Introduction to the Keynesian System

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Presentation transcript:

Introduction to the Keynesian System  The Keynesian system is based on the principle of aggregate demand, which can be stated as follows: in the short period (that is, the time period in which productive capacity is fixed within narrow limits), real output and employment are determined by aggregate demand.  Aggregate demand (AE) is defined as total or aggregate spending for newly produced goods and services.

"My spending is your receipt" Let: AE denote aggregate demand or aggregate expenditure. Y is real output or real GDP. YD is real disposable income.  For a closed economy without a public sector, the following must be true: AE  Y  YD [1]

The income-expenditure line AE AE = Y Income-expenditure line 450 Real Output = Real Income (Y)

The aggregate demand function  The aggregate demand or aggregate expenditure function (AE) reveals the plans of spending units at alternative levels of real income  In a closed economy with no public sector: AE = C + I [2]  Thus, developing a theory of aggregate demand logically begins with a theory of consumption and a theory of investment.

The consumption function Definitions: Autonomous consumption (C a) : Consumption spending determined independent of income. Ave. propensity to consume (APC):Ratio of consumption to real disposable income (YD). That is: APC = C/YD Marginal propensity to consume (MPC= c) : The change in consumption resulting from a one unit change in disposable income. That is : MPC =c= C/YD. Ave. propensity to save (APS): Ratio of saving to real disposable income. That is: APC = S/YD. Marginal propensity to save (MPS): The change in saving resulting from a one unit change in disposable income. That is: MPS =S/YD.

The consumption function, slide 2  The consumption function can be expressed mathematically by: C =C a + cYD [3]  The fundamental psychological law of consumption can be stated as follows: People are disposed, as a rule and on average, to increase their consumption when their income increases; but not by as much as the increase in income. Thus, we can say: 0 < c < 1

The MPC and the MPS The consumption function is given by: C = 30 + .7YD

The consumption function C = YD C = 30 + .7YD 300 S 240 C/YD = 1 YD C 100 30 100 300 YD

Slope of the consumption function Slope = C/YD = 70/100 = .7 C = 30 + .7YD 310 C 240 YD 100 30 300 400 100 YD

The slope of the saving function is given by MPS S = -30 + .3YD 30 200 YD 100 -30

Shifts of the consumption function The function could shift due to: C C2 C1 A change in household wealth A change in consumer confidence. Change in price or availability of credit. C0 YD