Econ Chapter 10 - Keynesian Macroeconomics and economic instability: A critique of the self-regulated economy

Since Disposable Income (Yd) can only change Saving (S) or Consumption (C), the Marginal Propensity to Consume (MPC) and the Marginal Propensity to Save (MPS) must?

must always equal 1. MPC+MPS= 1 Note: Exhibit 6 on page 228 illustrates: MPC of 0.80 + MPS of 0.20 = 1

The Total Production (TP) curve: (Page 239, real easy, understand this graph and draw it)

- TP curve, which is simply a 45-degree line. (It is called a 45- degree line because it bisects the 90-degree angle at the origin.) - It is important to notice that at any point on the TP curve, total production is equal to Real GDP (TP Real GDP). - This is because TP and RealGDP are different names for the same thing

The greek symbol delta Δ stands for

"change in"

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.

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

The Multiplier and Aggregate Demand (page 231-232) draw and understand this graph

- An initial increase in autonomous consumption raises total spending and shifts the aggregate demand curve from AD1 to AD2. - Because of the multiplier, the increase in autonomous spending generates additional incomes and additional spending, shifting the aggregate demand curve to AD3.

Can private sector spending (consumption and investment) move the economy from the recessionary gap by increasing spending enough to shift the aggregate demand curve rightward to go through point B? (page 233) understand the graph

- 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.

Keynes on Savings and Investment

- Keynes held that saving is more responsive to changes in income than to changes in the interest rate, and - Investment is more responsive to technological changes, business expectations, and innovations than to changes in the interest rate.

Keynesian Aggregate Supply Curve Page 232) draw and understand the graph

- The AS curve in the simple Keynesian model is horizontal until QN (Natural Real GDP) and vertical at QN. - Any changes in aggregate demand in the horizontal section do not change the price level, but any changes in aggregate demand in the vertical section do change the price level.

Natural Real GDP

- The Real GDP that is produced at the natural unemployment rate. - The Real GDP that is produced when the economy is in long run equilibrium.

Keynes on Wages (page 220)

- 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). (workers won't accept less wages) - 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.

The multiplier is

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

Real GDP

- The value of the entire output produced annually within a country's borders, adjusted for price changes (inflation).

Example of Keynes critique of Say's law

- Total Expenditure is $5,000 - If Consumption goes down $100, then Savings will go up $100. - However, everyone do not always choose to invest $100, they might only want to invest $40 - That will bring the Total Expenditure down to $4,960, less than the previous $5,000.

The Economy: In Equilibrium, and in a Recessionary Gap, Too. (page 240 graph, understand and draw it)

- Using the TE-TP framework, the economy is currently in equilibrium at point A, producing QE. - Natural Real GDP, however, is greater than QE, so the economy is in a recessionary gap as well as being in equilibrium.

Concerning prices, Keynes said that the internal structure of an economy is not

- always competitive enough to allow prices to fall.

Concerning prices, Keynes suggested that anticompetitive or monopolistic elements in the economy sometimes

- prevent price from falling.

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.

Marginal propensity to save (MPS) is

- the ratio of the change in saving to the change in disposable income Marginal Propensity to save= Change in Saving/Change in Disposable Income MPS = ΔS / ΔYd

Government's role in the economy

- unlike the classical economists, Keynes did not believe that the economy was self-regulating, and that economic instability is a possibility. - the economy could get stuck in a recessionary gap. - According to Keynes, if the private sector cannot self-regulate the economy at its Natural Real GDP level, then maybe government must help.

Example of MPC

-consumption rises from $800 to $900, as disposable income rises from $1,000 to $1,200. -the $100 change in consumption is divided by the $200 change in disposable income (100/200)=0.50 -the MPC=0.50

Autonomous Consumption (C0) is..... of disposable income, while Induced Consumption (MPC(Yd)) is .... of disposable income.

-independent -dependent

The MPC is always a positive number between

0 and 1, because of Keyne's points 2 and 3.

The multiplier (m) =

1 / (1 - MPC).

Three States of the Economy in the TE-TP Framework I (Page 239 graph) (page 240 tabell)

1. At QE, TE = TP - The economy is in equilibrium. 2. At Q1 , TE < TP. - This results in an unexpected increase in inventories, which signals firms that they have overproduced, which leads firms to cut back production. - The cutback in production reduces Real GDP. - The economy tends to move from Q1 to QE. 3. At Q2, TE > TP. - This results in an unexpected decrease in inventories, which signals firms that they have under produced, which leads firms to raise production. - The increased production raises Real GDP. - The economy tends to move from Q2 to QE

Why is the wage rate inflexible downward?

1. Because of long term labor contracts (like 3 years). Management want this because it brings fewer labor negotiations and fewer strikes. 2. At times, firms find it in their best interest to pay above equilibrium levels. For example: - Underpaying 75 employees and firing 25 of them will make all employees angry at work, and they will probably be less productive. - Instead, continue to pay the (previous) higher wage rate, but fire 40 of the workers. This will only make the 40 fired employees angry.

Keynes 3 basic points about consumption

1. Consumption depends on disposable income. 2. Consumption and disposable income move in the same direction. Yd ↑ C↑ 3. When disposable income changes, consumption changes by less (MPC).

In terms of AD and AS, the essence of the simple Keynesian model can be summarized in 5 statements:

1. The price level is constant until Natural Real GDP is reached. 2. The AD curve shifts if there are changes in C, I, or G. 3. According to Keynes, 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. 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 point B. 5. The government may have a management role to play in the economy. Government might have to raise aggregate demand enough to stimulate the economy to move it out of the recessionary gap and to its Natural Real GDP level.

In terms of TE and TP, the essence of the simple Keynesian model can be summarized in 5 statements:

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 (for example by increasing government purchases/spending) enough to stimulate the economy out of the recessionary gap and move it to its Natural Real GDP level.

The Derivation of the Total Expenditures (TE) Curve: (page 236-237) very easy, just look at it and understand it, draw graphs

All you do is add consumption, investment, government purchases/spending at different Real GDP levels to derive TE curve. TE=C+I+G The TE curve is an upward slope The TE curve will shift with a change in C,1, or G.

The multiplier process:

An initial rise in autonomous consumption leads to -->a rise in consumption for one person,--> generating additional income for another person,--> and leading to additional consumption spending by that person,--> and so on and so on....

If C0 is $800, the MPC is 0.80, and Yd is $1,500, how much is C?

C= $800+(0.80x$1,500)= $800+$1,200= $2,000

Difference in veiw of Investment

Classical Economists: - Amount invested is inversely related to interest rate. - Businesses invest more on lower interest rates and invest less at higher interest rates. Keynes: - If expectations are pessimistic, a lower interest rate may not stimulate additional investment.

Difference in veiw of Savings

Classical Economists: - Amount saved and interest rate are directly related. - Savers save more on higher interest rates and save less at lower interest rates. Keynes: - Savers may not save more on higher interest rates or save less at lower interest rates. - If savers have a saving goal in mind, then a higher interest rate means savers can save less and still reach their goal.

Difference in veiw of Prices

Classical Economists: - Flexible Keynes: - May be inflexible downward

Difference in veiw of Wages

Classical Economists: - Flexxible Keynes: - May not be inflexible downward

Difference in veiw of Say's law

Classical Economists: -Holds in a money economy. In other words, all output produced will be demanded. Keynes: -May not hold in a money economy. In other words, more output may be produced than will be demanded.

Disposable Income can only be used for?

Consumption or saving C+S= Yd

Saving formula (Do and understand exhibit 6, page 228)

Saving = Disposable Income - Consumption = Saving = Disposable Income - (Autonomous consumption - (Marginal Propensity to Consume x Disposable Income)) S=Yd-(C0-(MPCxYd))

Basic assumptions of "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 (financial/money) side of the economy is excluded.

What will cause an increase in consumption?

Increase in either one of these variables: 1. Raise Autonomous Consumption (C0) 2. Raise Disposable Income (Yd) 3. Raise the Marginal Propensity to Consume (MPC)

An Example of the Multiplier at Work (page 229)

Initial rise/change in autonomous spending = $40 Marginal Propensity to Consume = 0.80 Multiplier = 1/(1-0.80) = 1/0.2 = 5 Change in total spending = 5 x $40 = $200

(page 231) Change in total spending =

Multiplier x Change in autonomous spending Example: M x ΔC0 =5 x $40 =$200

C0 - Autonomous consumption:

The part of consumption that is independent of disposable income. -You are consuming more of various goods and services even though your disposable income has not changed at all. Example: - eating more food since you are bulking - spending more on medication because you became ill - spending more on language lessons because you moved to Italy.

MPC - Marginal propensity( to consume:

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

The consumption function is:

The relationship between consumption (household sector spending) and disposable income. -In the consumption function, consumption is directly related to disposable income and is positive even at zero disposable income: C= C0+ (MPC) (Yd) Total consumption= Autonomous consumption + (Marginal propensity to consume x Disposable income)

The Simple Keynesian Model in the TE-TP Framework is also known as:

Total Expenditure - Total production model The Keynesian cross

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. - A cut in wages can cause a decline in labor productivity, which in turn raises the firm's cost. - 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.