The Fixed-Price Keynesian Model: An Economy Below Full – Employment Focus on the Demand Side

Aggregate Expenditures = AE = GDP Y = AE = C + I + G + NX Consumption expenditures (C) ≈ 68% of GDP Investment expenditures (I) ≈ 18% of GDP Government expenditures (G) ≈ 18% of GDP Net exports (NX) ≈ - 3 % of GDP Imports exceed exports by about 3% of GDP

Some Identities Disposable income = Y d = Y-T, after tax income. Y d = Y - T = C + S Keynes: people save a fixed proportion of their disposable income on average  Consumption is related to disposable income (Y-T).  C = C a +cY d Saving either finances private investment (I) or the government’s deficit (G – T) S = I + (G – T) at equilibrium S + T = I + G Leakages from the spending stream (S + T) = Injections to the spending stream (I + G)

Average Propensities to Consume and to Save The average propensity to consume (APC): the proportion of disposable income spent for consumption APC = C/Y d The average propensity to save (APS): proportion of disposable income saved APS = S/Y d APC + APS = 1 since Y d = C + S 1 = C/ Y d + S/ Y d

Consumption and Disposable Income

Consumption Function & C = C a +cY d is a straight line with slope c. autonomous consumption & C a is autonomous consumption. marginal propensity to consume MPC & The slope, c, is the marginal propensity to consume from disposable income (MPC). 0 < MPC < 1.  MPC is  C/  Y d, the amount by which consumption changes for each dollar change in Y d C YdYd CaCa CC YdYd MPC =  C/  Y d

Saving and Dissaving Planned C Yd Yd (if C = Yd) Dissaving C > Yd Saving Yd > C Yd 1 Yd*Yd 2 C

Saving Function: When income increases, both consumption and saving increase Since Y = C + S + T and Y d = Y – T Y d = C + S C = C a + c Y d and S = -C a + (1-c) Y d S = S a + sY d [S a = autonomous saving = - C a ] S = S a + mps x Y d, where mps = s = marginal propensity to save Note: mps + mpc = 1

Consumption and Saving in a Hypothetical Economy

Marginal Propensity to Consume: additional consumption in response to each additional dollar of disposable income mpc = ΔC/ΔY d

Shifts in the Consumption Function Expected Future Income – An increase in expected future income will cause current consumption to rise and your saving to fall. Wealth – An increase in wealth raises current consumption and lowers current saving. Expected Real Interest Rate Higher real return  incentive to save more … but – Higher return to saving  less needs to be put aside to achieve the same desired future savings. – Net effect: increased real interest rates reduce consumption and increase saving. Demographics Taxes – Ricardian Equivalence?

Autonomous Shifts in Consumption and in Saving

Investment Spending (I) Capital goods have a long life. Capital goods take time to build. Capital goods involve large expenditure. The present value of a capital good depends on the income it generates over a long time horizon. – Businesses must form expectations about future conditions and profitability. – Investment is inherently risky. erratic Investment expenditure tends to be erratic.

Determinants of Investment Profit expectations Interest rate Technology Price (Cost) of Capital Goods Capacity Utilization Profit expectations

Investment as a Function of Current Income Investment depends more on expectations of the future than on what’s happening now.

Government Expenditures as a Function of Real GDP Government Expenditures are Largely Independent of the Current State of the Economy

Imports and Exports The demand for imports depends on current economic activity, Y IM = IM a + imY “im” is the marginal propensity to import (MPI). Exports are exogenously determined they don’t depend on conditions in our economy but rather on conditions in foreign economies Net exports is NX = EX – (IM a + imY) or NX = (EX-IM a ) – imY or NX = NX a – imY (a downward sloping line)

Net Exports as a Function of Real GDP

The Aggregate Expenditures Function