Economics 112

Keynesian Economics: The Keynesian Cross

This model emphasizes Aggregate Demand (AD)

Total Output = Planned Aggregate Expenditures

Real GNP = C + I + G + (X - M)

Keynesian Consumption Function:

Points about the graph:

• The consumption function, C(Y), is drawn with price level held constant.
• Along 45⁰ line, C = Q = Y, i.e., aggregate consumption equals total output equals total income.
• If income = 0, then C > 0 because people dissave. We see this by the intersection of the consumption function with the vertical axis. At zero income aggregate consumption is still positive. The only way to still have positive consumption when income is zero is to dissave.
• The fact that the consumption function is flatter than the 45⁰means that as income rises, consumption rises but not as rapidly as income. Out of every dollar of income received a portion is consumed and a portion is saved. So as income rises, savings, which is first negative (dissavings) and then is positive, rises. We call the amount of each additional dollar of income that is consumed the marginal propensity of consumption, mpc. Since the amount consumed out of each additional dollar of income is smaller than a dollar, then we know that mpc < 1.
• The slope of the consumption function may be written as . That is, the slope of the consumption function is simply the change in consumption over the change in income. Note that this is the mpc or .
• Recall that Y = income, S = savings, C(Y) = Consumption and S = Y - C. So we may write that  since mpc < 1.
• Again note that the slope of C(Y) is mpc, how much of each extra $ of income is consumed. Our result relies on the fact that mpc < 1.

To establish what shifts the consumption function we must remember two very important concepts: exogenous and endogenous variables. Recall that when we discussed the model of supply and demand we argued that certain variables are held constant for a given demand curve. As we move along a given demand curve it must be the case tht preferences and tastes, income, price expectations and the prices of other goods are held fixed. If any of these change then a shift in the curve will occur. We say that these variables are exogenous because they are determined outside the system, i.e., they are given and are not determined by supply and demand. What are the endogenous variables for supply and demand? As we move along a given demand curve we note that price and quantity of the good change, i.e., they are determined or explained by the model. Thus, we say that price and quantity of the good are endogenous variables.

Now we can answer our original question. What variables will cause the consumption function to shift?

C=C(Y) shifts if

(a) consumers change saving and consumption patterns

(b) taxes change: changing taxes in turn will change disposable income which in turn will cause consumption to change, i.e.,

(c) transfers change: changing transfers change disposable income which in turn changes consumption, i.e.,

Investment Demand

affected by

• interest rates
• taxes
• business confidence (but assume not affected by output)
• Technology and Innovation

Investment is a function of the interest rate. As the interest rate rises, investment falls, because people borrow to invest. Think of the plant and equipment that firms build to produce output. This investment requires that they borrow (from the bank, by issuing bonds, or by issuing stock). The interest rate is a key factor, no matter how the firm chooses to raise its funding, affecting the level of investment the firm is able to undertake.

Combining the aggregate investment function with the aggregate consumption function all on one graph will give us the following

Government Demand for Goods and Services

• Assume it is not affected by real output
• Assume that it is not affected by income

Net Export Demand: (X-M)

affected by

• exchange rates
• international price level differences
• again, assume that (X-M) is not affected by income
• Assume that (X-M) is not affected by output.

Keynesian Equilibrium:

• Keynesian Cross
• Recall that it assumes a fixed price level.
• Economy tends to move toward Q_e, the equilibrium level of output
• Real Output (Q) = Aggregate Expenditures (AE) which may be written as follows,

Why does the economy move to Q_e?

• If the economy is at Q₁, then planned AE is greater than real output, Q. That is, people want to buy more than what is actually produced. But if people want to buy more than is actually produced then the inventories that firms have built up, must be falling. If inventories are falling firms will have an incentive to increase their production and they will increase production just until Q_e is reached, were planned AE equals actual real output.
• If the economy is at Q₂, then planned AE is less than real output. That is, people want to buy less than what is actually produced. But if people want to purchase less than what is actually produced then the inventories of firms must be building up. If inventories are building up then firms will have an incentive to decrease their production of goods and services. They will decrease their production just until planned AE equals Q_e.

Summary:

• if at Q₁ 

• if at Q₂ 

• All adjustments occur via changes in quantities, not prices.

We developed the AD curve for the classical model last class, can we now do the same for the Keynesian model? Recall what the AD curve tells you. It gives the total quantity of real output produced in the economy at a given price level. Thus, we need to find the relationship between the price level and the real level of output. Since we assume that the price level remained constant thus far in our analysis, now we shall allow the price level to change.
 
 

Note: Here we assume that AE is shifting due to changes in the price level.

p₀ Þ p₁: The price level rise means that people cannot buy as much with the same level of income as they could before the rise. Therefore AE falls.

p₀ Þ p₂: The price level fall means that people can buy more with the same level of income than they could before the fall in the price level. Therefore AE rises.
 
 

moving along AD is the same as shifting AE

Keynesian cross tells us what shifts AD

Shifting AD

hold p constant
 
 

AE = C + I + (X - M)

Suppose that I or C rise Þ AE shifts up. In P-Q space we see below that AD shifts to the right b/c I and C are exogenous to AD.

Summary:       anything, other than P, which affects AE will shift AE and thus shift AD

Keynesian AS

if you start at Q_p and p rises from the current level, AS is the same as the classical AS. Prices are flexible upwards. But prices, wages are not flexible downward. Thus we have a horizontal AS at p₀.

Decrease in AD (suppose that I falls due to pessimism)
 
 

This model can explain persistent unemployment and below potential output, e.g., Great Depression. But it is not a satisfactory account of our economy.

Problems:

1. wages and prices in Depression decreased by 25%, contrary to the Keynesian model
2. in 1970s stagflation occurred, i.e., we had high unemployment and high inflation at the same time.

Short-run AS:

short-run brief enough time period such that decision makers donít have time to fully adjust to unexpected changes. Expectations are fixed.

long run- decision makers full adjust expectations are not fixed.

Q_p =potential GNP

P^e=expected price level

all along As^sr expected price level = p₀ if expectations are correct, output = potential GNP.

movements along AS keep p^e constant, but actual price level and output change

why upward sloping?

example: unanticipated increase in net export demand

(1) increasing net exports shifts AD

(2) since it is unanticipated, P increases and output increases
 
 

In the labor market

as the price of products a firm produces increase, the firm hires more labor

workers must anticipate the prices of the all goods

firms arenít smarter than workers it is just that the firm needs to know less than the worker. Firms only must know their own costs of doing business.

as a result of incomplete information by workers, S₀^L is fixed (i.e. price expectations are fixed).

nominal wage rises employment rises

workers supply more labor because they think that their real wage has gone up; actually their real wage has fallen since w₀/p₀ > w₁/p₁. Firms are now willing to hire more workers than before because the real wage has fallen.

Summary of expectations

1. Firms need to now only wages and price of their product.

2. Workers need to know all the prices in the economy to know what is happening to real wage. That is, stress the buying power aspect of the real wage.

workers have a harder time making price expectations, not because they are less intelligent but because they have to gather more information.

Consider another example: unanticipted fall in AD, due to say a fall in I.
 
 

1) a fall in I Þ AD falls

2) expectations are fixed Þ move along AS
 
 

3) as p falls and Q falls the demand for labor falls.

4) a workerís nominal wage w falls, but the worker thinks that they are getting a reduction in their real wage since p^e = p⁰ which implies that they work less than before. They do not offer as many hours of labor as they did before hand.

5) in fact the price falls more than w the nominal wage so the real wage increases which means that the firms hire fewer workers.
 

Long-Run

Reconsider our first example of an unanticipated increase in net export demand.

in the long run, expectations adjust

Workers realize that the price level adjusts from p₀ to p₂ and they adjust their expectations accordingly Þ AS shifts back and tothe left.

Long-run aggregate supply is at Q_p as in the classical model.

as workers change their priceexpectations,they realize that the real wage has fallen so they reduce the number of hours that they are willing to supply. Thus the nominal wage rises from W₀ to W₂ and the real wage returns to the previous level. The amount of hours of labor suppliedreturns to L_N. Note that the real wage that obtained before the uanticipated increase in net export demand is once again achieved after expectations have adjusted.

Observations

(1) Fully anticipated changes in AD: move from one LR equilibrium to the other directly. There isno movement along As^sr since price expectations change immediately.

(2) self-adjustment mechanism: if in SR, Q does not equal Q_p, price expectations adjust to return economy to Q_p.