THE KEYNESIAN MODEL: PART TWO

AGGREGATE DEMAND IN THE PRIVATE SECTOR:
THE KEYNESIAN MODEL: PART TWO

If (desired) investment is $1,000 no matter what output is, what will savings be when the economy is in equilibrium? How will income be affected if people want to save more?

• Savings will be $1,000 when the economy is in equilibrium. This is the only level of savings consistent with spending equaling income. If people want to save a larger share of their income, income will fall in order to reduce their savings back to $1,000.

How will the following events affect real consumption spending?
Event A: A rise in the general price level.
Event B: The real values of homes increase.
Event C: Taxes are increased.

Event A: Decreases consumption spending by reducing the real value of money holdings.
Event B: Increases consumption spending by increasing wealth.
Even C: Decreases consumption spending by decreasing disposable income.

Suppose the MPC is 0.6. If at each level of income, people want to consume $2,000 more, how will income change? How will consumption change (break C’s change into its initial autonomous increase and the induced secondary consumption respending)? Assume I is fixed.

• The multiplier is 1/0.4 (or 2.5), so income goes up by $5,000. Total consumption goes up by $5,000. This is the sum of the $2,000 initial autonomous increase and the induced $3,000 consumption respending (MPC times increase in income).

Suppose the MPC is 0.75. By how much must investment spending increase for GNP to go up $50 billion?

• The multiplier is 4 (1/0.25). So 4 times the increase in I should equal $50 billion. The increase in I needed is $12.5 billion.

Assume the following: (1) When the price level P falls from 2.00 to 1.00, real consumption spending at each level of Q increases by $2,000. (2) MPC = 0.8. (3) At P = 2, equilibrium Q is $20,000.
a. At P = 2.00, what is real income? Nominal income?
b. At P = 1.50, what is real income? Nominal income?

a. Real income = $20,000. Nominal income (P x Q) = $40,000.
b. Real income = $30,000 (increase in Q = spending multiplier times autonomous increase in C). Nominal income equals $30,000. Note that even though nominal income went down, real income went up!

Keynes assumed that people didn’t care whether their savings were invested (and earning interest) or kept in cash. This problem illustrates what happens if this isn’t true. Suppose an economy is in equilibrium at Q = $10,000. At this income, people want to hold $1,000 in cash, no more and no less. MPC = 0.8. What will happen if planned investment spending increases by $100?

• This question is answered by asking how business can get the $100 when income is still equal to $10,000. Since the economy is at equilibrium, all savings are invested. The only source of cash is from money holdings, but by assumption, people won’t reduce (or lend out) these holdings. So business will be trying to borrow more than people want to lend them. The interest rate will go up, causing business to reduce their planned investment spending back to its original level. The actual multiplier is 0, not 5 as it would be in the Keynesian model.

Copyright 2008 by Sujanto Rusli
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