Macro Chatper 8- The Keynesian Model

John Maynard Keynes

British economist who’s work offered an explanation of the Great Depression and suggested that the government should play a role in the economy

Classical Economists

A group of economists whose theory dominated economic thinking form the 1770s to the Great Depression. Believed recession would cure themselves because price system would automatically restore full employment

Say’s Law

The theory that supply creates its own demand. Long term underspending is impossible because the production of goods and services generates an equal amount of total spending for these goods and services

Keynes Book Name

The General Theory of Employment, Interest, and Money. Made in 1936. Battled Say’s Law

According to Keynes, what is the most important factor in determining spending for goods and services

Disposable Income (personal income to spend after taxes)

Consumption Function

The graph or table that shows the amount households spend for goods and services at different levels of real disposable income

Autonomous consumption

Consumption that is independent of the level of real disposable income. They must be paid

Dissaving

The amount by which real personal consumption expenditures exceed real disposable income

Saving

The part of disposable income households do not spend for consumer goods and services

Formula for Saving

S= Y1- C

S= Saving

Y1= Real disposable Income

C= Consumption

Marginal propensity to consume (MPC)

The change in consumption resulting from a given change in real disposable income. Measures how much of an additional dollar of disposable income households will spend for consumption

MPC formula

MPS= (change in consumption)/(change in income)

Marginal Propensity to Save (MPS)

The change in saving resulting from a given change in real disposable income. Measures how much of an additional dollar of disposable income households will save

Formula for MPS

MPS= (change in saving)/(change in real dispoable income)

What does MPC+ MPS always equal and why

1, each additional dollar of income not spent is saved. No other options besdies spending or saving

45 degree line

A geometric construct that indicates all points where real disposable income (horizontal axis) and real consumption (vertical axis) are equal. Makes it easier. to identify the break even or no saving income level

How do changes in MPC affect the consumption function

Higher the marginal propensity to consume, the steeper the consumption function

Non income Variables that can shift the consumption function

Expectations

Wealth

Price level

Interest rate

Expectations

Non-Income Variable. Direct Relationship. Anticipation of recession could cause less consumption. Anticipation of a recovery could cause more spending

Wealth

Non income variable. The more wealth households make, the more they will spend

The Wealth Effect

A shift in the consumption function caused by a change in the value of real and financial assets

Price Level

Non- income variable. Inverse relationship, increase in price level can cause a decrease in spending

Interest Rate

Non-Income Variable, inverse relationship, increase in interest rate can cause more saving rather than consumption. Vice Versa

Movements Along the consumption function vs shifts

A change in real disposable income causes movement. A shift is caused by a non-income variable

Major Cause of the Business Cycle

Changes in the private sector components of aggregate expenditures (personal consumption and investment spending)

What determines the level of investment spending?

Interest rate

According to Keynes, what determines the level of investment spending

Expectations of future profits are the primary factor, and the interest rate is the financing cost of any investment proposal

Investment demand curve

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

Major Factors that Shift Investment Demand Curve

Expectations

Technological Change

Capacity Utilization

Business Taxes

Expectations affect investment demand

Direct relationship, bad attitude towards economy causes leftward shift

Technological change affect investment demand

Direct Relationship. New technologies cause better investment

Capacity Utilization affect investment demand

Direct relationship, firms operating plants at high rate of capacity makes them need to invest for the greater demand to come

Business Taxes

Inverse Relationship, business decisions depend on the after-tax rate of profit, so an increase in business tax could cause decrease in investment

Autonomous Expenditure

Spending that does not vary with the level of real disposable income