04 the keynesian model
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  • 1. Chapter 18The Keynesian Model • Key Concepts • Summary • Practice Quiz • Internet Exercises ©2000 South-Western College Publishing 1
  • 2. In this chapter, you will learn to solve these economic puzzles: Why did Keynes believeWhy did economists believe that “animal components What are the spirits” and the the Keynesian Cross? Great Depression was government policy were of important to maintain impossible? full employment? 2
  • 3. Who were theClassical Economists?The Classical economists believed that a continuing depression is impossible because markets will eliminate persistent shortages or surpluses 3
  • 4. When were the ideas ofthe Classical Economists widely accepted?Prior to the Great Depression of the 1930’s 4
  • 5. What is Say’s Law?The belief of the Classical Economists that the economy was always tending toward full employment 5
  • 6. What doesSay’s Law say?Supply creates its own demand 6
  • 7. 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
  • 8. Under Say’s Law, isUnemployment possible?Yes, but it is a short-lived adjustment period in which wages and prices decline or people voluntarily choose not to work 8
  • 9. What changed people’smind about Say’s Law?The Great Depression and the publication of The General Theory of Employment, Interest, and Money published in 1936 9
  • 10. Why did Keynes’ believe that “supply did notcreate its own demand”?Aggregate expenditures (demand) can be forever inadequate for an economy to achieve full employment 10
  • 11. What is the mainidea of this chapter?Keynes’s theory for the determination of consumption and investment expenditures 11
  • 12. What determines yourfamily’s Spending for Goods and Services? Disposable income 12
  • 13. What is theConsumption Function?The graph that shows the amount households spend for goods and services at different levels of disposable income 13
  • 14. What is Savings?Disposable income minus consumption, the amount households do not spend for consumer goods and services 14
  • 15. What is Dissaving?The amount by which personal consumption expenditures exceed disposable income 15
  • 16. How do people Dissave? Negative savings is financed by by drawing down previously accumulated financial assets or by borrowing 16
  • 17. What is Autonomous Consumption? Consumption that is independent of the level of disposable income 17
  • 18. What happens when Disposable Income is Zero?Spending will equal autonomous consumption because households will dissave to satisfy basic consumption needs 18
  • 19. What is the MarginalPropensity to Consume?The change in consumption resulting from a given change in real disposable income 19
  • 20. ∆CMPC = ∆ Yd 20
  • 21. What is MarginalPropensity to Save?The change in saving resulting from a given change in real disposable income 21
  • 22. ∆SMPS = ∆ Yd 22
  • 23. MPC + MPS = 1 23
  • 24. The Consumption Function8 C = Yd Trillions of $ per year Real Consumption7 C Dissaving65 ∆C43 ∆Yd Saving21 Real Disposable Income 45° Trillions of $ per year 1 2 3 4 5 6 7 8 9 10 24
  • 25. What happens if Factors other than Income change?There is a shift or relocation in the consumption schedule 25
  • 26. The Consumption Function8 C = Yd Trillions of $ per year C2 Real Consumption765 C143 MPC = .752 MPC = .501 Real Disposable Income 45° Trillions of $ per year 1 2 3 4 5 6 7 8 9 10 26
  • 27. The Consumption Function8 Trillions of $ per year C2 = a2 + bYd Real Consumption765 B ∆ nonincome determinant4 A3 C1 = a1 + bYd21 ∆ real Real Disposable Income Trillions of $ per year consumption 1 2 3 4 5 6 7 8 9 10 27
  • 28. Why does the Consumption Function Shift? • Expectations • Wealth • Price level • Interest rate • Stock of durable goods 28
  • 29. How do Expectations affectthe Consumption Function? Consumers expectations of things to happen in the future will affect their spending decisions today 29
  • 30. 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
  • 31. 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
  • 32. 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
  • 33. How does the Stock ofDurable Goods affect theConsumption Function?When durable goods are suppressed, like during WWII, afterwards there is an increase in the demand for goods not previously made available 33
  • 34. How does Consumptioncompare with Investment?Consumption is more stable than investment 34
  • 35. According to the Classical Economists,what determined the level of Investment? The interest rate 35
  • 36. 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
  • 37. What is the Investment Demand Curve?The curve that shows the amount businesses spend for investment goods at different possible rates of interest 37
  • 38. Movement along the firm’s investment demand curve Interest rate16% A Investment12% Demand Curve B8%4% Real investment 5 10 15 20 38
  • 39. Shift in the firm’s investment demand curve16% Interest rate12% C8% B I24% Real investment I1 5 10 15 20 39
  • 40. Why is Investment Demand unstable?• Expectations• Technological change• Capacity utilization• Business taxes• Autonomous reasons 40
  • 41. How do Expectations affect Investment?Businesspeople are quite susceptible to moods of optimism and pessimism 41
  • 42. How does Technologicalchange affect Investment? The introduction of new products and new ways of doing things have a big impact on investment decisions 42
  • 43. What happens whenCapacity Utilization is low? When capacity utilization is low, firms can meet an increase in demand without expanding 43
  • 44. What happens whenCapacity Utilization is high?When capacity utilization is high, firms must increase investment to meet an increase in demand 44
  • 45. How do Business Taxes affect Investment? Business decisions depend on the expected after-tax rate of profit 45
  • 46. What isAutonomous Expenditure?Spending that does not vary with the current level of disposable income 46
  • 47. 16% Aggregate Investment Interest Rate14% Demand Curve12%10% 8% A 6% Autonomous 4% investment 2% Real Investment .2 .4 .6 .8 1.0 1.2 1.4 1.6 47
  • 48. Aggregate Autonomous1.6 Investment Demand Curve1.41.21.0 .8 .6 Autonomous .4 investment .2 Real Disposable Income trillions of dollars per year 1 2 3 4 5 6 7 8 48
  • 49. What is the AggregateExpenditure Function?The function that represents total spending in an economy at a given level of real disposable income 49
  • 50. Aggregate Expenditures8 Schedule and Function7 AE E6 C5 C +I4321 Real Disposable Income trillions of dollars per year 1 2 3 4 5 6 7 8 50
  • 51. Key Concepts 51
  • 52. Key Concepts• Who were the Classical Economists?• When were the ideas of the Classical Economis• What is Say’s Law?• What does Say’s Law say?• Why did Keynes’ believe that “supply did not c• What determines your family’s Spending for G 52
  • 53. 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 chan 53
  • 54. Key Concepts cont.• Why does the Consumption Function Shift?• According to the Classical Economists, what dete• 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
  • 55. Summary 55
  • 56. Say’s Law is the classical theorythat “supply creates its own demand”and therefore the Great Depressionwas impossible. Say’s Law is thebelief that the value of productiongenerates an equal amount of incomeand, in turn, total spending. 56
  • 57. The classical economists rejectedthe challenge that underconsumptionis possible because they believedflexible prices, wages, and interestrates soon establish balance betweensupply and demand. 57
  • 58. John Maynard Keynes rejected theclassical theory that the economy selfcorrects in the long run to fullemployment. The key in Keynesiantheory is aggregate demand, ratherthan the classicals’ focus on aggregatesupply. Unless aggregate spending isadequate, the economy can experienceprolonged and severe unemployment. 58
  • 59. The consumption function (C)is determined by changes in thelevel of disposable income.Autonomous consumption isconsumption that occurs even ifdisposable income equals zero.Changes in such nonincomedeterminants as expectations,wealth, the price level, interest rates,and the stock of durable goodscause shifts in the consumptionfunction. 59
  • 60. The Consumption Function8 C = Yd Trillions of $ per year Real Consumption7 C Dissaving65 ∆C43 ∆Yd Saving21 Real Disposable Income 45° Trillions of $ per year 1 2 3 4 5 6 7 8 9 10 60
  • 61. The marginal propensity toconsume (MPC) is the change inconsumption associated with a givenchange in disposable income. The MPCtells how much of an additional dollarof disposable income households willspend for consumption. 61
  • 62. The marginal propensity to save(MPS) is the change in savingassociated with a given change indisposable income. The MPSmeasures how much of an additionaldollar of disposable incomehouseholds will save. 62
  • 63. The investment demand curve(I) shows the amount businessesspend for investment goods atdifferent possible rates of interest.The determinants of this scheduleare the expected rate of profit andrate of interest. Shifts in theinvestment demand curve resultfrom expectations, technologicalchange, capacity utilization, andbusiness taxes. 63
  • 64. An autonomous expenditure isspending that does not vary with thecurrent level of disposable income.The Keynesian model applies thissimplifying assumption toinvestment. As a result, theinvestment demand curve is a fixedamount determined by the rate ofprofit and the interest rate. 64
  • 65. The aggregate expendituresfunction (AE) shows the totalspending in an economy at a givenlevel of disposable income.Assuming investment spending isautonomous, the slope of the AEfunction is determined by the MPC. 65
  • 66. Aggregate Expenditures8 Schedule and Function7 AE E6 C5 C +I4321 Real Disposable Income trillions of dollars per year 1 2 3 4 5 6 7 8 66
  • 67. Chapter 18 Quiz ©2000 South-Western College Publishing 67
  • 68. 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. 68
  • 69. 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. 69
  • 70. 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. 70
  • 71. 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. 71
  • 72. 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. 72
  • 73. The Consumption Function8 C = Yd Trillions of $ per year Real Consumption7 C Dissaving65 ∆C43 ∆Yd Saving21 Real Disposable Income 45° Trillions of $ per year 1 2 3 4 5 6 7 8 9 10 73
  • 74. 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. 74
  • 75. The Consumption Function8 C = Yd Trillions of $ per year C2 Real Consumption765 C43 MPC = .752 MPC = .501 Real Disposable Income 45° Trillions of $ per year 1 2 3 4 5 6 7 8 9 10 75
  • 76. 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. 76
  • 77. 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. 77
  • 78. 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. 78
  • 79. Shift in the firm’s investment demand curve16% Interest rate12% C8% B I24% Real investment I1 5 10 15 20 79
  • 80. 10. 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. 80
  • 81. Exhibit 118 Aggregate Expenditures7 Schedule and Function AE E6 C5 C +I4321 Real Disposable Income trillions of dollars per year 1 2 3 4 5 6 7 8 81
  • 82. 11. In Exhibit 11, what is the households’ marginal propensity to consume (MPC)? a. 0.5. b. 0.67. c. 0.75. d. 0.80.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. 82
  • 83. 12. In Exhibit 11, aggregate income will equal consumption plus investment and the economy will be in equilibrium when real disposable income is 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. 83
  • 84. Internet ExercisesClick on the picture of the book, choose updates by chapter for the latest internet exercises 84
  • 85. END 85