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

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

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

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

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

6 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

7 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

8 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

9 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

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

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

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

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

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

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

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

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

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

19 MPC =  C  Y d

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

21 MPS =  S  Y d

22 MPC + MPS = 1

The Consumption Function 10 Dissaving Saving C Real Consumption Trillions of $ per year Real Disposable Income Trillions of $ per year CC YdYd 45° C = Y d

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

The Consumption Function 10 C1C1 Real Consumption Trillions of $ per year Real Disposable Income Trillions of $ per year 45° MPC =.50 MPC =.75 C2C2 C = Y d

The Consumption Function 10 Real Consumption Trillions of $ per year Real Disposable Income Trillions of $ per year C 1 = a 1 + bY d C 2 = a 2 + bY d A B  real consumption  nonincome determinant

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

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

29 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

30 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

31 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

32 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

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

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

35 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

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

37 16% 12% 8% 4% Real investment Interest rate A B Investment Demand Curve Movement along the firm’s investment demand curve

38 16% 12% 8% 4% Interest rate C B Shift in the firm’s investment demand curve I1I1 I2I2 Real investment

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

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

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

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

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

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

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

46 8% 6% 4% 2% % 12% 14% 16% Autonomous investment A Aggregate Investment Demand Curve Interest Rate Real Investment

Autonomous investment Aggregate Autonomous Investment Demand Curve Real Disposable Income trillions of dollars per year

48 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 AE C C + I E Real Disposable Income trillions of dollars per year

50 Key Concepts

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

52 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?What happens if factors other than income change?

53 Key Concepts cont. Why does the consumption function shift? According to the Classical economists, what determined the level of investment?According to the Classical economists, what determined the level of investment? According to Keynes, what determines 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?

54 Summary

55 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.

56 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.

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

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

59 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.

The Consumption Function 10 Dissaving Saving C Real Consumption Trillions of $ per year Real Disposable Income Trillions of $ per year CC YdYd 45° C = Y d

61 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.

62 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.

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

64 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.

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

66 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.

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

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

Aggregate Expenditures Schedule and Function AE C C + I E Real Disposable Income trillions of dollars per year

70 Chapter 18 Quiz ©2002 South-Western College Publishing

71 1. The French classical economist Jean Baptiste Say transformed the equality of production and spending into a law that can be expressed as follows: a. The invisible hand creates its own supply. b. Wages always fall to the subsistence level. c. Supply creates its own demand. d. Aggregate output does not always equal consumption. C. Says law was developed in the early 1800s and is the cornerstone of classical economics.

72 2. Autonomous consumption is a. positively related to the level of consumption. b. negatively related to the level of consumption. c. positively related to the level of disposable income. d. independent of the level of disposable income. D. Autonomous consumption is the amount of spending from savings or borrowing that occurs even when disposable income is zero.

73 3. The consumption function represents the relationship between consumer expenditures and a. interest rates. b. saving. c. the price level. d. disposable income. D. Keynes argued the most important determinant of aggregate spending for consumer goods is personal income after taxes.

74 4. John Maynard Keynes’s proposition that a dollar increase in disposable income will increase consumption, but by less than the increase in disposable income, implies a marginal propensity to consume that is a. greater than or equal to one. b. equal to one. c. less than one, but greater than zero. d. negative. C. Each dollar change in disposable income is divided between changes in consumption and saving.

75 5. Above the break-even disposable income for the consumption function, which of the following occurs? a. Dissaving. b. Saving. c. Neither (a) nor (b). d. Both (a) and (b). B. Dissaving occurs below the break- even point on the consumption function.

The Consumption Function 10 Dissaving Saving C Real Consumption Trillions of $ per year Real Disposable Income Trillions of $ per year CC YdYd 45° C = Y d

77 6. Which of the following changes produces an upward shift in the consumption function? a. An increase in consumer wealth. b. A decrease in consumer wealth. c. A decrease in autonomous consumption. d. Both (b) and (c). A. Decreases in wealth and autonomous consumption shift the consumption function downward.

The Consumption Function 10 C Real Consumption Trillions of $ per year Real Disposable Income Trillions of $ per year 45° MPC =.50 MPC =.75 C2C2 C = Y d

79 7. An upward shift in the consumption schedule, other things being equal, could be caused by households a. becoming optimistic about the state of the economy. b. becoming pessimistic about the state of the economy. c. expecting future income and wealth to decline. d. none of the above. A. If consumers expect good economic ties ahead, they increase spending at each level of disposable income in the current time period.

80 8. The investment demand curve represents the relationship between business spending for investment goods and a. GDP. b. interest rates. c. disposable income. d. saving. B. As the interest rate declines, more business investment projects become profitable and investment spending increases.

81 9. Which of the following changes produces a leftward shift in the investment demand curve? a. A wave of optimism about future profitability. b. Technological change. c. High plant capacity utilization. d. An increase in business taxes. D. An increase in business taxes decreases after-tax profits on investment projects and businesses invest less at various possible interest rates.

82 16% 12% 8% 4% Interest rate C B Shift in the firm’s investment demand curve I1I1 I2I2 Real investment

The aggregate expenditures function (AE) represents which of the following? a. The consumption function only. b. Autonomous consumption only. c. The investment demand curve only. d. All three of the above combined. e. A combination of (a) and (c). D.

Exhibit 11 Aggregate Expenditures Schedule and Function AE C C + I E Real Disposable Income trillions of dollars per year

In Exhibit 11, what is the households’ marginal propensity to consume (MPC)?Exhibit 11 a. 0.5 b c d B. MPC is the change in consumption divided by the change in income. In this case, the change in consumption to income is two to three, or 0.67.

In Exhibit 11, aggregate income will equal consumption plus investment and the economy will be in equilibrium when real disposable income isExhibit 11 a. $2.33 trillion. b. $3 trillion. c. $7 trillion. d. $10 billion. C. The AE curve crosses the 45 degree line at $7 trillion.

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