EQ: What are the Assumptions of Keynesian Economic Theory?

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1 EQ: How is Keynesian Theory Different from Classical Theory? Classical Theory Supply-Focused (SRAS) Say s Law Economy is self-regulating Laissez-Faire Wages can go up or down Businesses will borrow & invest all saved money. Keynesian Theory Demand-Focused (AD) TE = C + I + G + (X M) Economy requires government intervention Wages only go up They are sticky downward Businesses only invest if they think they will profit. Wage rates in the labor market are flexible going up, but not down. Raises are acceptable but pay cuts are not because of: Long-Term Labor Contracts Labor Unions Employee Resistance If wage rates do not fall (as in Classical Theory): Production costs won t go down, SRAS will not shift right, and the economy will be stuck in a recessionary gap. The Economy is NOT Self-Regulating. If SRAS does not shift right on it s own, then the economy will not get out of a recessionary gap without intervention from economic leaders. Consumer spending is the driving force in the economy. The aggregate demand (AD) curve must shift right in order to close a recessionary gap. Consumption is primarily determined by National Income (Real GDP) and is the most important element. Consumption will increase as income increases and decrease as income decreases. The rate of increase/decrease is the Marginal Propensity to Consume (MPC). Investment, Government Spending, & Net Exports are unrelated to National Income (Real GDP) Businesses spend money (Investment) only when they think they will earn sufficient profits to justify the investment. Unlike Classical Theory that supposes that consumer savings will be exactly offset by business investment (Investment = Savings). Governments spend money based on policy decisions. Imports and Exports are determined by: Economic growth in other countries. Exchange rates. Classical Economic Theory Gap Q N Keynesian Economic Theory Gap Q N

2 EQ: What is the Marginal Propensity to Consume (MPC)? In economics, the word marginal means one more and generally refers to the additional cost or benefit from getting, using, or making one more unit of something. The Marginal Propensity to Consume (MPC) is the additional amount of money consumers will spend when they receive one more dollar of disposable income. It is the increase in Consumption due to increasing disposable income by $1. Disposable Income is household income after all taxes have been deducted and paid. This concept is important in Keynesian theory because Consumption is the largest portion of s, which determines Aggregate Demand. EQ: What is the Marginal Propensity to Consume (MPC)? As disposable income increases, Consumption increases proportionally. Each time: Disposable income increases by $5, Consumption increases by $3,75. The proportional rate at which Consumption grows in response to increases in disposable income is the MPC. EQ: How do I Calculate MPC? To calculate MPC, divide the change in consumption ( Consumption) by the change in disposable income ( Income). Consumption MPC = Income Example: Consumption increases by $3,75 when disposable income increases by $5,. Consumption MPC = Income $3,75 = = $5,.75 So, for every $1 of additional disposable income, households will consume an additional $.75. In order to understand the next part, you need to understand that Real GDP is also measurable as Income. Real GDP is total output in an economy. When that output is sold, the money received is income for the sellers. The income is then distributed to the owners and employees who made & sold the products. This increases the disposable income of their households. This disposable income is then spent at a proportional rate equal to the MPC. The bottom line is that an increase in Real GDP is considered an increase in income.

3 Remember that s is made up of four types of spending: Consumption This changes in response to changes in income (Real GDP) based on the MPC. Increase in Real GDP Increase in Consumption Decrease in Real GDP Decrease in Consumption Investment Government Spending Net Exports The s curve is a curve on a graph that shows all of the possible levels of aggregate expenditure given differing levels of Real GDP. It is the relationship between s and Income as Real GDP. The vertical axis is s The horizontal axis is Real GDP (Income) This is a positive relationship because: When Income increases, increases. Increase in Income Increase in Consumption Increase in TE MPC =.75 When Income increases by $1, Consumption increases by $75 because MPC =.75 TE is increasing by the exact amount that Consumption is increasing because I, G, & (X M) do not change in response to MPC =.75 Income changes = X-axis Y-axis

4 Income Increase = $1 Trillion TE Increase = $.75 Trillion Rise Run =.75 =.75 1 The slope of the TE curve is equal to the MPC. MPC =.75 EQ: What is the 45 Angle Line? EQ: What is the 45 Angle Line? In Keynesian Theory, the 45 angle line is a curve drawn with the s curve that represents every point at which s and Real GDP are equal. s and Real GDP are supposed to be equal to one another in the economy because TE is a measure of GDP. So, the 45 angle line shows all of the points where there is balance between Total Expenditures and Real GDP s = $13 Trillion Real GDP = $13 Trillion s = $12.1 Trillion Real GDP = $12.1 Trillion s = $12.6 Trillion Real GDP = $12.6 Trillion

5 EQ: What is Equilibrium Real GDP? EQ: What is Equilibrium Real GDP? Equilibrium Real GDP is the point where the s curve intersects with the 45 angle line. It represents the point on the s curve where s and Real GDP are equal (i.e., TE = Real GDP). Keynesian Theory proposes that Equilibrium Real GDP will be the actual level of economic output in an economy. That is, short-run equilibrium in the aggregate market will occur at the point where the Total Expenditures curve crosses over the 45 angle line Equilibrium Real GDP EQ: What is Equilibrium Real GDP? Equilibrium Real GDP (Real GDP = s)