Introduction to the Keynesian System

1
Introduction to the Keynesian System
? The Keynesian system is based on the principle
of aggregate demand, which can be stated as
follows in the short period (that is, the time
period in which productive capacity is fixed
within narrow limits), real output and employment
are determined by aggregate demand.
? Aggregate demand (AE) is defined as total or
aggregate spending for newly produced goods and
services.
2
"My spending is your receipt"

• Let
• AE denote aggregate demand or aggregate
  expenditure.
• Y is real output or real GDP.
• YD is real disposable income.

? For a closed economy without a public sector,
the following must be true AE ? Y ? YD
1
3
The income-expenditure line
AE
AE Y
Income-expenditure line
450
Real Output Real Income (Y)
4
The aggregate demand function
? The aggregate demand or aggregate expenditure
function (AE) reveals the plans of spending units
at alternative levels of real income
? In a closed economy with no public sector AE
C I 2 ? Thus, developing a theory of
aggregate demand logically begins with a theory
of consumption and a theory of investment.
5
The consumption function

• Definitions
• Autonomous consumption (C a) Consumption
  spending determined independent of income.
• Ave. propensity to consume (APC)Ratio of
  consumption to real disposable income (YD). That
  isAPC C/YD
• Marginal propensity to consume (MPC c) The
  change in consumption resulting from a one unit
  change in disposable income. That is MPC c
  ?C/?YD.
• Ave. propensity to save (APS) Ratio of saving to
  real disposable income. That is APC S/YD.
• Marginal propensity to save (MPS) The change in
  saving resulting from a one unit change in
  disposable income. That is MPS ?S/?YD.

6
The consumption function, slide 2
? The consumption function can be expressed
mathematically by C C a cYD 3
? The fundamental psychological law of
consumption can be stated as follows People are
disposed, as a rule and on average, to increase
their consumption when their income increases
but not by as much as the increase in income.
Thus, we can say 0 lt c lt 1
7
The MPC and the MPS
The consumption function is given byC 30
.7YD
8
The consumption function
C
C YD
C 30 .7YD
300
S
240
C/YD 1
YD
C
100
30
0
100
300
YD
9
Slope of the consumption function
C
Slope ?C/?YD 70/100 .7
C 30 .7YD
310
?C
240
?YD
100
30
0
300
400
100
YD
10
The slope of the saving function is given by MPS
The saving function
S
S -30 .3YD
30
0
YD
200
100
-30
11
Shifts of the consumption function
The function could shift due to
C
C2
C1

• A change in household wealth
• A change in consumer confidence.
• Change in price or availability of credit.

C0
0
YD