AD & the Keynesian Model

Chapter 9, Section 3
Keynesian Review
 Modern markets have “sticky” prices and
wages
 Prices adjust slowly
 Quantity adjustment more likely
 Hence the importance of Aggregate Demand
 “Animal spirits” suggest an unstable macro-
economy
 What explains the spending behavior of
consumers & businesses?
Consumption
 Numerically the most important element
of GDP
 Behavioral assumption:
 English:
 “Consumption depends on income”
 Math:
 C = f(Y) [general math notation]
 C = C + (mpc)Y [straight line relationship]
 C = 20 + (0.8)Y [Table 9.2 numerical example]
What the components mean:
 “C bar”
 Autonomous consumption, not related to income
 “mpc”
 Marginal propensity to consume
 What proportion of additional income is spent on
additional consumption
 mpc = ΔC/ ΔY
 “Y”
 Meaning “income” in this context
mps
 Any change in income is divided
between a change in consumption and a
change in savings
 Recall imports, and government [taxes] are
assumed away for the moment
 ΔY = ΔC + ΔS
 Divide both sides by ΔY
 mps = ΔS/ ΔY = 1 - mpc
 Table 9.2 The Consumption Schedule (and Saving)

(1) (2) (3) (4) (5)

Income Autonomous The part of consumption that Consumption Saving
(Y) Consumption depends on income, with mpc = C = 20 + 0.8 Y S=Y–C
(C ) 0.8 = column(2) = column(1)
=0.8  column(1) + column(3) – column(4)

0 20 0 20 -20
100 20 80 100 0
200 20 160 180 20
300 20 240 260 40
400 20 320 340 60
500 20 400 420 80
600 20 480 500 100
700 20 560 580 120
800 20 640 660 140

“Induced
consumption”
 Consumption =
Income Line
500
Consumption (C)
(= C + mpc Y)
Consumption (C)

400

340 Saving (S)

300

Slope = mpc
200

100

C = 20 45
0
100 400 Income (Y)

Figure 9.10 The Keynesian Consumption Function

Other forces affecting
consumption
 Think/share/pair: What else besides
income (Y) affects consumption
spending?
 What affects savings?
 S = f(interest rates?)
 Classical idea rejected by Keynes
 S = f(Y) says Keynes
Consumption Function: Group
Exercise

Question 3, page 9-36

Keynes: Investment Spending
 I = f(?)
 Interest rates?
 Profits? Profit expectations?
 “Animal spirits”?
 II = II
 All investment spending is autonomous
 Not “induced” by income
II

Intended Investment (II)

Intended
Investment (II)
II = 60
(= II )

Income

Figure 9.11 The Keynesian Investment Function

Putting the pieces together
 The “Fourth Essential” economic
activity: Consumption and investment
 Now we have a deeper understanding:
 AD = C + II, where
 C = C + (mpc)Y
 II = II
 Equilibrium occurs where:
 Y = AD, or
 S = II
Table 9.3 Deriving Aggregate Demand from the Consumption Function and Investment

(2) (3) (4)

(1) Consumption Intended Aggregate Demand
Income (C) Investment AD = C + II
(Y) (II) = column (2) + column (3)

0 20 60 80

300 260 60 320

400 340 60 400

500 420 60 480

600 500 60 560

700 580 60 640

800 660 60 720

Consumption, Investment, and
Aggregate Demand

Aggregate Demand (AD)

= C + II

Consumption (C)

400
340 Intended Investment (II)

C +II = 80

400
Income (Y)

Figure 9.12 Aggregate Demand

No Fault on AD
Volatility of intended
investment
 Keynes: The economy is unstable
 What might cause intended investment
to change?
 Result: A change in the AD curve [shift]
Table 9.4 Aggregate Demand with Higher Intended Investment

(1) (2) (3) (4)

Income Consumption Intended Investment Aggregate Demand
(Y) (C) (II) (AD)

0 20 140 160
300 260 140 400
400 340 140 480
500 420 140 560
600 500 140 640
700 580 140 720
800 660 140 800
Aggregate Demand 1000 AD (II = 140)
800 AD (II = 60)
700
600
500
480
400
300

C +II =200
160
C +II =100
80
0
100 400 800
Income (Y)

Figure 9.13 Aggregate Demand with a Higher Level of Intended Investment

 Keynesian Adjustment
Mechanism
 Classical school = price adjustments
 Keynes = production (output) adjustments
 Keynesian equilibrium (AD = Y; fig 9.14)
 The key signal: Unintended buildup of
inventories
ExPost  “Unintended investment”
 Actual I = II + excess inventory accumulation
or depletion
ExAnte
Table 9.5 The Possibility of Excess Inventory Accumulation or Depletion

(2) (3) (4)

(2) (1) Cons
(3) Intend Aggregate
(4) (5) (6)
(1) Aggregate Inco
Excess umpt
Inventory ed Demand
Intended Investment Check that the
Income Demand Accumulation
me ion (+)Invest
or Investment
AD = C + II (I) macroeconomic
(Y) (AD) (Y)Depletion
(C) (-) ment = column
(II) (2) = column(3) identity still holds:
= column(1)- (II) + column (3) + column(4) Y = C+I
Table column(2)
9.3 “C” [9.4]
0 20 60 80
300 260 -20 60 60
320
300 320 40 260 300

400 400 400 340 0 60 60

400 60 340 400

500 480 500 420 20 60 60

480 80 500

600 560 600 500 40 60 60

560 100 600

700 640 700 580 60 60 60

640 120 700

800 720 800 660 80 60 60

720 140 660 800
 Output =
Income Line
Aggregate Demand and Output

1000 Aggregate Demand (AD)

800
700 unintended
720
investment
600 (build up of
inventories)
500
E
400
300
200
100
80
45
0
100 400 800
Income (Y)

Figure 9.14 Unintended Investment in the Keynesian Model

The downward slide
 In Figure 9.14 as businesses react to
excess inventories by cutting production
 Income will fall (workers laid off; hours
reduced)
 A slide downward toward “E”
 Where AD = Y
Problem of Persistent
Unemployment

Equilibrium – but at less than full

employment
 Full Employment
Aggregate Demand and Output

1000 E0 AD0 (II = 140)

800
700
600
500
400
300
200
160
100
45
0
100 400 800
Income (Y)
Y*

Figure 9.15 Full Employment Equilibrium with High Intended Investment

 Full Employment
Aggregate Demand and Output

1000 E0 AD0 (II = 140)

800 AD1 (II = 60)
700
600
500
400 E1
300
Persistent
200
160 unemployment
equilibrium
100
80
45
0
100 400 800
Income (Y)
Y*

Figure 9.16 A Keynesian Unemployment Equilibrium

output (Y*)
Production
generates
Income goes
income
to households

income (Y*) 800

lower income 720

C = 660 S = 140
If leakages
lower spending are larger
lower output than
AD = lower Y injections…

Insufficient spending II = 60

AD < Y*

Figure 9.17 Movement to an Unemployment Equilibrium

It gets worse (for the
economy) ….
 Previous example: A $80 fall of
investment, led to a $400B fall in
income/output
 5 times as much!
 The multiplier
 “Ripple effect”
 Significance: it contributes to
macroeconomic instability
Table 9.6 The Multiplier at Work
(1) (2) (3)
Change in Change in Aggregate Demand Change in Consumption
Intended (as C or II change) ΔC = mpc Δ Y
Investment and in Output and Income = .8  Column (2)
(as firms respond to changes in AD)
1 Less production means less
Reduced investment spending leads directly income. With income
Investors
to Δ AD = -80. reduced by 80, households
lose
Producers respond to reduced demand for cut consumption
confidence.
their goods by cutting back on production. by mpc Δ Y
Δ II = -80
Δ Y = - 80 = .8  -80
ΔC = -64
2 Lowered consumption spending means Households cut
lowered AD consumption
Δ AD = -64 by mpc Δ Y
Producers respond. = .8  - 64
Δ Y = - 64 ΔC = - 51.2
3 = .8  -51.2
Δ Y = - 51.2
ΔC = - 40.96

4
Δ Y = - 40.96 ΔC = - 32.77

5
Δ Y = - 32.77 ΔC = - 26.21

etc. etc.

Sum of changes in Y
= -80 + -64 + -51.2 +-40.96 + -32.77 + ….
= -400
Multiplier math
 Why 5 times?
 m = 1/(1 – mpc)
 m = 1/(1 – 0.8) = 1/0.2 = 5
 ΔY = m* ΔII
 Actual multiplier over 12 months is
closer to 2
The Mustard Multiplier?

http://www.youtube.com/watch?v=CVyoYXw3TuI
Determining Equilibrium
 Exercise 6, page 9-37
 “Welcome to Macroland” [EL, p83]
Experimenting with alternative
scenarios
 Changing investment spending [-25]

http://nova.umuc.edu/~black/pageg.html