Chapter 10 provides the foundation relationships for our study of theories that attempt to explain the determinants of output, income and employment.  We will focus on the AD-AS model (Chapter 10) and the macroeconomic stabilization policies that flow from that model (Chapter 11).  In order to better understand what lies ahead, it is necessary to first review the historical background.   The summary that follows should give you a pretty good introduction to these important chapters.

Classical Theory:

    The Classical theorists assumed that unregulated market economies were inherently stable, and despite occasional external shocks, these economies would always tend toward a natural equilibrium state of full-employment.  This assumption was founded on Say's Law, supported by a system of self-regulating markets.  It is important to realize that if you accept the Classical assumption, then you are forced to accept the "laissez-faire" philosophy of government.

*    Say's Law is the disarmingly simple notion that the very act of producing the full employment level of national output (real GDP),  would generate a like amount of income with which the recipients (households) would go into the product markets and buy that full employment output.  In other words, the act of producing (supplying) output would create a like amount of spending (demand).  Say's Law is often summarized as "supply creates its own demand." Or, production creates its own spending.

*    But what about the fact that households will save some portion of their income?  Would that not result in some "underspending?"  According to the classical theorists, saving was not a problem, since flexible interest rates in a self adjusting credit market would always tend to cause the level of investment spending to equal the level of saving. $S =$ I.  Whatever households saved would be matched by a like amount of business spending on capital goods.  So, consumption spending by households plus investment spending (C + I) would be sufficient to purchase the full employment level of output.

*    Furthermore, the Classical Theory argued, any periods of  underspending or recession would be brief because during such periods, prices and wages would automatically fall, causing the economy to automatically return to full employment level of output which would sell for lower prices.  And, businesses would be willing to sell their output for lower prices because workers competing for available jobs would be willing to work for lower wages.   

Keynesian Theory:   Observing the U.S. economy during the darkest days of the Great Depression, the British economist John Meynard Keynes disputed the Classical Theory.  Noting that there did not appear to be any automatic mechanisms moving the economy back toward full employment, Keynes argued that:

    *    Flexible interest rates alone were not sufficient ensure that the level of saving would always tend to equal investment.  Therefore, it was not only possible but highly probable that, from time to time, there would be "underspending."

    *    Also, Keynes argued that, during periods of unemployment, wages and prices would not fall sufficiently to move the economy back to full employment.

    *    Keynes concluded that it was the responsibility of government to stimulate spending during recessions.

The Keynesian logic:

    *    The level of employment is directly related to the level of production.

    *    The level of production is directly related to the level of aggregate or total spending.

    *    Therefore, the level of employment must be directly related to total spending.

    *    So, if the problem is unemployment, it must be the result of "underspending" and the remedy must be to increase the level of spending.

    *    Keynes reasoned that, during periods of severe recession, it was possible for the economy to come to "rest" at an equilibrium level of national output/income that was far less than the full employment level.  Since equilibrium is a state in which there are no internal forces acting to cause change, it was necessary for some external force (government) to intervene to stimulate spending (prime the economic pump). 

The Keynesian model is a spending model.  Keynes reasoned that the level of output, income and employment is determined by the level of total spending.  It is commonly referred to as the aggregate expenditures model.  In equilibrium, the economy will tend to produce that level of real output/income (Y) which is equal to total spending (AE).

        Y  =  AE (total spending) or, 

        Y  =  AD (aggregate demand)  =  C  +  I_G   +  G  +  X_N 

Since aggregate or total output (Real GDP), or Y  may be viewed as AS (aggregate supply),  we can  re-write Y  =  AE as

           AD  =  AS     (Chapter 10)

For now we are concerned with understanding what determines the level of AE/AD.  This chapter will focus on the determinants of the two most important sources of spending:  Consumption and Investment.   Finally, this chapter introduces the spending multiplier. 

The Consumption and Savings Function:

What determines the level of consumption spending in a modern market economy?  According to John Keynes, the level of consumption and saving are directly related to the level of disposable income.  These relationships are described in very clear detail on pages 147-152 in your text, so I will not bother to re-write the text.  However, I will summarize some of the important elements of these relationships.

First, ceteris paribus, there is one level of DI, and only one, at which C=DI and S=0.  We refer to this as the breakeven level.  At levels of DI greater than the breakeven level, DI  > C, and the difference will be some level of positive savings.  At levels of DI less than the breakeven level, DI < C, and the difference will be some amount of  negative saving or dissaving.

The average propensity to consume (APC) is the fraction of any level of DI that will be spent on consumption.  The average propensity to save (APS) is the fraction of any level of DI that will be saved.  As the DI increases, the APC declines and the APS increases.  Because DI is either saved or consumed, the sum of the APC and APS will  equal that level of DI.  In other words, APC + APS = 1.

The marginal propensity to consume (MPC) is the fraction of any change in DI that is spent. The marginal propensity to save (MPS) is the fraction of any change in DI that is saved.  As DI changes, the MPC and MPS do not change.  The explanation is that the MPC is simply the slope of the consumption function (line), and the MPS is the slope of the saving function.  Because any change in DI will be partly consumed and partly saved, the sum of the MPC and MPS will equal to 100% of the change in DI.  In other words, MPC + MPS = 1.

On a concluding note, recall from your reading that the relationship between Disposable Income and Consumption and Saving assumes that all of those non-income factors that affect consumption and saving are held constant (ceteris paribus).  If we relax that important assumption, then the consumption and saving functions will shift.  On pp.151-152, your author discusses these non-income determinants and how each affects consumption spending and saving.  We will see these again in Chapter 10, so you might as well master them now!!  

The Investment Function:

Your author points out that investment decisions, like all economic choices, involves marginal-benefit-marginal-cost analysis.  The marginal benefit of purchasing a new piece of machinery is the expected rate of return or profitability.  The marginal cost is the real rate of interest, or the price of using money.  Ceteris paribus, businesses will undertake those investment opportunities for which the expected rate of return exceeds the real rate of interest.

Moving from the firm to the macro economy, if we arrange all possible investment opportunities in descending order of profitability or expected rate of return, all of those investments with an expected rate of return exceeding the real rate of interest will be undertaken.   Therefore, at any given interest rate, businesses will find it profitable to undertake some dollar amount of investment spending.  However, if the interest rate falls, some of those investments which were unprofitable at the higher interest rate will now be profitable, and the level of investment spending will increase.  From all this, we can conclude that there is an inverse relationship between the real rate of interest and the dollar value of business investment spending.  The investment demand curve appears just like any demand curve, reflecting the inverse relationship between the "price of money" or interest rate and the number of investment dollars demanded by business investors.

However, recall that the relationship between the real rate of interest and dollar investment demand assumes that all other factors that affect investment are held constant (ceteris paribus).  Those "other things" are found on pages 161-162. 

The Spending Multiplier

   Keynes theorized that any change in total spending (Aggregate Demand) would result in a change in output/income that was a multiple of the change in spending.  We call that the multiplier effect or the spending multiplier.  The Multiplier is calculated as the reciprocal of the MPS.

   Multiplier  =   1 / MPS     or    1 /  (1 - MPC)

It should be clear that the larger the MPC, the larger the Multiplier.

   Finally, the Multiplier that we will be working with is called the simple multiplier because it assumes that the only leakages from the spending stream is household saving.  But, in reality, taxes and spending on imports also constitute leakages.  The more realistic Multiplier that takes into account all leakages is called the complex multiplier.  The President's Council of Economic Advisors has estimated the complex multiplier to be about 2.

Problems:

                                                    Table I

                        Disposable Income           Consumption

                                    $300B                        $310B

                                      350                            355

                                      400                            400

                                      450                            445

                                      500                            490

                                      550                            535

I.    Table I represents Disposable Income and Consumption data from a hypothetical economy.  Using this data answer the following questions.

1.    What is the MPS  =  .1                             2.  When DI  =  450, the APC  =  .99

2.    What is the "breakeven" level of disposable income?  400B

                                                            Table II

                                Disposable Income            Consumption

                                        $1010B                         $ 980B

                                          1060                             1020

                                          1080                             1036

                                          1180                             1116

                                          1220                             1148

                                          1280                             ____?

II.    Table II shows levels of Disposable income and Consumption spending in a hypothetical economy.  Using the data in Table II, answer the following questions.

1.    MPC  =  .8                                                      3.    The Multiplier is  5

2.    When DI  =  $1080,  APS  =  .04              4.    When DI  =  $1280,  $C  = $1196

III.        When Mary's disposable income increases from $900 to $1100, her level of saving increases from  -$50 to +$50.  Mary's MPC  =  .5

IV.        The Acme Widget Corp. purchases a machine for $60,000.  If it has a useful life of 1 year and causes the company's net revenue (profits) to increase by $72,000. then the rate of return on this investment is  20% ?

V.        If the MPC  =  .6 and Investment Spending increases by $15,000, income/output in this hypothetical economy ultimately will increase by   $37,500

VI.       The actual Spending Multiplier in the U.S.  is estimated to be about  2.  How do you explain the fact that this actual Multiplier is smaller than the simple multiplier that we use in classroom examples?

VII.    Which of the following is correct?

    a.    APC + MPC  =  APS + MPS            c.    APC + MPS  =  APS + MPC

    b.    APS + APC  =  MPS + MPC            d.    APS - APC  =  MPC - MPS