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Keynesian Economics
Flow of the Economy
SPENDING
by four
groups
PRODUCTION
by firms
INCOME
received by
people
Income and Consumption
 Circular
Flow:
- Production ------- Income ------- Spending ------ Production ------………
Production
 National
Product (Y):
GDP, GNP
 Net Domestic Product
NDP = GDP - Depreciation
 National Income
NI = NDP - indirect business
taxes
Income
 National
Income (NI) or
 Personal Income
 Disposable income (DI)
DI = NI - Net Tax
 Net Tax = Tax - Transfer payment
Spending
 Aggregate
Expenditure (AE) or
 Aggregate Demand (AD)
 Spending by four groups of economic
agents:
Four economic agents




Consumers
Firms
Government
Rest of the World
Their spending consist of
four major components of AE
 Consumer
expenditure: Consumption
C
 Firms spending: Investment
I
 Government purchase:
G
 Spending by the rest of the world:
– Net exports = Export – Import
X - IM
Aggregate Expenditure (AE)
 AE
= C + I + G + (X - IM )
 Injection
C, I, G, X
 Leakage
S, IM
 Anything that will add to the
demand/spending on American
produced goods is “injection”
The Circular Flow of Expenditures
and Income
Rest of the
World
Financial System
3
2
Investors
Consumers
4
1
Government
5
6
Firms
(produce the
domestic product)
Demand Determination
Aggregate Supply
(AS)
Not constrained
GDP (Y)
Aggregate
Expenditure (AE)
Or AD
Demand determination
 Keynesian
economics emphasizes the
demand side
 During the great depression, the
supply side is not constrained (not
binding)
 The GDP (Y) is determined by the
demand side
 That is, determined by total spending
Components of
Total Spending
 Components
of the total spending
C, I, G and X-IM
 Aggregate Expenditure (AE)
 AE = C + I + G + ( X – IM )
Consumption C
 The
lion of share of AE
 About 70% of AE
 Stable during the business cycle
Income and Consumption
 Consumption
and Income
DI   C
 The relationship between DI and C
 The Consumption Function
Consumption function
C
C
0
DI (Disposable Income)
Consumer Spending and
Disposable Income
2001
2000
1999
1998
1997
Real Consumer Spending
$5,237
1995
1994
1992
1990
1991
1989
1988
1987
1986
1996
1985
1984
1979
1980
1976
1978
$2,869
1974
1970
1964
1960
1955
1947
1945
1941
1942 1943
1939
1929
0
$3,244
Real Disposable Income
$5,677
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Consumer Spending and
Disposable Income
Real Consumer Spending
1900
1963
1700
1500
1360
1300
B
$180 billion
1180
A
1100
$200
900
0
1947
900
1100
billion
1300
1500
1700
1900
Real Disposable Income
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
A Consumption Function
C
$4,200
3,900
3,600
$300
3,300
3,000
$400
2,700
0
3,200 3,600 4,000 4,400 4,800 5,200
Real Disposable Income,DI
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Consumption and Income in
Hypothetical Economy
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Consumption Function
C
$4,200
3,900
3,600
$300
3,300
3,000
$400
2,700
0
3,200 3,600 4,000 4,400 4,800 5,200
Real Disposable Income,DI
The Consumption Function
 Equation
form
C = 300 + 0.75 DI
 General form
C = a + b DI
Properties of the Consumption
Function
Upward sloping: Slope > 0
 Slope < 1
 Intercept "the subsistence level".


Marginal Propensity to Consume
 Marginal
Propensity to Consume
(MPC)
 Increase in consumption due to a
dollar increase in DI
 Slope of the consumption function

C
MPC = ---------DI

0 < MPC < 1
Marginal Propensity to Consume
 Consumers
distribute their
incremental income between
consumption and savings

0 < MPC < 1
The Consumption Function
 Movement
vs Shift in the
Consumption function
 Movement along the consumption
function
If DI changes
Shifts of the Consumption
Function
Real Consumer Spending
Movements along
consumption function
C1
C0
C2
A
Shifts of
consumption
function
Real Disposable Income
Copyright © 2003 South-Western/Thomson Learning. All rights reserved.
Shifters of
The Consumption Function
 Wealth
Wealth Effect
Price level  Wealth Effect
Example: the stock crash in 1929, a
negative wealth effect
 Expected future income.
 Demographics
Tax Cut and Consumption
 1964,
tax reduction. Success.
 1968 temporary tax increase.
Failure.
 1975 temporary tax cut. Failure.
 1981-84 Tax cut. Success.
 Reasons
Permanent versus Temporary
Tax Change
C’
C
C
By permanent tax cut
By temporary tax cut
0
DI (Disposable Income)
Saving
 DI
=C+S
 The remaining balance after
consumption goes to saving.
DI = C + S
Saving
 Marginal

Propensity to Save (MPS)
S
MPS = ---------DI
 The
sum of MPC and MPS equals
one.
1 = MPC + MPS