Keynesian Fiscal Policy

Overview of Keynesian Fiscal Policy

Chapters nine, ten, eleven, and twelve detail Keynesian fiscal policy, emphasizing aggregate demand and its components. Three key questions are addressed:

  • What are the components of aggregate demand?
  • What determines the level of spending for each component?
  • Is there enough demand to maintain full employment?
    Generally, the response is affirmative, but historical instances, like the Great Depression, highlight exceptions.

Historical Context

  • The Great Depression exemplified a severe lack of demand:
    • Approximately 13,000,000 jobs lost, resulting in a staggering 25% unemployment rate—the highest in U.S. history.
    • This economic downturn persisted from 1929 until 1940.
  • John Maynard Keynes identified insufficient demand for products as the cause of recessions, leading to the proposed solution of increasing demand.

Circular Flow of Money

Understanding the economy through the circular flow of money:

  • Money flows clockwise, while goods and services flow counterclockwise.
    • Flow of Money:
    • Households spend money in the product market.
    • Retailers send a portion of revenue to producers to increase output.
    • Producers pay wages to workers in the factory.
  • Flow of Goods/Services:
    • Households receive goods/services in exchange for their spending.
    • Households provide labor (goods/services) to the factor market.
    • Factories deliver goods/services back to firms.
    • Firms distribute products to the product market.
  • For Keynes, continuous movement in this circular flow is essential for economic growth.

Leakages and Injections

Leakages

Leakages are factors that draw money out of the circular flow:

  1. Taxes: Government takes a portion of household income, reducing funds available for spending in product markets.
  2. Savings: When households save wages instead of spending them.
  3. Imports: Money spent on foreign goods represents a loss to the domestic economy.
Injections

Injections add money to the circular flow:

  1. Business Investment: Occurs when businesses invest in capital.
  2. Government Spending: When governments reinvest collected taxes into public goods/services.
  3. Exports: Money received from foreign consumers buying domestic products.
Equilibrium of Leakages and Injections
  • Keynes posited that as long as leakages equal injections, the economy would grow efficiently, maintaining near-full employment levels.

Components of Aggregate Demand

The following groups contribute to aggregate demand, aligned with Gross Domestic Product (GDP) components:

GDP Formula

Aggregate demand expressed as:
AD=C+I+G+(X−M)AD = C + I + G + (X - M)
Where:

  • C: Consumption
  • I: Investment
  • G: Government Spending
  • (X-M): Net Exports (Exports - Imports)
Key Component: Consumption
  • Consumption accounts for approximately 70% of the economy.
  • Two types of consumption per Keynes:
    1. Income Dependent Consumption: Directly influenced by disposable income.
    2. Autonomous Consumption: Independent of changes in income, essential for understanding consumer behavior.
Consumption Function

The consumption function described mathematically as:
C=a+bYDC = a + b Y_D
Where:

  • C: Total consumption
  • a: Autonomous consumption
  • b: Marginal propensity to consume (MPC)
  • Y_D: Yearly disposable income

Autonomous Consumption Determinants

Autonomous consumption is influenced by:

  1. Availability of Credit: Increases spending irrespective of income.
    • Statistics: Approximately 900,000,000 credit cards in the U.S.
    • Total credit card debt exceeds $1 trillion.
  2. Wealth Effect: Changes in asset values impact spending.
    • Positive wealth effects arise with rising values of stocks or real estate, encouraging consumer spending.
    • Negative wealth effects occur during economic downturns, reducing consumer confidence and spending.
  3. Tax Changes: Lower taxes yield higher disposable income, enhancing autonomous consumption.
  4. Consumer Expectations: Future outlooks can shift spending habits, with optimism leading to increased spending and pessimism causing cutbacks.
Income Dependent Consumption

Only one determinant is recognized: Income (Y).
Focus is on the Marginal Propensity to Consume (MPC), defined as the change in consumption per change in income:
MPC=ΔCΔYMPC = \frac{\Delta C}{\Delta Y}

  • Contrast with Average Propensity to Consume (APC): Total consumption divided by total income.

Understanding MPC and MPS

  • MPC Examples:

    • If an individual earns $50,000 and spends $40,000, then:
      APC=40,00050,000=0.8APC = \frac{40,000}{50,000} = 0.8
    • A raise to $60,000 with spending of $45,000 gives:
      MPC=5,00010,000=0.5MPC = \frac{5,000}{10,000} = 0.5

  • Marginal Propensity to Save (MPS): Defined as 1 minus the MPC.

Consumption Function Visual Representation
  • The graphing of the consumption function starts at the intercept indicating autonomous consumption (constant).
  • Movements along the curve represent changes in spending due to income variations.
  • Shifts in the curve are caused by changes in autonomous consumption.

Additional Components of Aggregate Demand

Beyond consumption, additional components include:

Business Investment
  • Investment remains largely autonomous; independent of current income but influenced by business expectations and economic outlooks.
Government Spending
  • Level of government spending is primarily decided by public opinion and electoral votes, detached from actual income generation.
  • Breakdown of government spending:
    • 28% on healthcare (Medicare and Medicaid)
    • 25% on Social Security
    • Approximately 16.67% on military expenditures
Net Exports
  • Determined by foreign income levels; higher foreign earnings lead to an uptick in U.S. exports while domestic earnings affect imports.
  • Notable trends and implications on trade deficits during recessions, highlighting the interdependence of domestic and foreign economies.

Aggregate Expenditures Model

  • Transition from the consumption function to the Aggregate Expenditures Model captures the comprehensive aggregate demand dynamics.
  • This model aids in observing full employment equilibrium where expenditures and income align.

Conclusion

The upcoming chapters will continue to delve into the implications of changes within the Aggregate Expenditures Model, reinforcing the nuances of consumer behavior amidst varying economic conditions, and the broader impact on the economy.