Macroeconomics ECO1301 - Topic 3

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Who developed the Keynesian Theory of Effective Demand?

John Maynard Keynes

What is the main purpose of Keynes's book 'The General Theory of Employment, Interest & Money'?

To explain how an advanced market economy can experience persistent, large-scale unemployment and to identify remedies for it.

What does Keynes identify as the principal cause of unemployment in an economy?

A deficiency of aggregate demand.

Define Aggregate Demand.

The total amount of demand for the economy's output.

What should policymakers do when an economy is in a slump according to Keynes?

They should take steps to stimulate aggregate demand.

How can the macroeconomy be viewed according to Keynesian theory?

As either resource-constrained or demand-constrained.

What does the resource-constrained view focus on?

Supply-side factors and operating close to full capacity.

What is the Keynesian view of the economy's operation?

The economy normally operates below full capacity, regulated by the level of aggregate demand.

What happens when aggregate demand is higher than the current level?

The economy would produce a higher level of output.

What is the GDP Gap?

The difference between potential output and actual output in the economy.

What is the Circular Flow Diagram used to illustrate?

Macroeconomic equilibrium and the flow of income and expenditure in an economy.

What are leakages in the income-expenditure circuit?

Savings, taxes, and imports that reduce the amount of income spent on the economy's output.

What are injections in the income-expenditure circuit?

Investment, government spending, and exports that increase spending in the economy.

What condition must be met for the economy to be in equilibrium?

The level of output (Y) must match aggregate demand.

What happens when leakages exceed injections?

Total spending is less than the value of what the economy produced, leading to increased inventories and reduced production.

What occurs when injections exceed leakages?

Total spending is greater than the value of what the economy produced, leading to increased production and hiring.

How can macroeconomic equilibrium be defined?

The value of the economy's output must equal aggregate demand, and leakages must equal injections.

What are the two components of Aggregate Demand under the Effective Demand Mechanism assumptions?

Consumption Spending (C) and Investment Spending (I).

What does the Marginal Propensity to Consume (MPC) indicate?

How much consumption spending changes for every one dollar change in aggregate income.

If the MPC is 0.92, how much will total consumption spending increase with a $100 billion increase in income?

By $92 billion.

What is the Consumption Function?

C = co + cY, where co is autonomous consumption and c is the marginal propensity to consume.

What is the relationship between consumption and saving in an economy without taxes?

C + S = Y.

What does the Marginal Propensity to Save (MPS) indicate?

How much saving changes for every one dollar change in aggregate income.

If the MPC is 0.92, what is the MPS?

0.08.

What is the Saving Function if C = 1000 + 0.90Y?

S = -1000 + 0.10Y.

What happens to the economy's output level when it cannot be sold?

The output level cannot be sustained, leading to production cuts and layoffs.

What analogy is used to describe the economy in terms of leakages and injections?

The economy is likened to a bathtub, where leakages are drains and injections are faucets.