Lecture V Flashcards
Assuming the Keynesian Model
What was the condition for equilibrium in the Keynesian Model?
The simple Keynesian model hypothesised that equilibrium required aggregate supply
(output, Y) to be equal to aggregate demand (E).
Y = E
Assuming that the economy is closed with no imports or exports, aggregate demand
(E) consists of three components: consumption (C), investment (I), and government purchases (G). So in equilibrium we have:
Y = C + I + G
Recalling some of the simplification to national income accounts discussed in the first week of lectures, we know that we can define Y as both national income and national product. Defining Y as national product implies that:
Y ≡ C + Ir + G
What is the importance of investment and REAL investment in the Keynesian Model?
A firm will plan to have a
certain quantity of goods in inventory at the end of the year, but unexpectedly high or low sales may leave them with more or less inventory than the management had planned. So in equilibrium, it must be that:
C + I + G = Y ≡ C + Ir + G
Or that there are no unplanned changes in inventories:
I = Ir
What are the three ways of stating equilibrium?
The three ways of stating equilibrium are:
Y = E = C + I + G (aggregate demand equals aggregate supply) I + G = S + T (government spending and investment must be paid for by savings and taxes) I = Ir (no unexpected changes in inventory) Note that in this model it is aggregate demand (C + I + G) driving aggregate supply—the reverse of the Classical model and Say’s Law.
Consumption in aggregate demand for the Keynesian Model.
Consumption:
Unlike classical loanable funds theory which argued that interest rates drove savings
and consumption, Keynes argued that consumer expenditures was a stable function of disposable income, where disposable income (YD) is the difference between national income and taxes (Y – T). Keynes proposed the following consumption function:
C = a + b YD a > 0, 0 < b < 1
Or:
C = a + b(Y – T)
Describe the Saving Function in the Keynesian Model.
Recall that disposable income can be divided into consumption or savings:
YD = Y – T = C + S
Or
S = YD – C
Substituting for C yields:
S = YD – (a + b YD)
S = -a + (1 – b)YD
Why is the intercept of the savings function (-a)? Because remember that if disposable
income is zero, consumption is a. So people are therefore dissaving a, and saving is negative at zero income.
What is the Average Propensity to Consume (APC)?
The Keynesian consumption function therefore does not show a proportional relationship between consumption and income because of the autonomous consumption (a) term.
The ratio of consumption to income is given by the average propensity to consume (APC): Consumption reacts to actual current income. Any change in current disposable income will yield a change in consumption.
APC is therefore greater than the MPC and decreases as disposable income increases, just as Keynes’ statement above implies. This Keynesian consumption function is also known as the absolute income hypothesis.
What did Keynes list as the two major sources of change in investment?
Keynes listed two sources of changes in investment. The first, as in the classical
model, is the interest rate (MC of investment). Keynes also expected a negative relationship
between investment and the interest rate
Is it true that factors other than current income (Y) can influence investment?
Yes, current income (Y) does influence
investment—it is driven by expectations of future income. Therefore, we can take
investment as exogenous for now in our calculation of national income. The investment function for now will just be I, and it is independent of the current level of income. However, it is fundamentally volatile and can suddenly change.
What is the equilibrium output in the Keynesian Model?
Recall that equilibrium is where aggregate demand and aggregate supply are equal:
Y = C + I + G
Y is the endogenous variable we are trying to calculate. I and G, as well as T, are determined
exogenously, as well as the autonomous part of consumption, a. The other component of
consumption is income-induced expenditure which is dependent on the level of income.
Recalling that we defined consumption as:
C = a + b(Y – T)
Describe the Multiplier Effect.
Y = [1/(1 – b)] [(a – bT + I + G)]
For example, the investment multiplier is ∂Y/∂I = 1/(1 – b), which is 1/MPS. If MPC
(b) is 0.8, then MPS is 0.2. Therefore, the value of the multiplier is 1/(0.2) = 5. A $1
increase in investment increases income by $5. Since Y = C + I + G, and Y has increased by
$5, the right-hand side of the equation must also increase by $5 to maintain equilibrium
What happens to the equation I + G = S + T under the Multiplier Effect?
Therefore, when income increased by $5, consumption increased by
$4. The other 20% of the increased income $1) was saved—and channelled to investment, hence the original $1 increase in investment! Now our equation is in balance and equilibrium is attained. This result must be true because of the one of the other conditions for equilibrium:
I + G = S + T
Since nothing has happened to G or T, the increase in investment must be matched by
an increase in savings. Therefore, this $1 increase in investment has increased income by $5, consumption by $4, and savings by $1.
What was Keynes’ stance on fiscal policy and government intervention in the market?
We have established that fiscal policy—changes in taxes and government spending—can indeed influence aggregate demand and output in the Keynesian economy. Keynes argued that the government not only could influence output, but that it would be necessary to use policy to smooth out the fluctuations in aggregate demand that are caused by volatile investment.
What is the Life Cycle Hypothesis?
The life cycle theory suggests consumption depends on expected lifetime earnings, leading to consumption smoothing. During low-income periods like student years, people dis-save to maintain consumption, while during high-income periods, they save for retirement. Consumption may remain constant or gradually increase over time, but the goal remains consumption smoothing. Therefore, during each period t, he consumes 1/T of his expected lifetime resources. Further assume that the person wants to leave no bequest for his heirs; he wants to spend the total amount of his current wealth and future earnings.
