Download Chapter 1: Introduction: What is Economics?

Principles of Economics:
Econ101
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Keynes on Say’s Law
Keynes on Wage Rates and Prices
Consumption Function
Equilibrium Real GDP and Gaps
The Expenditure Multiplier
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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.
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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.
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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.
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
Suppose the economy is in a
recessionary gap at point 1.

Wage rates are $10 per hour,
and the price level is P1.

The issue may not be
whether wage rates and the
price level fall, but how long
they take to reach long-run
levels
(continued)
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 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 selfregulating over any
reasonable period of time
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1.
What do Keynesians mean when they say the economy is
inherently unstable?
Keynesians mean that an economy may not self-regulate at
Natural/Potential Real GDP (QN). Instead, an economy can get
stuck in a recessionary gap.
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.
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Consumer spending depends upon disposable
income......where, disposable income is national income
minus taxes plus transfers
Keynes’ Two Assertions About Consumption:


As disposable income rises, the amount spent by
consumers also rises.
As disposable income rises, the percent of disposable
income spent falls…..also known as the average
propensity to consume.
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Disposable Income
0
$1000
$2000
$3000
$4000
$5000
$6000
$7000
$8000
$9000
$10,000
Consumption
$1000
$1800
$2600
$3400
$4200
$5000
$5800
$6600
$7400
$8200
$9000
Average Propensity to Consume =
Savings
-$1000
-$ 800
-$ 600
-$ 400
-$ 200
0
$200
$400
$600
$800
$1000
Consumption
Disposable Income
So….as disposable income rises, consumption rises and the average
propensity to consume falls.
Marginal Propensity to Consume = Change in Consumption
Change in Disposable Income
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Equilibrium Real GDP: occurs when aggregate demand is equal to aggregate
supply.
Real GDP (= Income)
0
$1000
$2000
$3000
$4000
$5000
$6000
$7000
$8000
$9000
$10,000
$11,000
$12,000
$13,000
$14,000
$15,000
Consumption
+
Business Investment = Aggregate
Spending
Demand
$1000
$400
$1400
$1800
$400
$2200
$2600 Unintended Inventory $400
$3000
$3400 Investment falls $400
$3800
$4200
$400
$4600
$5000
$400
$5400
$5800
$400
$6200
$6600
$400
$7000
$7400
$400
$7800
$8200
$400
$8600
$9000
$400
$9400
$9800 Unintended Inventory $400
$10,200
Investment rises
$10,600
$400
$11,000
$11,400
$400
$11,800
$12,200
$400
$12,600
$13,000
$400
$13,400
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
Recessionary Gap:
if equilibrium real GDP is below potential real GDP

Inflationary Gap:
if equilibrium real GDP is above potential real GDP
According to Keynes, if nothing is done to correct
gaps, they will continue indefinitely.
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The
number that is multiplied by the change in initial spending to
obtain the overall change in total spending.
The
multiplier is equal to 1 / (1 - MPC).
Change
in total spending = Multiplier x Change in initial spending
The basic principle of the multiplier is that one person’s spending
generates another person’s income through a series of “induced
consumption”.
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




Initial rise in autonomous spending = $1000
Marginal Propensity to Consume = .80
Multiplier = 1/(1-.80) = 1/.2 = 5
Change in total spending = 5 x $1000 = $5000
“Multiplier likely to be smaller”
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1.
If the MPC = 0.70, what does the multiplier equal?
1/(1- 0.70) = 1/0.30 =3.33.
2.
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.
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
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.
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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/Potential Level of Real GDP.
The government may have a management role
to play in the economy. According to
Keynes, government may have to raise
aggregate demand enough to stimulate the
economy to move it out of the recessionary
gap and to its Natural/Potential Real GDP
level.
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