1 of 17

1
Keynesian Economics
Principles of Economics Econ101
2
In This Lecture.

• Keynes on Says Law
• Keynes on Wage Rates and Prices
• Consumption Function
• Equilibrium Real GDP and Gaps
• The Expenditure Multiplier

3
The Simple Keynesian Model

• Assumptions
• First, the price level is assumed to be constant
  until the economy reaches its full-employment or
  Natural Real GDP level.
• Second, there is no foreign sector. In other
  words, the model represents a closed economy, not
  an open economy. It follows that total spending
  in the economy is the sum of consumption,
  investment, and government purchases (GDPCIG).
• Third, the monetary side of the economy is
  excluded.

4
Keyness View of Says Law in a Money Economy
According to Keynes, a decrease in consumption
and subsequent increase in saving may not be
matched by an equal increase in investment. Thus,
a decrease in total expenditures may occur.
5
The Economy Gets Stuck in a Recessionary Gap

• If the economy is in a recessionary gap at point
  1, Keynes held that wage rates may not fall.
• The economy may be stuck in the recessionary gap.

6
A Question of How Long It Takes for Wage Rates
and Prices to Fall

• Suppose the economy is in a recessionary gap at
  point 1.
• Wage rates are 10 per hour, and the price level
  is P1.
• The issue may not be whether wage rates and the
  price level fall, but how long they take to reach
  long-run levels

(continued)
7
A Question of How Long It Takes for Wage Rates
and Prices to Fall

• If they take a short time, then classical
  economists are right the economy is
  self-regulating.
• If they take a long timeperhaps yearsthen
  Keynes is right the economy is not
  self-regulating over any reasonable period of time

8
Self-Test

• 1. What do Keynesians mean when they say the
  economy is inherently unstable?
• Keynesians mean that an economy may not
  self-regulate at Natural/Potential Real GDP (QN).
  Instead, an economy can get stuck in a
  recessionary gap.
• 2. What matters is not whether the economy is
  self-regulating or not, but whether prices and
  wages are flexible and adjust quickly. Comment.
• To say that the economy is self-regulating is
  the same as saying that prices and wages are
  flexible and adjust quickly. They are just two
  ways of describing the same thing.

9
The Consumption Function

• Consumer spending depends upon disposable
  income......where, disposable income is national
  income minus taxes plus transfers

• Keynes Two Assertions About Consumption
• As disposable income rises, the amount spent by
  consumers also rises.
• As disposable income rises, the percent of
  disposable income spent falls..also known as the
  average propensity to consume.

10
Calculating the Consumption Function
Disposable Income Consumption
Savings 0
1000 -1000 1000
1800 -
800 2000
2600 - 600 3000
3400 -
400 4000
4200 - 200 5000
5000
0 6000
5800 200 7000
6600
400 8000
7400 600 9000
8200
800 10,000
9000 1000
Average Propensity to Consume Consumption

Disposable Income So.as disposable
income rises, consumption rises and the average
propensity to consume falls. Marginal
Propensity to Consume Change in
Consumption
Change in
Disposable Income
11
Equilibrium Real GDP and Gaps

• Equilibrium Real GDP occurs when aggregate
  demand is equal to aggregate supply.

Real GDP ( Income) Consumption
Business Investment Aggregate

Spending
Demand 0
1000 400
1400 1000
1800
400 2200
2000 2600
400
3000 3000
3400 400
3800 4000
4200
400 4600
5000 5000
400
5400 6000
5800 400
6200 7000
6600
400 7000
8000 7400
400
7800 9000
8200 400
8600 10,000
9000
400 9400 11,000
9800
400 10,200
12,000 10,600
400
11,000 13,000
11,400 400
11,800 14,000
12,200
400 12,600 15,000
13,000
400 13,400
Unintended Inventory Investment falls
Unintended Inventory Investment rises
12
Equilibrium Real GDP and Gaps

• Recessionary Gap
• if equilibrium real GDP is below potential real
  GDP
• Inflationary Gap
• if equilibrium real GDP is above potential real
  GDP
• According to Keynes, if nothing is done to
  correct gaps, they will continue indefinitely.

13
The Multiplier Effect

• The number that is multiplied by the change in
  initial spending to obtain the overall change in
  total spending.
• The multiplier is equal to 1 / (1 - MPC).
• Change in total spending Multiplier x Change in
  initial spending
• The basic principle of the multiplier is that one
  persons spending generates another persons
  income through a series of induced consumption.

14
The Expenditure Multiplier at Work

• Initial rise in autonomous spending 1000
• Marginal Propensity to Consume .80
• Multiplier 1/(1-.80) 1/.2 5
• Change in total spending 5 x 1000 5000
• Multiplier likely to be smaller

15
Self-Test

• 1. If the MPC 0.70, what does the multiplier
  equal?
• 1/(1- 0.70) 1/0.30 3.33.
• 2. What happens to the multiplier as the MPC
  falls?
• The multiplier falls. For example, if MPC
  0.20, then the multiplier is 1.25, but if MPC
  0.80, then the multiplier is 5.

16
The Multiplier and Aggregate Demand

• An initial increase in autonomous consumption
  raises total spending and shifts the aggregate
  demand curve from AD1 to AD2.
• Because of the multiplier, the increase in
  autonomous spending generates additional incomes
  and additional spending, shifting the aggregate
  demand curve to AD3.

17
The Theme of the Simple Keynesian Model

• The private sector may not be able to get the
  economy out of a recessionary gap. In other
  words, the private sector (households and
  businesses) may not be able to increase C or I
  enough to get the AD curve in to intersect the AS
  curve at the Natural/Potential Level of Real GDP.

The government may have a management role to play
in the economy. According to Keynes, government
may have to raise aggregate demand enough to
stimulate the economy to move it out of the
recessionary gap and to its Natural/Potential
Real GDP level.