The Keynesian Theory

Keynes's theory of the determination of equilibrium real GDP, employment, and prices focuses on the relationship between aggregate income and expenditure. Keynes used his income-expenditure model to argue that the economy's equilibrium level of output or real GDP may not correspond to the natural level of real GDP. In the income-expenditure model, the equilibrium level of real GDP is the level of real GDP that is consistent with the current level of aggregate expenditure. If the current level of aggregate expenditure is not sufficient to purchase all of the real GDP supplied, output will be cut back until the level of real GDP is equal to the level of aggregate expenditure. Hence, if the current level of aggregate expenditure is not sufficient to purchase the natural level of real GDP, then the equilibrium level of real GDP will lie somewhere below the natural level. In this situation, the classical theorists believe that prices and wages will fall, reducing producer costs and increasing the supply of real GDP until it is again equal to the natural level of real GDP. Sticky prices. Keynesians, however, believe that prices and wages are not so flexible. They believe that prices and wages are sticky, especially downward. The stickiness of prices and wages in the downward direction prevents the economy's resources from being fully employed and thereby prevents the economy from returning to the natural level of real GDP. Thus, the Keynesian theory is a rejection of Say's Law and the notion that the economy is self-regulating. Keynes's income-expenditure model. Recall that real GDP can be decomposed into four component parts: aggregate expenditures on consumption, investment, government, and net exports. The income-expenditure model considers the relationship between these expenditures and current real national income. Aggregate expenditures on investment, I, government, G, and net exports, NX, are typically regarded as autonomous or independent of current income. The exception is aggregate expenditures on consumption. Keynes argues that aggregate consumption expenditures are determined primarily by current real national income. He suggests that aggregate consumption expenditures can be summarized by the equation

where C denotes autonomous consumption expenditure and Y is the level of current real income, which is equivalent to the value of current real GDP. The marginal propensity to consume ( mpc), which multiplies Y, is the fraction of a change in real income that is currently consumed. In most economies, the mpc is quite high, ranging anywhere from .60 to .95. Note that as the level of Y increases, so too does the level of aggregate consumption. Total aggregate expenditure, AE, can be written as the equation

where A denotes total autonomous expenditure, or the sum C + I + G + NX. Different levels of autonomous expenditure, A, and real national income, Y, correspond to different levels of aggregate expenditure, AE. Equilibrium real GDP in the income-expenditure model is found by setting current real national income, Y, equal to current aggregate expenditure, AE. Algebraically, the equilibrium condition that Y = AE implies that

where

In words, the equilibrium level of real GDP, Y*, is equal to the level of autonomous expenditure, A, multiplied by m, the Keynesian multiplier. Because the mpc is the fraction of a change in real national income that is consumed, it always takes on values between 0 and 1. Consequently, the Keynesian multiplier, m, is always greater than 1, implying that equilibrium real GDP, Y*, is always a multiple of autonomous aggregate expenditure, A, which explains why m is referred to as the Keynesian multiplier. The determination of equilibrium real national income or GDP using the income-expenditure approach can be depicted graphically, as in Figure 1 . This figure shows three different aggregate expenditure curves, labeled AE1, AE2, and A3, which correspond to three different levels of autonomous expenditure, A1, A2, and A3. The upward slope of these AE curves is due to the positive value of the mpc. As real national income Y rises, so does the level of aggregate expenditure. The Keynesian condition for the determination of equilibrium real GDP is that Y = AE. This equilibrium condition is denoted in Figure 1 by the diagonal, 45 line, labeled Y = AE.

Figure 1 The Keynesian income-expenditure approach to equilibrium real GDP

To find the level of equilibrium real national income or GDP, you simply find the intersection of the AE curve with the 45 line. The levels of real GDP that correspond to these intersection points are the equilibrium levels of real GDP, denoted in Figure 1 as Y1, Y2, and Y3. Note that each AE curve corresponds to a different equilibrium level for Y. Note also that each Y is a multiple of the level of autonomous aggregate expenditure, A, as was found in the algebraic determination of the level of equilibrium real GDP.

Graphical illustration of the Keynesian theory

The Keynesian theory of the determination of equilibrium output and prices makes use of both the income-expenditure model and the aggregate demand-aggregate supply model, as shown in Figure 2 .

Figure 2 The Keynesian income-expenditure approach and aggregate demand and supply Suppose that the economy is initially at the natural level of real GDP that corresponds to Y1 in Figure 2 . Associated with this level of real GDP is an aggregate expenditure curve, AE1. Now, suppose that autonomous expenditure declines, from A1 to A3, causing the AE curve to shift downward from AE1 to AE3. This decline in autonomous expenditure is also represented by a reduction in aggregate demand from AD1 to AD2. At the same price level, P1, equilibrium real GDP has fallen from Y1 to Y3. However, the intersection of the SAS and AD2 curves is at the lower price level, P2, implying that the price level falls. The fall in the price level means that the aggregate expenditure curve will not fall all the way to AE3 but will instead fall only to AE2. Therefore, the new level of equilibrium real GDP is at Y2, which lies below the natural level, Y1. Keynes argues that prices will not fall further below P2 because workers and other resources will resist any reduction in their wages, and this resistance will prevent suppliers from increasing their supplies. Hence, the SAS curve will not shift to the right as in the classical theory and the economy will remain at Y2, where some of the economy's workers and resources are unemployed. Because these unemployed workers and resources earn no income, they cannot purchase goods and services. Consequently, the aggregate expenditure curve remains stuck at AE2, preventing the economy from achieving the natural level of real GDP. Figure 2 therefore illustrates the Keynesians' rejection of Say's Law, price level flexibility, and the notion of a self-regulating economy.

What Does Consumption Function Mean?

The consumption function is a mathematical formula laid out by famed economist John Maynard Keynes. The formula was designed to show the relationship between real disposable income and consumer spending, the latter variable being what Keynes considered the most important determinant of short-term demand in an economy. The consumption function is represented as:

Where: C = Consumer spending A = Autonomous consumption, or the level of consumption that would still exist even if income was $0 M = Marginal propensity to consume, which is the ratio of consumption changes to income changes D = Real disposable income

Consumption function, in economics, the relationship between consumer spending and the various factors
determining it. At the household or family level, these factors may include income, wealth, expectations about the level and riskiness of future income or wealth, interest rates, age, education, and family size. The consumption function is also influenced by the consumers preferences (e.g., patience, or the willingness to delay gratification), by the consumers attitude toward risk, and by whether the consumer wishes to leave a bequest (see legacy). The characteristics of consumption functions are important for many questions in both macroeconomics and microeconomics. In macroeconomic models the consumption function tracks total aggregate consumption expenditures; for simplicity it is assumed to depend on a basic subset of the factors economists believe are important at the household level. Analysis of consumption expenditure is important for understanding short-term (business cycle) fluctuations and for examining long-run issues such as the level of interest rates and the size of the capital stock (the amount of buildings, machinery, and other reproducible assets useful in producing goods and services). In principle, the consumption function provides answers to both short-run and long-run questions. In the long run, since income that is not consumed is saved, the responsiveness of households to any tax policy (such as those meant to spur aggregate saving and increase the capital stock) will depend on the structure of the consumption function and particularly what it says about how saving responds to interest rates. In the short run, the effectiveness of tax cuts or other income-boosting policies (such as those meant to stimulate a recessionary economy) will depend on what the consumption function says about how much the typical recipient spends or saves out of the extra income. At the microeconomic level the structure of the consumption function is of interest in itself, but it also has a powerful influence on many other kinds of economic behaviour. For example, individuals with only a small stock of savings who are laid off from their jobs may be forced to take new jobs quickly, even if those jobs are a poor match for their skills. On the other hand, laid-off consumers with substantial savings may be able to wait until they can find a better job match.

Whether a consumer is likely to have much savings when laid off will depend on the degree of patience reflected in the consumption function. The standard version of the consumption function emerges from the life-cycle theory of consumption behaviour articulated by economist Franco Modigliani. The life-cycle theory assumes that household members choose their current expenditures optimally, taking account of their spending needs and future income over the remainder of their lifetimes. Modern versions of this model incorporate borrowing limits, income or employment uncertainty, and uncertainty about other important factors such as life expectancy. Economist Milton Friedman advocated a simplified version of this model, known as the permanent income hypothesis, which abstracts from retirement saving decisions. The figure shows the consumption function that emerges from a standard version of the permanent income hypothesis (assuming uncertain future income and a standard utility function that specifies consumers attitudes toward the level and riskiness of their spending). The figure relates the consumers current stock of spendable resources (also known as cash on hand, or the sum of current income and spendable assets) to his or her level of spending. Perhaps the most important feature of the figure, for both microeconomic and macroeconomic analysis, is what it says about the marginal propensity to consume (MPC)that is, how much extra spending will result from a given increase in cash on hand. When levels of cash on hand are low, the MPC is very high, indicating that poor households are likely to spend any windfall income rather quickly. However, when levels of cash on hand are high (that is, for wealthy households), the MPC becomes quite low, suggesting that a windfall will prompt only a small increase in current spending. Several strands of empirical research confirm the proposition that low-wealth households exhibit higher MPCs than high-wealth households.

Investment Function and Capital Expenditure from Managerial Economics

We already have discussed about consumption function. Now, we will study about investment chapter. Investment is known as capital expenditure i.e. the expenditure on purchasing physical assets, machinery, equipments etc. Types of Investment: a) Gross and Net Investment: Gross is total value of productive assets created during a given period i.e. one year. It tells us the resources mobilized by the economy, depreciation is part of gross investment, when we deduct amount of depreciation from gross investment, and we get net investment. Net investment creates new productive capacity and employment opportunity. b) Private Investment Public Investment: Investments made by private companies and corporate come under private investment. Investment made by Government and departmental undertakings is called public investment. c) Induced and Autonomous Investment: Autonomous investment is the investment which is income in elastic. According to this, even if the income is zero, there is some amount of investment done by the Government. It does not depend on the change in National Income.

In this figure, income is shown on X-axis and investment is shown on Y-axis. You can see that even when the income is zero, some amount of investment is made. Induced investment increases with increase in income and decreases with the decrease in income.

When income increases, the demand and consumption will increase In this figure, income is shown on X-axis and investment is shown on Y-axis. You can see when income increases the demand and consumption will increase and so the investment to increase the production and supply and vice versa.

Total Investment In this figure, income is shown on X-axis and investment is shown on Y-axis. We can see the total investment in the above figure. Total Investment = Autonomous + Induced Investment

A business cycle is a swing in total national output, income, and employment, usually lasting for a period of 20 to 10
years, marked by widespread expansion or contraction in most sectors of the economy. Typically economists divide business cycle into two main phases, recession and expansion. Peaks and troughs mark the turning points of the cycles. The downturn of a business cycle is called a recession, which is often defined as a period of in which real gross domestic product declines for at least two consecutive quarters. The recession begins at a peak and ends at a trough. According to the organization, which dates the beginning and end of business cycles, the National Bureau of Economic Research, the last U.S recession began after the economy peaked in the summer of 1990. This was followed by a brief recession, which ended in March 1991, after which United States enjoyed one of the longest expansions in its history. Note that the pattern of cycles is irregular. No two business cycles are quite the same. No exact formula, such as might apply to the revolutions of the planets or of a pendulum, can be used to predict the duration and timing of business cycles.

Question: What Is the Business Cycle? Answer: The business cycle is the periodic but irregular up-and-down movements in economic activity, measured by fluctuations in real GDP and other macroeconomic variables. If you're looking for information on how various economic indicators and their relationship to the business cycle, please see A Beginner's Guide to Economic Indicators. A business cycle is not a regular, predictable, or repeating phenomenon like the swing of the pendulum of a clock. Its timing is random and, to a large degree, unpredictable. A business cycle is identified as a sequence of four phases: Contraction: A slowdown in the pace of economic activity The lower turning point of a business cycle, where a contraction turns into an expansion Expansion: A speedup in the pace of economic activity Peak: The upper turning of a business cycle