ECON 9/18 Keynesian Theory (Aggregate)

Current Events:
- Mortgage rate drop short lived even though government bailed out Fannie May and Freddie Mac
- FED to keep interest rates where they are

Keynesian Theory:

Unemployment rate during the Great Depression:
- From 3% to 26% max and back down, up and down

The Central Concept:
- Equilibrium production requires output to equal aggregate demand or Y = E (where E is aggregate demand)
- For the domestic economy (no international sector), aggregate demand is: E = C + I + G (where C is consumption, I is investment, and G is government purchases)

Assumptions and Equilibrium Conditions:
- Price changes are ignored in chapter 5-7 and all variables are expressed in real terms
- I is intended (or planned) investment and Ir, is realized investment

In Equilibrium:
- Y = E = C + I + G = C + S + T
- S + T = I + G
- Ir = I

Adjustment to Disequilibrium:
- When Y > E and Ir > I there is unintended inventory accumulation
- Unintended inventory accumulation prompts reduced production which can lead to increased unemployment
- When Y < E and Ir < I there is unintended inventory shortfall
- Unintended inventory shortfall prompts increased production which can lead to increased employment

Consumption:
- Consumption function - the Keynesian relationship between income and consumption
- C = a + bYD
- Where a = autonomous consumption expenditure, b = marginal propensity to consume, 0 < b < 1, 1-b = marginal propensity to save, Yd is disposable income (Y subscript capitol D)

Saving function:
- S = -a + ( 1 - b ) YD

Investment:
- Investment is highly volatile and is the primary cause of business cycles in the Keynesian system
- Keynes believed that managers based investment decisions on expectations
- Expectations change over time and therefore investment decisions vary over time as well

Expectations:
- Managers tend to extrapolate past trends into the future
- Managers tend to conform to the behavior of the majority or average of their peers
- Consequently, investment "being based on so flimsy a foundation, it is subject to sudden and violent changes."

Table 5-1, Consumption and Investment as a Percentage of GNP, Selected Years
- Consumption is a stable function of income
- Investment changes abruptly over time, going up and down with no relative correlation