THE FIXED PRICE KEYNESIAN MODEL
The Keynesian Critique of the Classical Model
Wages, prices and interest may be “sticky,” or inflexible, so that markets may not always clear. The classical model assumed that wages were flexible enough so that labor markets always cleared; the price level was flexible enough so the product market always cleared; and real interest rates were flexible enough so that saving is always equal to investment so that the loanable funds markets cleared.
Money illusion may exist. Workers may not have information about price changes in the economy, so that they may not know the actual real wage being paid.
Short run fluctuations matter. Keynes believed that small changes in spending could lead to much larger changes in GDP in the economy.
Expectations matter. Keynes believed that the expectations of consumers and producers are important in determining the overall level of economic activity.
Expenditures matter. Keynes believed that expenditures were the determinant of real GDP in the economy.
Classical model (Say’s Law) → Spending adjusts to output
Fixed-price Keynesian Model → Output adjusts to spending
Assumptions of the Classical Model
Rational self-interest→decisions are made with a purpose.
Price level is fixed
Interest rates are fixed
GDP is equivalent to national income→ Net Factor Income from abroad is equal to zero and so it Capital Consumption Allowance.
Consumption spending depends on income
Investment, government spending, and exports are fixed
Imports are autonomous (fixed)
Taxes are equal to zero
The Consumption and Saving Functions
The consumption function is a model that shows the relationship between consumption spending and disposable income in the economy.
C = Consumption spending
Y = GDP, measured as either output or income
C0 = autonomous consumption spending, the level of subsistence consumption spending when income = 0
b = the marginal propensity to consume, or MPC
T = Taxes
Yd = Disposable income where Yd = Y – T
C = C0 + bYd
Consumption spending consists of two components.
Autonomics consumption spending is independent of income, and is the amount of consumption spending when disposable income is equal to zero.
There is also the part of consumption spending when that increases with disposable income.
MPC, or b, is the slope of the consumption function.
MPC = ΔC/ΔYd
Saving functions describe the relationship between saving and disposable income in the economy.
S = –C0 + (1 – b)Yd
MPC + MPS = 1
C = Yd
Since the Keynesian model focuses on the role of spending in the economy, the concept of aggregate expenditures is crucial to the development of the model as a whole.
Aggregate expenditures are just the sum of all the spending in the economy by the different sectors, such as households, firms, governments, and the foreign sector.
AE = C + I + G + (X – M)
AE = aggregate expenditures
C = consumption
I = investment
G = government spending
X = exports
M = imports
Aggregate expenditure function shows the amount of total spending in the economy at different levels of income.
If taxes are equal to zero, disposable income Yd = Y – T → Yd = Y
AE = C0 + bY + I + G + (X – M)
AE0 ¬= C0 + I + G + (X – M)
AE = [AE0] + bY
Equilibrium in the Fixed-Price Keynesian Model
In the model, output adjusts until it is equal to spending in the economy. In equilibrium, output, or real GDP (Y) must be equal to the amount of spending in the economy (AE). If not, inventories will change, causing firms to adjust their output.
Keynesian equilibrium is where output = spending.
Y = AE
Y = AE
Y = AE0 +bY
Y – bY = AE0
Y (1 – b) = AE0
Y* = 1/(1 – b) AE0
Equilibrium GDP = spending multiplier * autonomous aggregate expenditures