econ chapter 10

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.

The Simple Keynesian Model As portrayed in terms of Total Expenditure and Total Production, the essence of the simple Keynesian model is:

1. 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. 4. 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. 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.

If the MPC = 0.70, what does the multiplier equal?

1/(1- 0.70) = 1/0.30 =3.33.

Keynes's View of Say's Law in the 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.

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.

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. 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. For example, assume the MPC = 0.80. If Yd rises by $1,000, then consumption goes up by $800.

Consumption Function II

C= C0 + (MPC) (Yd)

In the consumption function, consumption is directly related to disposable income and is positive even at zero disposable income:

C= C0 + (MPC) (Yd).

Consumption Function III

Consumption depends on disposable income. Consumption and disposable income move in the same direction. Yd ↑ C↑ When disposable income changes, consumption changes by less (MPC).

Saving =

Disposable Income less Consumption

Yd -

Disposable income - Income received less taxes.

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

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.

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.

Marginal propensity to save (MPS) is the ratio of the change in saving to the change in disposable income:

MPS ΔS / ΔYd

MPC -

Marginal propensity to consume - The ratio of the change in consumption to the change in disposable income: MPC = ΔC / ΔYd.

Change in total spending =

Multiplier x Change in autonomous spending

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

Consumption Function I

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

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.

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).

. 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.

Simple Keynesian Model I

The price level is constant until Natural Real GDP is reached. The AD curve shifts if there are changes in C, I, or G. According to Keynes, it is possible for the economy to be in equilibrium and in a recessionary gap too.

Simple Keynesian Model II

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. The government may have a management role to play in the economy. it to its Natural Real GDP level.

"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

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

When TE is greater than TP, households and businesses want to buy more than firms are producing and offering for sale. As a result, business inventories fall below optimal levels. In reaction, firms increase their production of goods and services. This leads to a rise in Real GDP which stops rising when TP equals TE.

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.

Keynes said that the internal structure of an economy is not always competitive enough to allow prices to

fall.

Keynes suggested that anticompetitive or monopolistic elements in the economy sometimes prevent price from

falling.

The multiplier (m)

is equal to 1 / (1 - MPC).

Efficiency Wage Models are

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

If wage rates are inflexible downward, then the self-regulating properties of an economy are in question. Specifically, an economy might get stuck in

recessionary gap.

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

Keynes held that saving is more responsive to changes in income than to changes in the interest rate and that investment is more responsive to

technological changes, business expectations, and innovations than to changes in the interest rate.

A cut in wages can cause a decline in labor productivity, which in turn raises

the firm's cost.

According to classical economists and Say's law, 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.