demand unstable?

• Expectations• Technological change• Capacity utilization• Business taxes• Autonomous reasons

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How do Expectations affect Investment?

Businesspeople are quite susceptible to moods of optimism and pessimism

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How does Technological change affect Investment?The introduction of new

products and new ways of doing things have a big impact on investment decisions

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What happens when Capacity Utilization is low?

When capacity utilization is low, firms can meet an increase in demand without expanding

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What happens when Capacity Utilization is high?When capacity utilization is

high, firms must increase investment to meet an increase in demand

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How do Business Taxes affect Investment?

Business decisions depend on the expected after-tax rate of profit

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What isAutonomous Expenditure?Spending that does not vary

with the current level of disposable income

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8%6%4%2%

.2 .4 .6 .8

10%12%14%16%

1.0 1.2 1.4 1.6

Real Investment

Autonomous investment

A

Aggregate Investment Demand Curve

Inte

rest

Rat

e

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.8

.6

.4

.2

1 2 3 4

1.01.21.41.6

5 6 7 8

Autonomous investment

Aggregate Autonomous Investment Demand Curve

Real Disposable Income trillions of dollars per year

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What is the Aggregate Expenditure Function?The function that represents

total spending in an economy at a given level of real disposable income

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4321

1 2 3 4

5678

5 6 7 8

Aggregate Expenditures Schedule and Function AE

C

C + I

E

Real Disposable Income trillions of dollars per year

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Key Concepts

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Key Concepts• Who were the Classical Economists?

• When were the ideas of the Classical Economists widely accepted?

• What is Say’s Law?

• What does Say’s Law say?

• Why did Keynes’ believe that “supply did not create its own demand”?

• What determines your family’s Spending for Goods and Services?

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Key Concepts cont.

• What is the Consumption Function?

• What is Savings?

• What is Dissaving?

• What is Autonomous Consumption?

• What is the Marginal Propensity to Consume?

• What is Marginal Propensity to Save?

• What happens if Factors other than Income change?

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Key Concepts cont.• Why does the Consumption Function Shift?

• According to the Classical Economists, what determined the level of Investment?

• According to Keynes, what determines the level of Investment?

• What is the Investment Demand Curve?

• Why is Investment Demand unstable?

• What is Autonomous Expenditure?

• What is the Aggregate Expenditure Function?

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Summary

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Say’s Law is the classical theory that “supply creates its own demand” and therefore the Great Depression was impossible. Say’s Law is the belief that the value of production generates an equal amount of income and, in turn, total spending.

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The classical economists rejected the challenge that underconsumption is possible because they believed flexible prices, wages, and interest rates soon establish balance between supply and demand.

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John Maynard Keynes rejected the classical theory that the economy self corrects in the long run to full employment. The key in Keynesian theory is aggregate demand, rather than the classicals’ focus on aggregate supply. Unless aggregate spending is adequate, the economy can experience prolonged and severe unemployment.

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The consumption function (C) is determined by changes in the level of disposable income. Autonomous consumption is consumption that occurs even if disposable income equals zero. Changes in such nonincome determinants as expectations, wealth, the price level, interest rates, and the stock of durable goods cause shifts in the consumption function.

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4321

1 2 3 4

5678

5 6 7 8 9

The Consumption Function

10

Dissaving

Saving

CR

eal C

onsu

mp

tion

Tri

llio

ns

of $

per

yea

r

Real Disposable IncomeTrillions of $ per year

C

Yd

C = Yd

45°

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The marginal propensity to consume (MPC) is the change in consumption associated with a given change in disposable income. The MPC tells how much of an additional dollar of disposable income households will spend for consumption.

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The marginal propensity to save (MPS) is the change in saving associated with a given change in disposable income. The MPS measures how much of an additional dollar of disposable income households will save.

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The investment demand curve (I) shows the amount businesses spend for investment goods at different possible rates of interest. The determinants of this schedule are the expected rate of profit and rate of interest. Shifts in the investment demand curve result from expectations, technological change, capacity utilization, and business taxes.

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An autonomous expenditure is spending that does not vary with the current level of disposable income. The Keynesian model applies this simplifying assumption to investment. As a result, the investment demand curve is a fixed amount determined by the rate of profit and the interest rate.

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The aggregate expenditures function (AE) shows the total spending in an economy at a given level of disposable income. Assuming investment spending is autonomous, the slope of the AE function is determined by the MPC.

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4321

1 2 3 4

5678

5 6 7 8

Aggregate Expenditures Schedule and Function AE

C

C + I

E

Real Disposable Income trillions of dollars per year

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Chapter 18 Quiz

©2000 South-Western College Publishing

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1. The French classical economist Jean Baptiste Say transformed the equality of production and spending into a law that can be expressed as follows: a. The invisible hand creates its own supply.b. Wages always fall to the subsistence level.c. Supply creates its own demand.d. Aggregate output does not always equal

consumption.

C. Says law was developed in the early 1800s and is the cornerstone of classical economics.

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2. Autonomous consumption is a. positively related to the level of

consumption.b. negatively related to the level of

consumption.c. positively related to the level of disposable

income.d. independent of the level of disposable

income.

D. Autonomous consumption is the amount of spending from savings or borrowing that occurs even when disposable income is zero.

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3. The consumption function represents the relationship between consumer expenditures and a. interest rates.b. saving.c. the price level.d. disposable income.

D. Keynes argued the most important determinant of aggregate spending for consumer goods is personal income after taxes.

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4. John Maynard Keynes’s proposition that a dollar increase in disposable income will increase consumption, but by less than the increase in disposable income, implies a marginal propensity to consume that isa. greater than or equal to one.b. equal to one.c. less than one, but greater than zero.d. negative.

C. Each dollar change in disposable income is divided between changes in consumption and saving.

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5. Above the break-even disposable income for the consumption function, which of the following occurs? a. Dissaving.b. Saving.c. Neither (a) nor (b).d. Both (a) and (b).

B. Dissaving occurs below the break-even point on the consumption function.

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4321

1 2 3 4

5678

5 6 7 8 9

The Consumption Function

10

Dissaving

Saving

CR

eal C

onsu

mp

tion

Tri

llio

ns

of $

per

yea

r

Real Disposable IncomeTrillions of $ per year

C

Yd

C = Yd

45°

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6. Which of the following changes produces an upward shift in the consumption function?a. An increase in consumer wealth.b. A decrease in consumer wealth.c. A decrease in autonomous consumption.d. Both (b) and (c) .

A. Decreases in wealth and autonomous consumption shift the consumption function downward.

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4321

1 2 3 4

5678

5 6 7 8 9

The Consumption Function

10

CR

eal C

onsu

mp

tion

Tri

llio

ns

of $

per

yea

r

Real Disposable IncomeTrillions of $ per year

C = Yd

45°

MPC = .50MPC = .75

C2

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7. An upward shift in the consumption schedule, other things being equal, could be caused by households a. becoming optimistic about the state of the

economy.b. becoming pessimistic about the state of the

economy.c. expecting future income and wealth to

decline.d. none of the above.A. If consumers expect good economic

ties ahead, they increase spending at each level of disposable income in the current time period.

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8. The investment demand curve represents the relationship between business spending for investment goods and a. GDP.b. interest rates.c. disposable income.d. saving.

B. As the interest rate declines, more business investment projects become profitable and investment spending increases.

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9. Which of the following changes produces a leftward shift in the investment demand curve? a. A wave of optimism about future

profitability.b. Technological change.c. High plant capacity utilization.d. An increase in business taxes.

D. An increase in business taxes decreases after-tax profits on investment projects and businesses invest less at various possible interest rates.

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16%

12%

8%

4%

5 10 15 20

Inte

rest

rat

e

C

B

Shift in the firm’s investment demand curve

I1

I2Real investment

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10. The aggregate expenditures function (AE) represents which of the following?a. The consumption function only.b. Autonomous consumption only.c. The investment demand curve only.d. All three of the above combined.e. A combination of (a) and (c) .

D.

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4321

1 2 3 4

5678

5 6 7 8

Exhibit 11Aggregate Expenditures Schedule and Function AE

C

C + I

E

Real Disposable Income trillions of dollars per year

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11. In Exhibit 11, what is the households’ marginal propensity to consume (MPC)? a. 0.5.b. 0.67.c. 0.75.d. 0.80.

B. MPC is the change in consumption divided by the change in income. In this case, the change in consumption to income is two to three, or 0.67.

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12. In Exhibit 11, aggregate income will equal consumption plus investment and the economy will be in equilibrium when real disposable income is a. $2.33 trillion.b. $3 trillion.c. $7 trillion.d. $10 billion.

C. The AE curve crosses the 45 degree line at $7 trillion.

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END