Ch5ppt

Editor's Notes

1. The foundation of Keynesian macroeconomic theory is that prices, wages, and interest rates are fixed. Prices and wages are directly related because firms could not lower product prices if wages were not lowered. Classical economic theory suggested that high unemployment rates would lead to lower wage rates, which would lead to lower prices, which would lead to higher demand because of the increased purchasing power of existing wealth. But Keynes observed that wages were not falling (actually there was a decline in the average price level during the early 1930s but evidently not enough to matter). Keynes could not apply an economic theory to explain why those people out of work were unwilling to accept a lower wage in order to get a job. He simply accepted it as an unexplained socioeconomic fact of life and built a theory around the assumption that prices and wages were rigid. Interest rates are a different story. Classical theory suggests that during a recession or depression interest rates should fall, which would stimulate consumption and investment spending. Keynes observed that if interest rates were already near zero how could they go any lower. Moreover, even if interest rates could decline further why would that lead to an increase in investment? With factories running well below capacity because of the Depression, why build new production plants?
2. We begin with the definition of aggregate expenditures because this is the heart of the Keynesian model. The assumption that prices and interest rates are fixed implies the aggregate supply curve is flat. Consequently, any change in aggregate supply (i.e., a rightward or leftward shift) will have no effect on the economy. Aggregate spending is the driving force. On the supply side firms simply increase or reduce production at the constant market price to meet the level of demand.
3. Assumed to be a positive function of income Prices and other variables assumed to be constant (prices) or do not significantly affect consumption (interest rate) MPC = change in consumption per $1 change in income
4. Other explanations Geometric series - explain in terms of initial $1 change in spending following by subsequent consumption/income changes. Graphical derivation
5. AD Graph - further rearrange: AD = C0 + I0 + G0 + c(TR - T0) + c * (1 - t) * Y intercept slope
6. Implication in Keynesian model is that increase in government spending should be financed by a deficit. Larger multiplier effect. But, Keynesian model ignores impact of deficit on interest rates, trade deficit, etc.
7. Reduce the strength of upswings or downswings in demand that arise from an unexpected change in autonomous spending.