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The Keynesian Model (a.k.a.—demand-side stabilization policy)

The Keynesian Model (a.k.a.—demand-side stabilization policy). The model is a response to high unemployment during the Great Depression The goal of the policy is to increase or decrease demand using govt. spending and taxation Increased demand = increased GDP = lower unemployment.

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The Keynesian Model (a.k.a.—demand-side stabilization policy)

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  1. The Keynesian Model(a.k.a.—demand-side stabilization policy) • The model is a response to high unemployment during the Great Depression • The goal of the policy is to increase or decrease demand using govt. spending and taxation • Increased demand = increased GDP = lower unemployment

  2. GDP and Unemployment • If unemployment follows GDP; how can we manage GDP? • Keynes believed that any instability in any GDP would result in undesirable fluctuations • Keynes looked at what was the most unstable sector of GDP

  3. GDP= C + I + G + Xn • Xn or F (foreign sector)—was seen as being too small to have an impact • G—Government sector is relatively stable over time (they set budgets) • C—Consumer sector is even more stable (wages are generally stable) • I—Investment sector seemed to be the most unstable. Why? • Changes in stock

  4. Fiscal Policy • Keynes felt that only the government was large enough to offset any fluctuations in the investment sector • The government could use two tools: • Spending cuts/increases • Tax cuts/increases

  5. Income vs. Consumption • We can say that real GDP is = to Yd because an income was received as a result of the production of those goods and services

  6. Income vs. Consumption • The model shows us how much we consume at various levels of income

  7. Income vs. Consumption • The economy is most efficient when all of our income is spent (the red, 45 degree line)

  8. Income vs. Consumption • The intersection of the two curves shows the level of productivity that is ideal for the economy • Keynes would use fiscal policy to target this level of GDP

  9. Income-Consumption and Income-Savings Relationship • Savings is always (Yd) income – consumption • Therefore S+C=1 • APC—Average propensity to consume • Tells us what percentage of our disposable income is spent Consumption APC= Income

  10. Income-Consumption and Income-Savings Relationship • APS—Average propensity to save • Tells us what percentage of our disposable income is saved Saving APS= Income

  11. Income-Consumption and Income-Savings Relationship • MPC—Marginal propensity to consume • It is the additional consumption spending from an additional dollar of income • Tells us the change in consumption due to a change in income Change in consumption MPC= Change in income

  12. Income-Consumption and Income-Savings Relationship • MPS—Marginal propensity to save • Tells us the change in saving due to a change in income Change in savings MPS= Change in income

  13. The consumption function • C= a + b x Yd • C=consumption • a=autonomous consumption • b=marginal propensity to consume • Yd=disposable income

  14. The relationship between interest rates and investment (I) • A business will only invest if the marginal benefit is greater than the marginal cost (paid in interest) • Investment demand curve • As interest (the price of borrowing $) goes up, investment demand goes down • As interest goes down, investment demand goes up

  15. Investment Demand

  16. Determinants that shift investment demand • Maintenance/operating costs • A decrease in these costs increase the expected rate of return on investment shifting investment demand to the right

  17. Determinants that shift investment demand • Business taxes • Reductions in govt. taxes increases expected profitability of investments, increasing investment demand

  18. Determinants that shift investment demand • Technological change • stimulates investment • Stock of Capital Goods • Expectations • Future sales, operating costs, profits, etc.

  19. The Multiplier Effect • When a change in spending changes GDP by more than the initial change • One person’s spending becomes another’s income • How much does a given change in spending impact GDP? • The multiplier of course! Change in real GDP Multiplier= Initial change in spending

  20. The Multiplier Effect (cont.) • By rearranging the equation, we can also say that: initial change in spending Change in GDP=multiplier X

  21. The Multiplier Effect (cont.) • You can also find the multiplier if you know MPC: • Only for government and investment spending _____1_____ Multiplier = 1 - MPC or ___1___ Multiplier = MPS

  22. The Multiplier Effect (cont.) • The tax multiplier is used for determining the impact of a tax on GDP (it’s different from the investment and government spending multipliers): __-MPC__ Tax multiplier= [1-MPC] or -MPC Tax multiplier= MPS

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