Week 4 Flashcards
(22 cards)
Who was John Maynard Keynes, and what is he known for?
Keynes (1883-1946) was an influential economist whose work, especially in ‘The General Theory of Employment, Interest, and Money’ (1936), emphasized the role of aggregate demand and government intervention in managing the economy. His ideas shaped the Keynesian model and supported the use of active policies to maintain full employment.
What is the Keynesian approach to economic stabilization?
Keynesian economics suggests that aggregate demand is the primary driver of economic performance and that government intervention is necessary to mitigate recessions by increasing spending.
What are the two components of investment in the Keynesian model?
Fixed Investment: Investment in physical capital, like buildings and machinery.
Inventory Investment: Goods produced but not sold, which can be planned or unplanned, leading to adjustments in output if sales expectations are not met.
How does unplanned inventory investment signal changes in aggregate expenditure?
If firms have more inventory than expected (sales below expectations), it indicates aggregate expenditure is lower than planned, prompting firms to reduce output.
Define Planned Aggregate Expenditure (PAE).
PAE represents total planned spending in the economy, calculated as PAE=C+I_p+G+NX, where:
C = Consumption
I_p = Planned Investment
G = Government Spending
NX = Net Exports
What happens when actual spending (Y) does not equal PAE?
If Y>PAE, inventories rise, and output tends to decrease. If Y<PAE, inventories fall, leading firms to increase output to meet demand.
What is the Keynesian Consumption Function?
It expresses consumption as a function of disposable income: C=C̅+c(Y−T) where:
C̅ = autonomous consumption (independent of income),
c = marginal propensity to consume (MPC), and
Y−T = disposable income.
What is the Marginal Propensity to Consume (MPC)?
MPC represents the proportion of additional income that households spend on consumption. It ranges from 0 to 1 and indicates how much consumption changes with income.
How is short-run equilibrium output determined in the Keynesian model?
Short-run equilibrium occurs when Y=PAE, meaning total output equals planned aggregate expenditure.
Explain the two-sector Keynesian model.
In a two-sector model with households and firms:
Injections: Planned investment (I).
Withdrawals: Savings (S).
Equilibrium is reached when S=I, meaning planned savings equals planned investment.
What happens if Y>PAE?
If Y>PAE, inventories increase because output exceeds spending, prompting firms to reduce production, moving output back toward equilibrium.
What if Y<PAE?
If Y<PAE, inventories decrease, leading firms to increase production, which raises output toward equilibrium.
What is the Keynesian multiplier?
The multiplier quantifies how an initial change in exogenous spending (e.g., investment or government spending) affects total output. It is calculated as: Multiplier=1/(1−MPC), where a higher MPC results in a larger multiplier effect.
How does the multiplier work in a two-sector economy?
In a two-sector economy, an increase in autonomous spending (e.g., investment) increases income, which in turn raises consumption and further increases income, creating a cycle of income growth until equilibrium is reached.
What additional elements are included in the four-sector Keynesian model?
The four-sector model includes taxes (T) and imports (M), alongside consumption (C), planned investment (I_p), government spending (G), and exports (X).
How do injections and withdrawals operate in the four-sector model?
Injections: Include investment (I), government spending (G), and exports (X).
Withdrawals: Include savings (S), taxes (T), and imports (M).
Equilibrium occurs when Injections=Withdrawals.
How is equilibrium income determined in the four-sector model?
Equilibrium income is found where PAE=Y or equivalently (S+T+M)=(I+G+X).
What is the formula for the four-sector multiplier?
The four-sector multiplier is: Multiplier=1/(1−c(1−t)+m) where c is MPC, t is the tax rate, and m is the marginal propensity to import.
What does an output gap indicate in the Keynesian model?
The output gap shows the difference between actual output and potential output:
Positive Gap: Economy is producing above potential, possibly causing inflation.
Negative Gap: Economy is below potential, leading to unemployment.
How does fiscal policy influence aggregate expenditure and the output gap?
Fiscal policy, like government spending changes, shifts the PAE line. Increased spending can close a negative output gap by raising equilibrium output, while reduced spending can cool an overheated economy.
How would a government spending cut of $250 impact output if MPC is 0.8?
With an MPC of 0.8, the multiplier is 1/(1−0.8)=5. Therefore, a $250 cut reduces equilibrium output by $250 × 5 = $1250.
What happens if households reduce their spending due to economic pessimism?
A decrease in household spending shifts the PAE line down, leading to a lower equilibrium output, potentially creating or worsening a negative output gap.
