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EKN123 - Economics Summary 2004 Chapter 11 Keynesian Models...

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Economics Summary 2004 Chapter 11: Keynesian Models Model terminology: Variable: a value that can vary. Parameters : constant to help establish the relationship between variables. Exogenous variables: these are input values and do not change, also autonomous variables. Endogenous variables: these are outputs of the model, these values are determined inside the model. Also induced variables. Equilibrium : when there is no change in the inputs, the outputs do not change. A simple Keynesian model: The aim is to model the national income. We assume that the economy has excess productive capacity, thus when demand goes up, production will go up. We also assume that prices are fixed. The effect of exchange rates, inflation and interest rates are not included. The consumption function : C = a + bY d . a is the autonomous consumption, the minimum that is needed to survive. B = the marginal propensity to consume. MPC is the proportion of each marginal unit of disposable income that is spent on consumption. The disposable income function : Y d = Y + B – T d . Where T d = t d *Y. In equilibrium , planned national expenditure (aggregate demand, AD) is equal to actual national income. Aggregate demand is the amount that firms, households and the government plan to spend on goods and services at each level of income. The equilibrium condition of our simple Keynesian economic model is that national income equal aggregate demand. An alternative approach to solve the model is to not use the equilibrium condition Y = AD, but rather I + G + B + X = S + T e + T d + Z. Thus actual injections must equal actual leakages. In equilibrium planned injections must equal planned leakages. Money is either saved or consumed, with a consumption function C = 30 + 0.8*Y, the savings function can be determined by S = -30 + 0.2*Y. There 0.2 represent the marginal propensity to save. Thus MPS is the proportion of each marginal unit of disposable income that is saved. MPC + MPS = 1. Using the Keynesian model: Basically the model can be used to find new a equilibrium level of national income when one of the exogenous variables are varied. The Multiplier: The multiplier : an increase in an injection to the national income flow causes an increase in the equilibrium level of national income greater than the injection. This is the multiplier effect. The multiplier is the ratio of the increase in equilibrium national income to the original increase in the injection. The multiplier = 1/MPS or 1/(1 – MPC). The reason for the effect is because an injection, say an increase in government spending, will result is some factors of production receiving more, as they receive more, they spend more, and some other factors receive more (but less than before because op MPC). The multiplier with proportional taxes : Taxes reduce the multiplier effect as disposable income becomes less in each of the multiplication stages. Consequently economists sometimes define the term marginal propensity to consume out of national income as the proportion of each marginal unit of national income that is spent on consumption; and denoted as MPC’. The multiplier then

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