NID: Keynesian

Central Idea of Keynesian Theory

• Level of real NY and thus employment determined by level of Desired Aggregate Expenditure (AE) in the short run
• Desired AE: the total planned expenditure on goods and services in an economy
• AE = C + G + I + (X-M)
• Equilibrium level of NY = only level of NY where AE = total value of goods and services produced
• Factors that determine AE can therefore be manipulated in order to achieve full employment

2 Sector Economy

• Closed Economy with no savings
• AE = C + I
• Withdrawals/leakages = Investment

3 Sector Economy

• Closed economy with government intervention
• AE = C + I + G

4 Sector Economy

• Open economy with government intervention (real world situation)
• AE = C + G + I + (X-M)

Consumption Function

• The relationship between consumption and Income, when all other factors are held constant
• C = a + bY
• Diagram involves a 45 degree line (AE = Y) between C (Y-axis) and NY (X-axis); and the consumption function

Propensities to consume and save

Average Propensity to Consume (APC)

• The proportion of total income that is consumed
• Calculated by APC = (C / Y)
• Increase Y, APC decreases

Average Propensity on Save (APS)

• The proportion of total income which is saved
• Calculated by APS = (S / Y)

Marginal Propensity to Consume (MPC)

• Relates to the change in consumption as income changes
• Measured by MPC = (Change in C / Change in Y)
• b in C = a + bY

Marginal Propensity to Save (MPS)

• Relates the change in savings as income changes
• Measured by MPS = (Change in S / Change in Y)
• Gradient of SAVINGS function

Factors that shift consumption/savings functions

Movement along consumption/savings functions: Change in Income

Non-income determinants of consumption (shift)

• Wealth: Increase Wealth, f(C) increase, f(S) decrease
• GPL: Increase Px Level, Purchasing Power Decrease, f(C) decrease
• Expected future Y: Expected Y increase, f(C) increase
• Consumer credit: Increase credit offer, f(C) increase; Increase credit cost, f(C) decrease
• Distribution of Income: Increase equality, APC increase, f(C) increase
• Taxes: Increase Tax, f(C) decrease

Investment (I)

Expenditure over a given period on the production of capital goods and on net additions to stocks of goods

Significance

• Large injection and is volatile
• Fluctuations cause booms and slumps
• Major factor contributing to long term economic growth

Types:

Inventories or stocks

• Volatile
• Change due to change in rate of production and sales
• Higher rate of interest, lower desired stock of inventories

Residential construction

• Tends to vary directly with change in average Y and inversely with interest rate (i/r)

Plants and equipment

• Depends on expected rate of return and changes in NY

Marginal Efficiency of Investment (MEI)

• Shows negative relationship between i/r and level of I
• Diagram is a downward sloping graph with i/r on Y-axis, I on X-axis

Factors affecting MEI

• Business expectations: Increase expectations, I increases
• Cost of new capital goods: Increase cost, I decreases
• Innovation and technology: Increase Innovation and Tech., I increases
• Profit taxes (corporate taxes): Increase Tax, I decreases

Government Expenditure (G)

Assumed to not vary with NY

Net Exports (X-M)

Assumed to be independent of NY

Equilibrium National Income

One that once reached will be maintained unless economy is further disturbed

• Point where AE = Y intersects AE = C + I + G + (X-M)

Deflationary Gap

• Shortfall of AE below NY at Y_FE
• Upward shift of AE required to close the gap
• C and I remain low in depressed economy

Inflationary Gap

• Demand-pull inflation occurs
• Downward shift of AE required to close the gap

MULTIPLIER

Multiplier ratio (K) refers to the multiple by which change in NY exceeds change in AE

K = (Change in Y / Change in AE) = (1 / MPW) = (1 / (1-MPC)) = (1 / (MPS+MPT+MPM))

• MPW: Marginal Propensity to Withdraw
• MPT: Marginal Propensity to be Taxed
• MPM: Marginal Propensity to Import
• Singapore’s K is low because of higher MPS and MPM

Keynesian Demand Management

• Use fiscal policy to influence AE
• Greater multiplier, Smaller increase in G need to increase money NY
• Large multiplier, Increase in money NY is in Real output, therefore effective Fiscal Policy (FP)
• Therefore ineffective in Singapore

Paradox of Thrift

• Increased savings leads to economic downturn, NY decreases
• Good if increase S and I, leading to increase in future AE
• Bad if unemployment already increasing, increase S will decrease NY

Conclusion

Keynes believes that Government has a role in business cycle, dampening NY fluctuations.