1. The Keynesian Theory C, S & I  Aggregate Consumption (C)  Aggregate Saving (S)  Planned Investment (I)  The Determination of Equilibrium Output/Income (Y)  Aggregate Expenditure (AE) Approach  The S = I Approach  The Multiplier

2. 2 The circular flow of income Two-Sector Economy: Firms Households Goods and services Services of Economic resources Spending on goods & services (C) Factor income= (Y) Y = C Firms Households Bank Y = RM1 juta C = RM0.8 juta Saving (S) RM0.2 juta Investment (I) RM0.2 juta Y = C + S Y = C + I S ≡ I

3. Consumption Expenditure (C): C = expenditures by consumers on goods and services. There are 3 main categories of consumer expenditures: durable goods, nondurable goods, and services. Durable goods = goods that last a relatively long time, such as cars, furniture and household appliance. Nondurable goods = goods that are used up fairly quickly, such as food and clothing. Services = the thing we buy that do not involve the physical things, such legal, medical services and education.

4. Consumption function = the relationship between consumption and income, C = f (Y) C = a + bY, where a = a constant, or the value of C when Y = 0, b = ∆C/∆Y = marginal propensity to consume (MPC) Y = aggregate of output (income) C = a + bY C Y ∆C ∆Y a 0 Slope = ∆C/∆Y = b = MPC 0 < MPC < 1

5. Aggregate saving (S) = the part of aggregate income that is not consumed. S = Y – C. Substitute C = a + bY S = Y – a – bY = – a + (1 – b)Y, or S = – a + sY (1 – b) = s = marginal propensity to save (MPS) MPC = the fraction of a change in income that is consumed, or spent. MPS = the fraction of a change in income that is saved. MPC + MPS = 1

6. Lets C = 100 + 0.75Y, MPC = 0.75 Y = C + S; S = Y – C S = – 100 + 0.25Y; MPS = 0.25 Agg Income (Y)Agg Consumption (C)Agg Saving (S) 0100 – 100 100175 – 75 200250 – 50 400 0 60055050 800700100 1000850150

7. 45° C = 100 + 0.75Y 100 Y C 0400 Y S = – 100 + 0.25Y S 0 - 100

8. Non-income determinants of Consumption and Saving: 1.Wealth = the value of real assets (houses and land) and financial asset (cash, savings accounts, stocks, bonds, pensions): wealth↑ → C↑ and S↓. C curve shifts upwards and S curve shifts downwards. 2.Real Interest Rate (r) : r↓ - ↓cost of borrowing - C↑ (goods bought on credit). -↓interest payment to saver - S↓ 3.Expectation about the future: if households are optimistic and expect to do better in the future – then they spend more at present. C curve shift will shift up, and S curve will shift down. Or expectations of a recession and thus lower income in the future may lead households to reduce C and save more today. 4.Taxation: an increase in taxes will shift both C & S schedules downwards.

9. Planned Investment (I): Investment = the purchase of new capital – plants, housing, equipments & inventories. Inventories = the goods that firm produce now but intend to sell later. Planned Investment Vs Actual investment Planned Investment (I) = the investment that firms plan to make Actual Investment = the actual amount of investment that take place.

10. Planned Investment Vs Actual investment: Example: Suppose an automobile firm plans to buy RM5 million in machines to produce 10,000 cars, expecting to sell all of them. Thus, no change in its inventory. If the firm sells only 9,500 cars, the actual investment is RM5 million plus the value of 500 cars. So, actual investment > planned investment. Firm has misestimated its sales, it means an increase in its inventories (unplanned change in inventories).

11. Planned Investment Function: Planned investment spending (I) is an autonomous expenditure. Autonomous expenditure = spending that does not vary with the current level of income. I = 25 Aggregate income (Y) Planned investment, I 25 0

12. The Determination of Equilibrium Output (Income) – for simple economy Planned aggregate expenditure: AE = C + I Aggregate output = Y. Equilibrium output: Y = C + I When Y > C + I, it means the firm sold less than they planned to – unplanned increase in inventories. When Y < C + I, it means the firm sold more than they planned to – unplanned decrease in inventories. When Y = C + I, there will be no unplanned inventory investment.

13. C = 100 + 0.75Y, I = 25 YCIAE = C + IUnplanned Inventory Change: Y – (C + I) 10017525200– 100 20025025275 – 75 400 25425 – 25 500475255000 60055025575+ 25 80070025725+ 75 100085025875+ 125 Equilibrium output: Y = C + I = 100 + 0.75Y + 25 = 125 + 0.75Y 0.25Y = 125 Y = 500

14. Equilibrium Aggregate Output AE = C + I Aggregate output, Y 125 Planned AE, C + I 0500 E Unplanned rise in inventory: output falls Unplanned fall in inventory: output rises 45° 500 S I – 100 0 25 S & I Aggregate output, Y Y = AE

15. AE line intersects the 45° line at a level of real GDP of RM500 million. Consider if real GDP total production. Firm’s inventory will fall, thus firms will increase production. This will increase income and consumption. AE line moves up as consumption increases. If GDP > RM500 million, AE line < total production. Firm’s inventory will increase, thus firms decrease production. Income falls and consumption will also fall. AE line moves down as consumption decreases.

16. 16 Multiplier: Multiplier effect = the process by which an increase in autonomous expenditure leads to a larger increase in GDP. Multiplier = The ratio of the change in equilibrium level of output to a change in some autonomous variable, i.e ΔI, ΔG or ΔTx. For a two-sector economy: multiplier = ΔY/ΔI – Suppose I↑ from 25 to 50. i.e. ΔI = 25 – New GDP: Y = 100 + 0.75Y + 50 0.25Y = 150 → Y = 600 – This mean when I increases by 25, equilibrium output has increased by RM100 juta (500 - 600), or four times the amount of the increase in I. – Multiplier = ΔY/ ΔI = 100/25 = 4

17. 17 Multiplier equation: Equilibrium output: Y = C + I = a + bY + I As I increases by ΔI, equilibrium output has increased by ΔY ΔY = bΔY + ΔI (1 – b) ΔY = ΔI → ΔY = x ΔI From example: ΔI = 25 and b = 0.75 ΔY = 25/(0.25) = 100, new equilibrium output: 500+100 = 600 AE 0 = C + I 0 AE 1 = C + I 1 500600Agg output, Y0 AE ΔY=100 125 150 ∆I = 25