The Keynesian short run model: An Introduction

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The Keynesian (short run) model An Introduction

• Outline
• Spending and real GDPthe connection
• Components of aggregate expenditure
• Determinants of consumption spending
• The consumption function
• The fundamental law of consumption
• The consumption-income line
• Shifts of the consumption-income line

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Principle of aggregate expenditure

• The Keynesian model is based on the idea that
  total spending is subject to short run
  fluctuations.
• Short run fluctuations in total spending for
  domestically-produced goods and services, or
  aggregate expenditure, produce changes in real
  GDP, employment, and prices.

Its spending, stupid!
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Components of aggregate expenditure (AE)

• AE C IP G NX, where
• AE is aggregate expenditure
• C is personal consumption expenditure
• IP is planned investment expenditure
• G is government expenditure for goods services.
• NX is net exports, or exports minus imports.

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For Keynes, real GDP and employment depend on
spending. So that begs the question What does
spending depend on?
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Determinants of Consumption Spending
RealDisposable Income

InterestRate
RealConsumptionSpending
-

Wealth

ConsumerConfidence
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www.bea.gov
1991
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Hypothetical Data on Disposable Income and
Consumption
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ConsumptionFunction
Slope 0.6
The consumption function reveals the spending
plans of households at alternative levels of
(real) disposable income.
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Representing the consumption function by a
linear equation
The equation for the consumption function can be
written as
C a bYD

• where
• a is the intercept of the function
• b is the slope of the function or the marginal
  propensity to consume.
• YD is real disposable income, or GDP net of all
  taxes but including transfer payments.

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MPC
The marginal propensity to consume (or MPC) is
the amount by which consumption spending changes
when disposable income changes by one dollar.
The MPC gives the slope of the consumption
function. Let ?C represent the change in
consumption from one point to another on the
line. Let ?YD denote the corresponding change in
disposable income. Thus we have
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Fundamental law of consumption
People show a tendency, as a rule an on
average, to increase their consumption when their
income increasesbut not by as much as the
increase in income
Thus we can say
0 lt b lt 1
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The Relationship Between Real GDP and Consumption
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Real Consumption (Billions)
The Consumption-Income Line
5,600
B
5,000
A
800
0
7,000
8,000
Real Income or GDP (Billions)
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Shifts of the consumption-income line

• The consumption-income can shift due to
• A change in taxes, ceteris paribus
• A change in transfers, ceteris paribus
• A change in autonomous consumption (a)

Note thatTransfer payments ?? Net
Taxes? Taxes?? Net Taxes?
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Income?
Consumption?
DisposableIncome?
A change in net taxes (T) will impinge on
aggregate expenditure indirectly, by its affect
on disposable income
Consumption?
DisposableIncome?
Taxes?
Consumption-income line shifts upward
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Consumption-Income line when T 500
Consumption-Income line when T 2,000
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Change in automous consumption (a)

• The Consumption-Income line will shift upward
  when
• ?Household wealth
• ?Interest rates
• ?Consumer confidence

• The Consumption-Income line will shift downward
  when
• ? Household wealth
• ? Interest rates
• ? Consumer confidence

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Real Consumption (Billions)
a 1800
a 1300
a 800
1800
Change in autonomous consumption produces a
shift of the income-consumption line
1300
800
0
Real Income or GDP (Billions)
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(No Transcript)
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Billions of 1999 dollars
Source Poterba (2000)
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Percent of Assets Owned by U.S. Households, 1998
Source Poterba (2000), based on 1998 Survey of
Consumer Finances