Chapter 18

The Keynesian Model

Key Concepts
Summary
Practice Quiz
Internet Exercises
1

Who were the

Classical Economists?
The Classical economists
believed that a continuing
depression is impossible
because markets will
eliminate persistent
shortages or surpluses

When were the ideas of

the Classical Economists
widely accepted?
Prior to the Great
Depression of the 1930s
3

What is Says Law?

The belief of the
Classical Economists
that the economy was
always tending toward
full employment
4

What does
Says Law say?
Supply creates its
own demand

Why is Says Law a Full

Employment theory?
Generally speaking,
producers produce goods
that consumers want and
consumers have the
money to buy because of
the wages they were paid
6

Under Says Law, is

Unemployment possible?
Yes, but it is a short-lived
adjustment period in which
wages and prices decline or
people voluntarily choose
not to work
7

What changed peoples

mind about Says Law?
The Great Depression and
the publication of The
General Theory of
Employment, Interest, and
Money published in 1936
8

Why did Keynes believe

that supply did not
create its own demand?
Aggregate expenditures
(demand) can be forever
inadequate for an economy
to achieve full employment
9

What is the main

idea of this chapter?
Keyness theory for the
determination of
consumption and
investment expenditures
10

What determines your

familys Spending for
Goods and Services?
Disposable income

11

What is the
Consumption Function?
The graph that shows the
amount households spend
for goods and services at
different levels of
disposable income
12

What is Savings?
Disposable income minus
consumption, the
amount households do
not spend for consumer
goods and services
13

What is Dissaving?
The amount by which
personal consumption
expenditures exceed
disposable income

14

How do people Dissave?

Negative savings is
financed by by drawing
down previously
accumulated financial
assets or by borrowing
15

What is Autonomous
Consumption?
Consumption that
is independent of
the level of
disposable
income
16

What happens
when Disposable
Income is Zero?
Spending will equal
autonomous consumption
because households will
dissave to satisfy basic
consumption needs
17

What is the Marginal

Propensity to Consume?
The change in consumption
resulting from a given change
in real disposable income

18

C
MPC =
Yd
19

What is Marginal
Propensity to Save?
The change in saving
resulting from a given
change in real
disposable income
20

S
MPS =
Yd
21

MPC + MPS = 1

22

Real Consumption
Trillions of $ per year

8
7
6
5
4
3
2
1

C = Yd

The Consumption Function

Dissaving
C
Yd

45

Saving

Real Disposable Income

Trillions of $ per year

1 2 3 4 5 6 7 8 9 10

23

What happens if
Factors other than
Income change?
There is a shift or
relocation in the
consumption schedule
24

Real Consumption
Trillions of $ per year

8
7
6
5
4
3
2
1

C = Yd

The Consumption Function

C2
C1
MPC = .75
MPC = .50

45

Real Disposable Income

Trillions of $ per year

1 2 3 4 5 6 7 8 9 10

25

Real Consumption
Trillions of $ per year

8
7
6
5
4
3
2
1

The Consumption Function

C2 = a2 + bYd
B
A

nonincome
determinant

C1 = a1 + bYd

Real Disposable Income

real
Trillions of $ per year
consumption

1 2 3 4 5 6 7 8 9 10

26

Why does the Consumption

Function Shift?
Expectations
Wealth
Price level
Interest rate
Stock of durable goods
27

How do Expectations affect

the Consumption Function?
Consumers expectations of
things to happen in the
future will affect their
spending decisions today
28

How does Wealth affect the

Consumption Function?
Holding all other factors
constant, the more wealth
households accumulate,
the more they spend at
any current level of
disposable income
29

How does the Price

Level affect the
Consumption Function?
Any change in the general
price level shifts the
consumption schedule by
reducing or enlarging the
consumers purchasing power
30

How does the Interest

Rate affect the
Consumption Function?
A high interest rate will
discourage people from
borrowing money and a low
interest rate will encourage
people to borrow money
31

How does the Stock of

Durable Goods affect the
Consumption Function?
When durable goods are
suppressed, like during
WWII, afterwards there is an
increase in the demand for
goods not previously made
available
32

How does Consumption

compare with Investment?
Consumption is more stable
than investment

33

According to the
Classical Economists,
what determined the level
of Investment?
The interest rate

34

According to Keynes,
what determines the level
of Investment?
Expectations of future
profits is the primary
factor, the interest rate is
the financing cost of any
investment proposal
35

What is the Investment

Demand Curve?
The curve that shows the
amount businesses spend for
investment goods at different
possible rates of interest
36

12%

Interest rate

16%

Movement along the firms

investment demand curve

Investment
Demand Curve

8%
4%

Real investment

10

15

20

37

Shift in the firms

investment demand curve

12%
8%
4%

Interest rate

16%

C
B

Real investment

10

I1
15

I2
20

38

Why is Investment
Demand unstable?
Expectations
Technological change
Capacity utilization
Business taxes
Autonomous reasons

39

How do Expectations
affect Investment?
Businesspeople are quite
susceptible to moods of
optimism and pessimism

40

How does Technological

change affect Investment?
The introduction of new
products and new ways
of doing things have a
big impact on
investment decisions
41

What happens when

Capacity Utilization is low?
When capacity utilization
is low, firms can meet an
increase in demand
without expanding
42

What happens when

Capacity Utilization is high?
When capacity utilization is
high, firms must increase
investment to meet an
increase in demand
43

How do Business Taxes

affect Investment?
Business decisions
depend on the expected
after-tax rate of profit

44

What is
Autonomous Expenditure?
Spending that does not vary
with the current level of
disposable income

45

Aggregate Investment
Demand Curve

Interest Rate

16%
14%
12%
10%
8%
6%
4%
2%

A
Autonomous
investment
Real Investment

.2

.4

.6

.8 1.0 1.2 1.4 1.6

46

Aggregate Autonomous
Investment Demand Curve

1.6
1.4
1.2
1.0
.8
.6
.4
.2

Autonomous
investment
Real Disposable Income
trillions of dollars per year

47

What is the Aggregate

Expenditure Function?
The function that represents
total spending in an
economy at a given level of
real disposable income
48

8
7
6
5
4
3
2
1

Aggregate Expenditures
Schedule and Function

AE
C

E
I
+
C

Real Disposable Income

trillions of dollars per year

49

Key Concepts

50

Key Concepts
Who were the Classical Economists?
When were the ideas of the Classical Eco
nomists widely accepted?
What is Says Law?
What does Says Law say?
Why did Keynes believe that supply did
not create its own demand?
What determines your familys Spending
for Goods and Services?
51

Key Concepts cont.

What is the Consumption Function?

What is Savings?
What is Dissaving?
What is Autonomous Consumption?
What is the Marginal Propensity to Consume?
What is Marginal Propensity to Save?
What happens if Factors other than Income c
hange?
52

Key Concepts cont.

Why does the Consumption Function Shift?
According to the Classical Economists, what d
etermined the level of Investment?
According to Keynes, what determines the
level of Investment?
What is the Investment Demand Curve?
Why is Investment Demand unstable?
What is Autonomous Expenditure?
What is the Aggregate Expenditure Function?
53

Summary

54

Says Law is the classical theory

that supply creates its own demand
and therefore the Great Depression
was impossible. Says Law is the belief
that the value of production generates
an equal amount of income and, in
turn, total spending.

55

The classical economists rejected

the challenge that underconsumption
is possible because they believed
flexible prices, wages, and interest
rates soon establish balance between
supply and demand.

56

John Maynard Keynes rejected the

classical theory that the economy self
corrects in the long run to full
employment. The key in Keynesian
theory is aggregate demand, rather
than the classicals focus on aggregate
supply. Unless aggregate spending is
adequate, the economy can experience
prolonged and severe unemployment.
57

The consumption function (C)

is determined by changes in the
level of disposable income.
Autonomous consumption is
consumption that occurs even if
disposable income equals zero.
Changes in such nonincome
determinants as expectations,
wealth, the price level, interest rates,
and the stock of durable goods
cause shifts in the consumption
function.

58

Real Consumption
Trillions of $ per year

8
7
6
5
4
3
2
1

C = Yd

The Consumption Function

Dissaving
C
Yd

45

Saving

Real Disposable Income

Trillions of $ per year

1 2 3 4 5 6 7 8 9 10

59

The marginal propensity to

consume (MPC) is the change in
consumption associated with a given
change in disposable income. The MPC
tells how much of an additional dollar
of disposable income households will
spend for consumption.

60

The marginal propensity to save

(MPS) is the change in saving
associated with a given change in
disposable income. The MPS
measures how much of an additional
dollar of disposable income
households will save.
61

The investment demand curve

(I) shows the amount businesses
spend for investment goods at
different possible rates of interest.
The determinants of this schedule
are the expected rate of profit and
rate of interest. Shifts in the
investment demand curve result
from expectations, technological
change, capacity utilization, and
business taxes.
62

An autonomous expenditure is
spending that does not vary with the
current level of disposable income.
The Keynesian model applies this
simplifying assumption to
investment. As a result, the
investment demand curve is a fixed
amount determined by the rate of
profit and the interest rate.
63

The aggregate expenditures

function (AE) shows the total
spending in an economy at a given
level of disposable income.
Assuming investment spending is
autonomous, the slope of the AE
function is determined by the MPC.

64

8
7
6
5
4
3
2
1

Aggregate Expenditures
Schedule and Function

AE
C

E
I
+
C

Real Disposable Income

trillions of dollars per year

65

Chapter 18 Quiz

66

1. The French classical economist Jean Baptiste

Say transformed the equality of production
and spending into a law that can be expressed
as follows:
a. The invisible hand creates its own supply.
b. Wages always fall to the subsistence level.
c. Supply creates its own demand.
d. Aggregate output does not always equal
consumption.

67

2. Autonomous consumption is
a. positively related to the level of consumption.
b. negatively related to the level of
consumption.
c. positively related to the level of disposable
income.
d. independent of the level of disposable
income.

68

3. The consumption function represents the

relationship between consumer expenditures
and
a. interest rates.
b. saving.
c. the price level.
d. disposable income.

69

4. John Maynard Keyness proposition that a

dollar increase in disposable income will
increase consumption, but by less than the
increase in disposable income, implies a
marginal propensity to consume that is
a. greater than or equal to one.
b. equal to one.
c. less than one, but greater than zero.
d. negative.

70

5. Above the break-even disposable income for

the consumption function, which of the
following occurs?
a. Dissaving.
b. Saving.
c. Neither (a) nor (b).
d. Both (a) and (b).

71

Real Consumption
Trillions of $ per year

8
7
6
5
4
3
2
1

C = Yd

The Consumption Function

Dissaving
C
Yd

45

Saving

Real Disposable Income

Trillions of $ per year

1 2 3 4 5 6 7 8 9 10

72

6. Which of the following changes produces an

upward shift in the consumption function?
a. An increase in consumer wealth.
b. A decrease in consumer wealth.
c. A decrease in autonomous consumption.
d. Both (b) and (c) .

73

Real Consumption
Trillions of $ per year

8
7
6
5
4
3
2
1

C = Yd

The Consumption Function

C2
C
MPC = .75
MPC = .50

45

Real Disposable Income

Trillions of $ per year

1 2 3 4 5 6 7 8 9 10

74

7. An upward shift in the consumption schedule,

other things being equal, could be caused by
households
a. becoming optimistic about the state of the
economy.
b. becoming pessimistic about the state of the
economy.
c. expecting future income and wealth to
decline.
d. none of the above.

75

8. The investment demand curve represents

the relationship between business spending
for investment goods and
a. GDP.
b. interest rates.
c. disposable income.
d. saving.

76

9. Which of the following changes produces a

leftward shift in the investment demand curve?
a. A wave of optimism about future
profitability.
b. Technological change.
c. High plant capacity utilization.
d. An increase in business taxes.

77

Shift in the firms

investment demand curve

12%
8%
4%

Interest rate

16%

C
B

Real investment

10

I1
15

I2
20

78

10. The aggregate expenditures function (AE)

represents which of the following?
a. The consumption function only.
b. Autonomous consumption only.
c. The investment demand curve only.
d. All three of the above combined.
e. A combination of (a) and (c) .

79

8
7
6
5
4
3
2
1

Exhibit 11
Aggregate Expenditures
Schedule and Function

AE
C

I
+
C

Real Disposable Income

trillions of dollars per year

80

11. In Exhibit 11, what is the households

marginal propensity to consume (MPC)?
a. 0.5.
b. 0.67.
c. 0.75.
d. 0.80.

81

12. In Exhibit 11, aggregate income will equal

consumption plus investment and the
economy will be in equilibrium when real
disposable income is
a. $2.33 trillion.
b. $3 trillion.
c. $7 trillion.
d. $10 billion.

82

END
83