Part IV: The Keynesian Revolution: 1945 1970

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Part IV: The Keynesian Revolution: 1945 - 1970

Objectives for Chapter 13: Basic Keynesian Economics

At the end of Chapter 13, you will be able to answer the following:

1. According to Keynes, consumption depends on (is a function of) what?

2. Define "disposable income" (review) . "average propensity to consume". "marginal propensity to consume".

3. From a number set, calculate the marginal propensity to consume and the marginal

propensity to save. From this number set, calculate the equilibrium real GDP. First, do so with only consumption and investment spending. Then, add it government purchases. Finally, add in net taxes and net exports. (Relate to the circular flow model.)

4. If real GDP is below (or above) equilibrium real GDP, why will it rise (fall) to equilibrium? (That is, why can these other levels of real GDP NOT be equilibrium?) What is meant by "unintended inventory investment"?

5. What is a recessionary? an inflationary (expansionary) gap? Show these on the aggregate demand - aggregate supply graph. (Review)

6. Explain why a change in investment spending (or government purchases) causes equilibrium real GDP to change by more than the change in investment spending (or government purchases).

7. What is meant by the “multiplier"?

8. How is the expenditures multiplier calculated? Why is the real expenditures multiplier lower than indicated by the multiplier formula?

Chapter 13: Basic Keynesian Economics (latest revision May 2006)

John Maynard Keynes, arguably the most influential economist of the 20th century, was introduced in the previous chapter. The Great Depression of the 1930s had called into question the Classical View of Economics, a view that had prevailed for over 150 years. Remember that the basic conclusion of the Classical View was that cyclical unemployment would not last very long. Since unemployment rates would fall automatically, there was no need for any government action to lower them. But rates of cyclical unemployment had been very high from 1929 until the beginning of World

War II in 1941. In the previous chapter, Keynes’ criticisms of the Classical View were discussed. In this chapter, we will examine the economic theory that Keynes developed to replace the Classical view. This theory is known as Keynesian Economics. It became somewhat influential after World War II and then became very influential in the 1960s. We can break this theory into just a few components: (1) consumption, (2) Equilibrium Real GDP, (3) inflationary and recessionary gaps, (4) multipliers, and (5) fiscal policy. Fiscal policy will not be discussed until Chapter 18.

(1) Consumption
Let us begin to understand Keynesian economics by examining its analysis of consumer spending. According to Keynes, consumer spending depends upon disposable income. This relationship is known as the consumption function. We described disposable income earlier. Disposable income is calculated as the National Income minus Taxes Paid plus Transfers. Let us examine the following consumption function:

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
Notice that there are only two things one can do with disposable income: spend it or save it. The amount spent on consumption plus the amount saved must equal the amount of disposable income. Notice also that savings can be negative. What does this mean? It means that the person has either borrowed or has used previous savings to pay for the consumption.

Keynes made two assertions about consumption. First, as disposable income rises, the amount spent by consumers also rises. This is shown clearly in the table on the previous page. Second, as disposable income rises, the percent of disposable income spent on consumer goods falls. Notice in the table that, if disposable income is $5000, consumers spend $5000. This is 100% of disposable income. But if disposable income is $10,000, consumers spend $9000. This is only 90% of disposable income.

This second point needs some illustration. Assume there are two people: Joe and Bill. Each is married with five children. Joe has an income of $10,000 per year. How much will Joe spend on consumer goods? Surely, Joe will spend all $10,000, and probably more. The need for shelter, food, and transportation will likely absorb all of Joe’s income (100%). Bill has an income of $100,000,000. How much will Bill spend on consumer goods? Let’s say Bill can get by on $10,000,000. This would only represent 10% of Bill’s income. What happens to the other $90,000,000? The answer is that it goes into some form of saving. Bill spends a smaller percent of his income because Bill can afford to save. Joe cannot afford to save at all.

Keynes gave a name to the percent of disposable income spent on consumer goods. He called it the “average propensity to consume”. So, as disposable income rises, consumption rises and the average propensity to consume falls. Keynes also named another important concept: the marginal propensity to consume. This is defined as the change in consumption that results from a given change in disposable income.

Average Propensity to Consume = Consumption

Disposable Income

Marginal Propensity to Consume = Change in Consumption

Change in Disposable Income

Notice that the marginal propensity to consume must be a number between zero and one. A number of zero tells you that if disposable income rises by $1, consumption will not rise at all. The entire additional dollar will be saved. A number of one tells you that if disposable income rises by $1, consumption will rise by the entire additional dollar. None of the increase will be saved. Go back to the table on the previous page. What is the marginal propensity to consume? Notice that, as you read down the table, disposable income always changes by $1000 (0 to 1000, 1000 to 2000, etc.). As it does, consumption always changes by $800 (1000 to 1800, 1800 to 2600, etc.). So the marginal propensity to consume is $800 divided by $1000, which equals 0.8 or 4/5. This tells us that every time disposable income rises by $1, an extra $0.80 will be spent and an extra $0.20 will be saved.

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