The Fixed-Price Keynesian Model : An Economy Below Full – Employment Focus on the Demand Side
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The Fixed-Price Keynesian Model: An Economy Below Full – Employment
Focus on the Demand Side
Aggregate Expenditures = AE = GDP
Y = AE = C + I + G + NXConsumption expenditures (C) ≈ 68% of
GDP Investment expenditures (I) ≈ 18% of GDPGovernment expenditures (G) ≈ 18% of
GDPNet exports (NX) ≈ - 3 % of GDP
Imports exceed exports by about 3% of GDP
Some IdentitiesDisposable income = Yd = Y-T, after tax
income.
Yd = Y - T = C + S Keynes: people save a fixed proportion of their
disposable income on average Consumption is related to disposable income (Y-T).
C = Ca +cYd
Saving either finances private investment (I) or the government’s deficit (G – T)
S = I + (G – T) at equilibrium S + T = I + G
Leakages from the spending stream (S + T) = Injections to the spending stream (I + G)
Average Propensities to Consume and to Save
The average propensity to consume (APC): the proportion of disposable income spent for consumption
APC = C/Yd The average propensity to save (APS):
proportion of disposable income saved
APS = S/Yd
APC + APS = 1
since Yd = C + S 1 = C/ Yd + S/ Yd
Consumption and Disposable Income 1947-2002
Consumption Function
C = Ca +cYd is a straight line with slope c.
Ca is autonomous autonomous consumptionconsumption.
The slope, c, is the marginal marginal propensity to consumepropensity to consume from disposable income (MPCMPC).
0 < MPC < 1. MPC is C/Yd, the amount by
which consumption changes for each dollar change in Yd
C
Yd
CaC
Yd
MPC = C/Yd
Saving and Dissaving
Planned C
Yd
Yd (if C = Yd)
DissavingC > Yd
SavingYd > C
Yd1 Yd* Yd2
C
Saving Function: When income increases, both consumption and saving increase
Since Y = C + S + T and Yd = Y – T
Yd = C + S
C = Ca + c Yd and
S = -Ca + (1-c) Yd
S = Sa + sYd [Sa = autonomous saving = - Ca ]
S = Sa + mps x Yd ,where mps = s = marginal propensity to save
Note: mps + mpc = 1
Consumption and Saving in a Hypothetical Economy
Marginal Propensity to Consume: additional consumption in response to each additional dollar of
disposable income mpc = ΔC/ΔYd
Shifts in the Consumption Function Expected Future Income
– An increase in expected future income will cause current consumption to rise and your saving to fall.
Wealth– An increase in wealth raises current consumption
and lowers current saving. Expected Real Interest Rate
Higher real return incentive to save more … but– Higher return to saving less needs to be put
aside to achieve the same desired future savings.
– Net effect: increased real interest rates reduce consumption and increase saving.
Demographics Taxes – Ricardian Equivalence?
Autonomous Shifts in Consumption and in Saving
Investment Spending (I)Capital goods have a long life.Capital goods take time to build.Capital goods involve large expenditure.The present value of a capital good
depends on the income it generates over a long time horizon.– Businesses must form expectations
about future conditions and profitability.
– Investment is inherently risky. Investment expenditure tends to be
erraticerratic.
Determinants of Investment
Profit expectationsInterest rateTechnologyPrice (Cost) of Capital GoodsCapacity UtilizationProfit expectations
Investment as a Function of Current IncomeInvestment depends more on expectations of the future than on what’s happening now.
Government Expenditures as a Function of Real GDP
Government Expenditures are Largely Independent of the Current State of the Economy
Imports and Exports The demand for imports depends on current
economic activity, Y
IM = IMa + imY “im” is the marginal propensity to import (MPI). Exports are exogenously determined
they don’t depend on conditions in our economy but rather on conditions in foreign economies
Net exports is NX = EX – (IMa + imY) or NX = (EX-IMa) – imY or NX = NXa – imY (a downward sloping line)
Net Exports as a Function of Real GDP
The Aggregate Expenditures Function