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Chapter 11

Basic Keynesian Model

Expenditure and Tax Multipliers

• how aggregate expenditure (C,I,G,X and M) is determined

when the price level is fixed.

• how the equilibrium level of real GDP (Y) is determined

when the price level is fixed

• multipliers - the expenditure and tax multiplier

• the relationship between aggregate expenditure and

aggregate demand

• NOTE: Fixed price level is a key assumption of the basic

Keynesian model. We consider variable price level in the

aggregate demand/ aggregate supply model presented

later.

This chapter presents the basic Keynesian

model and explains:

Short-run with Fixed Prices

• The Keynesian model describes the

economy in the short run - when prices are

fixed (rigid, sticky).

• Because the overall price level is fixed -

– Aggregate expenditure (demand) determines real

GDP.

– Basic Keynesian model is called the Aggregate

Expenditure model.

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Short-run with Fixed Prices

• Recall: In the long run: K, L and technology determine full

employment potential GDP – Chapter 6.

• The basic Keynesian model explains why the economy may

not be at full employment potential in the short-run.

Short-run with Fixed Prices

• We know:

Real GDP = C + I + G + X – M (definition, Ch. 4)

Real GDP = Y = Aggregate output(Ch. 6)

AE = C + I + G + X – M (definition)

• At equilibrium: Aggregate output (Y) is equal to

Aggregate Expenditure (AE):

Y = AE.

Y = C + I + G + X – M

• At equilibrium: what is produced (Y) is sold

Short-run with Fixed Prices

• In this basic model, two of the components of

aggregate expenditure, household

consumption (C) and imports (M), are

influenced by Y (real GDP) .

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Household Consumption Plans

Household Consumption and Saving Plans, i.e.,

what households plan to do.

• Household consumption expenditure is influenced

by many factors but the most direct one is

disposable income.

• Disposable income is aggregate income Y, minus

net taxes, T.

Net taxes = taxes + transfer payments

• We denote disposable income as YD.

• Disposable income is

YD = Y – T.

Household Consumption Plans

Disposable income, YD, is either spent on

consumption C, or saved, S.

That is, YD = C + S.

Y – T = C + S

Y = C +S +T

• The relationship between consumption expenditure

and disposable income, other things remaining the

same, is the consumption function.

• The relationship between saving and disposable

income, other things remaining the same, is the

saving function.

All points on the 450 line

represent points where C = YD.

When consumption expenditure

exceeds disposable income,

saving is negative (dissaving).

When consumption expenditure

is less than disposable income,

there is saving.

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Quarterly U.S. Consumption (C) and Disposable Income

(Y-T), 2000–2014 C

(Y-T) 11

C = 453.95 +0.8713(Y-T)

R² = 0.9783

8000.0

8500.0

9000.0

9500.0

10000.0

10500.0

11000.0

8500.0 9000.0 9500.0 10000.0 10500.0 11000.0 11500.0 12000.0

Marginal Propensity to Consume and

Marginal Propensity to Save

Figure 11.2(a) shows that

the MPC is the slope of the

consumption function.

When disposable income

increases by $2 trillion, …

consumption expenditure

increases by $1.5 trillion.

The MPC is 0.75.

Look at the Table on Figure

11.1.

MPC

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MPS

Figure 11.2(b) shows

that the MPS is the slope

of the saving function.

When disposable income

increases by $2 trillion,

saving increases by $0.5

trillion.

The MPS is 0.25.

MPC + MPS = 1

MPS

Consumption as a Function of Y

• Disposable income changes when either real

GDP (Y) changes or net taxes (T) change.

• If T does not change, Y is the only influence on

disposable income, so consumption

expenditure is a function of Y (real GDP).

• We can put Y (not Y-T) on the horizontal axis,

holding T fixed.

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The Consumption Function with Y on the horizontal axis.

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Y (Real income,$ billions)

Consumption

Function

Real Consumption

Spending ($ Billions)

1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000

6,000

5,000

4,000

3,000

2,000

1,000 800

A change in T will cause the Consumption Function to

Shift.

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Real income ($ billions)

Consumption

Function

Real Consumption

Spending ($ Billions)

1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000

6,000

5,000

4,000

3,000

2,000

1,000

800

1,700

Consumption function

when net taxes drop

A decrease in T is caused

by a reduction in taxes or

an increase in transfer

payments.

Other factors that Shift the Consumption

Function

– Wealth (W), which is accumulated

household savings and investments

– Interest rates (r), which is the cost to

borrow.

– Expectations about the future

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Other factors that Shift the Consumption

Function

• an increase in household wealth (W)

• a decrease in interest rates (r)

• households become more optimistic

about the future ( )

• Shift the consumption function

upward

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Upward Shift in the Consumption Function

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Real income ($ billions)

Consumption

Function

Real Consumption

Spending ($ Billions)

1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000

6,000

5,000

4,000

3,000

2,000

1,000

W↑, r ↓, T ↓ ,

Shift in the Consumption Function

• a decrease in household wealth (W)

• an increase in interest rates (r)

• household became more pessimistic

about the future ( )

• Shift the consumption function downward

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Downward Shift in the Consumption Function

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Real income ($ billions)

Consumption

Function

Real Consumption

Spending ($ Billions)

1,000 2,000 3,000 4,000 5,000 6,000 7,000 8,000 9,000

6,000

5,000

4,000

3,000

2,000

1,000

W ↓, r ↑, T ↑,

Movement Along Versus a Shift

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Imports – The second component of

AE influenced by Y

• U.S. imports are influenced primarily by U.S. real

GDP (Y).

• The marginal propensity to import (MPM) is the

fraction of an increase in real income (real GDP)

spent on imports.

• If an increase in real income of $1 trillion

increases imports by $0.25 trillion, the marginal

propensity to import is 0.25.

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Putting the Model Together

• Planned aggregate expenditure is planned

consumption expenditure (C) plus planned

investment (I) plus planned government

expenditure (G) plus planned exports (X)

minus planned imports (M).

• Planned consumption expenditure (C) and

planned imports (M) are influenced by real

GDP (Y).

Putting the Model Together

• We assume in this simple short-run model planned investment (I) and planned government

expenditure (G) and planned exports (X) are not

influenced by real GDP (Y).

• I, G, and X are autonomous (the values are given.

• But, in the loanable funds model I depends on______?

Planned Aggregate Expenditure

• The relationship between aggregate planned

expenditure and real GDP can be described by an

aggregate expenditure schedule, …

• which lists the level of aggregate expenditure

planned at each level of real GDP.

• The relationship is also called the aggregate

expenditure curve, which is a graph of the planned

aggregate expenditure schedule.

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Trillions of $

Real

GDP (Y)

C I G X M AE

A 0 0 2.5 3.5 2.0 0 8

B 5 3.5 2.5 3.5 2.0 1 10.5

C 14 9.8 2.5 3.5 2.0 2.8 15.0

D 15 10.5 2.5 3.5 2.0 3.0 15.5

E 16 11.2 2.5 3.5 2.0 3.2 16.0

F 17 11.9 2.5 3.5 2.0 3.4 16.5

Planned Aggregate Expenditure Schedule

MPC = 0.7 and MPM = 0.2

Amount

produced

---------- Planned (“desired”) spending ----------------------

Figure 11.3 shows how

the aggregate expenditure

curve (AE) is built from its

components.

Short-run Model: Real GDP with a Fixed

Price Level

How the Short-run Model Works With a Fixed

Price Level • Consumption expenditure (C) and imports (M),

change as a result of a change in Y (real GDP)

• Called induced expenditure.

• Investment (I), government expenditure (G), and

exports (X), which do not vary with GDP, are

called autonomous expenditure.

• NOTE: Consumption expenditure (C) and imports

(M) can have an autonomous component –

constant term.

• Autonomous components for C are W, T, interest

rate (r) and expectations.

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Real GDP with a Fixed Price Level

Actual Expenditure, Planned Expenditure, and

Real GDP

Planned aggregate expenditure may differ

from actual aggregate expenditure because

firms may experience unplanned changes

in inventories which is included as part of

actual expenditure. <= Important!

Key concept here is unplanned changes in

inventories.

•A 45° line = translator line

It allows us to measure any horizontal

distance as a vertical distance instead

The 45o Line

Using a 45° Line to Translate Distances

Dollars

Consumption

Function

Dollars

0

1. Using a 45° line . . .

45°

B

A

2. we can translate any horizontal

distance (such as 0B) . . .

3. into an equal vertical

distance (BA).

SLOPE = 𝑩𝑨

𝑶𝑩= 𝟏

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• Real GDP is what is

produced. Its measured along

the horizontal axis and the 450

line.

• Equilibrium occurs at the point

at which the AE curve crosses

the 45° line in the upper

graph.

• Equilibrium occurs when there

are no unplanned changes in

business inventories in part

(b).

Equilibrium occurs when aggregate planned

expenditure equals real GDP.

From Below Equilibrium

If aggregate planned

expenditure exceeds real

GDP (point B),

there is an unplanned

decrease in inventories.

To restore inventories, firms

hire workers and increase

production.

Firms adjust production

quantity not price.

Real GDP increases.

Convergence to Equilibrium

From Above Equilibrium

If real GDP exceeds aggregate

planned expenditure (point F),

there is an unplanned increase

in inventories.

To reduce inventories, firms lay

off workers and decrease

production.

Prices are assumed to be fix.

Firms don’t have a sale and

lower prices. They cut

production and real GDP

decreases.

Convergence to Equilibrium

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Equilibrium

If aggregate planned

expenditure equals real

GDP (the AE curve

intersects the 45° line), …

there is no unplanned

change in inventories.

And firms maintain their

current production.

Real GDP remains

constant.

Real GDP with a Fixed Price Level

Trillions of $

Real GDP(Y) Planned Aggregate

Expenditure (AE)

Unplanned

Inventory Change

A 13 14.5 -1.5

B 14 15.0 -1.0

C 15 15.5 -0.5

D 16 16.0 0

E 17 16.5 5

F 18 17.0 1.0

Equilibrium GDP

Trillions of $

Real GDP(Y) Planned Aggregate

Expenditure (AE)

Unplanned

Inventory Change

A 13 14.5 -1.5

B 14 15.0 -1.0

C 15 15.5 -0.5

D 16 16.0 0

E 17 16.5 5

F 18 17.0 1.0

Equilibrium GDP