Building the Aggregate Expenditures Model Keynesian Economics

John Maynard Keynes British Economist ( ) British Economist ( ) Theorized that “Classical Economics” was plagued by a periodic recession and required government assistance to help jump start the economy Theorized that “Classical Economics” was plagued by a periodic recession and required government assistance to help jump start the economy Recent resurgence due to the instability and corruption of 2008 Recent resurgence due to the instability and corruption of 2008

John Maynard Keynes General Theory of Employment General Theory of Employment Bretton Woods conference prior to WWII gave birth to the creation of the World Bank and the I.M.F. which still exist today Bretton Woods conference prior to WWII gave birth to the creation of the World Bank and the I.M.F. which still exist today

Equilibrium GDP Firms look to produce an amount equal to that of what they believe will be purchased Firms look to produce an amount equal to that of what they believe will be purchased Aggregate Expenditures schedule depicts these outputs at various levels Aggregate Expenditures schedule depicts these outputs at various levels Remember, for this chapter consumption is directly related to the income level where investment is not. Investment is planned regardless of income situation Remember, for this chapter consumption is directly related to the income level where investment is not. Investment is planned regardless of income situation

Disequilibrium The economy will work to achieve equilibrium from either the consumer end or the producer end, but according to Keynes, requires the government to intervene and stimulate aggregate demand. The economy will work to achieve equilibrium from either the consumer end or the producer end, but according to Keynes, requires the government to intervene and stimulate aggregate demand.

Other Features GDP = Investment + Consumption GDP = Investment + Consumption Savings represents a leakage from the spending stream and causes C to be less than GDP Savings represents a leakage from the spending stream and causes C to be less than GDP Investment is referred to as an injection Investment is referred to as an injection

Simplifications For this chapter we need to assume the following: For this chapter we need to assume the following: Aggregate spending only consists of consumption and investment Aggregate spending only consists of consumption and investment GDP = NI = PI = DI GDP = NI = PI = DI There is no account of government spending or foreign trade in this chapter for purposes of simplicity There is no account of government spending or foreign trade in this chapter for purposes of simplicity

Consumption & Savings Consumption is the largest component of aggregate expenditures Consumption is the largest component of aggregate expenditures DI = Consumption + Savings DI = Consumption + Savings What is not spent is considered savings What is not spent is considered savings Disposable income has a direct relationship with both consumption & savings Disposable income has a direct relationship with both consumption & savings

Consumption & Savings Break-even Income – Point at which household consumption = income Break-even Income – Point at which household consumption = income APC – Avg. Propensity to Consume APC – Avg. Propensity to Consume APS – Avg. Propensity to Save APS – Avg. Propensity to Save APC = Consumption / Income APC = Consumption / Income APS = Savings / Income APS = Savings / Income

Marginal Propensities MPS – Marginal Propensity to Save MPS – Marginal Propensity to Save MPC – Marginal Propensity to Consume MPC – Marginal Propensity to Consume Is measured to see how income will change the amounts that are saved and spent Is measured to see how income will change the amounts that are saved and spent MPC + MPS always = 1, APC + APS =1 MPC + MPS always = 1, APC + APS =1

Non-Income Determinants Wealth Wealth Expectations of Future Economic Activity Expectations of Future Economic Activity Taxation Taxation Household Debt Household Debt

Investment Second component of private spending Second component of private spending Investment decision weighs marginal benefit vs. marginal cost Investment decision weighs marginal benefit vs. marginal cost Rate of return = Benefit Rate of return = Benefit Interest Rate = Cost Interest Rate = Cost Rate of Return = Revenue – Cost Rate of Return = Revenue – Cost If Real Interest Rate exceeds Rate of Return, investment should not be made If Real Interest Rate exceeds Rate of Return, investment should not be made

Investment Data Measured with Investment Demand Schedule Measured with Investment Demand Schedule Shows inverse relationship between Return and Interest Shows inverse relationship between Return and Interest Understand reduction of interest rates directly effects investment Understand reduction of interest rates directly effects investment

Investment Data Shifts in the curve are caused by other factors. These include: Shifts in the curve are caused by other factors. These include: Capital Goods acquired, maintained, & operated Capital Goods acquired, maintained, & operated Business Taxes Business Taxes Technology Technology Stock of Capital Goods Stock of Capital Goods Future Expectations Future Expectations

Investment Schedules Economists define by determining exactly how much individual businesses will invest at every level of GDP or DI. Economists define by determining exactly how much individual businesses will invest at every level of GDP or DI. Assume investment is independent from income Assume investment is independent from income

Investment Volatility Capital Goods are durable meaning investment can be postponed Capital Goods are durable meaning investment can be postponed Innovation occurs irregularly Innovation occurs irregularly Profits vary considerably Profits vary considerably Expectations Change Easily Expectations Change Easily

Equilibrium GDP We measure producer output and income by depicting these graphically We measure producer output and income by depicting these graphically Producers seek to reach equilibrium Producers seek to reach equilibrium It is assumed that income level = output It is assumed that income level = output Investment is independent of income and planned regardless Investment is independent of income and planned regardless C + Ig = GDP (Output) C + Ig = GDP (Output)

Equilibrium GDP Savings and planned investment are equal Savings and planned investment are equal Saving represent a “leakage” in consumption causing it to be less than GDP Saving represent a “leakage” in consumption causing it to be less than GDP The economy is in never ending state to reach this equilibrium. The goal is to have Income = Output. Until that happens, inventories will always fluctuate based on circumstance. The economy is in never ending state to reach this equilibrium. The goal is to have Income = Output. Until that happens, inventories will always fluctuate based on circumstance.