Question

4. “In a Short-run Keynesian model is used to explain the relationship between aggregate expenditure and aggregate demand and how the multiplier gets smaller as the price level changes.” a) Discuss autonomous expenditure as a component of aggregate expenditure. b) State any three assumptions of a Keynesian model.

Answer 1

a. The autonomous expenditure defines the total spending components of an economy that are not influenced by the real income level of that same economy. Such form of spending is considered to be routine and necessary, be it at the level of government or individual level. The classical economic theory states that any increase in autonomous spending generates at least an equal threat. To order to be considered an autonomous expenditure, it is generally necessary to find the expenditure sufficient to preserve a basic level of function and survival in an individual context. Regardless of personal disposable income or national income, these costs often do not differ. Autonomous expenditure is linked to autonomous consumption, including all the financial obligations necessary to maintain a basic living standard. Any expenses beyond these are known as part of induced spending that is affected by changes in disposable income.

b. The first of three key assumptions underlying Keynesian economics is the presumption that, especially in the downward direction, prices are inflexible or rigid. The Keynesian interpretation of persistent inflation is central to this market rigidity. If prices do not decline, particularly wages, then the resulting surplus on the labor market means unemployment.
There may be fixed rates for a number of reasons. First, producers often have long-term, multi-year agreements that define product rates with commodity suppliers. Such deals prohibit increases in prices. Second, workers prefer to see compensation as an indicator of intrinsic self-worth and therefore resist efforts to lower wages.

The second key Keynesian principle is the notion of effective demand, that spending on investment is based on the actual disposable income available to the private sector rather than on the income available at full employment. Strong demand means people spend the money because, under other conditions, they don't necessarily have the revenue they might have.
This assumption implies that changes in income, especially disposable income, are the main influence on spending on consumption. If the household sector has more income as the economy expands, then consumption expenditures are increased.

Keynesian's third crucial theory is that savings and spending are affected by factors other than interest rates. These other factors that prevent the equality between saving and investment, or may require savings only at a negative interest rate. The lack of equality between saving and investment can lead to a downward spiral of declining production and income being cumulatively reinforced.
Household saving's most significant non-interest-rate determinant is disposable income. As disposable income changes, it not only changes consumer spending in the household sector, it also changes savings.