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Chapter 18
The Keynesian Model
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2000 South-Western College Publishing
1
In this chapter, you will
learn to solve these
economic puzzles:
Why did Keynes believe
Why
did
economists
believe
that
“animal
spirits”
and
What are the components
the
Great
Depression
was
government
policy
were
of
the
Keynesian
Cross?
important
to maintain
impossible?
full employment?
2
Who were the
Classical Economists?
The Classical economists
believed that a continuing
depression is impossible
because markets will
eliminate persistent
shortages or surpluses
3
When were the ideas of
the Classical Economists
widely accepted?
Prior to the Great
Depression of the 1930’s
4
What is Say’s Law?
The belief of the
Classical Economists
that the economy was
always tending toward
full employment
5
What does
Say’s Law say?
Supply creates its
own demand
6
Why is Say’s 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
7
Under Say’s 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
8
What changed people’s
mind about Say’s Law?
The Great Depression and
the publication of The
General Theory of
Employment, Interest, and
Money published in 1936
9
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
10
What is the main
idea of this chapter?
Keynes’s theory for the
determination of
consumption and
investment expenditures
11
What determines your
family’s Spending for
Goods and Services?
Disposable income
12
What is the
Consumption Function?
The graph that shows the
amount households spend
for goods and services at
different levels of
disposable income
13
What is Savings?
Disposable income minus
consumption, the
amount households do
not spend for consumer
goods and services
14
What is Dissaving?
The amount by which
personal consumption
expenditures exceed
disposable income
15
How do people Dissave?
Negative savings is
financed by by drawing
down previously
accumulated financial
assets or by borrowing
16
What is Autonomous
Consumption?
Consumption that
is independent of
the level of
disposable
income
17
What happens
when Disposable
Income is Zero?
Spending will equal
autonomous consumption
because households will
dissave to satisfy basic
consumption needs
18
What is the Marginal
Propensity to Consume?
The change in consumption
resulting from a given change
in real disposable income
19
C
MPC =
 Yd
20
What is Marginal
Propensity to Save?
The change in saving
resulting from a given
change in real
disposable income
21
S
MPS =
 Yd
22
MPC + MPS = 1
23
Real Consumption
Trillions of $ per year
8
7
6
5
4
3
2
1
C = Yd
The Consumption Function
Dissaving
C
Yd
45°
C
Saving
Real Disposable Income
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
24
What happens if
Factors other than
Income change?
There is a shift or
relocation in the
consumption schedule
25
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
26
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
consumption Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
27
Why does the Consumption
Function Shift?
• Expectations
• Wealth
• Price level
• Interest rate
• Stock of durable goods
28
How do Expectations affect
the Consumption Function?
Consumers expectations of
things to happen in the
future will affect their
spending decisions today
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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
30
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
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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
32
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
33
How does Consumption
compare with Investment?
Consumption is more stable
than investment
34
According to the
Classical Economists,
what determined the level
of Investment?
The interest rate
35
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
36
What is the Investment
Demand Curve?
The curve that shows the
amount businesses spend for
investment goods at different
possible rates of interest
37
12%
Interest rate
16%
Movement along the firm’s
investment demand curve
A
Investment
Demand Curve
B
8%
4%
Real investment
5
10
15
20
38
Shift in the firm’s
investment demand curve
12%
8%
4%
Interest rate
16%
C
B
Real investment
5
10
I1
15
I2
20
39
Why is Investment
Demand unstable?
• Expectations
• Technological change
• Capacity utilization
• Business taxes
• Autonomous reasons
40
How do Expectations
affect Investment?
Businesspeople are quite
susceptible to moods of
optimism and pessimism
41
How does Technological
change affect Investment?
The introduction of new
products and new ways
of doing things have a
big impact on
investment decisions
42
What happens when
Capacity Utilization is low?
When capacity utilization
is low, firms can meet an
increase in demand
without expanding
43
What happens when
Capacity Utilization is high?
When capacity utilization is
high, firms must increase
investment to meet an
increase in demand
44
How do Business Taxes
affect Investment?
Business decisions
depend on the expected
after-tax rate of profit
45
What is
Autonomous Expenditure?
Spending that does not vary
with the current level of
disposable income
46
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
47
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
1
2
3
4
5
6
7
8
48
What is the Aggregate
Expenditure Function?
The function that represents
total spending in an
economy at a given level
of real disposable income
49
8
7
6
5
4
3
2
1
Aggregate Expenditures
Schedule and Function
AE
C
E
Real Disposable Income
trillions of dollars per year
1
2
3
4
5
6
7
8
50
Key Concepts
51
Key Concepts
• Who were the Classical Economists?
• When were the ideas of the Classical
Economists widely accepted?
• What is Say’s Law?
• What does Say’s Law say?
• Why did Keynes’ believe that “supply did
not create its own demand”?
• What determines your family’s Spending
for Goods and Services?
52
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
change?
53
Key Concepts cont.
• Why does the Consumption Function Shift?
• According to the Classical Economists, what
determined 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?
54
Summary
55
Say’s Law is the classical theory
that “supply creates its own demand”
and therefore the Great Depression
was impossible. Say’s Law is the belief
that the value of production generates
an equal amount of income and, in
turn, total spending.
56
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.
57
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.
58
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.
59
Real Consumption
Trillions of $ per year
8
7
6
5
4
3
2
1
C = Yd
The Consumption Function
Dissaving
C
Yd
45°
C
Saving
Real Disposable Income
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
60
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.
61
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.
62
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.
63
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.
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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.
65
8
7
6
5
4
3
2
1
Aggregate Expenditures
Schedule and Function
AE
C
E
Real Disposable Income
trillions of dollars per year
1
2
3
4
5
6
7
8
66
Chapter 18 Quiz
©2000 South-Western College Publishing
67
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.
C. Says law was developed in the early
1800s and is the cornerstone of
classical economics.
68
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.
D. Autonomous consumption is the amount of
spending from savings or borrowing that
occurs even when disposable income is zero.
69
3. The consumption function represents the
relationship between consumer expenditures
and
a. interest rates.
b. saving.
c. the price level.
d. disposable income.
D. Keynes argued the most important
determinant of aggregate spending for
consumer goods is personal income
after taxes.
70
4. John Maynard Keynes’s 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.
C. Each dollar change in disposable
income is divided between changes in
consumption and saving.
71
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).
B. Dissaving occurs below the break-even
point on the consumption function.
72
Real Consumption
Trillions of $ per year
8
7
6
5
4
3
2
1
C = Yd
The Consumption Function
Dissaving
C
Yd
45°
C
Saving
Real Disposable Income
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
73
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) .
A. Decreases in wealth and autonomous
consumption shift the consumption
function downward.
74
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
75
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.
A. If consumers expect good economic
ties ahead, they increase spending at
each level of disposable income in the
current time period.
76
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.
B. As the interest rate declines, more business
investment projects become profitable and
investment spending increases.
77
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.
D. An increase in business taxes decreases
after-tax profits on investment projects
and businesses invest less at various
possible interest rates.
78
Shift in the firm’s
investment demand curve
12%
8%
4%
Interest rate
16%
C
B
Real investment
5
10
I1
15
I2
20
79
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) .
D.
80
8
7
6
5
4
3
2
1
Exhibit 11
Aggregate Expenditures
Schedule and Function
AE
C
E
Real Disposable Income
trillions of dollars per year
1
2
3
4
5
6
7
8
81
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.
B. MPC is the change in consumption divided
by the change in income. In this case, the
change in consumption to income is two to
three, or 0.67.
82
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.
C. The AE curve crosses the 45 degree line
at $7 trillion.
83
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END
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