1. The Keynesian Model (a.k.a.—demand-side stabilization policy) The model is a response to high unemployment during the Great Depression The model is a response to high unemployment during the Great Depression The goal of the policy is to increase or decrease demand using govt. spending and taxation The goal of the policy is to increase or decrease demand using govt. spending and taxation Increased demand = increased GDP = lower unemployment Increased demand = increased GDP = lower unemployment

2. GDP and Unemployment If unemployment follows GDP; how can we manage GDP? If unemployment follows GDP; how can we manage GDP? Keynes believed that any instability in any GDP would result in undesirable fluctuations Keynes believed that any instability in any GDP would result in undesirable fluctuations Keynes looked at what was the most unstable sector of GDP Keynes looked at what was the most unstable sector of GDP

3. GDP= C + I + G + Xn Xn or F (foreign sector)—was seen as being too small to have an impact Xn or F (foreign sector)—was seen as being too small to have an impact G—Government sector is relatively stable over time (they set budgets) G—Government sector is relatively stable over time (they set budgets) C—Consumer sector is even more stable (wages are generally stable) C—Consumer sector is even more stable (wages are generally stable) I—Investment sector seemed to be the most unstable. Why? I—Investment sector seemed to be the most unstable. Why? Changes in stock Changes in stock

4. Fiscal Policy Keynes felt that only the government was large enough to offset any fluctuations in the investment sector Keynes felt that only the government was large enough to offset any fluctuations in the investment sector The government could use two tools: The government could use two tools: Spending cuts/increasesSpending cuts/increases Tax cuts/increasesTax cuts/increases

5. Income vs. Consumption We can say that real GDP is = to Yd because an income was received as a result of the production of those goods and services We can say that real GDP is = to Yd because an income was received as a result of the production of those goods and services

6. Income vs. Consumption The model shows us how much we consume at various levels of income The model shows us how much we consume at various levels of income

7. Income vs. Consumption The economy is most efficient when all of our income is spent (the red, 45 degree line) The economy is most efficient when all of our income is spent (the red, 45 degree line)

8. Income vs. Consumption The intersection of the two curves shows the level of productivity that is ideal for the economy The intersection of the two curves shows the level of productivity that is ideal for the economy Keynes would use fiscal policy to target this level of GDP Keynes would use fiscal policy to target this level of GDP

9. Income-Consumption and Income- Savings Relationship Savings is always (Yd) income – consumption Savings is always (Yd) income – consumption Therefore S+C=1Therefore S+C=1 APC—Average propensity to consume APC—Average propensity to consume Tells us what percentage of our disposable income is spentTells us what percentage of our disposable income is spent APC= Income Consumption

10. Income-Consumption and Income- Savings Relationship APS—Average propensity to save APS—Average propensity to save Tells us what percentage of our disposable income is savedTells us what percentage of our disposable income is saved APS= Income Saving

11. Income-Consumption and Income- Savings Relationship MPC—Marginal propensity to consume MPC—Marginal propensity to consume It is the additional consumption spending from an additional dollar of incomeIt is the additional consumption spending from an additional dollar of income Tells us the change in consumption due to a change in incomeTells us the change in consumption due to a change in income MPC= Change in income Change in consumption

12. Income-Consumption and Income- Savings Relationship MPS—Marginal propensity to save MPS—Marginal propensity to save Tells us the change in saving due to a change in incomeTells us the change in saving due to a change in income MPS= Change in income Change in savings

13. The consumption function C= a + b x Yd C= a + b x Yd C=consumptionC=consumption a=autonomous consumptiona=autonomous consumption b=marginal propensity to consumeb=marginal propensity to consume Yd=disposable incomeYd=disposable income

14. The relationship between interest rates and investment (I) A business will only invest if the marginal benefit is greater than the marginal cost (paid in interest) A business will only invest if the marginal benefit is greater than the marginal cost (paid in interest) Investment demand curve Investment demand curve As interest (the price of borrowing $) goes up, investment demand goes downAs interest (the price of borrowing $) goes up, investment demand goes down As interest goes down, investment demand goes upAs interest goes down, investment demand goes up

15. Investment Demand

16. Determinants that shift investment demand Maintenance/opera ting costs Maintenance/opera ting costs A decrease in these costs increase the expected rate of return on investment shifting investment demand to the right

17. Determinants that shift investment demand Business taxes Business taxes Reductions in govt. taxes increases expected profitability of investments, increasing investment demand

18. Determinants that shift investment demand Technological change Technological change stimulates investment Stock of Capital Goods Stock of Capital Goods Expectations Expectations Future sales, operating costs, profits, etc.

19. The Multiplier Effect When a change in spending changes GDP by more than the initial change When a change in spending changes GDP by more than the initial change One person’s spending becomes another’s incomeOne person’s spending becomes another’s income How much does a given change in spending impact GDP? How much does a given change in spending impact GDP? The multiplier of course!The multiplier of course! Multiplier= Change in real GDP Initial change in spending

20. The Multiplier Effect (cont.) By rearranging the equation, we can also say that: By rearranging the equation, we can also say that: Change in GDP=multiplier X initial change in spending

21. The Multiplier Effect (cont.) You can also find the multiplier if you know MPC: You can also find the multiplier if you know MPC: Only for government and investment spendingOnly for government and investment spending Multiplier = _____1_____ 1 - MPC or MPS Multiplier = ___1___

22. The Multiplier Effect (cont.) The tax multiplier is used for determining the impact of a tax on GDP (it’s different from the investment and government spending multipliers): The tax multiplier is used for determining the impact of a tax on GDP (it’s different from the investment and government spending multipliers): Tax multiplier= [1-MPC] __-MPC__ or -MPC MPS