Week 3: The Keynesian Model and

1. The key assumption of Keynesian Model is that the prices are fixed, which looks like unbelievable to Keynes at first but he did believe that when economy in recessionary range, prices and wages were sufficiently inflexible, so income would adjust much faster than prices.

Week 3: The Keynesian Model and Fiscal Policy

2. when Real GDP=Income=AE=AP

    1) The AE curve intersects the vertical axis above zero, because even if the income is zero, people will still spend a certain amount of money on consumption (autonomous consumption) . How can autonomous consumption exist when income is zero ? There is a saving from the past. Induced Consumption: Level of consumption that depends on an individual's disposable income.

    Consumption: durable goods, non-durable goods, services.

    2) Why AE curve is flatter than AP curve ? Because people would like to save a part of their income from their spending. (MPC<1)

    Marginal Propensity to Save/Consume. =MPC/MPS

    3) C=C0+MPC*Yd

Week 3: The Keynesian Model and Fiscal Policy

3. The imbalance between “injections” and “leakages”drives macroeconomic gaps of recession and inflation.

  1) Government spending is discretionary.

  2) Automatic Stabilizer: Government's programs that automatically increase spending to fight recession and decrease government's spending to control inflation.

Week 3: The Keynesian Model and Fiscal Policy Week 3: The Keynesian Model and Fiscal Policy

4. Keynesian expenditures multiplier=1/MPS=1/(1-MPC), that's to say, higher MPC, higher Multiplier.

5. Crowing out

Government increases expenditures to fight recession=> Create budget deficit=> Government's borrows money to finance deficit=> drives up interest rates=> Business Investment falls