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