Chapter 18
The Keynesian Model
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2002South-Western College Publishing
1
Who were the
Classical economists?
The Classical economists
believed that a continuing
depression is impossible
because markets will
eliminate persistent
shortages or surpluses
2
When were the ideas
of the Classical
economists widely
accepted?
Prior to the Great
Depression of the 1930’s
3
What is Say’s Law?
The belief of the
Classical economists
that the economy was
always tending toward
full employment
4
What does
Say’s Law say?
Supply creates its
own demand
5
Why is Say’s Law a full
employment theory?
Generally speaking,
producers produce goods
that consumers want and
consumers have the
money to buy because of
the wages they were paid
6
Under Say’s Law, is
unemployment
possible?
Yes, but it is a short-lived
adjustment period in which
wages and prices decline
or people voluntarily
choose not to work
7
What changed
people’s mind about
Say’s Law?
The Great Depression and
the publication of The
General Theory of
Employment, Interest, and
Money published in 1936
8
Why did Keynes’
believe that “supply
did not create its
own demand”?
Aggregate expenditures
(demand) can be forever
inadequate for an
economy to achieve full
employment
9
What is the main
idea of this chapter?
Keynes’s theory for the
determination of
consumption and
investment expenditures
10
What determines your
family’s spending for
goods and services?
Disposable income
11
What is the
consumption function?
The graph that shows the
amount households
spend for goods and
services at different levels
of disposable income
12
What is savings?
Disposable income
minus consumption,
the amount
households do not
spend for consumer
goods and services
13
What is dissaving?
The amount by which
personal consumption
expenditures exceed
disposable income
14
How do people dissave?
Negative savings is
financed by by drawing
down previously
accumulated financial
assets or by borrowing
15
What is autonomous
consumption?
Consumption that is
independent of the level
of disposable income
16
What happens
when disposable
income is zero?
Spending will equal
autonomous
consumption because
households will dissave
to satisfy basic
consumption needs
17
What is the marginal
propensity to
consume?
The change in
consumption resulting
from a given change in
real disposable income
18
C
MPC =
 Yd
19
What is marginal
propensity to save?
The change in saving
resulting from a
given change in real
disposable income
20
S
MPS =
 Yd
21
MPC + MPS = 1
22
Real Consumption
Trillions of $ per year
8
7
6
5
4
3
2
1
The Consumption Function
C = Yd
Dissaving
C
Yd
45°
C
Saving
Real Disposable Income
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
23
What happens if
factors other than
income change?
There is a shift or
relocation in the
consumption schedule
24
Real Consumption
Trillions of $ per year
8
7
6
5
4
3
2
1
45°
The Consumption Function
C = Yd
C2
C1
MPC = .75
MPC = .50
Real Disposable Income
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
25
Real Consumption
Trillions of $ per year
The Consumption Function
8
C
=
a
+
bY
2
2
d
7
6
 nonincome
5
B
determinant
4
A
3
C1 = a1 + bYd
2
Disposable Income
1  real consumption Real
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
26
Why does the consumption
function shift?
• Expectations
• Wealth
• Price level
• Interest rate
• Stock of durable goods
27
How do expectations affect
the consumption function?
Consumers expectations
of things to happen in
the future will affect
their spending
decisions today
28
How does wealth affect the
consumption function?
Holding all other factors
constant, the more
wealth households
accumulate, the more
they spend at any
current level of
disposable income
29
How does the price
level affect the
consumption function?
Any change in the
general price level shifts
the consumption
schedule by reducing or
enlarging the consumers
purchasing power
30
How does the interest
rate affect the
consumption function?
A high interest rate will
discourage people from
borrowing money and a
low interest rate will
encourage people to
borrow money
31
How does the stock of
durable goods affect the
consumption function?
When durable goods are
suppressed, like during
WWII, afterwards there is
an increase in the
demand for goods not
previously made available
32
How does consumption
compare with investment?
Consumption is more
stable than investment
33
According to the
Classical Economists,
what determined the
level of investment?
The interest rate
34
According to Keynes,
what determines the
level of investment?
Expectations of future
profits is the primary
factor, the interest rate is
the financing cost of any
investment proposal
35
What is the investment
demand curve?
The curve that shows the
amount businesses
spend for investment
goods at different
possible rates of interest
36
12%
Interest rate
16%
Movement along the firm’s
investment demand curve
A
Investment
Demand Curve
B
8%
4%
Real investment
5
10
15
20
37
16%
12%
8%
Interest rate
Shift in the firm’s investment
demand curve
C
B
4%
Real investment
5
10
I1
15
I2
20
38
Why is investment
demand unstable?
• Expectations
• Technological change
• Capacity utilization
• Business taxes
• Autonomous reasons
39
How do expectations
affect investment?
Businesspeople are
quite susceptible to
moods of optimism and
pessimism
40
How does technological
change affect investment?
The introduction of new
products and new
ways of doing things
have a big impact on
investment decisions
41
What happens when
capacity utilization is low?
When capacity utilization
is low, firms can meet
an increase in demand
without expanding
42
What happens when
capacity utilization is high?
When capacity utilization is
high, firms must increase
investment to meet an
increase in demand
43
How do business taxes
affect investment?
Business decisions
depend on the
expected after-tax
rate of profit
44
What is
autonomous expenditure?
Spending that does not
vary with the current
level of disposable
income
45
Aggregate Investment
Demand Curve
Interest Rate
16%
14%
12%
10%
8%
6%
4%
2%
A
Autonomous
investment
Real Investment
.2
.4 .6
.8 1.0 1.2 1.4 1.6
46
Aggregate Autonomous
Investment Demand Curve
1.6
1.4
1.2
1.0
.8
.6
.4
.2
Autonomous
investment
Real Disposable Income
trillions of dollars per year
1
2
3
4
5
6
7
8
47
What is the aggregate
expenditure function?
The function that
represents total
spending in an economy
at a given level of real
disposable income
48
8
7
6
5
4
3
2
1
Aggregate Expenditures
Schedule and Function
AE
C
E
Real Disposable Income
trillions of dollars per year
1
2
3
4
5
6
7
8
49
Key Concepts
50
Key Concepts
• Who were the Classical economists?
• When were the ideas of the Classical
economists widely accepted?
• What is Say’s Law?
• What does Say’s Law say?
• Why did Keynes’ believe that “supply did
not create its own demand”?
• What determines your family’s spending
for goods and services?
51
Key Concepts cont.
•
•
•
•
•
•
•
What is the consumption function?
What is savings?
What is dissaving?
What is autonomous consumption?
What is the Marginal Propensity to Consume?
What is Marginal Propensity to Save?
What happens if factors other than income
change?
52
Key Concepts cont.
• Why does the consumption function shift?
• According to the Classical economists, what
determined the level of investment?
• According to Keynes, what determines the level
of investment?
• What is the investment demand curve?
• Why is investment demand unstable?
• What is autonomous expenditure?
• What is the aggregate expenditure function?
53
Summary
54
Say’s Law is the classical theory
that “supply creates its own
demand” and therefore the Great
Depression was impossible.
Say’s Law is the belief that the
value of production generates an
equal amount of income and, in
turn, total spending.
55
The Classical economists rejected
the challenge that
underconsumption is possible
because they believed flexible
prices, wages, and interest rates
soon establish balance between
supply and demand.
56
John Maynard Keynes believed
that unless aggregate spending
is adequate, the economy can
experience prolonged and
severe unemployment.
57
The consumption function (C) is
determined by changes in the
level of disposable income.
58
Autonomous consumption is
consumption that occurs even if
disposable income equals zero.
Changes in such nonincome
determinants as expectations,
wealth, the price level, interest
rates, and the stock of durable
goods cause shifts in the
consumption function.
59
Real Consumption
Trillions of $ per year
8
7
6
5
4
3
2
1
The Consumption Function
C = Yd
Dissaving
C
Yd
45°
C
Saving
Real Disposable Income
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
60
The marginal propensity to consume
(MPC) is the change in consumption
associated with a given change in
disposable income. The MPC tells
how much of an additional dollar of
disposable income households will
spend for consumption.
61
The marginal propensity to save
(MPS) is the change in saving
associated with a given change
in disposable income. The MPS
measures how much of an
additional dollar of disposable
income households will save.
62
The investment demand
curve (I) shows the amount
businesses spend for
investment goods at different
possible rates of interest.
63
The determinants of investment
demand curve are the expected
rate of profit and rate of interest.
Shifts in the investment demand
curve result from expectations,
technological change, capacity
utilization, and business taxes.
64
An autonomous expenditure
is spending that does not
vary with the current level of
disposable income.
65
The Keynesian model
autonomous expenditure to
investment. As a result, the
investment demand curve is a
fixed amount determined by the
rate of profit and the interest rate.
66
The aggregate expenditures
function (AE) shows the total
spending in an economy at a
given level of disposable income.
67
Assuming investment
spending is autonomous, the
slope of the AE function is
determined by the MPC.
68
8
7
6
5
4
3
2
1
Aggregate Expenditures
Schedule and Function
AE
C
E
Real Disposable Income
trillions of dollars per year
1
2
3
4
5
6
7
8
69
Chapter 18 Quiz
©2002 South-Western College Publishing
70
1. The French classical economist Jean
Baptiste Say transformed the equality of
production and spending into a law that
can be expressed as follows:
a. The invisible hand creates its own
supply.
b. Wages always fall to the subsistence
level.
c. Supply creates its own demand.
d. Aggregate output does not always
equal consumption.
C. Says law was developed in the early
1800s and is the cornerstone of
classical economics.
71
2. Autonomous consumption is
a. positively related to the level of
consumption.
b. negatively related to the level of
consumption.
c. positively related to the level of
disposable income.
d. independent of the level of disposable
income.
D. Autonomous consumption is the
amount of spending from savings or
borrowing that occurs even when
disposable income is zero.
72
3. The consumption function represents
the relationship between consumer
expenditures and
a. interest rates.
b. saving.
c. the price level.
d. disposable income.
D. Keynes argued the most
important determinant of
aggregate spending for consumer
goods is personal income after
taxes.
73
4. John Maynard Keynes’s proposition that a
dollar increase in disposable income will
increase consumption, but by less than
the increase in disposable income, implies
a marginal propensity to consume that is
a. greater than or equal to one.
b. equal to one.
c. less than one, but greater than zero.
d. negative.
C. Each dollar change in disposable
income is divided between
changes in consumption and
saving.
74
5. Above the break-even disposable
income for the consumption function,
which of the following occurs?
a. Dissaving.
b. Saving.
c. Neither (a) nor (b).
d. Both (a) and (b).
B. Dissaving occurs below the breakeven point on the consumption
function.
75
Real Consumption
Trillions of $ per year
8
7
6
5
4
3
2
1
The Consumption Function
C = Yd
Dissaving
C
Yd
45°
C
Saving
Real Disposable Income
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
76
6. Which of the following changes
produces an upward shift in the
consumption function?
a. An increase in consumer wealth.
b. A decrease in consumer wealth.
c. A decrease in autonomous
consumption.
d. Both (b) and (c) .
A. Decreases in wealth and
autonomous consumption shift the
consumption function downward.
77
Real Consumption
Trillions of $ per year
8
7
6
5
4
3
2
1
45°
The Consumption Function
C = Yd
C2
C
MPC = .75
MPC = .50
Real Disposable Income
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
78
7. An upward shift in the consumption
schedule, other things being equal, could
be caused by households
a. becoming optimistic about the state of
the economy.
b. becoming pessimistic about the state
of the economy.
c. expecting future income and wealth to
decline.
d. none of the above.
A. If consumers expect good
economic ties ahead, they
increase spending at each level of
disposable income in the current
79
time period.
8. The investment demand curve
represents the relationship between
business spending for investment
goods and
a. GDP.
b. interest rates.
c. disposable income.
d. saving.
B. As the interest rate declines, more
business investment projects become
profitable and investment spending
increases.
80
9. Which of the following changes produces
a leftward shift in the investment demand
curve?
a. A wave of optimism about future
profitability.
b. Technological change.
c. High plant capacity utilization.
d. An increase in business taxes.
D. An increase in business taxes
decreases after-tax profits on
investment projects and businesses
invest less at various possible
interest rates.
81
16%
12%
8%
Interest rate
Shift in the firm’s
investment demand curve
C
B
4%
Real investment
5
10
I1
15
I2
20
82
10. The aggregate expenditures function
(AE) represents which of the
following?
a. The consumption function only.
b. Autonomous consumption only.
c. The investment demand curve only.
d. All three of the above combined.
e. A combination of (a) and (c) .
D.
83
8
7
6
5
4
3
2
1
Exhibit 11
Aggregate Expenditures
Schedule and Function
AE
C
E
Real Disposable Income
trillions of dollars per year
1
2
3
4
5
6
7
8
84
11. In Exhibit 11, what is the households’
marginal propensity to consume
(MPC)?
a. 0.5
b. 0.67
c. 0.75
d. 0.80
B. MPC is the change in consumption
divided by the change in income. In this
case, the change in consumption to
income is two to three, or 0.67.
85
12. In Exhibit 11, aggregate income will
equal consumption plus investment
and the economy will be in equilibrium
when real disposable income is
a. $2.33 trillion.
b. $3 trillion.
c. $7 trillion.
d. $10 billion.
C. The AE curve crosses the 45 degree
line at $7 trillion.
86
END
87