Mac Econ Chap 8 -Keynesian Employment Theory

Chapter 8:


The purpose of this topic is to analyze how aggregate expenditure and aggregate output can be represented, establish why an equilibrium may be present below full employment, and identify the process of the multiplier.


The purpose of Keynesian employment theory is to offer a solution to periods of excessive unemployment (i.e. recession). This solution is tied to the idea that employment depends on what firms need to produce, and their production level, in turn, depends on what individuals and firms plan to buy: this is what Keynes calls aggregate expenditure.

During the great depression, people were afraid to spend. Businesses were reluctant to hire workers because they could not expect any pick up in sales. This was especially true for key sectors of the economy such as automobile purchases.


Aggregate expenditure (in the opinion of Keynes) is the key to economic activity. That is, what households, businesses and government plan to buy will be the determinant of what firms will eventually produce. In the first step of the analysis, a simplified model excludes government, assumes that no foreign sector is present, and the level of real income (not prices) is the major determinant of aggregate expenditure.

When a family is planning to buy a car or put new appliances in the house, that would be a carefully thought out decision which considers the long term situation of the family. Such purchases are key items of aggregate expenditure.


Aggregate expenditure AE is the sum of what households plan to buy (or consumption C), and what businesses plan to buy in terms of capital (or investment I): AE=C+I Later, the model will also include government purchases (G).

Purchases from all sources should be included in aggregate expenditure: both foreign and domestic, public and private. For instance, what foreign consumers could buy from American computer manufacturers next year, would be an important element. However, government and foreign purchases are affected by other than purely domestic economic conditions.


Consumption is what individuals (or households) want to (or plan to) buy. Their ability to consume is entirely dependent on their income. What is not consumed (in income) is set aside for future consumption: this is saving.

What is of interest is not the physical consumption, such as the use of a car, but the time pattern of purchases. If members of a family need to drive to work, they will have to have a car whether it is brand new or very old. The purchase of the car can be postponed. What prompts a family to buy a car now is a great interest to economists: such purchase is consumption.


The major determinant of consumption is the willingness or propensity to use the real income to buy goods and services. Thus consumption and income are directly related. Other determinants of consumption are the price level, wealth, stock of durables, level of indebtedness and expectations about the future.

The perception of a family’s income is what allows it to be confident that it will be able to make the necessary payments or to afford to take out the savings, to buy a car. If it does not feel confident about its level of current and future income, it may want to use the car one more year.


The pattern of consumption tends to be quite stable. Consumption shifts upward through time: the proportion of consumption out of income remains about the same.

Statistics show that consumption, i.e. purchases of households, is the most stable component of aggregate expenditure.


The willingness to use a proportion of income (Y) for consumption (C) is known as average propensity to consume (APC): APC=C/Y As income increases, the average propensity to consume decreases. This is indeed observable in the fact that wealthy individuals consume a smaller proportion of their income than to poorer people who may in fact be force to receive money from others.

If the income of a family is $50,000 and that family spends $45,000 per year, the average propensity to consume is APC = 45,000/50,000 = .9 or 90%.


The marginal propensity to consume (MPC) is the proportion of additional consumption (dC) which will be taking place out of an increase in income (dY): MPC=dC/dY MPC is the slope of the consumption line. It is constant throughout reflecting a stable pattern of consumption in our society.

If the income of the family increases by $1,000 and the family decides to buy an additional television worth $600 with that new income, the marginal propensity to consume is MPC = 600/1000 = .6 or 60%.


Saving is what is left from income after consumption is taken out. Saving is primarily determined by the level of real income. The higher the income, the more individuals are willing and able to save.

Saving is what will permit consumption in the future. In today’s society, a lot of saving is institutional. For instance, social security contributions and pension plan deductions are a form of saving.


The willingness of individuals to save (S) a proportion of their income is called average propensity to save (APS): APS=S/Y.

If a family earns $50,000 and saves $5,000 each year, the average propensity to save is APS = 5,000/50,000 = .1 or 10%.


The marginal propensity to save (MPS) is the proportion of additional saving (dS) out of an additional income (dY): MPS=dS/dY The marginal propensity to save is the slope of the savings line. Since income can only be consumed or saved, the sum of the marginal propensities to consume and to save is one: MPC+MPS=1.

If a family has an increase in income of $1,000 and decides to save $400 of that increase, the marginal propensity to save is MPS = 400/1,000 = 0.4 or 40%.


Investment is determined by the rate of return from various possible projects and the cost of borrowing (or interest rate). The pattern of rate of return gives the demand for investment (also known of the marginal efficiency of investment): it is inversely related with interest rates. The cost of borrowing or interest rate is determined in the money market and is essentially the product of monetary policy.

Most companies determine their current investment plans with the help of long range planning and capital budgeting. Forecasts of future sales are the major determinants in these calculations.


In addition to the rate of return, investment demand is determined by state of technology, maintenance and level of existing capital, as well as expectations about future sales. Some of these components are highly unstable, such as new inventions and innovations and changes in future sales expectations. Thus, it is not entirely useful to model investment with other elements than investment demand and the given interest rate.

Historically, the investment component of aggregate expenditure and of gross national product has been the most erratic of all. In periods of economic slow down, it is often negative. It jumps back up as soon as expectations of future sales look brighter.


Real aggregate output (or net national product NNP) is the 45 degree line in the Keynesian model because total income is equal to total output since taxes and transfer payments are omitted, and total output can be shown vertically as the 45 degree line.

Graph G-MAC8.1


Aggregate output is very closely correlated to national income; in fact, if there were no government, it would be almost identical.


The equilibrium occurs where aggregate expenditure (AE) is equal to aggregate real output (NNP):

AE=NNP. Should firm produce more, they will be forced to cut back production because of excess inventories. Should they produce less, they will have to increase production because their inventories will be depleted. The equilibrium may very well occur below the full employment level of output.

Graph G-MAC8.2


Businesses adjust their production to sales by observing their inventories. If the inventories are insufficient, production is increased. If the inventories are excessive, production is cut back.


Saving can be viewed as a leakage of funds out of the circular flow model. (Taxes are also a form of leakage, so are imports).

If the economy is looked upon as a circular flow of funds similar to an engine with the funds as fuel, a loss of funds to saving would slow down the economy just as a loss of fuel would slow down the engine.


Investment can be viewed as a form of injection of funds in the circular flow model. (Exports would also be an injection).

In the circular funds and engine comparison, a new input of funds speed up the economy just as an additional fuel injection into the motor.


The equilibrium in the leakage-injection graph is where saving is equal to investment:

I=S. Should firms produce more an unintended saving would be present in the form of inventory accumulation. Should firms produce less, dissaving would occur in the form of inventory depletion.

Graph G-MAC8.3


Many modern automobiles are equipped with vapor recirculation devices: what is lost to gasoline evaporation in the tank and carburetor is returned to the engine with that device so that the motor does not lose power. A similarity can be established with the circular fund flow model.


The multiplier effect comes from the fact that a positive change in planned expenditure by households or businesses will require a change in production putting new employees to work. This will result in new income that will cause a second round of increased aggregate demand. Successive rounds will add up so that a small change in aggregate demand (dAE) causes a multiple (M) change in real output (dNNP)


Just think about how many hands the money one has in one’s wallet, has gone through! A payment for one additional purchase will not stop there, but will create income for several successive persons. That is the multiplier effect.


The value of the multiplier is equal to the inverse of the marginal propensity to save or M=1/MPS=1/(1-MPC)

If the marginal propensity to save is .4, the multiplier is M = 1/MPS = 1/0.4 = 2.5.


Empirical estimates of the multiplier when all other forms of leakage are included, such as taxes, exports as well as saving, give a value of the complex multiplier of close to 2.

All forms of funds usage other than spending reduce the multiplier. Taxes and import are two such diversions.


If a society attempts to save more, its aggregate expenditure will decrease causing the equilibrium and real output to also decrease. As real output and income have shrunk, the society will not be able to save more, but only the same amount (or may be even less).

The great depression is a vivid and regrettable example of the paradox of thrift. People tried to put more money aside because they were afraid. But, their very reluctance to spend caused income to decrease.


The extent to which the aggregate expenditure falls short of the full employment level of aggregate expenditure is called the recessionary gap. This is also the amount by which aggregate expenditure should be increased to achieve full employment.

The administration calculates the potential GNP or full-employment income, which is presented in the Economic Report of the President.


The extent to which the actual aggregate expenditure exceeds the full employment level of aggregate expenditure is called the inflationary gap because such excess demand can only cause inflation as businesses already are producing at full capacity.


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