5. “ I believe myself to be writing a book on economic theory which will largely revolutionize—not, I suppose, at once but in the course of the next ten years— the way the world thinks about economic problems. ” -- John Maynard Keynes The book, The General Theory of Employment, Interest, and Money, systematically analyzed the relationship between changes in aggregate expenditure and changes in GDP. In any particular year, the level of GDP is determined mainly by the level of aggregate expenditure.

7. Real GDP CS GDP - C IgC + IgU nplanned I nventory 370375______20______ 390 ______ 410405______ 430420______ 450435______ 470450______ 490465______ 510480______ 530495______ 550510______

8. Real GDP CS GDP - C IgC + IgU nplanned I nventory 370375-52039525 390 02041020 41040552042515 430420102044010 45043515204555 47045020 4700 4904652520485-5 5104803020500-10 5304953520515-15 5505104020530-20

9. C GDP 0

11. Real Consumption A smooth, upward trend, interrupted infrequently by brief recessions.

12. After taxes (-) and transfers (+) Every $1 increase increases consumption by 4-5 cents Doesn’t seem to have much affect up or down Price levels affect real wealth more than total consumption Higher rates - more savings, lower rates - more consumption

13. GDP 1500 1600 1700 1800 1900 2000 2100 2200 GDP 1500 1600 1700 1800 1900 2000 2100 2200 C 1540 1620 1700 1780 1860 1940 2020 2100 C 1540 1620 1700 1780 1860 1940 2020 2100 S ____ S ____

14. 369 Planned consumption (trillions of $) Real disposable income (trillions of dollars) 6 9 12 3 45º 45º line C Dis-saving Saving

15. Savings Consumption

16. The Relationship between Consumption and Income, 1960–2010 The line, which represents the relationship between consumption and disposable income, is called the consumption function. The slope of the consumption function is the marginal propensity to consume.

17. Marginal propensity to consume (MPC) The slope of the consumption function: The amount by which consumption spending changes when disposable income changes. Between 2006 and 2007, disposable income increased by $228 billion and consumption spending increased by $208 billion.

18. Marginal propensity to save (MPS) Between 2006 and 2007, disposable income increased by $228 billion and if consumption spending increased by $208 billion, then savings increased by $20 billion. The amount by which saving changes when disposable income changes. 1 = MPC + MPS

19. Real GDPConsumption $9,000$8,000 10,0008,600 11,0009,200 12,0009,800 13,00010,400 Calculating the MPC and MPS

20. Real GDPConsumptionSaving $9,000$8,0001000 10,0008,6001400 11,0009,2001800 12,0009,8002200 13,00010,4002600 Calculating the MPC and MPS

21. Real GDPConsumptionSavingMPCMPS $9,000$8,0001000.60.40 10,0008,6001400.60.40 11,0009,2001800.60.40 12,0009,8002200.60.40 13,00010,4002600.60.40 Calculating the MPC and MPS

23. Real Investment Planned Investment

24. Higher rates - more savings, lower rates - more consumption Corporate taxes (-) Investment tax credits (+) The more profitable a firm is, the greater its cash flow and the greater its ability to finance investment.

25. 369 Planned consumption (trillions of $) Real disposable income (trillions of dollars) 6 9 12 3 45º 45º line C Dis-saving Saving Unplanned Inventory Reduction Unplanned Increases in Inventory

28. Lower inflation rates attract more consumption Higher incomes increase consumption Appreciating currency increases import consumption, but decreases export consumption.

29. Output (Real GDP -- trillions of $) 45º Equilibrium (AE = GDP) 10.6 AE = C + I + G + NX 10.3 9.4 9.7 10.0 Keynesian equilibrium Full Employment (potential GDP) Planned aggregate expenditures (trillions of $) AE = C + I + GAE = C + IAE = C

30. Output (Real GDP -- trillions of $) 45º (AE = GDP) 10.6 AE = C + I + G + NX,P 1 10.6 9.4 10.0 Planned aggregate expenditures (trillions of $) AE = C + I + G + NX,P 2 AE = C + I + G + NX, P 3 P1P1 P2P2 P3P3 AD 10.69.410.0

32. The Multiplier : A change in an spending (e.g. investment) leads to an even larger change in output and employment. The multiplier is the number by which the initial change in spending is multiplied to obtain the total increase. The size of the multiplier depends on how much is spent of each increase. The greater this %, the greater the effect

33. injections will increase the size of the multiplier; leakages will decrease the size of the multiplier,

34. Expenditure stage Additional income (dollars) Marginal propensity to consume Additional consumption (dollars) For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. 1,000,000 750,000 562,500 421,875 316,406 949,219 750,000 562,500 421,875 316,406 237,305 711,914 Round 1 Round 2 Round 3 Round 4 Round 5 Total 4,000,0003,000,000 All others 3/4 The multiplier concept is based upon the proportion of additional income that households choose to spend (here assumed to be 75% = 3/4).

35. Assume the people will spend.8 (80%) of a change in their income and the change in business investment is $10 (billion). Complete the table below. How much will they save? ______ change in income change in consumption change in savings increase in investment of $10 billion + $10______ 2 nd round______ 3 rd round______ 4 th round______ 5 th round______ all other rounds16.3813.103.28 Totals______

36. MPC Size of multiplier 9/10 4/5 3/4 2/3 1/2 1/3 10.0 5.0 4.0 3.0 2.0 1.5 M =M = 1 1 - %spent Higher Spending Means a Larger Multiplier As the spending % increases more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.). The effect is that for higher spending, higher multipliers result, specifically the relationship follows this equation:

37. Change in investment% savedmultiplier effect $10 20%________ $10 10% ________ $10 25%________ $20 20%________ Calculating the effect of the multiplier: change in the injection % not spent (saved)

38. Total Output (Real GDP)Planned Aggregate Expenditures $5,000$5,250 5,500 6,0005,750 6,5006,000 7,0006,250 a. If the current output rate is $5,000, what will tend to happen to business inventories, future output, and employment? b. If the current output rate is $6,500, what will tend to happen to business inventories, future output and employment? c. What is the equilibrium rate of income of this economy? d. If the economy’s full employment rate of output is $6,000, will the rate of unemployment be high, low, or normal, assuming the current planned demand persisted into the future? e. What would happen if there was an increase in investment of $250?

39. During a downturn, business pessimism, declining investment, and the multiplier principle combine to plunge the economy further toward recession. During an economic upswing, business and consumer optimism and expanding investment interact with the multiplier to propel the economy to an inflationary boom. The theory suggests that a market-directed economy, left to its own devices, will tend to fluctuate between economic recession and inflationary boom. Keynesian View of the Business Cycle

40. Keynesian View of the Business Cycle Regulation of aggregate expenditures is the crux of sound macroeconomic policy according to the Keynesian view. If we could assure aggregate expenditures large enough to achieve capacity output, but not so large as to result in inflation, the Keynesian view implies that maximum output, full employment, and price stability would be attained.