The Keynesian model

Recall: GDP is the total market of all final goods and services produced within a country in a
given time period.

The first thing to understand is three flows:

Production=Income=Spending

Note: GDP( P)  GDP( E )  GDP(Y )

However, the expenditure approach is the most used measure of GDP

GDP( E )  C  I  G  X  M ....................................................................................................(1a )
AE  C  I  G  X  M

Where

AE  Aggregate expenditure

C  Consumption Expenditure

I  Investment spending

X  Exports

M  Imports

Note: There is a two way link between aggregate expenditure and real GDP namely:

1) An increase in real GDP increases aggregate expenditures

2) An increase in aggregate expenditures increases real GDP

Assumptions of the model

1) Prices, wages and interest rates are given or fixed i.e. these variables are not explained
in the model
2) Keynesian model is used to analyse changes in real economy i.e. spending is the driving
force in the economy

The consumption function

 The relationship between consumption expenditure by households and total income

 There are three important characteristics:
1) There is a positive relationship between consumption and income. i.e. as income
increases, consumption expenditure also increases
2) Consumption is positive even if income is zero. i.e. consumption would take
place even if people had no current income
 3) If consumption increase is less than income increase, part of the additional
income is saved
 The consumption function proposed by Keynes
C  C 0  cY ...........................................................................................................(2b)

Where C 0  autonomous consumption

c  marginal propensity to consume
Y  level of income
cY  the induced consumption
 The value of the induced consumption depends on:
a) The marginal propensity to consume (MPC or c)
b) The level of income (Y)
 However, the level of consumption depends on the level of income after tax. The
consumption function proposed by Keynes will be as follows:

C  C 0  c(1  t )Y ..............................................................................................................(2.1b)

Note: The marginal propensity to consume (MPC or c) is the fraction of a change in

income that is spent on consumption. It is the slope of the consumption function given as:

C
MPC  .....................................................................................................................(3c)
Y

Where C  change in consumption

Y  change in income

Note: The marginal propensity to save (MPS or s) is the fraction of a change in income that is
saved. It is the slope of the savings function given as:

S
MPS  ..........................................................................................................................(4d )
Y

Where S  change in savings

Y  change in income

MPC  MPS  1

The multiplier is the amount by which a change in autonomous expenditure is magnified or

multiplied to determine the change in equilibrium expenditure and real GDP.

 When there are no income taxes, the simple multiplier is as follows in a closed
economy:
 1 1
Multiplier ( 1 )   ......................................................................(5e)
1  MPC (1  c)
 The equilibrium expenditure will be given as follows:
The equilibrium expenditure in the closed economy will be as follows:
1
(YE / AE )  (C  I  G  X  M )......................................................................(6 f )
(1  c)

 When there are incomes taxes, the simple multiplier is as follows in a closed economy:
Multiplier
1
( 2 )  ......................................................................................................(7 g )
1  c(1  t )
 The equilibrium expenditure in the closed economy will be as follows:
1
(YE / AE )  (C  I  G  X  M ).........................................................................(8h)
1  c(1  t )
 When there are taxes and imports, the multiplier for the open economy is as follows:
Multiplier
1
( 3 )  ................................................................................................(9i)
1  c(1  t )  m
 The equilibrium expenditure in the open economy will be as follows:
1
(YE / AE )  (C  I  G  X  M )................................................................(10 j )
1  c(1  t )  m
Examples
1) Suppose that the consumption and investment functions are as follows:
C  100  0.75Y
I  20
i. Calculate the equilibrium expenditure

Solution:

1 1 1
i.  1    4
1  c (1  0.75) 0.25

1
 (YE / AE )  (C  I  G  X  M )
1 c
 4(100  20)
 480

2) Suppose that the hypothetical economy of Mbombela is described by the

consumption and investment functions as follows:
C  2  0.6Y
I 2
i. Calculate the equilibrium expenditure
 ii. If the investment spending increases by 12 million, what will be the
new equilibrium expenditure

Solution:

1 1 1
1     2.5
1  c 1  0.6 0.4
1
 (YE / AE )  (C  I  G  X  M )
1 c
 2.5(2  2)
 2.5(4)
 10

1
(YE / AE )  (C  I  G  X  M )
1 c
 2.5(2  12)
 2.5(14)
 35

3) Consider the following information for the Republic of Eastville:

C  120  0.84Y
I  78
G  69
X  40
M  12
t  32%
i. Calculate total autonomous spending
ii. Calculate the equilibrium expenditure
iii. If the tax function is given as T  108  0.32Y , how much would
the government of Eastville collect in taxes when the economy
remains in equilibrium
iv. Would the budget of Eastville represent a deficit or surplus
v. If the government of Eastville decided to cancel all taxes, implying
the tax rate would be now be 0%, what would the new equilibrium
expenditure be

Solution:

i. Total autonomous spending

C  I G X M
 120  78  69  (40  12)
 295
1 1 1 1
ii. 2      2.33
1  c(1  t ) 1  0.84(1  0.32) 1  0.84(0.68) 0.4288
 1
 (YE / AE )  (C  I  G  X  M )
1  c(1  t )
 2.33(295)
 687.97

iii.
T  108  0.32Y
 108  0.32(687.966)
 112.15
iv. The government has a surplus because tax revenue (112.15) is more than
government expenditure (69).
v. If the tax rate is zero, the multiplier becomes:
1 1 1
1     6.25
1  c 1  0.84 0.16
1
 (YE / AE )  (C  I  G  X  M )
1 c
 6.25(295)
 1843.75
The equilibrium expenditure when there are no taxes increases from 687.97 to
1843.75
3. Suppose that the following information describes the economy of Eufenland:

C  100  0.75Yd
I  200
G  150
X  200
M  150  0.4Y
t  20%

i. Calculate equilibrium expenditure of Eufenland economy

Solution:

1 1 1
3     1.25
1  c(1  t )  m 1  0.75(1  0.20)  0.4 1  0.6  0.4
1
 (YE / AE )  (C  I  G  X  M )
1  c(1  t )  m
 1.25(100  200  150  200  150)
 1.25(500)
 625