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Chapter 12 Understanding Keynesian Economics

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I. Understanding aggregate demand (C + I + G + E_N )
     A. Consumption and Saving
          1. Average Propensity to Consume (APC) is consumption (C)
              divided by income (Y).
              a. APC = C/Y
              b. APC decreases as income increases as people can afford to
                  save.
          2. Marginal Propensity to Consume (MPC) is the change in
              consumption divided by the change in income.
              a. MPC decreases as income increases.
              b. This makes sense because when an average is falling, what is
                  happening on the margin must be less.
                  1) Suppose your test average after one test is 90 and after
                      2 tests its 80.
                  2) Your second test had to be below 80 to pull the average
                      down. Test 2 was a 70 and (90 + 70) / 2 = 80.

          3. Saving (S) is income minus consumption. S = Y - C
          4. Average Propensity to Save (APS) is saving divided by income
              a. APS = S/Y
              b. If APC drops as income increases, then APS increases as
                  income increases because APC + APS = 1
          5. Marginal Propensity to Save is change in saving divided by
              change in income.
              a. MPS increases as income increases because wealthy people can
                  afford to save a higher percentage of income.
              b. This makes sense because when an average is rising, what is
                  happening on the margin must be higher.

           6.
           7. Other factors affecting consumption and therefore saving include
               wealth (savings), expectations about personal needs and future
               economic activity, and concerns about consumer, business, and
               government debt.
B. Investment is business spending on capital goods, inventory, and research
    & development.
     1. The level of investment is a function of expected profit, interest rates,
        and the level of technology required to maintain a desired competitive
        position.
   2. Investment spending tends to be somewhat volatile.
C. Government Spending is assumed to be constant.
D. Net Exports, exports minus imports, are also assumed to be constant
     for this simplified model.

Note: Points on a 45-degree line
equate values on the x and y axes

II. Aggregate Demand and Equilibrium
A. Equilibrium (E) is where planned and actual AD and AS are equal.
          1. Equilibrium is where all goods produced for sale are sold.
        2. At points below equilibrium, AD < AS, inventories are building and business
              activity is contracting. This level of economic activity was depicted by the
              horizontal (Keynesian) range of AS explained in the previous model.
        3. At points above equilibrium AD > AS, inventories are decreasing and
              business activity is expanding
              as depicted by the intermediate range and eventually the classical range of AS.
          4. Economic activity (Real GDP) will be wherever AD intersects AS.
              Equilibrium seldom exists as
              economic activity is usually in one stage or another of the business cycle.
     B. If economic activity is not in balance, a dynamic situation exists and will continue
             until equilibrium is reached.
     C. Keynes believed that E could settle at a level of economic activity with large
          amounts of unemployment.
         1. If potential Real GDP is greater than what actual AD yields, a recessionary
             gap exists and may persist indefinitely. The solution to this unacceptable
             equilibrium is to increase AD.
         2. If potential Real GDP is less than what actual AD yields, an inflationary gap
             exists and the inflation may persist indefinitely. The solution to this unac-
             ceptable level of economic activity is to decrease AD.

III. Fine Tuning Economic Activity
      A. In chapter 14 we investigate how
           government taxing and spending
           is used to affect AD and AS and
           affect the business cycle.
    B. In chapter 15 we investigate how
           the Federal Reserve uses monetary
           policy to affect interest rates, AD
           and AS.
    C. The goal is to maximize growth
           while minimizing the inflationary
           and deflationary gaps.

View Macroeconomic Phenomena in the AD/AS Model by Dennis Kaufman of the University of Wisconsin-Parkside.

III. Multiplier
   A. When determining the required change in AD needed to achieve E, the Multiplier (K) concept must be considered.
   B. This concept states that a change in AD will result in a larger change in Real GDP as these changes multiply (are spent
            and re-spent or not spent and re-not spent) throughout the economy.
       C. Saving will act as a leakage eventually stopping the change.
       D. Suppose more is spent on investment and people receive this as income.
           1. People receiving the income spend some (MPC) and save some (MPS)
           2. A second group receives the spending of the first group as income and they also spend some (MPC) and
               save some (MPS).
           3. The process continues until savings eventually stops the progression.
       E. Calculating multiplier (K), the multiple by which GDP will increase given some increase in AD.
       1. K = 1 / MPS = 1 /(1 - MPC)
           2. As MPS increases, K decreases
           3. If MPS = 20% then 1/MPS = 1/.2 = 5
           4. An increase of $100 billion in investment will result in 5($100) = $500 billion in new national income.
           5. K = change in Real GDP / change in AD = 500/100 = 5
       F. Accelerator/multiplier theories from Wikipedia

IV. For more concerning Keynesian economics view information from the Institute for Economic Analysis.

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