Keynesian Economics: Unemployment, Consumption, and Investment

Keynesian Economics and Business Cycles

• Foundation of Keynesian Theory: The investigation of the economy and its movement through business cycles is heavily influenced by John Maynard Keynes, specifically his seminal text, The General Theory of Employment, Interest, and Money (referred to as The General Theory).

• Consumer Spending as the Engine: Keynes argued that consumer spending is the primary engine that moves the economy. To understand the economy, one must understand how individuals spend money.

• The Link Between Jobs and Spending: Consumption is contingent upon having an income, which generally requires a job. Keynesian analysis focuses on why individuals might lack employment and, consequently, why spending might fluctuate.

Understanding Unemployment

• Definition of Unemployment in the United States: To be officially categorized as unemployed, an individual must meet three criteria:

  • They must be willing to work.

  • They must be able to work.

  • They must be actively seeking employment.

• Employment vs. Non-Employment: Simply not having a job does not make a person unemployed in an economic sense; the active search for a job is the defining factor.

• Types of Unemployment identified by Keynes:

  • Frictional Unemployment: This refers to unemployment due to people being "between jobs." For example, if you quit your job today and spend a week searching for another, you are frictionally unemployed. Keynes viewed this as temporary and not a major concern for economic policy because it resolves itself as individuals find new roles.

  • Cyclical Unemployment: This is unemployment caused by downturns in the business cycle. It includes Seasonal Unemployment, where jobs are only available during certain times of the year. Like frictional unemployment, Keynes considered this temporary and generally not a fundamental threat to the long-term structure of the economy.

  • Structural Unemployment: This was Keynes's primary concern. It is defined as unemployment due to a permanent change in the economy. Reasons for structural shifts include changing laws or changes in what a country produces. When a change is permanent, workers lose jobs they can never return to.

    • Historical Example: The shutting down of the steel industry in the United States. Many workers became structurally unemployed because the country moved away from steel production, meaning a steelworker could no longer find employment in that specific industry.

The Natural Rate of Unemployment

• Definition: The natural rate of unemployment is the level around which the actual unemployment level fluctuates.

• The US Benchmark: In the United States, the natural rate of unemployment is approximately $4\%$.

• Economic Implications of the Rate:

  • Below $4\%$: If unemployment falls below this threshold (as it did before February 2020), economists worry about inflation and the economy "overheating."

  • Above $4\%$: If unemployment rises significantly above this threshold, there is a concern regarding a recession.

• The Constant Worry: Economic policy often involves managing the different issues that arise depending on whether the current rate is above or below this natural mark.

The Relationship Between Spending, Income, and Savings

• Employment as a Function of Spending: Keynes believed that the levels of employment and spending were inextricably linked; specifically, employment is a function of the total spending in the economy.

• Income Allocation: According to Keynes, there are only two possible uses for income:

  1. Consumption: Spending it now.

  2. Savings: Defined verbatim as "postponed consumption."

The Consumption Function

• Overview: The consumption function is a mathematical formula used to illustrate how individuals spend their money.

• Formula:   $C = a + b(Y_d)$

• Components of the Function:

  • $C$: Total consumption.

  • $a$: Autonomous Consumption. This is the amount of consumption that occurs regardless of income. Even if income ($Y_d$) were zero, a certain amount of consumption must happen for survival.

  • $b$: The percentage of income spent (a decimal value representing the slope).

  • $Y_d$: Disposable Income. This is defined as after-tax income.

  • $b(Y_d)$: This product is referred to as Discretionary Consumption, representing the portion of consumption that the individual chooses to do based on their income levels.

• Simplifying the Model: In this specific model, we ignore the government and taxes to focus strictly on how a paycheck is allocated between spending and saving.

Marginal and Average Propensities

• Marginal Propensity to Consume (MPC): Defined as the change in consumption ($\Delta C$) resulting from a change in income ($\Delta Y$). If you receive an additional dollar, the MPC tells you what portion of that dollar you will spend.

• Marginal Propensity to Save (MPS): Defined as the change in savings ($\Delta S$) resulting from a change in income ($\Delta Y$). It represents the portion of an additional dollar that you will save.

• The Fundamental Identity: Since there are only two things to do with income, the sum of the propensities must equal one:   $MPC + MPS = 1$

• Average Propensity to Consume (APC): Indicates, on average, how much of total income goes to consumption.

• Average Propensity to Save (APS): Indicates, on average, how much of total income goes to savings.

Investment and Interest Rates

• Definition of Investment: In the context of GDP, investment is defined as business spending.

• The Role of Borrowing: Businesses typically need to borrow money to fund investments.

• Cost-Benefit Analysis: Businesses decide whether to invest based on two factors:

  1. Interest Rate: The cost of borrowing the money.

  2. Expected Rate of Return: How much the business expects to make on the investment.

• Decision Logic: If a business borrows at a $3\%$ interest rate but has an expected rate of return of $15\%$, the investment makes sense because they net a $12\%$ return.

• The Negative Relationship: There is a negative (inverse) relationship between the interest rate and the volume of investment:

  • If interest rates are high, investment will be low.

  • If interest rates are low, investment will be high.

Calculation Exercise and Practical Application

• The Provided Consumption Function:   $C = 280 + 0.6(Y_d)$

  • $280$ represents autonomous consumption.

  • $0.6$ represents the marginal propensity to consume (or the discretionary spending rate of $60\%$).

• Task Parameters:

  • Incomes for calculation: $900$ and $1100$.

  • Variable to determine: Consumption ($C$) and Savings ($S$).

  • Change in income ($\Delta Y$) is $200$ ($1100 - 900$).

  • Investment (I): A constant value of $160$.

• Calculation Steps:

  1. Plug income into the consumption formula to find $C$.

  2. Subtract $C$ from income to find $S$.

  3. Calculate the difference between the first and second levels of consumption to find the change in consumption.

  4. Examine the relationship by adding $C + I$.

National Income Accounting and Marginal Propensity Review

• National income accounting requires a careful examination of the relationship between income, consumption, and savings to determine economic stability.

• In the provided data set, at an income level of $900$, the following values are observed:

  • Consumption ($C$): $820$

  • Savings ($S$): Calculated as income minus consumption ($Y - C$). In this case, $900 - 820 = 80$.

• Marginal Propensity to Consume ($MPC$):

  • At the income level of $900$, the $MPC$ is calculated at $0.6$.

  • The $MPC$ is represented by the coefficient "$b$" in the consumption function formula ($C = a + bY$).

  • Consistency check: If the $MPC$ used to calculate consumption levels does not match the $MPC$ derived from those consumption levels during analysis, a mathematical error has occurred.

• Average Propensity to Consume ($APC$):

  • Formula: $APC = \frac{\text{Consumption}}{\text{Income}}$

  • For an income of $900$ and consumption of $820$, the $APC = \frac{820}{900} = 0.91$.

• Average Propensity to Save ($APS$):

  • Formula: $APS = \frac{\text{Savings}}{\text{Income}}$

  • For an income of $900$ and savings of $80$, the $APS = \frac{80}{900} = 0.09$.

• Fundamental Identities in Accounting:

  • The sum of marginal propensities must equal one: $MPC + MPS = 1$.

  • The sum of average propensities must equal one: $APC + APS = 1$.

Consumption and Savings Trends Across Income Levels

• Impact of Rising Income on $APC$ and $APS$:

  • As income increases, the Average Propensity to Consume ($APC$) typically drops. Even if an individual spends high absolute amounts of money (e.g., more than a billionaire like Bill Gates), their average spending relative to total income decreases as they get wealthier.

  • Conversely, as income increases, the Average Propensity to Save ($APS$) must rise.

• Political and Economic Implications of $APS$:

  • The observation that the wealthy have a higher $APS$ forms the foundation for conservative economic arguments regarding tax breaks for the rich.

  • The logic is that providing the wealthy with more money leads to higher average levels of savings.

• The Importance of Savings:

  • Savings are critical for the banking system and the circular flow of the economy.

  • Without savings, there is no pool of funds available for businesses to borrow and invest. Therefore, savings are a prerequisite for investment: $\text{Savings} \rightarrow \text{Investment}$.

Identifying Equilibrium Income

• Definition: Equilibrium income ($Y$) is defined as the income level at which the economy is stable and "comes to rest."

• Aggregate Demand ($AD$):

  • In a model with two primary players (consumers and producers), total demand is the sum of what these players want.

  • Consumer demand is measured by Consumption ($C$).

  • Producer demand is measured by Investment ($I$).

  • Total Demand = $C + I$.

• Aggregate Supply ($AS$):

  • Total supply is represented by National Income ($Y$).

  • This identification is based on the circular flow diagram, which establishes that the total value of goods and services produced equals the total income created.

• Equilibrium Condition:

  • Equilibrium occurs where total supply equals total demand: $Y = C + I$.

  • Based on the data chart, when national income is $1100$, the sum of $C + I$ is also $1100$. Therefore, the equilibrium income level for this economy is $1100$.

Graphical Representation of Equilibrium (The Keynesian Cross)

• Axes:

  • The horizontal axis ($X$-axis) represents Disposable Income ($Y_d$).

  • The vertical axis ($Y$-axis) represents Consumption ($C$) and Total Demand ($C + I$).

• The Consumption Line ($C$):

  • The consumption line does not start at the origin (zero) because of autonomous consumption ($a$).

  • Autonomous consumption is the level of spending when income is zero ($Y = 0$). In the example, $a = 280$.

  • From the intercept of $280$, the line slopes upward based on the $MPC$.

• The Investment Line ($I$):

  • Investment is assumed to be constant across all income levels. In this example, $I = 160$.

• The Total Demand Line ($C + I$):

  • This line represents the vertical summation of consumption and investment.

  • When income is zero, the $C + I$ intercept is the sum of autonomous consumption ($280$) and investment ($160$), which equals $440$.

• The 45-Degree Line:

  • This line represents all points where the value on the horizontal axis equals the value on the vertical axis (e.g., $5$ units over, $5$ units up).

  • In economics, it represents all possible points where total supply ($Y$) equals total demand ($C + I$).

• Graphical Equilibrium:

  • The equilibrium income level is found exactly where the $C + I$ line intersects the 45-degree line.

  • In the provided example, this intersection occurs at an income level of $1100$.

Potential GDP and Economic Gaps

• Potential GDP:

  • This is the maximum Level of GDP a country can achieve without triggering a recession or causing high inflation.

  • It is graphically represented as being on the Production Possibilities Curve ($PPC$).

• Comparison of Equilibrium Income and Potential GDP:

  • Keynes focused on comparing the level where the economy naturally "comes to rest" (equilibrium) against the "Potential GDP."

• Deflationary (Recessionary) Gap:

  • Occurs when Potential GDP is greater than Equilibrium Income (\text{Potential GDP} > Y^*).

  • This indicates the economy has settled at a point below its full potential, placing it "under" the Production Possibilities Curve and resulting in a recession.

• Inflationary Gap:

  • Occurs when Potential GDP is less than Equilibrium Income (\text{Potential GDP} < Y^*).

  • In this scenario, demand is significantly higher than supply, which causes price levels to rise rapidly (inflation).

• The Keynesian Revolution and Government Intervention:

  • Keynes argued that if the economy stabilizes (reaches equilibrium) at a point other than Potential GDP, government intervention may be necessary to move the economy toward its potential and close the resulting gaps.

Inflationary and Deflationary Gaps and Economic Efficiency

• The economy often comes to rest at a point of equilibrium that does not align with the potential Gross Domestic Product (GDP). These discrepancies are referred to as inflationary or deflationary gaps.

• A gap between equilibrium and potential GDP represents a significant economic problem because it indicates that supply and demand are not equal at the optimal level of production.

• When equilibrium is reached below potential GDP, the economy is wasting resources and is failing to operate efficiently.

• Based on specific numerical data provided:

  • Current equilibrium income: $1100$

  • Potential GDP: $1300$

  • This scenario represents a deflationary gap of $200$.

• To correct this, the economy must bridge the gap by moving the equilibrium from its current stationary point to the potential GDP level.

Potential GDP as Equilibrium

• Equilibrium is defined graphically as the point where the $C + I$ (Consumption plus Investment) line intersects the 45-degree line.

• For potential GDP to become the new equilibrium, the $C + I$ line must be shifted so that it intersects the 45-degree line at the higher income level (in this case, reaching the $1300$ mark).

• While the goal is to change the overall GDP by $200$, this does not require an equivalent $200$ increase in demand components (such as consumption or investment) due to the multiplier effect.

The Multiplier Process and the Ripple Effect

• The multiplier process is an economic principle stating that a change in a single component of GDP will result in a larger, proportional change in the total GDP.

• This happens due to a "rippling effect" through the economy, illustrated by the following example:

  • An individual increases their consumption by spending an extra $40$ at a local grocery store.

  • The grocer receives this $40$ as unanticipated income. Their income rises by $40$.

  • The grocer spends a portion of that new income based on the Marginal Propensity to Consume (MPC). In this case, the MPC is $60\%$ ($0.6$).

  • The grocer spends $60\%$ of $40$, which equals $24$ (for example, at Barnes & Noble buying books).

  • The owners of Barnes & Noble now have an unanticipated increase in income of $24$.

  • They, in turn, spend $60\%$ of that $24$, which is roughly $14.40$ (referred to as $14$ in the transcript).

• This sequence of spending continues through various layers of the economy. The total impact on GDP is the sum of the initial spending ($40$) plus all subsequent ripples.

Calculating the Multiplier Effect

• To determine the total impact on GDP, we use the multiplier effect formula:

  • $\Delta \text{GDP} = \Delta \text{Component} \times \text{Multiplier}$

• The multiplier is calculated as:

  • $\text{Multiplier} = \frac{1}{1 - \text{MPC}}$

• Given an MPC of $0.6$:

  • $1 - 0.6 = 0.4$

  • $\frac{1}{0.4} = 2.5$

• Using the initial grocery store example with a $\$40$ change in consumption:

  • $40 \times 2.5 = 100$

• Therefore, a $\$40$ increase in consumption creates a $\$100$ total increase in GDP.

Closing a Specific Deflationary Gap

• Returning to the initial problem of moving GDP from $1100$ to $1300$:

  • The required $\Delta \text{GDP}$ is $200$.

  • Using the same multiplier of $2.5$:

  • $200 = \Delta \text{Consumption} \times 2.5$

  • Dividing both sides by $2.5$ ($200 / 2.5$) gives $80$.

• To achieve a $200$ increase in GDP, the government or private sector must boost a component of demand (like consumption) by $80$.

Keynesian Perspectives and Government Intervention

• The change required to close a gap can come from any component of GDP:

  • $C$ = Consumption

  • $I$ = Investment

  • $G$ = Government Spending

  • $NX$ = Net Exports

• From a Keynesian perspective, the component used to address these gaps is most frequently $G$ (Government Spending).

• The Keynesian Revolution posits that the government can and should intervene to move the economy from a stagnant equilibrium to its potential GDP.

• Methods of intervention include:

  • Direct government spending.

  • Providing tax rebates to citizens.

• A contemporary example used is the stimulus checks distributed in early 2020. The primary purpose of these checks was to:

  • Increase consumption ($C$).

  • Enable citizens to pay bills, mortgages, rent, and buy groceries.

  • Stimulate GDP movement and encourage the economy to produce more goods.

• There is an ongoing debate in economic theory regarding these interventions:

  • Keynesian economists support government manipulation to stabilize the economy.

  • Other groups of economists argue against such interventions, believing they may not be beneficial.