Keynesian theory. Simple Keynesian analysis.

Consumption function

1. The role of AD in Keynesian theory

2. Consumption function

3. Non-income determinants of consumption

1. The role of AD in Keyn. theory

Δ in AD determine the level of Y & price level

Assumptions in Keyn. analysis:

• Absence of inflation (amount of money corresponds to Δ in AD as r =const)

• Absence of business fluctuations (equilibrium between Inj and W)

• Inj are exogenous variables (don’t depend on Δ in Y) and domestic consumption Cd and W are endogenous (depend on Δ in Y)

• Originally Keynes assumed absence of government intervention in to economy: G=0, T=0, M;X=0 All savings are individual (personal) savings.

But in our analysis we shall include Government and Foreign components (g;t;m;X)

AD= C + I + G + Xn

AD= Cd(C-Cm) + Id + Gd(govern. ex. on domes. pr. g&s) + Xd (total X-reexport)

AD= Cd + J = Cd + W

Main determinants of AD are Cd, W, J; if AD>Y YW until W=J

Originally K. analyzed C(total consumption): C=Cd+Tind (indirect taxes)+M(expenditures on import)

2. Consumption function (relationship between C &Y)

choice of each family: to consume or to save

DI (disposable income…after paying taxes)=C+S

Each nation may use Y either on Cd or W: Y=Cd+W (S+T+M)

Y is the main determinant of C

Relationship between C&Y m.b. illustrated with the consumption fun-n, C=f(Y) represented by 45’ degree line diagram.

• As Y rises, so does C

• At low level of Y before A point consumption f-n lies above 45’line, that is country spends more, than it earns by borrowing from other countries, using previous savings. This situation is called dissavings.

• At point A, C=Y. Country spends all its incomes; income corresponding to p.A is called break-even income. E.g. income is fully consumed

• Above p.A C<Y. Part of incomes goes to savings

• The slope of C fun-n depends on Marginal Propensity to Consume. mpc=the proportion of a rise in Y that goes on con-n; mpc =ΔC/ΔY (cons. F-n is a straight line=> mpc=const, no slope); average propensity to consume =proportion of total Y that goes on C: apc=C/Y.

If Y we have a movement along con-n function.

3. Non-income determinants of consumption

• Assets or wealth: (real assets (cars,houses), financial assets(shares,deposits); the wealth the C (on average)

• Price level; the  Plevel ,the real value of wealth, C

• Level of taxes ­, the ¯C (con-n depends on DI)

• Availability & the price of consumers’ credit; the easier it’s to get consumer credit, the cheaper consumer credit, the ­C

• Consumer indebtedness ­, the ¯C

• Expectations of future prices and incomes. If people expect ­ in prices or ­ in incomes they consume more now.

• Distribution of income: if total income is redistributed from poor to rich, it will ¯C. Poor people don’t save.

• Attitude to consumption: if people have a habit to consume more, C­; “buy now, pay later” mentality => ­C

• The age of durables: if ppl have old age durable (end of recession), ­money are spent

Y ¯ - At the peak of the boom ppl’ll probably spend less on durables as they have already bought the items they wanted

Y ­ – After period of recession C ­, during which ppl had cut back on the con-n of durables