Chapter 25: Equilibrium in the Product Market
A Simple Keynesian Model of Income Determination
Simplifying Assumptions
To explain the determination of the equilibrium level of income in the
product market with the Keynesian model, we make the following
simplified assumptions:
- We are dealing in a Closed Economy (There are neither imports
nor exports)
- There are no government expenditures, taxes and government
transfer payments
- Households spending and saving decisions depend only on their
income
- Firms decide to spend a fixed amount for new investment.
Investment is Autonomous (independent of income)
- The economy is operating with unemployed labor and other
resources
- The price level is contstant, realitive prices might change in the
individual markets, but the average level of prices remains the
same.
Ex Ante and Ex Post Concepts
- Ex Ante (Before the fact) concepts relate to plans or intentions
- Ex Post (After the fact) concepts relate to realized or actual
(historical) facts
- Ex ante concepts rather then ex post concepts are relevant in
the process of equilibrium income determination.
The Aggregate Expenditure-Aggregate Output Approach
- Aggregate Expenditure is the total spending in the economy
- Aggregate Output is the total production of goods and services in
an economy.
Aggregate Expenditure = Consumption Spending + Investment
Spending
Arithmetical Analysis
- If desired AE exceeds AO, inventories will fall below desired
levels. Firms will then tend to increase their production, and the
level of income will tend to rise.
- If desired AE falls short of AO, there will be an unintended
increase in inventory; firms will tend to reduce their production
and income will tend to fall.
- The economy will be in equilibrium when desired AE equals AO
The Consumption-Income Relation
- A Consumption Schedule shows the relation between total
income and total consumption.
- The Average Propensity of Consume (APC) is the ratio of
consumption to income.
APC = (Consumption) divided by (Income)
- The Average Propensity to Save (APS) is the ratio of saving to
income
APS = (Saving) divided by (Income)
1 = APC + APS
-
-
The Marginal Propensity to Consume (MPC) is the ratio of the
change in consumption to the change in income.
MPC = (Change in Consumption) divided by (Change in Income)
The Marginal Propensity to Save (MPS) is the ratio of the change
in saving to the change in income.
MPS = (Change in Saving) divided by (Change in Income)
1 = MPC + MPS
- At the Break-Even Level of Income, saving is zero.
- Dissaving occurs when consumers finance consumption by
borrowing from past savings.
The Consumption Curve
- The Consumption Curve illustrates a consumption schedule of
current income and consumption
- The marginal propensity to consume is the slope of the
consumption curve.
- Any point on the 45-degree line represents the equality of total
expenditure and total income.
- The graph of equilibrium level of income is often refered to as
the Keynesian Cross
- Equilibrium in the closed economy without government is shown
graphically by the intersection of the AE line and the 45-degree
line.
The Injections-Withdrawals Approach
- An Injection tends to increase the flow of income while a
Withdrawal tends to reduce it.
- Injections include investment, government purchases, and
exports.
- Withdrawals include saving, taxes, and imports.
Arithmetical Analysis
- If planned investment exceeds panned saving, the level of
income will tend to rise.
- If intended investment is less than intended saving, the level of
income will tend to fall.
- The economy will be in equilibrium when intended saving equals
intended investment.
Tabular and Graphical Analyses
- The Break-Even Level of Income is that level at which saving is
zero.
The Saving-Income Relation
- The slope of the saving curve is the marginal propensity to save
- Equilibrium occurs at the intersection of the saving curve and the
investment line.