Chapter 17
A simple Keynesian model in
the economy
Objectives
• Explain the equilibrium level of total income in the
economy
• Describe the major features of the consumption
function
• Indicate what the determinants of investment are
• Determine the equilibrium level of income in an
economy which consists of households & firms
Introduction
• Economic theory has three purposes
• To explain what is happening in the economy
• To predict what will happen if something changes
• To help us analyse economic policy
• Model introduced by John Maynard Keynes
• The idea that output and income are determined by
spending
• A Y: demand creates supply
• Say’s law: Y A (supply creates demand)
Total production, income and spending
• Three major flows:
• Production Income Spending
• Economic activity
• Production and consumption of goods and services
• National Accounts:
• Total production = Income = Spending
Introduction
• Keynesian Model
• Production = Income = Spending
• GDP = C + I + G + (X – Z)
• Where C = consumption
I = Investment
G = Government
X = exports
Z = imports
Total production, income and spending
• National Accounting Systems
• Measures economic activities after it has occurred
• Ex post: measurement occurs after the event
• National Accounts:
• Total spending = Total production and income
• However, this is never guarantee in theory
• Not always have an Equilibrium Level in the economy
Total production, income and spending
• There are 3 possibilities:
• Spending = Production and Income
• Production and income are at their equilibrium level
• No tendency to change
• Spending > Production and Income
• Production and income will tend to increase
• Spending < Production and Income
• Production and income will tend to fall
Total production, income and spending
• Y = total production or output or income
• A = aggregate spending or demand
• A = Y: Equilibrium level of production and
income
• A > Y: Level of production and income will tend
to increase
• A < Y: Level of production and income will tend
to fall
Basic assumptions of the model
• Keynesian Model:
• Households and firms
• No government
• No foreign sector
• Prices are given
• Wages are given
• The money stock and interest rates are given
• Spending is the driving force
Consumption spending
• Households consume goods and services
• Durable goods
• Semi-durable goods
• Non-durable goods
• Services
• Households spend their income on these goods
• Positive relationship between household spending and
income
• Consumption Function:
• relationship between total spending and total income
The consumption function
• 3 important characteristics:
• Consumption increases as income increases
• Consumption is positive even if income is zero
• When income increases, consumption increases – the
increase in consumption is less than the increase in income
• Figure 17.1 (page 318)
• Consumption is on the vertical axis (y-axis)
• Total production/income is on the horizontal axis (x-axis)
The consumption function
• Consumption has two components:
• Autonomous consumption – independent of the income level
• Induced consumption – determined by the level of income
• Consumption function:
C = Ċ + cY
Where:
C = consumption function
Ċ = autonomous consumption
cY = induced consumption
c = slope of consumption function
Y = level of income (disposable income)
The consumption function
• C = Ċ + cY
• Induced consumption: cY
• Depends on two things:
• c = slope = marginal propensity to consume
• Y = disposable income
• Marginal propensity to consume (c)
• c = ∆C/∆Y
• When Y increases, C increases but the increase in C is
smaller than the increase in Y
The consumption function
• Marginal propensity to consume (MPC or c):
• Relates to changes in consumption to the change in
disposable income (Y)
• Measures the extent to which consumption changes when
income changes
• MPC lies between zero and 1
• Y = MPC + MPS
• MPS = ∆C/∆Y
MPC
• MPC = measures the proportion of extra income that is
spent on consumption
• MPC is a certain percentage of your income spent on
consumption
• If an individual gains an extra R10, and spends R7.50,
then the marginal propensity to consume will be
R7.5/10 = 0.75
• The MPC will tend to be between 0 and 1
Investment spending
• Aggregate spending consists of consumption and
investment spending
• Consumption spending (C) and Investment spending (I)
•A = C + I
• Production and purchase of capital goods
• Investment is not a function of income
• I is independent of income
• Investment is therefore autonomous I = Ī (Figure 17.4)
Investment Spending
• Determinants of Investment Spending
• Expected Rate of Return:
• Firms invest in projects where expected rate of return exceeds
the interest rate
• Interest Rate:
• Inverse relationship between investment and the real interest
rate
Simple Keynesian Model
• Total spending
• Consumption is a function of income
• Investment is not a function of income
• Aggregate spending = C + I
• Equilibrium level: A = Y
• 45-degree line
• To determine the equilibrium points
Simple Keynesian Model
• Figure 17.5(a)
• A = Y: equilibrium level
• Figure 17.5(b) and Figure 17.6
• A > Y: excess demand
• Current production levels are inefficient
• Unplanned decrease in inventories
• A < Y: excess supply
• An increase in unsold goods
• Unplanned increase in inventories
Chapter 18
Keynesian models including
the government and the
foreign sector
Objectives
• Explain how government spending affects the level of
production and income
• Use the simple Keynesian model to analyse the effects
of fiscal policy
• Explain how exports and imports affect the level of
income in domestic economy
• Analyse the effects of changes in government
spending in the open economy
Introduction
• Include four additional flows:
• Government spending (G)
• Taxes (T)
• Exports (X)
• Imports (Z)
• Economic theory has three purposes
• To explain what is happening in the economy
• To predict what will happen if something changes
• To help us analyse economic policy
Keynesian model with gov. sector
• Simple Keynesian model: GDP = C + I
• Include the government
• GDP = C + I + G
• Production = Income = Spending
•A = C + I + G
• By adding government, we need to consider taxation
• Equilibrium level
•Y=A
Keynesian model with gov. sector
• Government spending (G)
• What determines the size of government spending?
• Government spending is a political issue
• Does not depend on level of income
• Government spending is autonomous
•G = Ĝ
• Aggregating spending = C + I + G
• Figure 18.2
Keynesian model with gov. sector
Taxes (T)
• Circular flow of income and spending
• Government spending is a injection
• Taxes is a leakage
• Taxes reduce the incomes of households
• Taxes indirectly reduce consumption spending by
households
• C = Ĉ + cY
Keynesian model with gov. sector
• C = Ĉ + cY
• Y = income
• Taxes are a certain proportion (t) of income
• Therefore the tax rate = T = tY
• Yd = Y – T
• Disposable income (Yd) = Total income (Y) minus
Tax (T)
Keynesian model with gov. sector
• Yd = Y – T
• Yd = Y - tY
• Yd = (1 – t)Y
• C = Ĉ + cYd
• Remember Yd = (1 – t)Y
• C = Ĉ + c(1 – t)Y
• Y = Ĉ + c(1 – t)Y + Ī + Ĝ
Foreign sector in the Keynesian model
• Introduce the foreign sector in the model:
• exports (X) and imports (Z)
• Domestic expenditure = C + I + G
• Exports = injections
• Imports = leakages
• Level of aggregate expenditure
• Equilibrium level of income (Y)
Foreign sector in the Keynesian model
• Exports (X):
• What determines the level of exports?
• Economic conditions in the rest of the world
• International competitiveness
• Exchange rates
• Exports do not depend on the level of income
• Exports are autonomous
•X=Ẋ
• Figure 18.7
Foreign sector in the Keynesian model
• Imports (Z):
• What determines the level of imports?
• Domestic income
• Z = Ẑ + mY
• Where Ẑ = autonomous imports
• m = marginal propensity to import
• Y = level of income
• A = C + I + G + (X – Z)
• Y = Ĉ + c(1 – t)Y + Ī + Ĝ + [Ẋ - (Ẑ + mY)]
Foreign sector in the Keynesian model
• A = C + I + G + (X – Z)
• Equilibrium point: A = Y
• Y = Ĉ + c(1 – t)Y + Ī + Ĝ + [Ẋ - (Ẑ + mY)]
• Y = Ĉ + c(1 – t)Y + Ī + Ĝ + Ẋ - Ẑ - mY
• Figure 18.8(b)
• Figure 18.9c
• Calculate the following:
1) Equilibrium Income
a) C = 70 + 0.7Y and I = 120
b) Consumption function: C = 85 + 0.5Y
Investment Function: I = 75
Government Spending: G = 60
Net export: NX = 10
c) C = 50 + 0.8Y and I = 150
d) C = 200 + 0.6Y and I = 100
e) C = 250 + 0.7Y and I = 200
f) C = 30 + 0.9Y; X = 70 and M = 10 + 0.2Y
g) C = 30 + 0.8Y; Yd = Y – T; I = 110; G = 100; NX = 40 – 0.1Y
h) C = 200 + 0.6Y; I = 75; G = 100; X = 35; M = 10 +0.2Y
Calculate GDP using expenditure method:
a) C = 1430; I = 540; G = 400; NX = 90
b) Consumer expenditure: 650; Government purchases:
100; Investment: 80; Net taxes: 25; Imports: 5;
Exports: 13; Corporate profits: 75
Consider the following information for a
private open economy. The letters Y, C, I, X,
and M stand for GDP, consumption,
investment, exports, and imports respectively.
Figures are in billions of rands.
C = 26 + 0.75Y
I = 60
X = 24
M = 10