CHAPTER 6
A SIMPLE KEYNESIAN MODEL OF THE ECONOMY
Production, income and spending
I am able to explain the relationship between the three central macroeconomic
flows
Total production (or output)
Total income
Total spending (or expenditure)
The National accounts are concerned with measuring the above:
These are recorded ex post (after the events have occurred)
Total production = total income (as economists are only interested in income
earned in the process of production)
Total spending (or expenditure) = total production and income (because of the
way in which spending is defined – changes in inventories are added to total
investment spending (i.e. capital formation), one of the components of total
spending
In macroeconomic theory there is no guarantee that total spending will equal to
total production or income
If income is only sufficient to purchase the total product – there is no incentive for
producers to expand production (as no one will have the money to buy the extra
products). In this case production is at its equilibrium level
“Recall that equilibrium is a situation in which there is no tendency to
change. Equilibrium occurs when none of the participants have any
incentive to change their behaviour. Things will therefore remain the
same (as long as the underlying forces do not change.)
But spending CAN exceed production (the demand for goods and services is
greater than the available production or supply – is an incentive to expand
production) – How spending can exceed income: if savings from a previous
period are used, or they can buy on credit
Total spending can also be less than total income – total demand for goods and
services will be less than total production – incentive to reduce
production. Happens when money is saved and does not make its way back into
the circular flow of income, production and spending
Therefore there are three possibilities (where Y = total production, output or
income and A = total or aggregate spending (or aggregate demand)
o Spending may be equal to production and income (A = Y). In this
case production and income are at their equilibrium levels – there is no
tendency to change
Will always occur at the full-employment level of production or
income.
Full employment level of income = Y₁
o Spending may be greater than production and income (A > Y). In this
case production and income will tend to increase. They are therefore not
at their equilibrium level
o Spending may be less than production and income (A < Y). In this case
production and income will tend to fall. They are therefore not at their
equilibrium
I am able to define Say's law
, Y→A
Supply creates its own demand
This is the belief that A will always = Y and this occurs at the full-employment level of
production or income (Y₁)
Jean-Baptiste Say formulated the idea that all leakages will automatically find their way
back into the circular flow of income and spending. If this happens, total spending will
always equal to total income. There can never be insufficient demand for goods and
services
In this model there is no requirement for the government to intervene in the economy
Extra notes:
The Keynesian model:
A→Y
Keynes took into account the Great Depression that proved that full-employment is not
automatic, and that aggregate demand is not always sufficient to purchase all the goods
and services produced
He said A is the force which determines Y
This means that equilibrium (where A = Y) can occur at ANY LEVEL, and not just
at full-employment (Yf)
There is no automatic tendency in the economy to full employment – spending has
to be stimulated, or over-employment reduced in order to create equilibrium
This means there is often a need for government intervention (to stimulate or
dampen)
Other names for A and Y
Y is also known as: total production, total output, aggregate output, national output,
aggregate production, aggregate income, national product and national income. It is the
theoretical equivalent of national accounts such as GDP and GNI
A is also known as: total spending, aggregate spending, total expenditure and
aggregate expenditure
Activity:
In macro-economic theory there is no guarantee that total spending will be
equal to total production or income
In the national accounts, total spending during any particular period is also
always equal to total production and income during that period.
Macro-economic theory is used to explain and predict how the various sectors of
the economy will react under certain circumstances and to analyse the possible
effects on policy.
National Accounts are a set of accounts which record what actually happened in
an economy during a particular period. – can only describe what has already
happened
.
Basic assumptions of the model
A SIMPLE KEYNESIAN MODEL OF THE ECONOMY
Production, income and spending
I am able to explain the relationship between the three central macroeconomic
flows
Total production (or output)
Total income
Total spending (or expenditure)
The National accounts are concerned with measuring the above:
These are recorded ex post (after the events have occurred)
Total production = total income (as economists are only interested in income
earned in the process of production)
Total spending (or expenditure) = total production and income (because of the
way in which spending is defined – changes in inventories are added to total
investment spending (i.e. capital formation), one of the components of total
spending
In macroeconomic theory there is no guarantee that total spending will equal to
total production or income
If income is only sufficient to purchase the total product – there is no incentive for
producers to expand production (as no one will have the money to buy the extra
products). In this case production is at its equilibrium level
“Recall that equilibrium is a situation in which there is no tendency to
change. Equilibrium occurs when none of the participants have any
incentive to change their behaviour. Things will therefore remain the
same (as long as the underlying forces do not change.)
But spending CAN exceed production (the demand for goods and services is
greater than the available production or supply – is an incentive to expand
production) – How spending can exceed income: if savings from a previous
period are used, or they can buy on credit
Total spending can also be less than total income – total demand for goods and
services will be less than total production – incentive to reduce
production. Happens when money is saved and does not make its way back into
the circular flow of income, production and spending
Therefore there are three possibilities (where Y = total production, output or
income and A = total or aggregate spending (or aggregate demand)
o Spending may be equal to production and income (A = Y). In this
case production and income are at their equilibrium levels – there is no
tendency to change
Will always occur at the full-employment level of production or
income.
Full employment level of income = Y₁
o Spending may be greater than production and income (A > Y). In this
case production and income will tend to increase. They are therefore not
at their equilibrium level
o Spending may be less than production and income (A < Y). In this case
production and income will tend to fall. They are therefore not at their
equilibrium
I am able to define Say's law
, Y→A
Supply creates its own demand
This is the belief that A will always = Y and this occurs at the full-employment level of
production or income (Y₁)
Jean-Baptiste Say formulated the idea that all leakages will automatically find their way
back into the circular flow of income and spending. If this happens, total spending will
always equal to total income. There can never be insufficient demand for goods and
services
In this model there is no requirement for the government to intervene in the economy
Extra notes:
The Keynesian model:
A→Y
Keynes took into account the Great Depression that proved that full-employment is not
automatic, and that aggregate demand is not always sufficient to purchase all the goods
and services produced
He said A is the force which determines Y
This means that equilibrium (where A = Y) can occur at ANY LEVEL, and not just
at full-employment (Yf)
There is no automatic tendency in the economy to full employment – spending has
to be stimulated, or over-employment reduced in order to create equilibrium
This means there is often a need for government intervention (to stimulate or
dampen)
Other names for A and Y
Y is also known as: total production, total output, aggregate output, national output,
aggregate production, aggregate income, national product and national income. It is the
theoretical equivalent of national accounts such as GDP and GNI
A is also known as: total spending, aggregate spending, total expenditure and
aggregate expenditure
Activity:
In macro-economic theory there is no guarantee that total spending will be
equal to total production or income
In the national accounts, total spending during any particular period is also
always equal to total production and income during that period.
Macro-economic theory is used to explain and predict how the various sectors of
the economy will react under certain circumstances and to analyse the possible
effects on policy.
National Accounts are a set of accounts which record what actually happened in
an economy during a particular period. – can only describe what has already
happened
.
Basic assumptions of the model
