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 doesnt 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 isnt 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 were 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 < C/Yd < 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 < S/Yd < 1

the mpc and the mps

C/Yd is called the mpc (marginal propensity to consume) S/Yd is called the mps (marginal propensity to save)

C/Yd + S/Yd = 1 and mps = 1 b

C/Yd + S/Yd = 1 and mps = 1 b

Proof:

C/Yd + S/Yd = 1 and mps = 1 b

Proof: If Yd = C + S, then

C/Yd + S/Yd = 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.

C/Yd + S/Yd = 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, Yd = C + S

C/Yd + S/Yd = 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, Yd = C + S Divide both sides by Yd, and we get:

C/Yd + S/Yd = 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, Yd = C + S Divide both sides by Yd, 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.
15 10 5 45

45 0 5 10 15

Keynesian Model
45 Expenditure

C<Y

C = a + bY

a+I

C=Y
a

C>Y

0
-a

Y1

Yf

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 = C/Yd = rise/run = slope)

C = a + bYd
What is the slope of the consumption function? b (b = mpc = marginal propensity to consume = C/Yd = 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 = C/Yd = 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 = S/Yd = rise/run = slope)

Keynesian Model
45 Expenditure

C<Y

C = a + bY

a+I

C=YS=0
a

S = - a + (1 b) Y

C>Y

S>0
S< 0

0
-a

Y1

Yf

Dissaving

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<Y

C = a + bY

a+I

C=YS=0
a

S = - a + (1 b) Y

C>Y

S>0
S< 0

0
-a

Y1

Yf

Dissaving

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<Y

C = a + bY

a+I

C=YS=0
a

S = - a + (1 b) Y

C>Y

S>0
S< 0

0
-a

Y1

Yf

Dissaving

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

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

0
-a

Y1

Y*

Yf

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

0
-a

Y1

Y*

Yf