CHAPTER 10

Keynes's View of Say's Law in a Money Economy

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.

Aggregate demand depends

on C, consumption; I, investment; and G, government purchases.

Consumption depends

on disposable income.

Keynes suggested that anticompetitive

or monopolistic elements in the economy sometimes prevent price from falling.

An initial increase in autonomous consumption

raises total spending and shifts the aggregate demand curve from AD1 to AD2.

If the economy is operating below Natural Real GDP

, then the multiplier turns out to be the number that is multiplied by the change in autonomous spending to obtain the change in Real GDP

Keynes on Savings and Investment

1) Saving is more responsive to changes in income than to changes in the interest rate 2) Investment is more responsive to technological changes, business expectations, and innovations than to changes in the interest rate.

3. An economist who believes the economy is self-regulating is more likely to advocate laissez- faire than an economist who believes the economy is inherently unstable. Do you agree or disagree? Explain your answer.

Agree. The economist who believes the economy is inherently unstable sees a role for government. Government is supposed to stabilize the economy at Natural Real GDP. The economist who believes the economy is self-regulating (capable of moving itself to Natural Real GDP) sees only a small, if any, role for government in the economy because the economy is already doing the job government would supposedly do.

Classical Economists x Investment

Amount invested is inversely related to interest rate. Business invest more at lower interest rates and invest less at higher interest rates

Classical Economists + Savings

Amount saved and interest rate are directly related. Savers save more at higher interest rates and save less at lower interest rates

C0 -

Autonomous consumption - The part of consumption that is independent of disposable income.

How is autonomous consumption different from consumption?

Autonomous consumption is one of the components of overall consumption. To illustrate, look at the consumption function: C = C0 +(MPC)(Yd). The part of overall consumption (C ) that is autonomous is C0. This part of consumption does not depend on disposable income.

C=

C0 + (MPC) (Yd).

Saving =

Disposable Income less Consumption

Yd -

Disposable income - Income received less taxes.

2. What will happen to real GDP if autonomous spending rises and the economy is operating at the horizontal section of Keynesian AS curve? Explain your answer.

The increase in autonomous spending will lead to a greater increase in total spending and to a shift rightward in the AD curve. If the economy is operating in the horizontal section of the Keynesian AS curve, Real GDP will rise, and there will be no change in prices.

The Simple Keynesian Model

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 (GDP=C+I+G). Third, the monetary side of the economy is excluded.

Classical Economists x Prices + Wages

Flexible

Classical Economists + Say's Law:

Holds in a money economy. In other words, all output produced will be demanded

Keynes x Investment

If expectations are pessimistic, a lower interest rate may not stimulate additional investments

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.

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 time—perhaps years—then Keynes is right: the economy is not self-regulating over any reasonable period of time

Can the Private Sector Remove the Economy from a Recessionary Gap?

Keynes believed that sometimes it could not. No matter how low interest rates fell, investment spending would not rise because of pessimistic business expectations with respect to future sales.

What was Keynes's position with respect to the self-regulating properties of an economy?

Keynes believed that the economy may not always self regulate itself at Natural Real GDP. In other words, households and businesses (the private sector of the economy) are not always capable of generating enough aggregate demand in the economy so that the economy equilibrates at Natural Real GDP.

Keynes Challenged Classical Macroeconomics

Keynes challenged all four of the following classical position beliefs: (1) Say's law holds, so that insufficient demand in the economy is unlikely. (2) Wages, prices, and interest rates are flexible. (3) The economy is self-regulating. (4) Laissez-faire is the right and sensible economic policy.

What do Keynesians mean when they say the economy is inherently unstable?

Keynesians mean that an economy may not self-regulate at Natural Real GDP (QN). Instead, an economy can get stuck in a recessionary gap.

MPC -

Marginal propensity to consume - The ratio of the change in consumption to the change in disposable income:

Keynes x Prices + Wages

May be inflexible downward

Change in total spending =

Multiplier x Change in autonomous spending

Keynes + Say's Law

Savers may not save more at higher interest rates or save less at lower interest rates. If savers have a savings goal in mind, then a higher interest rate means savers can save less and still reach their goal

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

The issue may not be whether wage rates and the price level fall, but how long they take to reach long-run levels.

Can the Private Sector Remove the Economy from a Recessionary Gap?

The economy is at point A producing Q1. Q1 is less than QN, so the economy is in a recessionary gap.

Keynes on Wages

The labor market may adjust slowly. In particular, a lowered demand for labor may not be met with a declining wage rate. Wage rates might be inflexible downward (at least for some time). If wage rates are inflexible downward, then the self-regulating properties of an economy are in question. Specifically, an economy might get stuck in a recessionary gap.

3. According to Keynes, why might aggregate demand be too low?

The main reason is that Say's law may not hold in a money economy. The question is why doesn't Say's law hold in a money economy? Keynes argued that an increase in saving (which leads to a decline in demand) does not necessarily bring about an equal amount of additional investment (which would lead to an increase in demand), because neither saving nor investment is exclusively affected by changes in the interest rate.

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.

Multiplier

The number that is multiplied by the change in autonomous spending to obtain the overall change in total spending.

How is autonomous consumption different from consumption?

The part of consumption that does depend on disposable income (i.e., the part that changes as disposable income changes) is the (MPC )(Yd) part.

The Simple Keynesian Model

The price level is constant until Natural Real GDP is reached. 2. The TE curve shifts if there are changes in C, I, or G. 3. It is possible for the economy to be in equilibrium and in a recessionary gap too.The private sector may not be able to get the economy out of a recessionary gap. 5. The government may have a management role to play in the economy. 6. According to Keynes, government may have to raise TE enough to stimulate the economy out of the recessionary gap and move it to its Natural Real GDP level.

The multiplier,

m = 1 / (1 - MPC).

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.

C -

Total consumption

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 Level of Real GDP.

1. What happens in the economy if total production (TP ) is greater than total expenditures (TE )?

When TP is greater than TE, firms are producing and offering for sale more units of goods and services than households and government want to buy. As a result, business inventories rise above optimal levels. In reaction, firms cut back on their production of goods and services. This leads to a decline in Real GDP, which stops falling when TP equals TE.

Efficiency Wage Models

models that hold it is sometimes in the best interest of business firms to pay their employees higher-than-equilibrium wage rates.

Real GDP is determined by

aggregate demand and aggregate supply.

A cut in wages can

cause a decline in labor productivity, which in turn raises the firm's cost.

The price level is

constant until Natural Real GDP is reached.

When disposable income changes,

consumption changes by less (MPC).

In the consumption function,

consumption is directly related to disposable income and is positive even at zero disposable income:

By paying an above-equilibrium wage,

firms provide an incentive to workers to be productive and do less shirking among other things. If shirking declines, so do the monitoring (management) costs of the firm.

The AS curve in the simple Keynesian model is

horizontal until QN (Natural Real GDP) and vertical at QN.

Classical Economists on Savings and Investment

if consumption spending falls because saving increases, then total spending will not fall, because the added saving will simply bring about more investment spending. This will happen through changes in the interest rate. The added saving will put downward pressure on the interest rate, and at a lower interest rate businesses will borrow and invest more. Through changes in the interest rate, the amount of saving will always equal the amount invested.

According to Keynes, it is possible for the economy to be

in equilibrium and in a recessionary gap too.

Consumption and disposable income move

in the same direction. Yd ↑ C↑

Keynes said that the internal structure of an economy

is not always competitive enough to allow prices to fall.

Any changes in aggregate demand in

the horizontal section do not change the price level

Because of the multiplier,

the increase in autonomous spending generates additional incomes and additional spending, shifting the aggregate demand curve to AD3

Marginal propensity to save (MPS) is

the ratio of the change in saving to the change in disposable income:

The consumption function is

the relationship between consumption (household sector spending) and disposable income.

But any changes in aggregate demand in

the vertical section do change the price level.

The purpose of the simple Keynesian model is

to explain changes in Real GDP.

MPC =

ΔC / ΔYd.

MPS

ΔS / ΔYd