Overview of Keynesian Economics

• Keynesian economics focuses on the role of aggregate demand in determining economic activity.

• Traditionally explained through the Income-Expenditure Model or Keynesian Cross model, emphasizing aggregate expenditure's relationship with GDP and national income.

Income-Expenditure Model

• Fundamental Assumption: Economic activity (output and employment) is primarily driven by aggregate demand (total spending).

• Unemployed Labor & Capital: When significant resources are unemployed, the issue is not a lack of resources but a lack of demand.

• Model does not explicitly incorporate aggregate supply or price levels but can infer these relationships through analysis.

• GDP Definition: GDP can be viewed as both the value of spending on final goods and the value of their production.

• National Income (Y): The total income received from contributing resources to GDP.

Components of Aggregate Expenditure

• Aggregate expenditure comprises four components:

  • Consumption (C)

  • Investment (I)

  • Government Spending (G)

  • Net Exports (X - M)

• Aggregate Expenditure Equation:

  • $ext{Aggregate Expenditure} = C + I + G + (X - M)$

Aggregate Expenditure Schedule

• The model determines the equilibrium level of real GDP which correlates with employment in the economy.

• The aggregate expenditure schedule indicates how aggregate expenditures rise with increasing national income.

Consumption Function

• Consumption Function: Describes the relationship between consumption expenditure and national income.

• Consumption primarily depends on personal disposable income.

• Each dollar of additional income can be consumed or saved.

• Definitions:

  • Marginal Propensity to Consume (MPC): The fraction of additional income spent.

  • Marginal Propensity to Save (MPS): The fraction of additional income saved.

  • Relationship: $MPC + MPS = 1$

• Example: If $MPC = 0.9$, then $MPS = 0.1$.

• At zero income, individuals still consume a baseline amount, known as Autonomous Consumption, e.g., $600.

• Consumption equation incorporating MPC and autonomous consumption:

  • $C = a + MPC imes Y$ where $a$ = autonomous consumption, $Y$ = national income.

Factors Shifting the Consumption Function

• Various factors, like consumer expectations and household wealth changes, can shift the consumption function.

  • Shifting up indicates higher consumption at each income level.

Investment Function

• Investment Function: Illustrates how real GDP is related to investment expenditure.

• Dependent more on future expectations and interest rates than on current GDP levels.

• Represented as a horizontal line in the diagram, indicating a fixed level of investment, despite changes in GDP.

• Factors might shift this function include technological changes and economic forecasts.

Government Spending and Taxes

• Government spending is determined via budget processes and appears as a horizontal line in diagrams.

• Tax considerations lower the marginal propensity to consume due to marginal tax rates affecting disposable income.

• Resulting consumption function reflects lower consumption levels due to taxation.

• Consumption Function with Taxes: The flatter line represents reduced after-tax consumption.

Export and Import Functions

• Export Function: Shows exports change with the global trade demand, represented as horizontal because it’s influenced by foreign demand.

• Import Function: Negative slope as imports subtract from national expenditure; influenced by national income changes and marginal propensity to import (MPI).

• Calculating Imports:

  • $ext{Imports} = ext{Income} imes -MPI$

Aggregate Expenditure Function

• Formed by summing the consumption, investment, government spending, and net exports functions.

• The aggregate expenditure curve intersects the vertical axis at autonomous expenditure.

• Slope determined by:

  • Marginal Propensity to Consume

  • Tax rates

  • Marginal Propensity to Import

Equilibrium in the Income-Expenditure Model

• Equilibrium Condition: Occurs where aggregate expenditure equals national income.

• Graphically found where the aggregate expenditure function intersects the 45-degree line (points where AD = AS).

• If above equilibrium, output piles up unsold and firms reduce production; if below, firms increase production due to high aggregate demand.

Real Aggregate Supply in the Income-Expenditure Model

• The model can extend to discuss aggregate supply implicitly; below potential GDP, any AD change affects GDP.

• Above potential GDP, changes in AD affect the price level instead of GDP.

Spending Multiplier in the Income-Expenditure Model

• A change in expenditure leads to a larger proportional change in GDP, known as the Spending Multiplier.

• Multiplier Calculation:

  • Defined as: $ext{Multiplier} = rac{ ext{Change in GDP} ( ext{ΔY})}{ ext{Change in Expenditure} ( ext{ΔAE})}$

  • Typically greater than one, illustrating the higher impact of spending changes on GDP.

Addressing Economic Gaps

• Recessionary Gap: Occurs when equilibrium is below potential GDP; results in higher unemployment.

• Inflationary Gap: Occurs when equilibrium is above potential GDP; can cause inflation as demand exceeds supply.

• Policy Solutions: Adjusting tax rates and government spending can shift the aggregate schedule upward in recessions or downward in inflationary scenarios.