Chapter 3

In the Short
Run: The
Keynesian
Model

by
Ooi Soon Beng
1883-1946
After studying this chapter, you should be able to
understand:
 Determinants of Aggregate Demand
 Consumption
 Investment
 Government Expenditure
 Exports and Imports (Net Exports)
 Keynes Multiplier
 The Great
Depression
was triggered
by stock
market crash of
1929.
 Deepest and Longest Depression
The Great
Depression was the
worst economic
catastrophe in
modern history.
About one quarter
of the U.S. labor
force were
unemployed!

Over 3000 American banks went bankrupt! Wall Street

plunged 89%! The U.S. economy contracted one third!
Unemployed,
Angry and
Hungry
Despair and Homeless
Desperate
and
Tragic
A penniless
mother hides her
face in shame
after putting her
children up for
sale, Chicago.
The 1930s Great Depression legitimized the
economic theories of British economist John
Maynard Keynes.
Keynes argues that private sector decisions
sometimes lead to inefficient macroeconomic
outcomes.
He, therefore, advocates active policy responses by
the government to stabilize output over the
business cycle.
Keynes firmly objects To Keynes, wages are rigid
Classical school’s downwards, because of:
idea that flexibility in • Minimum wage laws
wages would
• Strong trade unions
automatically bring
full employment. • Wage contracts
• Efficiency wage
• Insider-Outsider
Theory
 Almost all economists agree that World War II (1939-
1945) cured the Great Depression.

U.S. spent massively on defence, and went from the greatest

depression to the greatest economic boom it has ever known.
 Keynesian economics served well as the economic model
during the latter part of the Great Depression, World War II
(1939-45), and the post-war economic expansion (1945–73).

From American Nightmare to

American Dream!
Keynes's influence waned in the early 1970s.
This was due to:
a) stagflation problems
that began to afflict
the Anglo-
American
economies, and
b) critiques from Milton
Friedman who was
pessimistic about
the ability of
governments
regulate the to Milton Friedman (1912-2006)
business cycle. Nobel prize in Economics (1976)
The four components of aggregate expenditure
sum to real GDP.
Y = C + I + G + (X – M)

C= Consumption spending
I = Investment spending
G= Government spending
X = Export
M = Import
(X-M) = Net export
Consumption expenditure can be divided into two
components: (a) autonomous consumption, and
(b) induced consumption.
 Autonomous consumption occurs when income
levels are zero.
 The main influence of induced consumption is
disposable income.
Disposable income is aggregate income (Y)
minus taxes plus transfers payments (NT).
YD = Y – NT

Disposable income is either spent on

consumption (C) or saved (S).

YD = C + S
 Planned
Disposable consumption Planned
income expenditure saving
(billions USD)
A 0 150 ─150
B 200 300 ─100
C 400 450 ─50
D 600 600 0
E 800 750 50
F 1,000 900 100
 45o line
Consumption expenditure

1000

Saving F
800

E
600 Dissaving
D Consumption
(billions)

C
400 function
B

200 A

0 200 400 800 1000

600 Disposable income (billions)
 Saving
(billions)

100 F function
Saving

Saving
Dissaving E

D
0
200 600 800 1000
400
C Disposable income
B (billions )
-150 A
Any change in disposable income is either spent on
consumption (C) or saved (S).

C + S = YD
Divide this equation by YD:

C/YD + S/YD = YD/YD,

Hence: MPC + MPS = 1

Marginal propensity
to consume (MPC)
is the fraction of any
change in disposable MPC = C/YD
income spent on
consumption.
 45o line
1000 Consumption
Consumption expenditure

Function
MPC= 0.75 F
800
E
600
D  C=$150 billion
C
(billions)

400
B  YD = $200 billion
200 A

0 200 400 800 1000

600 Disposable income (billions)
Marginal
propensity to save
(MPS) is the fraction MPS = S/YD
of a change in
disposable income
that is saved.
(billions)
Saving

Saving
100 MPS = 0.25
F function
E
 S=$50 billion
D
0
200 600 800 1000
400
C Disposable income
B (billions)
-150 A
 YD = $200 billion
Average propensity to consume (APC) is the fraction
of income consumed.

APC =
C/Y
Average propensity to save (APS) is the fraction of
income saved .

APS = S/Y
A person’s income is either spent on consumption
(C) or saved (S).

C + S = YD.
Divide this equation by YD:

C/YD + S/YD = YD/YD

Hence: APC + APS = 1

The most important determinant of
consumption and saving is the:
A. level of bank credit.
B. level of income.
C. interest rate.
D. price level.
The APC is calculated as:
A. change in consumption / change in income.
B. consumption / income.
C. change in income / change in consumption.
D. income / consumption.
Which of the following relations is not correct?
A. 1 - MPC = MPS
B. APS + APC = 1
C. MPS = MPC + 1
D. MPC + MPS = 1
When an influence other than disposable income changes ,
the consumption function and saving function shift.

There are four Wealth

Wealth
determinants of
consumption. Expected
Future Prices
and Income
Real
interest
rate
Price & Wage
Levels
Wealth: An increase in wealth shifts the consumption
schedule up.
Expectations: Higher expected future prices or wealth shift
the consumption schedule up.
Real interest rates: Declining interest rates increase the
incentive to borrow and consume, and shift the
consumption up.
Price &Wage level: If people’s price rise slower than
wages, then real incomes will increase, shift consumption
up. Ex: P increase 5% < W increase 10%; real income
increase.
 45o line
1000 CF1
Consumption expenditure

CF0
800

600

400
(billions)

200

0 200 400 800 1000

600
Disposable income (billions)
(billions)
Saving

200

SF0

0 SF1
200 600 800 1000
400

Disposable income
-200 (billions year)
For simplicity, we assume investment (I) and
government expenditure (G) are independent of
the level of domestic GDP.
Investment consists of spending on new plants, capital
equipment, machinery, inventories, construction, etc.
In real life, investment
decision depends on
expected rate of returns
and the real interest
rate.
As long as expected
rates of return rise
faster than real interest
rates, investment
spending may increase.
Investment is a very unstable type of spending.
This is because:
1) Capital goods are durable, so spending can be
postponed or not. This is unpredictable.
2) Innovation occurs irregularly.
3) Profits vary considerably.
4) Expectations can be easily changed.
Export depends on foreign GDP.
Import varies positively with domestic GDP.
Hence, import function is upward sloping.
Aggregate planned expenditure
(billions)

1500 AE = C+I + G + (X – M)

(X-M)

1000 Consumption
F expenditure
E
D
C
B
A
500 I+G+X
I+G
I
Real GDP
0 500 1000 1500
(billions)
A two-way link exists between aggregate expenditure
and GDP.

An increase in
aggregate
expenditure
increases real GDP.
Aggregate GDP
An increase in real Expenditure
GDP, in turn,
increases aggregate
expenditure.
Hence, changes in aggregate expenditures ripple through the
economy to generate even larger changes in real GDP.
This is called the multiplier effect.
MPC determines the magnitude of the multiplier.

1
Multiplier  1 -MPC

The size of the MPC and the multiplier are

directly related.
What will the multiplier be when the MPC is 1,
0.9, 0.5, and 0?
And, since MPC + MPS = 1:

1
Multiplier  MPS

The size of the MPS and the multiplier are

inversely related.
What will the multiplier be when the MPS is 0,
0.4, 0.6, and 1?
 Aggregate planned expenditure
Real GDP Original New
(Y) (AE0) (AE1)
(billions dollars)
800 A 825 A’ 875
900 B 900 B’ 950
1,00 C 975 C’ 1,025
1,100 D 1,050 D’ 1,100
1,200 E 1,125 E’ 1,175
 45o line AE 1
(billions)
Aggregate planned expenditure

1,200
A $50 billion
AE0
increase in D'
1,100 E
initial spending
C'
D
1,000 B' What is the
C
900
A’ B
800
…increases
real GDP by
multiplier?
A
$200 billion

0 800 900 1,000 1,100 1,200

Real GDP (billions)
To calculate the multiplier,

Change in real GDP

Multiplier =
Change in initial spending

$200 billion
= = 4
$50 billion
Multiplier can be rearranged to read:

 in real GDP
Multiplier =
 in initial
spending

 in real GDP = Multiplier x  in initial

spending