Transcript The Keynesian Model the possibility of macroeconomic equilibrium with unemployment

The Keynesian Model
the possibility of
macroeconomic equilibrium
with unemployment
Great Depression
• From 1929-1941, the United States (and
the world) was in a huge economic
depression, in the U.S. the official
unemployment rate was 25%. This
doesn’t count the millions living in the
“Hoovervilles” the homeless camps named
for the President. Not until the U.S.
entered WWII did the economy recover.
Questioning Neoclassical Theory
• Economists and others began to ask the
question: why isn’t the economy
recovering, where is the self-adjusting
mechanism.
• Neoclassical theory says the economy will
recover in the long run, but how long is
that? One famous economist, Joseph
Schumpeter said: “The short run is long
enough to bring about the ruin if a nation.
John Maynard Keynes
• Another famous economist from
Cambridge University in England, he
remarked: “In the long run we’re all dead.”
• Keynes, writing in the midst of the Great
Depression, criticized neoclassical theory,
and put forward an
alternative way of looking
at the macroeconomy.
Keynes on
consumption and income
• Keynes began with a very simple
proposition: when income goes up,
consumption increases, but not by as
much as income. So:
0 < ΔC/ΔYd < 1
Keynes on income and savings
• If that is true, then it must also be true
(since Yd = C + S) that when income goes
up, savings increases, but not by as much:
0 < ΔS/ΔYd < 1
the mpc and the mps
• ΔC/ΔYd is called the mpc (marginal
propensity to consume)
• ΔS/ΔYd is called the mps (marginal
propensity to save)
ΔC/ΔYd + ΔS/ΔYd = 1
and mps = 1 – b
ΔC/ΔYd + ΔS/ΔYd = 1
and mps = 1 – b
• Proof:
ΔC/ΔYd + ΔS/ΔYd = 1
and mps = 1 – b
• Proof:
• If Yd = C + S, then
ΔC/ΔYd + ΔS/ΔYd = 1
and mps = 1 – b
• Proof:
• If Yd = C + S, then
• Any change in Yd must resolve itself some
part of a change in C and some part a
change in S.
ΔC/ΔYd + ΔS/ΔYd = 1
and mps = 1 – b
• Proof:
• If Yd = C + S, then
• Any change in Yd must resolve itself some
part of a change in C and some part a
change in S.
• So, ΔYd = ΔC + ΔS
ΔC/ΔYd + ΔS/ΔYd = 1
and mps = 1 – b
• Proof:
• If Yd = C + S, then
• Any change in Yd must resolve itself some
part of a change in C and some part a
change in S.
• So, ΔYd = ΔC + ΔS
• Divide both sides by ΔYd, and we get:
ΔC/ΔYd + ΔS/ΔYd = 1
and mps = 1 – b
• Proof:
• If Yd = C + S, then
• Any change in Yd must resolve itself some
part of a change in C and some part a
change in S.
• So, ΔYd = ΔC + ΔS
• Divide both sides by ΔYd, and we get:
• 1 = mpc + mps (from 1 = mpc + mps)
the consumption function
the consumption function
• mpc = additional consumption from an
additional dollar of disposable income.
the consumption function
• mpc = additional consumption from an
additional dollar of disposable income.
• mps = additional saving from an additional
dollar of disposable income.
the consumption function
• mpc = additional consumption from an
additional dollar of disposable income.
• mps = additional saving from an additional
dollar of disposable income.
• So we can think of present consumption
as a function of disposable income:
the consumption function
• mpc = additional consumption from an
additional dollar of disposable income.
• mps = additional saving from an additional
dollar of disposable income.
• So we can think of present consumption
as a function of disposable income:
C = bYd
autonomous consumption
• But is present income the only determinant
of present consumption?
autonomous consumption
• But is present income the only determinant
of present consumption? No. What else?
autonomous consumption
• But is present income the only determinant
of present consumption? No. What else:
• accumulated past savings
autonomous consumption
• But is present income the only determinant
of present consumption? No. What else:
• accumulated past savings
• access to credit
autonomous consumption
• But is present income the only determinant
of present consumption? No. What else:
• accumulated past savings
• access to credit
• expectations of future income
autonomous consumption
• But is present income the only determinant
of present consumption? No. What else:
• accumulated past savings
• access to credit
• expectations of future income
• social standards
• etc.
Keynesian consumption function
• all these and other determinants of
present consumption other than present
disposable income we will call a, or
autonomous consumption; so:
C = a + bYd
Keynesian consumption function
• all these and other determinants of
present consumption other than present
disposable income we will call a, or
autonomous consumption; so:
C = a + bYd
This is our consumption function.
Keynesian consumption function
• all these and other determinants of present
consumption other than present disposable
income we will call a, or autonomous
consumption; so:
C = a + bYd
(takes form y = mx + b; linear function; m is
slope and b is y-intercept)
This is our consumption function. We can graph
this in expenditure/output (=income) space.
45 Degree Line
exp.
45°
15
10
5
45°
Y
0
5
10
15
Keynesian Model
45°
Expenditure
C = a + bY
C<Y
a+I
C=Y
a
I
C>Y
0
-a
Y1
Yf
Y
C = a + bYd
C = a + bYd
What is the slope of the consumption
function?
C = a + bYd
What is the slope of the consumption
function? b (b = mpc = marginal propensity
to consume = ΔC/ΔYd = rise/run = slope)
C = a + bYd
What is the slope of the consumption
function? b (b = mpc = marginal propensity
to consume = ΔC/ΔYd = rise/run = slope)
What is the y intercept of the C function?
C = a + bYd
What is the slope of the consumption
function? b (b = mpc = marginal propensity
to consume = ΔC/ΔYd = rise/run = slope)
What is the y intercept of the C function? a
(a = autonomous consumption = y intercept)
savings function
S = -a + (1 - b) Yd
savings function
S = -a + (1 - b) Yd
What is the y intercept of the savings
function?
savings function
S = -a + (1 - b) Yd
What is the y intercept of the savings
function? –a (= autonomous savings)
savings function
S = -a + (1 - b) Yd
What is the y intercept of the savings
function? –a (= autonomous savings)
What is the slope of the savings function?
savings function
S = -a + (1 - b) Yd
What is the y intercept of the savings
function? –a (= autonomous savings)
What is the slope of the savings function?
(1 – b) ( = mps = marginal propensity to
save = ΔS/ΔYd = rise/run = slope)
Keynesian Model
45°
Expenditure
C = a + bY
C<Y
a+I
S = - a + (1 – b) Y
C=Y→S=0
a
I
0
-a
C>Y
S>0
S< 0
“Dissaving”
Y1
Yf
Y
savings function
• When the savings function is below the xaxis savings is negative, when the savings
function is above the x-axis savings is
positive and when the savings function
intersects the x-axis savings = 0.
Keynesian Model
45°
Expenditure
C = a + bY
C<Y
a+I
S = - a + (1 – b) Y
C=Y→S=0
a
I
0
-a
C>Y
S>0
S< 0
“Dissaving”
Y1
Yf
Y
Relation of consumption and
savings functions
At all those levels of income where the C func is
above the 45 d line, the savings func is below
the x-axis, meaning C > Yd so S is negative.
And at all those levels of income where the C
func is below the 45 d line the savings func is
above the x-axis, meaning C < Yd, so savings
is positive. And at exactly that one and only one
level of income where the cons func intersects
the 45 d line, the savings func intersects the xaxis, so C = Yd so savings is zero.
Keynesian Model
45°
Expenditure
C = a + bY
C<Y
a+I
S = - a + (1 – b) Y
C=Y→S=0
a
I
0
-a
C>Y
S>0
S< 0
“Dissaving”
Y1
Yf
Y
autonomous investment
• In Keynes, investment is determined by a
number of factors, most importantly investor
expectations of future conditions.
• The important point here, though, is that
investment, unlike consumption and savings,
is NOT a function of income. It is
autonomous in the same sense as
autonomous consumption.
• Neither is it a simple function of interest rates,
as in the neoclassical model.
• The investment function will be horizontal.
Keynesian Model
45°
Expenditure
I=I
I
0
Y1
Y*
Yf
Y
aggregate spending (C+I)
• We add the constant amount of
autonomous investment to consumption to
derive the aggregate spending function
(no government, no foreign trade).
• The y-intercept of the aggregate spending
function is (a+I), and the slope is b. This is
because the only thing changing when
income changes is consumption.
Keynesian Model
45°
Expenditure
AS = C + I
C = a + bY
a+I
S = - a + (1 – b) Y
a
I
I
0
-a
Y1
Y*
Yf
Y
Savings, investment, and
equilbrium
• Note that the savings function intersects
the investment function at the same level
of income as the aggregate spending
function intersects the 45 degree line,
indicating that savings = investment at the
macroequilibrium.
• Note that this macroequilibrium occurs
below the full employment level of output,
Yf.
Keynesian Model
45°
Expenditure
AS = C + I
C = a + bY
a+I
S = - a + (1 – b) Y
a
I
I
0
-a
Y1
Y*
Yf
Y