INCOME AND EXPENDITURES Wages (salaries) earned by labor Rents earned by land owners Interest earned by capitalists Profits earned by entrepreneurs INCOME AND EXPENDITURES

Consumption Investment Government INCOME AND EXPENDITURES

Consumption Investment Government Wages Rents Interest Profits Y C + I + G =

Income-Expenditure analysis, as introduced by John Maynard Keynes in 1936, hinges not on how people earn their incomes but rather on how they spend them. If all the income gets spent, then the economy is in “equilibrium,” but it is not necessarily performing at its full- employment potential. YC + I + G=

Does Y always equal C + I + G? No. The equality holds only when the economy is in macro-equilibrium. Is the economy always in macro-equilibrium? No. Only when all income is spent (Y = C + I + G) is the economy in macro-equilibrium. Does macro-equilibrium imply full employment? No, it’s only by “accident or design” that Y eq = Y fe. Does full employment imply an unemployment rate of zero? No, it implies no unemployment beyond the 5-6% that characterizes a healthy economy.

WHY DIVIDE EXPENDITURES INTO THREE COMPONENTS? Consumption Investment Government C + I + G Stable Unstable Stabilizing Stabilizable Not constant but predictable on the basis of income. Based on guesses about market conditions in the future. Deliberately altered to offset changes in investment activity. Potentially stable—with wise and well-time stimulus packages.

FOR STARTERS, WE WORK WITH ONLY TWO COMPONENTS. Consumption Investment C + I Stable Unstable

I. EARNING MONEY AND SPENDING IT A. The Expenditure Sequence

Read Chapter 8, pp in Case, Fair, and Oster’s Principles of Macroeconomics

E = Y

The E strands for total expenditures for a wholly private economy, i.e., E = C + I For starters, let’s just deal with the first component.

Suppose you earn an income of $1200/mo. And you spend $1000/mo on consumption.

Now your income increases to $2700/mo. So, you now spend $2000/mo. A raise of $1500/mo.! An increase in consumption of $1000/mo.

Your Marginal Propensity to Consume, abbreviated MPC, is 1000/1500 = 2/3. $1500/mo. $1000/mo. Marginal Propensity to Consume Average Propensity to Consume

A straight line connecting these two combinations of C and Y shows how consumption spending varies with income.

The MPC is the slope of the line and is symbolized here by “b.” The vertical intercept is symbolized by “a.” So, a = 200, and b = 2/3. C = a + bY C = /3 Y

The 45-degree line allows us to measure saving as the difference between income and consumption. That is, S = Y – C.

The 45-degree line allows us to measure saving as the difference between income and consumption. That is, S = Y – C.

For a wholly private economy: S = Y – C, where C = a + bY S = Y – (a + bY) S = Y – a – bY S = – a + Y – bY S = – a + (1 – b)Y

Proof: C = a + bY S = – a + (1 – b)Y C + S = 0 + bY + (1 – b)Y C + S = (b + 1 – b) Y C + S = Y

C = a + bY S = – a + (1 – b)Y If you know the consumption equation, you can write the saving equation by inspection. Note:

C = a + bY S = – a + (1 – b)Y Note: Just change the sign on the intercept term and choose an MPS so that the two marginal propensities add up to one.

C = Y What is the saving equation? S = Y S = – a + (1 – b)Y For example:

For a wholly private economy: The equilibrium condition is: Y = C + I It’s necessarily true that: Y = C + S --since S = Y - C What can you say, then, about the relationship between I and S in macroeconomic equilibrium?

For a wholly private economy in macroeconomic equilibrium, Y = E C + S = Y = E = C + I C + I = C + S I = S The equality of saving and investment implies an income- expenditure equilibrium.

According to Keynes: It isn’t movements in the interest rate that bring saving and invest- ment in line with one another. Rather, it is movements in the level of income that bring saving in line with investment.

According to Keynes, this is the great inherent fault of a totally decentralized capitalist system. The variable that is in charge of macroeconomic equilibration (Y) is at the same time the magnitude upon which the prosperity of the economy depends.

So, what part of the totally decentralized capitalist system do you think Keynes wanted to centralize? As Keynes saw things, “a somewhat comprehensive socialization of investment will prove the only means of securing an approximation to full employment.”

When Y = 2700, C = How much investment would there have to be for Y = 2700 to be an equilibrium? I = 700 And just how might that investment be financed? (S = 700) Y = 2700 C = 2000

You can actually calculate the equilibrium value of Y if you know the parameters of the consumption equation ( a and b) and you know the current level of investment (I).

A wholly private economy is in macroeconomic equilibrium when: Y = C + I Consumers spending is given by: C = a + bY With I = 200 and C = /3 Y, we can write Y = ( /3 Y) Y = /3 Y + 200

Y - 2/3 Y = 400 1/3 Y = 400 Y = 1200 Proof: C = /3 Y = /3 (1200) C = = 1000 C + I = = 1200 = Y

You can actually calculate the equilibrium value of Y if you know the parameters of the consumption equation ( a and b) and you know the current level of investment (I).

I = 200 C = 1000 Y = 1200 Y fe

Suppose that investment increases by some amount, say,  I = 600. By how much will the equilibrium level of Y increase? That is, what value of  Y corresponds to a  I of 600 Y fe

Watch the economy spiral upwards. Y fe

Watch the economy spiral upwards W N Going wage 3000 Y fe

Watch the economy spiral upwards. Y fe

Watch the economy spiral upwards. Y fe

Watch the economy spiral upwards. Y fe

We see that the economy is currently mired in an equilibrium in which income is only Full-employment income, however, is So, the change in income that we need (the  Y) is 900. The MPC is 2/3, which means that the government spending multiplier is 3. So, let’s increase government spending by 300 and let income and spending spiral up by 900 to the full-employment level of Y = 3000.

Tax-free Lopokova was recently in macroeconomic equilibrium with its labor force fully employed. Then, the business community cut back on investment spending by $12 million, causing the economy to spiral down from $8,000 million to $7,952 million. What is Lopokova’s investment spending multiplier? What is the implied marginal propensity to consume? What is the corresponding marginal propensity to save? What is Lopokova’s government spending multiplier? How much would the government have to spend to drive the economy back to full employment?

Tax-free Lopokova is put back in macroeconomic equilibrium with its labor force fully employed. Suppose, now, that the business community, riled by the “animal spirits,” undertakes additional investments of $12 billion. If not offset by fiscal policy, this increase in investment spending would cause the economy to spiral up from $8,000 billion to $8,048 billion. What change in the level of government spending would keep the economy at full employment without inflation? What tax levy would have the same remedial effect?

Bonus: Suppose that, with macroeconomic equilibrium reestablished with the economy, once again, experiencing full employment without inflation, investment spending and government spending totals to $2,000 million. Assume that Lopokova remains tax-free. Calculate the value of “a” in Lopokova’s consumption equation (C = a + bY).