Chapter 18 The Keynesian Model Key Concepts Summary Practice Quiz Internet Exercises ©2002South-Western College Publishing

Who were the Classical economists? The Classical economists believed that a continuing depression is impossible because markets will eliminate persistent shortages or surpluses

When were the ideas of the Classical economists widely accepted? Prior to the Great Depression of the 1930’s

What is Say’s Law? The belief of the Classical economists that the economy was always tending toward full employment

What does Say’s Law say? Supply creates its own demand

Why is Say’s Law a full employment theory? Generally speaking, producers produce goods that consumers want and consumers have the money to buy because of the wages they were paid

Under Say’s Law, is unemployment possible? Yes, but it is a short-lived adjustment period in which wages and prices decline or people voluntarily choose not to work

What changed people’s mind about Say’s Law? The Great Depression and the publication of The General Theory of Employment, Interest, and Money published in 1936

Why did Keynes’ believe that “supply did not create its own demand”? Aggregate expenditures (demand) can be forever inadequate for an economy to achieve full employment

What is the main idea of this chapter? Keynes’s theory for the determination of consumption and investment expenditures

What determines your family’s spending for goods and services? Disposable income

What is the consumption function? The graph that shows the amount households spend for goods and services at different levels of disposable income

What is savings? Disposable income minus consumption, the amount households do not spend for consumer goods and services

What is dissaving? The amount by which personal consumption expenditures exceed disposable income

How do people dissave? Negative savings is financed by by drawing down previously accumulated financial assets or by borrowing

What is autonomous consumption? Consumption that is independent of the level of disposable income

What happens when disposable income is zero? Spending will equal autonomous consumption because households will dissave to satisfy basic consumption needs

What is the marginal propensity to consume? The change in consumption resulting from a given change in real disposable income

 C  Yd MPC =

What is marginal propensity to save? The change in saving resulting from a given change in real disposable income

 S  Yd MPS =

MPC + MPS = 1

C 8 C = Yd 7 6 5 4 3 2 1 1 2 3 4 5 6 7 8 9 10 Dissaving C Yd Saving The Consumption Function 8 C = Yd C 7 Dissaving 6 Real Consumption Trillions of $ per year 5 C 4 3 Yd Saving 2 1 Real Disposable Income Trillions of $ per year 45° 1 2 3 4 5 6 7 8 9 10

What happens if factors other than income change? There is a shift or relocation in the consumption schedule

The Consumption Function 8 C = Yd C2 7 6 Real Consumption Trillions of $ per year C1 5 4 MPC = .75 3 2 MPC = .50 1 Real Disposable Income Trillions of $ per year 45° 1 2 3 4 5 6 7 8 9 10

The Consumption Function 8 C2 = a2 + bYd 7 6 Real Consumption Trillions of $ per year 5  nonincome determinant B 4 A 3 C1 = a1 + bYd 2 1 Real Disposable Income Trillions of $ per year  real consumption 1 2 3 4 5 6 7 8 9 10

Why does the consumption function shift? Expectations Wealth Price level Interest rate Stock of durable goods

How do expectations affect the consumption function? Consumers expectations of things to happen in the future will affect their spending decisions today

How does wealth affect the consumption function? Holding all other factors constant, the more wealth households accumulate, the more they spend at any current level of disposable income

How does the price level affect the consumption function? Any change in the general price level shifts the consumption schedule by reducing or enlarging the consumers purchasing power

How does the interest rate affect the consumption function? A high interest rate will discourage people from borrowing money and a low interest rate will encourage people to borrow money

How does the stock of durable goods affect the consumption function? When durable goods are suppressed, like during WWII, afterwards there is an increase in the demand for goods not previously made available

How does consumption compare with investment? Consumption is more stable than investment

According to the Classical Economists, what determined the level of investment? The interest rate

According to Keynes, what determines the level of investment? Expectations of future profits is the primary factor, the interest rate is the financing cost of any investment proposal

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

Movement along the firm’s investment demand curve 16% Interest rate A Investment Demand Curve 12% B 8% 4% Real investment 5 10 15 20

Shift in the firm’s investment demand curve 16% 12% C Interest rate 8% B I2 4% I1 Real investment 5 10 15 20

Why is investment demand unstable? Expectations Technological change Capacity utilization Business taxes Autonomous reasons

How do expectations affect investment? Businesspeople are quite susceptible to moods of optimism and pessimism

How does technological change affect investment? The introduction of new products and new ways of doing things have a big impact on investment decisions

What happens when capacity utilization is low? When capacity utilization is low, firms can meet an increase in demand without expanding

What happens when capacity utilization is high? When capacity utilization is high, firms must increase investment to meet an increase in demand

How do business taxes affect investment? Business decisions depend on the expected after-tax rate of profit

What is autonomous expenditure? Spending that does not vary with the current level of disposable income

Aggregate Investment Demand Curve Autonomous investment 16% Aggregate Investment Demand Curve 14% 12% Interest Rate 10% A 8% 6% Autonomous investment 4% 2% Real Investment .2 .4 .6 .8 1.0 1.2 1.4 1.6

Aggregate Autonomous Investment Demand Curve 1.6 1.4 1.2 1.0 .8 .6 Autonomous investment .4 Real Disposable Income trillions of dollars per year .2 1 2 3 4 5 6 7 8

What is the aggregate expenditure function? The function that represents total spending in an economy at a given level of real disposable income

Aggregate Expenditures Schedule and Function 8 AE 7 E C 6 5 C + I 4 3 2 Real Disposable Income trillions of dollars per year 1 1 2 3 4 5 6 7 8

Key Concepts

Key Concepts Who were the Classical economists? When were the ideas of the Classical economists widely accepted? What is Say’s Law? What does Say’s Law say? Why did Keynes’ believe that “supply did not create its own demand”? What determines your family’s spending for goods and services?

Key Concepts cont. What is the consumption function? What is savings? What is dissaving? What is autonomous consumption? What is the Marginal Propensity to Consume? What is Marginal Propensity to Save? What happens if factors other than income change?

Key Concepts cont. Why does the consumption function shift? According to the Classical economists, what determined the level of investment? According to Keynes, what determines the level of investment? What is the investment demand curve? Why is investment demand unstable? What is autonomous expenditure? What is the aggregate expenditure function?

Summary

Say’s Law is the classical theory that “supply creates its own demand” and therefore the Great Depression was impossible. Say’s Law is the belief that the value of production generates an equal amount of income and, in turn, total spending.

The Classical economists rejected the challenge that underconsumption is possible because they believed flexible prices, wages, and interest rates soon establish balance between supply and demand.

John Maynard Keynes believed that unless aggregate spending is adequate, the economy can experience prolonged and severe unemployment.

The consumption function (C) is determined by changes in the level of disposable income.

Autonomous consumption is consumption that occurs even if disposable income equals zero. Changes in such nonincome determinants as expectations, wealth, the price level, interest rates, and the stock of durable goods cause shifts in the consumption function.

C 8 C = Yd 7 6 5 4 3 2 1 1 2 3 4 5 6 7 8 9 10 Dissaving C Yd Saving The Consumption Function 8 C = Yd C 7 Dissaving 6 Real Consumption Trillions of $ per year 5 C 4 3 Yd Saving 2 1 Real Disposable Income Trillions of $ per year 45° 1 2 3 4 5 6 7 8 9 10

The marginal propensity to consume (MPC) is the change in consumption associated with a given change in disposable income. The MPC tells how much of an additional dollar of disposable income households will spend for consumption.

The marginal propensity to save (MPS) is the change in saving associated with a given change in disposable income. The MPS measures how much of an additional dollar of disposable income households will save.

The investment demand curve (I) shows the amount businesses spend for investment goods at different possible rates of interest.

The determinants of investment demand curve are the expected rate of profit and rate of interest. Shifts in the investment demand curve result from expectations, technological change, capacity utilization, and business taxes.

An autonomous expenditure is spending that does not vary with the current level of disposable income.

The Keynesian model autonomous expenditure to investment The Keynesian model autonomous expenditure to investment. As a result, the investment demand curve is a fixed amount determined by the rate of profit and the interest rate.

The aggregate expenditures function (AE) shows the total spending in an economy at a given level of disposable income.

Assuming investment spending is autonomous, the slope of the AE function is determined by the MPC.

Aggregate Expenditures Schedule and Function 8 AE 7 E C 6 5 C + I 4 3 2 Real Disposable Income trillions of dollars per year 1 1 2 3 4 5 6 7 8

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