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tma 1 8/3/94.
(a)
The lasting legacy of Keynes was that models of the economy can help with the understanding needed
for better policy decisions. The model he developed related national output to several variables, but he singled out
investment as the key because it was most prone to fluctuation. He suggested that these fluctuations were due to the
irrational expectations of businessmen.
Details of the model were summarised by Matthews and it became the basic explanation of the trade
cycle and part of the post war economic consensus.
National output is determined by aggregate demand in the economy which is the sum of consumption,
investment and government expenditure adjusted for exports minus imports. It is important that these components of
aggregate demand are separately identified because their levels depend on different decisions made by different groups of
people with different motivations. Aggregate demand is often represented by economists by the letter e, and the summation
of the other variables by the equation :e = c + i + g +(x-h)
Keynes focused on investment, and investment fluctuations.
In addition to goods and services which are directly consumed, the economy produces other types of
goods which are used for production. These are often called capital goods, or investment goods, and include all the plant and
machinery used by firms. Investment spending also includes expenditure on stocks of raw materials, part complete products
and finished products awaiting sale. It is this private sector expenditure, represented by i, which tends to be erratic.
Investment involves a commitment of scarce resources for the future and is likely to be difficult. This is
not only because the future is unknown but also because there are always alternatives. For example, the resources could be
saved or used for immediate pleasurable consumption. Investment levels change when these agonising decisions feed off
mindless optimism or pessimism.
Future expectations control motivation and expectations are subject to very individual perspectives and
moods, and the reactions of consumers or competitors are never clear. In the end, Keynes suggested, the decision maker falls
back onto 'gut feel' or, what he called 'animal spirits'.
Harris has conclude that this proposition is unsatisfactory because the model itself gives us no insight into this
most important cause of fluctuation, irrational psychology. The variable becomes exogenous, or outside of the model. He
further suggests that a more appropriate explanation of investment decisions is that they are the result of detailed planning,
investigation and appraisal.
(b)
The income/expenditure model can be represented diagrammatically.
The first variable in the equation, consumption, c, depends on income level, y, and is an endogenous
variable, one which is analysed within the model. Although the relationship between consumption and income can only be
determined empirically, fig 1. assumes a theoretical linear function :-
The diagram indicates that at any level of income, consumption can be determined. Thus, if national income is y
consumption will be c .
Consumption is only one of the variables in the model, and fig 2. indicates the other variables making up aggregate
demand; investment, i, government expenditure, g, and exports minus imports, (x - h). These variables are independent of
income and are be represented by constant increments over and above consumption.
The vertical axis in fig 2. becomes aggregate demand in total not just consumption.
The line representing a summation of the elements in aggregate demand is the line AB. Thus, at national income
y , aggregate demand e
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1
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= c + i + g + (x - h).
The discussion so far has related aggregate demand to the various elements of national
income/expenditure, but the real concern is national output; output determines standard of living. It is fundamental to
Keynes' model and much of economics that output must equal income. The way national income is measured by the
summation of each incremental added value results in someone somewhere getting paid for everything that is produced. This
payment could be in the form of wages or rent or profit, but in the money economy output is always paid for.
If aggregate expenditure always equals national output and, thus, national income, a plot of e against y
and q will be a 45 degree diagonal as CD in fig 3. At every point on the plot expenditure equals income and output, e = y =
q , e = y = q etc. Demand equals supply.
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2
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2
Both figs 2 & 3. represent an infinity of possible positions for the economy. At any time it could be
anywhere along the lines AB or CD. However, if we combine the two diagrams, which are both plots of demand against
income, see fig 4., there is crucially only one point, X, where demand, income and output are identical. The model predicts
that this is where the actual economy must be, the only place where there is equilibrium between the variables.
It is easy to see that there must be an equilibrium if we consider a lower or higher position of the
economy at X or X . At X the demand for goods and services resulting from national income y , would be e , thus
exceeding supply, q ,and firms would be out of stock and losing potential sales and profit. We would expect an automatic
increase in the supply of goods to move the economy equilibrium to the point X, and output to q . Similarly if the economy
was at point X , with demand e , below the potential supply, q , we would expect high stocks and a cut back in output to
avoid the excess cost associated with such disequilibrium. X is the only point where supply and demand are equal.
A diagrammatic representation of fluctuations of output following changes in investment can be seen in
fig 5. which is a development of fig.4.
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2
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x
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An increase in investment, from i to i , would shift the aggregate demand line AB to EF. Consumption, moving
inline with income, and government spending and exports and imports remaining the same. This is in line with the theory
that investment is exogenous and would result in a constant increase at all points on the income axis. As investment
increases total aggregate demand increases and it can be seen that a new equilibrium position for the economy would result
at point Y with output at q . Similarly it follows that a decrease in investment would reduce national output.
(c)
Although the focus of the discussion has been investment, the full model for aggregate demand includes
other variables:1
2
y
e = c + i + g +(x-h)
c is the representation of consumption expenditure which results from purchases of consumer goods and
services by all of us during everyday life. The money we spend on food and leisure, clothing and household equipment,
travel and gifts are all part of this type of expenditure. Consumption expenditure has been assumed to depend on income
level. It is reasonable to argue that consumption is dependent on total money resources; that is wealth as well as income.
Although this is possible the behavioural assumption Keynes concentrated on was the dependence of consumption on
income alone.
Governments spend money on both consumer goods and investment goods. Roads and schools are
examples of investment goods and when governments purchase supplies for their employees they spend on consumer goods.
This type of expenditure is represented by, g. It is important to note that this expenditure is included in aggregate demand
because it is used to purchase goods and services. Governments are involved, also, in transfer payments which simply shift
the purchasing power form one group of people to another, resulting in no net increase in aggregate demand.
The economy also produces goods and services for export, and although these are not consumed in this
country they are part of the national output. The reverse is true of imports. Thus, the final item in the equation is an
adjustment for exports minus imports, (x - h).
The expenditure model includes only those items to which money values can be assigned. This results in
the exclusion of large areas of activity. Housework and self help of all kinds are not part of the model.
The theory can be applied to examine the current emergence of the UK economy from recession.
A recent article in the Financial Times identified an increase in exports as the driving force increasing
national output, the variable (x - h) is increasing. The article also indicated that consumption is expected to rise following an
increase in the level of orders. This is corroborated by a slowdown in the rate of job losses.
However, the 'animal spirits' are still at work and the CBI survey points to declining intentions to invest,
in spite of reporting general business optimism.
The investment problem appears to be a fear that export demand may not be maintained in the future as
the main export markets in Europe emerge more slowly from recession. There is also an indication in the article that
destocking is slow. High stocks will deter firms from investing. Furthermore, 63% of firms are reporting operating below
capacity. This is yet another factor which may be deterring investment.
The article reporting the CBI survey illustrates succinctly the many factors which may cause a
fluctuation in investment, and importantly suggests that the subjective fear of being unable to earn an adequate return on
committed resources is the biggest constraint. 'Animal spirits' and investment fluctuations are still with us!