The Keynesian ModelThe Keynesian Model(a.k.a.—demand-side stabilization (a.k.a.—demand-side stabilization

policy)policy)

The model is a response to high The model is a response to high unemployment during the Great unemployment during the Great DepressionDepression

The goal of the policy is to increase The goal of the policy is to increase or decrease demand using govt. or decrease demand using govt. spending and taxationspending and taxation

Increased demand = increased GDP Increased demand = increased GDP = lower unemployment= lower unemployment

GDP and UnemploymentGDP and Unemployment

If unemployment follows GDP; how If unemployment follows GDP; how can we manage GDP?can we manage GDP?

Keynes believed that any instability Keynes believed that any instability in any GDP would result in in any GDP would result in undesirable fluctuationsundesirable fluctuations

Keynes looked at what was the most Keynes looked at what was the most unstable sector of GDPunstable sector of GDP

GDP= C + I + G + XnGDP= C + I + G + Xn

Xn or F (foreign sector)—was seen as Xn or F (foreign sector)—was seen as being too small to have an impactbeing too small to have an impact

G—Government sector is relatively G—Government sector is relatively stable over time (they set budgets)stable over time (they set budgets)

C—Consumer sector is even more C—Consumer sector is even more stable (wages are generally stable)stable (wages are generally stable)

I—Investment sector seemed to be I—Investment sector seemed to be the most unstable. Why?the most unstable. Why?

Changes in stockChanges in stock

Fiscal PolicyFiscal Policy

Keynes felt that only the government Keynes felt that only the government was large enough to offset any was large enough to offset any fluctuations in the investment sectorfluctuations in the investment sector

The government could use two tools:The government could use two tools:• Spending cuts/increasesSpending cuts/increases• Tax cuts/increasesTax cuts/increases

Income vs. ConsumptionIncome vs. Consumption

We can say We can say that real GDP that real GDP is = to Yd is = to Yd because an because an income was income was received as a received as a result of the result of the production of production of those goods those goods and servicesand services

Income vs. ConsumptionIncome vs. Consumption

The model shows The model shows us how much we us how much we consume at consume at various levels of various levels of incomeincome

Income vs. ConsumptionIncome vs. Consumption

The economy is The economy is most efficient most efficient when all of our when all of our income is spent income is spent (the red, 45 (the red, 45 degree line)degree line)

Income vs. ConsumptionIncome vs. Consumption

The intersection The intersection of the two curves of the two curves shows the level shows the level of productivity of productivity that is ideal for that is ideal for the economythe economy

Keynes would Keynes would use fiscal policy use fiscal policy to target this to target this level of GDPlevel of GDP

Income-Consumption and Income-Income-Consumption and Income-Savings RelationshipSavings Relationship

Savings is always (Yd) income – Savings is always (Yd) income – consumptionconsumption• Therefore S+C=1Therefore S+C=1

APC—Average propensity to consumeAPC—Average propensity to consume• Tells us what percentage of our disposable Tells us what percentage of our disposable

income is spentincome is spent

APC=APC=IncomeIncome

ConsumptionConsumption

Income-Consumption and Income-Income-Consumption and Income-Savings RelationshipSavings Relationship

APS—Average propensity to saveAPS—Average propensity to save• Tells us what percentage of our Tells us what percentage of our

disposable income is saveddisposable income is saved

APS=APS=IncomeIncomeSavingSaving

Income-Consumption and Income-Income-Consumption and Income-Savings RelationshipSavings Relationship

MPC—Marginal propensity to consumeMPC—Marginal propensity to consume• It is the additional consumption spending from It is the additional consumption spending from

an additional dollar of incomean additional dollar of income• Tells us the change in consumption due to a Tells us the change in consumption due to a

change in incomechange in income

MPC=MPC=Change in incomeChange in income

Change in consumptionChange in consumption

Income-Consumption and Income-Income-Consumption and Income-Savings RelationshipSavings Relationship

MPS—Marginal propensity to saveMPS—Marginal propensity to save• Tells us the change in saving due to a Tells us the change in saving due to a

change in incomechange in income

MPS=MPS=Change in incomeChange in incomeChange in savingsChange in savings

The consumption functionThe consumption function

C= a + b x YdC= a + b x Yd• C=consumptionC=consumption• a=autonomous consumptiona=autonomous consumption• b=marginal propensity to consumeb=marginal propensity to consume• Yd=disposable incomeYd=disposable income

The relationship between interest The relationship between interest rates and investment (I)rates and investment (I)

A business will only invest if the A business will only invest if the marginal benefit is greater than the marginal benefit is greater than the marginal cost (paid in interest)marginal cost (paid in interest)

Investment demand curveInvestment demand curve• As interest (the price of borrowing $) As interest (the price of borrowing $)

goes up, investment demand goes downgoes up, investment demand goes down• As interest goes down, investment As interest goes down, investment

demand goes updemand goes up

Investment DemandInvestment Demand

Determinants that shift investment Determinants that shift investment demanddemand

Maintenance/Maintenance/operating costsoperating costs• A decrease in these A decrease in these

costs increase the costs increase the expected rate of expected rate of return on return on investment shifting investment shifting investment investment demand to the demand to the rightright

Determinants that shift investment Determinants that shift investment demanddemand

Business taxesBusiness taxes• Reductions in Reductions in

govt. taxes govt. taxes increases increases expected expected profitability of profitability of investments, investments, increasing increasing investment investment demanddemand

Determinants that shift investment Determinants that shift investment demanddemand

Technological Technological change change • stimulates stimulates

investmentinvestment Stock of Capital Stock of Capital

GoodsGoods ExpectationsExpectations

• Future sales, Future sales, operating costs, operating costs, profits, etc.profits, etc.

The Multiplier EffectThe Multiplier Effect When a change in spending changes GDP When a change in spending changes GDP

by more than the initial changeby more than the initial change• One person’s spending becomes another’s One person’s spending becomes another’s

incomeincome How much does a given change in How much does a given change in

spending impact GDP?spending impact GDP?• The multiplier of course!The multiplier of course!

Multiplier=Multiplier= Change in real GDPChange in real GDPInitial change in spendingInitial change in spending

The Multiplier Effect The Multiplier Effect (cont.)(cont.)

By rearranging the equation, we can By rearranging the equation, we can also say that:also say that:

Change in GDP=multiplier X Change in GDP=multiplier X initial change initial change in spendingin spending

The Multiplier Effect The Multiplier Effect (cont.)(cont.)

You can also find the multiplier if you know You can also find the multiplier if you know MPC:MPC:• Only for government and investment spendingOnly for government and investment spending

Multiplier = Multiplier = __________11__________

1 - MPC 1 - MPC

or or

MPS MPS Multiplier = Multiplier = ______11______

The Multiplier Effect The Multiplier Effect (cont.)(cont.)

The The tax multipliertax multiplier is used for is used for determining the impact of a tax on GDP determining the impact of a tax on GDP (it’s different from the investment and (it’s different from the investment and government spending multipliers):government spending multipliers):

Tax multiplier=Tax multiplier=[1-MPC][1-MPC]__-MPC____-MPC__

oror

Tax multiplier=Tax multiplier= -MPC-MPCMPSMPS