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Handout #22P
Keynesian View of the Economy
Takes a Licking But Won’t Keep Ticking
John Maynard Keynes challenged the beliefs of the classicists. Based on the evidence of the
Great Depression, he felt that the economy was basically unstable, for a number of reasons.
1) Interest rates do not balance savings and investment—Keynes felt that changes in the
interest rate would not necessarily cause changes in saving to be exactly offset by an
equal change in investment. In this case, aggregate demand will not automatically equal
aggregate supply, a necessary assumption for the classicists.
Total Expenditures (TE) = C + I + G + NX. If savings increase, C will fall, ceteris paribus.
If lower interest rates from the increased savings do not cause I to rise by the same
amount that C dropped, total expenditures will end up lower than before. If output
equaled TE at the start, then now aggregate supply is greater than aggregate demand.
Keynes believed that savings would not necessarily change if interest rates changed—he
felt that savings levels were more responsive to changes in income. Keynes also felt that
investment was responsive to interest rates but there were other factors such as
expected profits, technology changes and innovations, with even larger impacts on
changing investment levels. So if interest rates dropped but profits from a possible
investment project were expected to be low, there might not be any increase in
investment, even with lower interest rates.
2) Wage rates are inflexible downward—Keynes felt that surpluses in the labor market
would not lead to lower wages. He felt that wages were inflexible downward. Without
falling wages, the price level would not fall, and no increase in real GDP demanded would
be forthcoming. In other words, the economy could not fix itself and can be stuck in an
recessionary gap.
3) Prices are not always flexible downward —Keynes felt that anti-competitive forces in the
economy could prevent prices from falling. Again, if the price level could not fall
sufficiently, no increase in real GDP demanded would be forthcoming and again, the
economy could not fix itself.
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Keynesian or Income-Expenditure (TE-TP) Model of the Economy
The Keynesian model applies to the very short run in which firms have fixed the prices of
their goods and services. As a result in this model, the price level is fixed and so total
expenditures or aggregate demand determines real GDP.
Total Expenditures (TE) = C + I + G + NX. Of these components, the consumption function is
the most important. Keynes developed a consumption function to analyze how consumption
responds to changes. The consumption function is: C = C0 + (MPC)(Yd). Or, in English,
consumption equals autonomous consumption plus the marginal propensity to consume times
disposable income. The MPC time Yd is called induced consumption because it depends on
disposable income.
Autonomous consumption (C0) is a constant level of consumption, representing a basic level of
consumption that does not depend on disposable income. Autonomous consumption changes
from factors other than disposable income.
The marginal propensity to consume is a number between zero and one, representing the
portion of each additional dollar of disposable income that is spent on consumption. It is the
ratio of ∆ in consumption to ∆ in disposable income, or ∆C/∆Yd. And, since disposable income
is either spent or saved, 1-MPC is the MPS, or marginal propensity to save. It can be
calculated as the ratio of ∆ in saving to ∆ in disposable income.
Consumption
C
Slope=MPC<1
C0
C0
Disposable Income
Working through the consumption function, consumption can be increased by increasing any
of its components: C0, MPC, or Yd. However, increasing C0 will increase only the level of
consumption, while increasing MPC or Yd will also change the level of saving.
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There is also the average propensity to consume (APC) which shows the portion of total (not
additional!) disposable income spent on consumption. It is the ratio of total consumption to
total disposable income, or C/Yd. And again, since disposable income is either spent or saved,
1-APC is the APS, or average propensity to save, or S/∆Yd.
The simple Keynesian model uses the consumption function to create a total expenditure
function and curve, based only on domestic spending, excluding the foreign sector (though
your book includes imports in its discussion). The simple model also assumes a constant level
of I and G.
TE = C0 + (MPC)(Yd) + I + G
Graphically, the TE curve is upward sloping to the right.
Total
Expenditures
(TE)*
TE*
Slope=MPC<1
G
I
C0
Real GDP
*Aggregate planned expenditures (AE) in your book
The total production curve in the Keynesian model is a 45o line which represents all the
points where TE or AE = Real GDP.
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Total
Expenditures
(TE)
TP (TE=Real GDP)
Slope= 1
45o
Real GDP
The Three States of the Economy
Using the Keynesian model, in this closed economy:
 total expenditures (TE) can be equal to total production (TP)
 total expenditures (TE) can be less than total production (TP)
 total expenditures (TE) can be greater than total production (TP)
In the last two states (disequilibrium), the economy would move toward the first state
(equilibrium). Business inventories would be the mechanism for the economy’s adjustment.
Producers hold some level of business inventory that is optimal. In the state of the economy
where TE < TP, firms will notice that their inventories are growing. Since they wish to keep
the optimal level of inventory on hand, they will cut back total production. As TP falls, it will
become closer to the level of TE. This process will continue until TP = TE, where firms will
reach their optimal inventory and maintain TP at that level. No incentive to change will
remain, ceteris paribus.
In the state of the economy where TE > TP, firms will notice that their inventories are
falling. Since they wish to keep the optimal level of inventory on hand, they will increase
total production. As TP rises, it will become closer to the level of TE and again, this process
will continue until TP = TE, where firms will reach their optimal inventory and maintain TP at
that level. No incentive to change will remain, ceteris paribus.
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Total expenditures (TE) equal to total production (TP)
TE, TP
$
TP
TE
TE=TP
QE
Real GDP
Total expenditures (TE) not equal to total production (TP)
TP
TE, TP
$
TE
TE=TP
Falling inventories,
increase output
$TE > $TP
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Rising inventories,
decrease output
QE
$TE=$TP
$TE < $TP
Real GDP
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The TE/TP model will only show short run equilibrium unless the level of full employment
output is known (include all labels if asked to draw the TE/TP model).
TP
TE, TP
$
TE=C+I+G
TE=TP
Slope=MPC
C0+I+G
45o
QE
Real GDP
Note that there is nothing to relate the equilibrium point of TP=TE to the full-employment
real GDP level. In this framework, the economy could easily be in a recessionary gap, at an
output less than full employment output, with no automatic force operating to push output
higher. Unless you know where QN is, do not draw it on the graph of the TE/TP model.
If the economy is in a recessionary gap, Qe is less than Qn – that would show on the TE/TP
model graph with the vertical line for Qn drawn to the right of the intersection of TP and
TE, like in the graph below. That shows that Qe is less than Qn and which mean that
unemployment was greater than Un.
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TE, TP
$
TP
TE
TE=TP
U>UN
QE < Q N
Real GDP
If the economy is in an inflationary gap, Qe is greater than Qn – that would show on the
TE/TP model graph with the vertical line for Qn drawn to the left of the intersection of TP
and TE, like in the graph below. That shows that Qe is greater than Qn which would mean
that unemployment was less than Un.
TP
TE, TP
$
TE
TE=TP
U<UN
QN
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<
QE
Real GDP
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If the economy is in long run equilibrium, Qe is equal to Qn – that would show on the TE/TP
model graph with all the lines meeting at the same point. The vertical line for Qn is drawn at
the intersection of TP and TE, like in the graph below (include all labels).
TP
TE, TP
$
TE
TE=TP
U=UN
QN = QE
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Real GDP
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There is an underlying assumption in the Keynesian model that there are idle resources
available at each expenditure round. If there were no idle resources to bring into
production, real GDP could not increase. In that case, the autonomous spending increase
would only increase prices.
Because the Keynesian model assumes prices are constant until full employment output is
reached (changes are real, not nominal below QN) and idle resources exist at each
expenditure level, any change in aggregate spending changes output only. In the AD/AS
model, with the assumption of constant prices and idle resources, Keynes’ theory shows an
increase in aggregate demand before full employment output is reached (meaning there are
idle resources) increases QE but not price.
Price
Level
AS
PE
AD1
AD
QE
QE1
QN
Real GDP
Natural Real GDP at
full employment
the economy is already at full employment level of output, an increase in aggregate demand
will only increase prices, not output.
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Price
Level
AS
PE1
PE
AD1
AD
QN
Real GDP
Natural Real GDP at
full employment
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