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Principles of Economics: Econ101

Keynes on Say’s Law

Keynes on Wage Rates and Prices

Consumption Function

Equilibrium Real GDP and Gaps

The Expenditure Multiplier

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Assumptions:

First, the price level is assumed to be constant until the economy reaches its full-employment or Natural Real GDP level.

Second, there is no foreign sector. In other words, the model represents a closed economy, not an open economy. It follows that total spending in the economy is the sum of consumption, investment, and government purchases (GDP=C+I+G).

Third, the monetary side of the economy is excluded.

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According to Keynes, a decrease in consumption and subsequent increase

in saving may not be matched by an equal increase in investment. Thus, a decrease in total expenditures may

occur.

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If the economy is in a recessionary gap at point 1, Keynes held that wage rates may not fall.

The economy may be stuck in the recessionary gap.

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Suppose the economy is in a recessionary gap at point 1.

Wage rates are $10 per hour, and the price level is P1.

The issue may not be whether wage rates and the price level fall, but how long they take to reach long-run levels

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If they take a short time, then classical economists are right: the economy is self-regulating.

If they take a long time—perhaps years—then Keynes is right: the economy is not self-regulating over any reasonable period of time

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1. What do Keynesians mean when they say the economy is inherently unstable?

Keynesians mean that an economy may not self-regulate at Natural/Potential Real GDP (QN). Instead, an economy can get stuck in a recessionary gap.

2. “What matters is not whether the economy is self-regulating or not, but whether prices and wages are flexible and adjust quickly.” Comment.

To say that the economy is self-regulating is the same as saying that prices and wages are flexible and adjust quickly. They are just two ways of describing the same thing.

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Consumer spending depends upon disposable income......where, disposable income is national income

minus taxes plus transfers

Keynes’ Two Assertions About Consumption:

As disposable income rises, the amount spent by consumers also rises.

As disposable income rises, the percent of disposable income spent falls…..also known as

the average propensity to consume.

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Disposable Income Consumption Savings 0 $1000 -$1000 $1000 $1800 -$ 800 $2000 $2600 -$ 600 $3000 $3400 -$ 400 $4000 $4200 -$ 200 $5000 $5000 0 $6000 $5800 $200 $7000 $6600 $400 $8000 $7400 $600 $9000 $8200 $800

$10,000 $9000 $1000

Average Propensity to Consume = Consumption Disposable Income

So….as disposable income rises, consumption rises and the average propensity to consume falls.

Marginal Propensity to Consume = Change in Consumption Change in Disposable Income 10

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Equilibrium Real GDP: occurs when aggregate demand is equal to aggregate supply.

Real GDP (= Income) Consumption + Business Investment = Aggregate Spending Demand 0 $1000 $400 $1400 $1000 $1800 $400 $2200 $2000 $2600 $400 $3000 $3000 $3400 $400 $3800 $4000 $4200 $400 $4600 $5000 $5000 $400 $5400 $6000 $5800 $400 $6200 $7000 $6600 $400 $7000 $8000 $7400 $400 $7800 $9000 $8200 $400 $8600 $10,000 $9000 $400 $9400 $11,000 $9800 $400 $10,200 $12,000 $10,600 $400 $11,000 $13,000 $11,400 $400 $11,800 $14,000 $12,200 $400 $12,600 $15,000 $13,000 $400 $13,400

Unintended Inventory Investment falls

Unintended Inventory Investment rises

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Recessionary Gap: if equilibrium real GDP is below potential real GDP

Inflationary Gap: if equilibrium real GDP is above potential real GDP

According to Keynes, if nothing is done to correct gaps, they will continue indefinitely.

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The number that is multiplied by the change in initial spending to obtain the overall change in total spending.

The multiplier is equal to 1 / (1 - MPC).

Change in total spending = Multiplier x Change in initial spending

The basic principle of the multiplier is that one person’s spending generates another person’s income through a series of “induced

consumption”.

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Initial rise in autonomous spending = $1000 Marginal Propensity to Consume = .80 Multiplier = 1/(1-.80) = 1/.2 = 5 Change in total spending = 5 x $1000 = $5000 “Multiplier likely to be smaller”

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1. If the MPC = 0.70, what does the multiplier equal?

1/(1- 0.70) = 1/0.30 =3.33.

2. What happens to the multiplier as the MPC falls?

The multiplier falls. For example, if MPC = 0.20, then the multiplier is 1.25, but if MPC = 0.80, then the multiplier is 5.

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An initial increase in autonomous consumption raises total spending and shifts the aggregate demand curve from AD1 to AD2.

Because of the multiplier, the increase in autonomous spending generates additional incomes and additional spending, shifting the aggregate demand curve to AD3.

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The private sector may not be able to get the economy out of a recessionary gap. In other words, the private

sector (households and businesses) may not be able to increase C or I enough to get the AD curve in to intersect the AS curve at the Natural/Potential Level of Real GDP.

The government may have a management role to play in the economy. According to

Keynes, government may have to raise aggregate demand enough to stimulate the economy to move it out of the recessionary gap and to its Natural/Potential Real GDP

level.

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