Part III Determining Output
and Employment:
Keynesian Macroeconomics
and Fiscal Policy
Chapter 7: Classical Macroeconomics and the Keynesian Challenge
7.1 The Classical Tradition and Say’s Law
7.2 Self-Regulating Markets
7.3 The Quantity Theory of Money
7.4 The Keynesian Revolution
7.5 The Keynesian Alternative
Chapter 8: The Keynesian Model
8.1 Key Aspects of the Keynesian View
8.2 The Aggregate Expenditure Function
8.3 Adding Government and the Foreign Sector
8.4 Changes in Aggregate Expenditure and the Expenditure Multiplier
8.5 The Keynesian Model and Aggregate Demand
Chapter 9: Government Spending, Taxes, and Fiscal Policy
9.1 Why Fiscal Policy?
9.2 How Fiscal Policy Works
9.3 Fiscal Policy Tools
9.4 Discretionary Fiscal Policy
9.5 Limitations of Fiscal Policy
Chapter 10: Budget Deficits and the National Debt
10.1 Debt and Deficits
10.2 Growth of the National Debt Since 1980
10.3 Should the Budget Be Balanced?
10.4 Do Deficits Matter?
10.5 Obstacles to Deficit Reduction
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The four chapters in this section will introduce you to the theory and practice of fiscal policy.
Fiscal policy consists of the use of the taxing and spending powers of government to affect
the level of output, employment, and prices. Chapter 7 highlights the ongoing confrontation
between economists in the classical tradition and those in the Keynesian tradition. Chapter 8
develops the Keynesian model as an explanation of why an economy might come to rest at an
output level that is considerably below the full-employment level and how that output level
might change.
Chapter 9 explores the tools of fiscal policy, showing how government can use its taxing and
spending powers to influence the levels of output, employment, and prices. This is a practical
chapter that looks at not only the theory of fiscal policy but also the myriad practical problems and issues raised by using the government’s budget as a macro policy tool.
Chapter 10 focuses on the most significant fiscal policy issue of the past decade: the budget
deficit and the national debt. This chapter looks at the source of the deficit, its impact on the
national economy, and the options that exist for addressing the deficit and the national debt.
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7
Classical Macroeconomics and
the Keynesian Challenge
Everett Collection/Superstock
Learning Outcomes
After reading this chapter, you should be able to
• Explain Say’s law and describe why the economy should be self-correcting.
• Understand why the product, labor, and credit markets help ensure that the economy will return to the fullemployment level of output.
• State the quantity theory of money and explain why an increase in the money supply leads to an increase in
the price level.
• Describe limitations of the classical model and explain why the Keynesian theory took over.
• Comprehend the primary foundations of the Keynesian model.
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The Classical Tradition and Say’s Law
Section 7.1
Introduction
It was July 2007 and the Wall Street Investment firm Bear Stearns had two mutual funds that
had bet heavily on mortgages and were losing badly. Employees attempted to get a hold of
CEO Jimmy Cayne, but Jimmy was playing in a bridge tournament in Nashville, TN, with no cell
phone or email access. The funds collapsed and that was only the beginning for Bear Stearns.
The stock price was still valued at over $150 a share, but the price was plummeting and investors were heading for the door. Soon the company was out of money and only a cash infusion
would save it from bankruptcy. On March 13, 2008, the company’s board of directors held an
emergency meeting. However, the CEO, Jimmy Cayne, was again not present.
The next day Bear Stearns’s stock price dropped 47% and the company officially ran out of
cash. What should the Federal Reserve do? Economists like Milton Friedman believe that the
market should correct itself. But Keynes didn’t believe that, and Keynesian economics eventually won the day. The Federal Reserve loaned Bear Stearns $12 billion through its new buyer
JP Morgan after the company was acquired for only $2 a share. But what would have happened if the government didn’t get involved? Friedman argues corrections would have been
made within the market. Keynes would argue that many other banks would have gone bankrupt, leading to a financial crisis rivaling the Great Depression. The Federal Reserve believed
it had to act in this case, to inject cash and to save the economy. But how does government
involvement affect things in the long run? In the famous words of John Maynard Keynes, “In
the long run we are all dead.”
7.1 The Classical Tradition and Say’s Law
There are several reasons to begin the study of macroeconomic theory with the classical
school of thought. First, classical macroeconomics represents the best efforts of early economists to develop a theoretical system to explain the aggregate level of economic activity and
to predict the effects of changes of various kinds on economic activity. Second, classical macroeconomics provided the background against which John Maynard Keynes, the great British
economist, developed his new ideas. Third, the classical theory takes a long-run focus on the
economy. Finally, the ideas of the classical school have received renewed attention in the economic debates of the past few decades.
The model of aggregate supply and demand is helpful in understanding the ideas of the classical school. Remember that aggregate supply is the total amount of goods and services that
firms are willing to sell at a given price level during a specific time period in an economy;
aggregate demand is the total demand for final goods and services in an economy at a given
time and price level. Figure 7.1 shows a vertical AS curve (AS) and a downward-sloping AD
curve (AD). Classical economists believed that the interaction of labor supply and labor
demand determines the real wage and the level of employment. The level of employment
then determines how much total real output will be produced (output being the amount of
goods or services produced in a given time period, Y). In Figure 7.1 output does not vary with
the price level, because the level of real output is determined by the interaction of labor supply and labor demand. Thus, the AS curve is vertical at Y1. The AD curve has no influence on
real output. It only serves to determine the price level, P1. Shifts in aggregate demand will only
change the price level.
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The Classical Tradition and Say’s Law
Section 7.1
Figure 7.1: A classical view of output, employment, and prices
A vertical AS curve (AS) and a downward-sloping AD curve (AD) determine the price level (P) in the
economy.
P
AS
P1
AD
0
Y1
Y
Classical macroeconomics has several recurring themes that lead to the effect shown in Figure 7.1: Say’s law, self-regulating markets, and the quantity theory of money.
Say’s Law
A central idea of 19th-century classical macroeconomics was Say’s law, which states that supply creates its own demand. This law is named for Jean-Baptiste Say, a 19th-century French
economist who pointed out that enough income is created in the process of production to
buy everything that is produced. He agreed that individual goods can be overproduced if suppliers fail to correctly read the signals from the market. These suppliers will be penalized
for producing the wrong things by incurring losses. Meanwhile, those who read the market
signals correctly will be rewarded with profits. General overproduction for any length of time,
however, is not possible.
The statement “supply creates its own demand” means that the production of goods and services generates an amount of income equal to the value of the products produced. If firms
produce output with a value of $1,000, then they also create incomes for the resources equal
to $1,000. Because the income created is the same as the value of output, the production process creates the amount of income necessary to purchase the goods and services produced.
Say’s Law With Saving and Investment
This simple form of Say’s law implies that a market economy will not be subject to severe
or prolonged periods of overproduction. Say himself realized that this view was rather simplistic. What would happen if households let part of their income leak out of the circular
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The Classical Tradition and Say’s Law
Section 7.1
flow in order to save, instead of spending it all on consumption? If people save a part of their
incomes, spending could be less than the value of what is produced, resulting in unsold goods.
As producers pile up inventories, they cut back on production and lay off workers, leading to
unemployment. Thus, Say’s law fails if households save.
The circular flow model offers a good way to visualize this objection to Say’s law. In the circular flow diagram in Figure 7.2, firms produce $1,000 in products and generate $1,000 in
incomes. Households, however, choose to save $200 of their income, so there is not enough
spending to purchase all the output. Left with unsold products ($200 worth) on their hands,
firms will decrease production and employment.
Figure 7.2: Saving—a problem?
When business firms produce $1,000 in goods and services, they generate $1,000 in incomes to the
resources. If $200 of this income is saved, only $800 is spent for goods and services, and $200 of goods
remain unsold. As firms build up inventories of unsold goods, they cut production. Incomes fall and
unemployment rises.
$200 of unsold
inventory
$1,000 in
goods and
services
DUCT MARKE
PRO
T
Purchase of
$800 in goods
And services
$200 in
saving
$1,000 in
resource
income
RE
SOU
RCE MARK
ET
$1,000 in
resource
incomes
Say had an answer for that objection. Household saving would flow into banks and be lent to
business firms that would inject it back into the income stream as investment. In an economy
with small government and foreign sectors, saving (defined as income not spent, or deferred
consumption) and investment (defined as the capital outlay or expenditure of money for
income, profit, or the purchase of something of value) would be equal. In the national income
accounts, investment consists of some combination of business plants and equipment, residential construction, and changes in inventories. In our example, the $200 of unsold output, or change in inventories, is the investment that matches the saving of households. Thus,
actual, or realized, saving has to be equal to realized investment. In Figure 7.2, $200 in realized saving is matched by $200 in realized investment in the form of added inventory.
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Self-Regulating Markets
Section 7.2
Defining unsold output as inventory investment merely balances the accounts. It does not
result in an equilibrium level of output and employment. Even in Say’s time, economists recognized the distinction between a balancing of accounts and the concept of macroeconomic
equilibrium. Macroeconomic equilibrium is the level of output at which there is no tendency
to change. The amount that buyers wish to buy is exactly equal to what is being produced. If
firms build up unwanted inventories, their initial response may be to cut prices. However,
after cutting prices to unload excess inventories, firms are likely to cut back production in the
next period. Then the size of the flows of income and output will shrink.
Key Ideas: Summarizing Say’s Law
• Say’s law, named for Jean-Baptiste Say, is an economic theory that states that supply
creates its own demand.
• In theory, enough income is created in the process of production to buy everything
that is produced.
• According to Say’s law, savings and investment would be equal in an economy with
small government and foreign sectors.
7.2 Self-Regulating Markets
Classical economists believed that the forces of three markets would bring the macroeconomy to equilibrium: the product market, the labor market, and the credit market. If these
three markets functioned properly, Say’s law would hold, in the sense that the sum of planned
spending for consumption and for investment would be enough to purchase all that was being
produced. Classical economists believed that full employment of resources was almost a sure
thing in a market economy if markets were allowed to operate freely and given enough time. A
free market generally means that prices are determined by supply and demand with very little, if any, government intervention. The classical economists did not claim that the economic
system would always operate at a level of full employment. Occasional problems of overproduction and unemployment would occur. However, the presence of self-regulating markets,
or markets where the economy automatically moves to a new equilibrium after a shift in
supply or demand, automatically work to solve the problem. Equilibrium will be restored by
adjustments in either prices or output, or both, without any government intervention. Classical economists believed that the same kind of corrective forces that restore equilibrium in
markets for single products are also at work in aggregate markets. Although temporary shortages or surpluses are possible in either individual or aggregate markets, the economy would
eventually move to a new equilibrium through self-correcting markets.
The Product and Labor Markets
The two primary markets in the circular flow diagram are the product market (upper flow)
and the resource market (lower flow). The labor market is the largest part of the resource
market. Classical economists believed that flexible prices and wages in the product and labor
markets were the first line of defense against unemployment and recession.
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Self-Regulating Markets
Jeff Greenberg/age fotostock/Superstock
Section 7.2
The labor market played a central role in the classical model. The supply and demand for labor
together determined both the wage level and the
amount of labor employed. If there were unemployed workers, the quantity supplied must be
more than the quantity demanded. This was a
clear indication that the market price (the wage)
was too high for equilibrium, and wages would
automatically decrease as a result, bringing the
labor market back into equilibrium.
In the product market, if firms find that they have
unsold output (or a surplus of goods), they can
dispose of it by decreasing prices. Firms could
also respond to the increasing inventories by reducing production and decreasing the need
for labor. With excess labor in the labor market, competition among workers for jobs will
drive down both real and nominal wages (wages with and without adjustments for changes
in the price level). With lower wages, a firm will find it possible to produce the same output
at lower cost. Firms will then choose to hire more workers at the lower wages. Although
sellers will have to lower prices to sell the extra output, they can afford to because of lower
labor costs. These automatic adjustments are possible with flexible wages and prices and will
(theoretically) always restore output to the full-employment level.
Firms with unsold goods can cut prices to
increase sales.
The Credit Market
The classical answer to the problem of overproduction was to recognize that, in addition to
a product market and a resource market, there is a third market—the credit market. The
credit market, sometimes referred to as the market for loanable funds, is where the saving of
households is used to provide funds for business investment. A self-regulating credit market
was another important part of the classical explanation of why unemployment and unsold
output would not persist. Through the credit market, household income that is saved flows
into the hands of business firms, which in turn spend it on investment. The interest rate is the
price of borrowing and provides the incentive to lend. Changes in the interest rate assure that
planned saving and planned investment spending will be equal.
Supply and Demand for Loanable Funds
Figure 7.3 shows how the credit market works to make saving available to finance investment.
In the classical view, the supply of credit (loanable funds) comes from household’s decisions
to save. The demand for credit reflects the desire by business firms to borrow for investment
purposes. The supply curve has a positive slope. This slope indicates that saving is directly
related to the interest rate. People save (give up some spending) only if there is an incentive
to do so. The interest rate is the incentive for saving. By saving now, individuals can earn interest and accumulate larger sums of money to spend in the future. When the interest rate rises,
saving will increase because the same amount of current saving will provide more future
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Self-Regulating Markets
Section 7.2
consumption. Thus, a higher interest rate will call forth more saving, or a greater supply of
loanable funds. Lower interest rates, on the other hand, will lead to less saving, or a smaller
supply of loanable funds. There is less incentive to save at lower interest rates.
Figure 7.3: The classical view of the credit market
In the classical view, changes in the interest rate ensure that the quantity of loanable funds supplied
(saving) and the quantity demanded (investment) will be equal (at Q1) when the interest rate is, for
example, 5%. There would be a surplus of loanable funds at higher interest rates, such as 7%, and a
shortage at lower rates, such as 3%.
Interest
rate
Surplus of loanable funds
Saving (supply of
loanable funds)
7%
5%
3%
Shortage of loanable funds
0
Q1
(Saving = Investment)
Investment (demand
of loanable funds)
Quantity of
loanable funds
The demand curve in Figure 7.3 shows the amount of loanable funds borrowers want at various interest rates. The price of borrowing is the interest rate that firms pay to obtain credit.
Investment spending increases when the interest rate declines. Projects or purchases of
investment goods that would be profitable at lower interest rates may not look as attractive
at higher interest rates. Planned investment spending will be lower at higher interest rates.
Thus, the demand for loanable funds has the familiar negative slope.
The Role of Interest Rates
According to classical economists, the interaction of borrowers and lenders in the credit market should establish an equilibrium interest rate. At this interest rate, the quantity of planned
saving will be equal to planned investment spending. This interest rate, in Figure 7.3, is determined by the intersection of the saving and investment curves. At higher interest rates, such
as 7%, the quantity of loanable funds supplied exceeds the quantity demanded. The surplus
of saving over planned investment spending will push the interest rate downward toward
5%. At lower interest rates, such as 3%, the quantity of loanable funds demanded exceeds the
quantity supplied. This shortage causes the interest rate to be bid up to 5% as would-be borrowers compete for the limited amount of credit.
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The Quantity Theory of Money
Section 7.3
Either supply or demand can shift and create disequilibrium. Either way, natural forces will
restore equilibrium in a self-regulating market. Suppose a fear of recession or a high level of
consumer debt causes people to suddenly become thriftier. The amount of saving will increase
at every possible interest rate. That is, the saving curve will shift to the right. The new equilibrium interest rate will be lower than 5%. An increase in saving puts downward pressure
on the price of loanable funds. The lower interest rate leads to an increase in the amount of
investment spending. Thus, changes in the interest rate ensure that any income not spent on
consumption will be channeled into desired investment.
Key Ideas: The Invisible Hand in the Macroeconomy
• Self-regulating markets are markets in which automatic forces move the economy to
a new equilibrium whenever there is a shift in supply or demand.
• At the equilibrium wage rate, the quantity of labor supplied is equal to the quantity
of labor demanded.
∘∘ If there is excess labor in the labor market, competition among workers for jobs
will drive down both real and nominal wages.
• At the equilibrium interest rate, the quantity of planned saving is equal to planned
investment spending.
∘∘ At higher interest rates, the quantity of loanable funds supplied exceeds the quantity demanded, pushing the interest rate down.
∘∘ At lower interest rates, the quantity of loanable funds demanded exceeds the
quantity supplied, causing the interest rate to be bid up.
• Either supply or demand can shift and create disequilibrium. Natural forces will
restore the economy to equilibrium in a self-regulating market.
7.3 The Quantity Theory of Money
The classical idea that markets will automatically work to eliminate unemployment is one
that is still widely held. However, even classical economists would have agreed that a more
complex explanation is needed for the determination of the general price level.
The classical explanation of the price level is based on the equation of exchange and the
quantity theory of money. This theory states that changes in the price level are proportional to changes in the money supply. This theory, along with the equation of exchange, was
developed as a way to explain certain economic events.
The Equation of Exchange
Classical economists believed that there was a very simple relationship among the money
supply Ms, the price level P, and the level of output Y:
Ms × V = P × Y
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The Quantity Theory of Money
Section 7.3
This relationship is called the equation of exchange. The idea behind this relationship is that
the value of spending must be equal to the value of what was bought. Here, V is the velocity
of money, or the number of times the average dollar is spent per year. The faster that money
changes hands between holders, the greater the velocity of money. Thus, Ms × V equals total
spending. For example, if the money supply is $2,000 and V = 3, then total spending is $6,000.
If dollars turn over more often, then the same amount of spending could be supported by a
smaller money supply. For example, with V = 5, the same $6,000 in spending could be sustained by a money supply of only $1,200. Classical economists generally believed that velocity
(V) was quite stable. Therefore, any change in the money supply would result in a proportional change in spending (P × Y).
If Y is at the equilibrium levels determined by Say’s law and self-regulating markets, this
equation becomes an explanation of the link between the money supply and the price level.
For example, what is the effect of a 2% increase in the money supply on inflation? In the
long run, output and velocity remain relatively constant. Thus, the equation becomes 2% ×
V = x × Y. In this case a 2% increase in the money supply would result in a 2% increase in
inflation.
Inflation and the Quantity Theory of Money
Among the early theorists was the Scottish philosopher David Hume (1711–1776). Hume was
interested in the very practical problem of explaining the inflation that followed the European
discovery of the Americas. Gold and silver were the main forms of money in Europe until the
19th century. Europeans first arrived in the Americas in the late 15th century, and several
European nations colonized the Americas in the next 2 centuries. Spain seized the gold and
silver of the Aztec in Mexico and the Inca in Peru and brought it to Europe. As this gold and
silver flowed in, Spaniards went on a spending spree. They bid against other potential buyers and drove up the prices of goods and services all over Europe. Hume and other theorists
sought to explain the link between the inflow of money and the rising price level.
Although these early theorists did not have the tools of demand and supply, their reasoning
can be expressed in those terms. In the 17th century the newly wealthy Spanish demanded
more woolens from both Spanish and English suppliers. In the supply and demand diagram of Figure 7.4, an inflow of gold and silver has caused the demand for woolen goods
to increase while the supply curve remains unchanged. Of course, the people who sold
woolens then had extra money, so they too demanded more goods of all kinds. As demand
for a broad range of products increased, aggregate demand shifted to the right, as shown
in Figure 7.5.
As long as money was flowing into Spain and from there to the rest of Europe, prices were
destined to continue rising. Aggregate demand kept shifting to the right. Rising demand
spilled over from Spain to other countries, causing aggregate demand to increase in all
of these countries. Thus, the money inflow to Spain led to higher price levels throughout
Europe.
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The Quantity Theory of Money
Section 7.3
Figure 7.4: A 17th-century shift in the demand curve for woolens
An inflow of gold and silver from the New World led Europeans to increase their demand for various
goods, such as woolen goods. The rightward shift of the demand curve drove up the price of woolen goods
from P1 to P2. Quantity increased along the supply curve from Q1 to Q2 in response to the higher price.
Price of
woolen
goods
S1
P2
P1
D2
D1
0
Q1
Q2
Quantity of
woolen goods
Figure 7.5: Adjusting to an inflow of money
The general increase in demand for goods drives up both prices and costs. The rise in costs shifts the AD
curve to the right. As a result, there is an increase in price from P1 to P2.
P
AS
P2
P1
AD2
AD1
0
Y*
Y
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The Quantity Theory of Money
Section 7.3
Global Outlook: Zimbabwean Hyperinflation
One of the reasons people are afraid of inflation is that they expect it to develop into
hyperinflation. Hyperinflation is when prices increase rapidly as a currency loses its
value, and inflation hits very high rates. It is relatively rare, occurring mostly after wars,
revolutions, or other disasters. Hyperinflations have occurred in Germany after World War
I, Hungary after World War II, and several Latin American countries in the past half century.
However, they only occur under extreme circumstances (CrisisTimes, 2015). A more recent
example of a country that has experienced hyperinflation is Zimbabwe.
Zimbabwe experienced inflation and hyperinflation between 2003 and 2010 due to civil war,
discriminatory land reforms, lenient economic policies, and corrupt political leadership. Its
living standards plummeted, unemployment skyrocketed to 85%–90%, and the Zimbabwean
dollar lost practically all of its value (Hanke & Kwok, 2009). How did this once productive
country become so ruined?
In 2008 Zimbabwe reached the second greatest hyperinflation rate in history, estimated at
90 sextillion percent (90,000,000,000,000,000,000,000%). The country was in such political
and economic turmoil that it was a prime situation for hyperinflation. Nevertheless, any kind
of inflation can be interpreted in terms of the equation of exchange. If the price level is rising
rapidly, something has to be happening to the other components of the equation of exchange
(the velocity of money, V; the money stock, Ms; and the GDP, Y).
Expansion of the money supply is an important part of the explanation of hyperinflation
in Zimbabwe. Like citizens of other countries, Zimbabweans get their currency from the
printing presses of their central bank. When Gideon Gono, the governor of the Reserve
Bank of Zimbabwe, ordered the printing presses to print more money, this sent the whole
country into a tailspin. Hyperinflation, however, rarely occurs without some other element
besides monetary expansion. In the case of Zimbabwe, the second important element was
a decline in real output. The inflation rate was stable until President Robert Mugabe’s land
reforms took land from White citizens and redistributed it to Black citizens, causing food
production and revenues to drop dramatically. The land reforms and surge of currency
into the Zimbabwean economy wiped out export earnings and decreased manufacturing
output—food output capacity fell by 45%, and manufacturing output fell by 29% in 2005,
26% in 2006, and 28% in 2007 (Hanke & Kwok, 2009). In the equation of exchange, when
an increasing money supply (Ms) encounters falling real output (Y), there is a double source
of upward pressure on the price level. If, for example, the money supply expanded by 50%
while output fell by 10%, the price level would rise by a percentage equal to 6 × V, with V
being the velocity of the money.
Once inflation sets in, citizens spend their money quickly before it declines in value. Even
with interest rates as high as 85%, lenders are unwilling to tie up their money for very long
because the purchasing power they get back is so much less than what they lend. Workers
spend their wages on the way home for fear they will be worth less when they wake up the
next morning.
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The Quantity Theory of Money
Section 7.3
Changes in the Money Supply and in the Price Level
When would such a rise in the price level come to an end? If the inflow of money never stopped,
classical economists could see no end to rising prices. However, suppose the money inflow
did end. After the economy adjusted to changes in the price level, the equilibrium quantity of
real output would be the same as before the inflow of money, as shown in Figure 7.5. Thus,
there was no reason why total output would change once the economy adjusted fully to the
larger money supply.
With more money but no more real output, the increase in the price level would be proportional to the increase in the money supply. Classical economists would say that a money supply that was twice as large would lead to a price level that was twice as high. A money supply
that was four times as large would mean a price level that was four times as high. Land prices
and wages would also rise in proportion to increases in the money supply.
However, changes in the price level may not be exactly proportional to the rise in the money
supply. While the money supply is rising, other things that affect the price level may also be
changing. For example, the productivity of labor may rise. Like most economic predictions,
those based on the quantity theory are subject to ceteris paribus conditions.
The insight that the long-run level of prices is directly related to the money stock was a notable
insight of classical economics. To the question “How much will the price level change when
the money supply increases?,” it gives a reasonably precise answer: The price level changes in
proportion to the change in the money supply. However, the quantity theory could not predict
how long it would take the price level to change. Furthermore, you should have noticed in Figure 7.4 that output of a particular good will initially increase when demand increases. Thus,
in the short run, changes in the money supply may affect real output as well as the price level.
In the long run, real output returns to the level that existed before the added money came into
the system, back to Y* in Figure 7.5.
The obvious questions that come to mind are: How much will output increase at the start?
How long will it take output to settle back to its old level? Classical economists could not find
answers to these questions in the quantity theory. The quantity theory offered an explanation
for long-run changes in the price level but did little to explain the short-run effects of changes
in the money supply on real output and employment.
The Quantity Theory and Money Demand
The quantity theory of money underwent some changes in the late 19th century because of
the work of British economist Alfred Marshall (1842–1924). One of Marshall’s most important contributions was to reinterpret the equation of exchange (Ms × V = P × Y) as a theory of
the demand for money. The demand for money is the amount of money that people want to
hold in the form of currency or checking account balances. The demand for money is not that
different from the demand for other goods and services. People demand money because it is
useful in making market transactions. However, holding money has a price, or an opportunity
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The Quantity Theory of Money
Section 7.3
cost. Choosing to hold money means giving up the things that it could buy or giving up the
interest that could be earned if it were converted into other kinds of financial assets. Money
plays a special role in a market economy.
Marshall argued that people normally want to hold part of their wealth in the form of money.
He assumed that the amount of wealth that individuals choose to hold in the form of currency
or bank account balances (as opposed to stocks, bonds, and other financial assets) is positively related to their incomes. The higher a person’s income, the higher the average amount
of money balances that person will want to hold to meet day-to-day transaction needs. For the
economy as a whole, the total demand for money should be positively related to the aggregate
level of income and output.
Classical economists favored a strictly laissez-faire
approach to most markets. Many of them did agree,
however, that regulation of the money supply would
help control ups and downs in output and employment. If a temporary decline occurred in output, falling prices and wages could be avoided by expanding
the money supply. An increase in the money supply
could lead to at least a short-run improvement in
the level of real output as well as (or instead of) a
rise in the price level.
The quantity theory of money, Say’s law, and the
idea of self-regulating markets provided a complete
classical model of macroeconomics. This model
explained the level of employment, output, and
prices. According to this model, recessions would
be temporary and self-correcting. Thus, the role of
the government should be limited to careful management of the money supply.
Chad Baker/Jason Reed/Ryan McVay/
Photodisc/Thinkstock
Even today cash currency is necessary
for many market or interpersonal
transactions.
Key Ideas: Elements of Classical Macroeconomic Theory
•
•
•
•
•
Employment is determined by the forces of supply and demand in the labor market.
Output is determined by equilibrium in the labor market.
The AS curve is vertical at the full-employment level of output.
The price level is determined by the supply of and demand for money.
An economy always tends toward the full-employment level of output because
enough income is created during production to purchase the output (Say’s law), and
self-regulating markets correct temporary disequilibria.
• In the product market, falling prices ensure that all output is sold.
• In the labor market, adjustments in wages clear the labor market.
• In the credit market, changes in interest rates make saving equal to investment.
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The Keynesian Revolution
Section 7.4
7.4 The Keynesian Revolution
The classical model showed with reasoned arguments that prolonged unemployment was
impossible; but actual unemployment seemed to defy the model by lasting for long periods.
The classical model said that output would always be at, close to, or tending toward the fullemployment level; but real-world experience showed that large and prolonged deviations
from the full-employment level of output not only were possible but occurred with alarming
frequency. It was time for another option.
The Great Depression challenged the classical model with the reality of a long depression
and high unemployment. Keynes argued against the classical model in two important ways.
First, he identified some flaws in the model. Second, unlike the business cycle theorists, he
offered a well-developed alternative model of the macroeconomy. This model was the basis
for the Keynesian revolution, the change in macroeconomic theory and policy that occurred
when Keynes’s ideas displaced the classical explanation of how output and employment are
determined. The Keynesian model begins with aggregate demand and works from there to
employment, instead of the other way around.
Keynes on Say’s Law
Keynes was critical of Say’s law. Classical economists argued that the existence of saving by
households and investment by firms did not invalidate Say’s law, because changes in the interest rate will ensure that planned saving is equal to planned investment at the full-employment
level of output. Keynes identified several reasons why individuals or households may save
besides the desire to earn interest: (a) to build reserves in case of unforeseen future needs,
(b) to develop a nest egg for retirement, (c) to establish a financial base for an increased
standard of living in the future, (d) to gain economic independence, (e) to build reserves for
speculative purposes, (f) to leave an inheritance, and (g) to satisfy the urge to accumulate.
These motives, he argued, generate considerable saving that is relatively independent of the
interest rate.
Keynes also argued that the interest rate was only one influence on investment decisions.
Firms will invest in new plants and equipment only if they expect to make a profit. Based on
their expectations of the profit from a given investment project, businesses often borrow even
when interest rates are high or refuse to borrow when they are low. According to Keynes, final
demand by consumers, the size and age of existing capital stock, and new technology all play
more important roles than the interest rate in determining investment.
If both saving and investment respond more strongly to other influences than to the interest
rate, Keynes argued, planned saving could exceed planned investment at the full-employment
level of output. Thus, Say’s law would be invalid. According to the classical model, if planned
saving exceeds planned investment, the interest rate will fall. Keynes said that a fall in interest rates may have little effect on either saving or investment, but excess saving will lead to
a decline in the level of output and income. Thus, if credit markets fail to work as the classical model describes, severe depression and unemployment can persist for long periods in a
market economy.
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The Keynesian Revolution
Section 7.4
Policy Focus: Keynes and the Politics of the Keynesian
Revolution
John Maynard Keynes, born in Cambridge, England, was the son of a well-known economist
who taught at Cambridge University. The young Keynes grew up in an atmosphere of intense
debates over the public policy issues of the day. He divided his life between teaching at
Cambridge and active involvement in government and business affairs. Having worked for
the British treasury, he rose rapidly during World War I, becoming a British delegate to the
Paris Peace Conference that led to the peace treaties ending World War I in 1919. He was
disillusioned by the negotiations at the conference and the harsh conditions imposed on the
losers, especially Germany.
In his book The Economic Consequences of the Peace, Keynes argued that the harsh economic
conditions imposed on Germany would lead to additional problems in the future. This book
ended Keynes’s employment by the treasury because he dared to criticize British policy. He
returned to Cambridge and turned to business, making a great deal of money via shrewd
investments. He also wrote essays on policy topics and biographical essays on many people,
including economists, as well as a treatise on the theory of probability.
Along with his other activities, Keynes revolutionized macroeconomics. During the 1920s he
wrote the two-volume Treatise on Money, which was published in 1930 after the beginning
of the Great Depression. The Treatise was basically a quantity theory approach to macro
problems in the spirit of Keynes’s teacher, Alfred Marshall. By the time the Treatise was
published, Keynes was unhappy with this approach and had begun what he called his “long
struggle” to see macro questions from a different perspective. The new view he was working
toward was contained in The General Theory of Employment, Interest, and Money, published
in 1936. This book presented an alternative macroeconomic model aimed at explaining how
economies had fallen into the Great Depression and how they could get out of it.
Keynes’s ideas were considered radical by many at the time. Keynes himself considered his
proposals conservative. During a period when communism, fascism, and other antimarket
philosophies were very popular, Keynes saw his economic policy as a way to rescue the
market economy from its most serious weakness—persistent and recurring downturns in
output and employment. Recessions and depressions offered fertile ground for socialist or
communist proposals to shift to a more centrally planned economy. Keynes wanted to salvage
the market economy by reducing its tendency to go into recessions.
After World War II, Keynesian ideas were more widely accepted. The Great Depression
had brought a great deal of suffering, and classical economic theory offered no immediate
relief. Classical economists advised people to wait until prices fell, markets readjusted, and
equilibrium was restored. In short, their policy was to do nothing until, in the long run, the
economy returned to its full-employment equilibrium. Keynes offered a policy that could
make things better in the short run. This option was much more appealing to both politicians
and people who were unemployed. At the same time, Keynes offered frustrated economists a
plausible explanation of the Great Depression. The Keynesian revolution was a huge political
and economic success. Today most government officials still adhere to at least part of the
Keynesian view. They believe it is better to do something about economic conditions than to
wait for the economy to correct itself—especially if the correction may not take place until
after the next election!
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The Keynesian Revolution
Section 7.4
Keynes on Self-Regulating Markets
According to classical theory, temporary overproduction and unemployment in individual
markets would be eliminated as unemployed workers competed for jobs and drove down
wages. Keynes argued that neither the product nor labor market would adjust quickly and
automatically to eliminate unemployment and overproduction. He argued that labor unions
and large corporations had enough market power to keep wages and prices from falling. Faced
with rising unemployment, labor unions would fight to keep wages from declining to protect
their members who were still working. Without declining wages, business firms would not
be willing to reduce prices. Furthermore, when facing overproduction, large corporations are
likely to choose to reduce production levels rather than prices. In a capitalist economic system, it would be difficult to reduce either prices or wages. According to Keynes, prices and
wages are “sticky downward.” Because prices and wages are not fully flexible, there will be
no automatic adjustment process in product and labor markets to restore full-employment
equilibrium.
Finally, Keynes pointed out that even if wages and prices could fall, the result would not necessarily be to restore output to the full-employment level. Falling prices mean that buyers can
purchase more output, but falling wages mean that workers can buy less. In a macroeconomy,
supply and demand are not entirely independent, because they are parts of the same circular
flow.
Keynes on the Quantity Theory of Money
Keynes admitted that the quantity theory of money was useful in describing the long-run
movement of the economy from one equilibrium to another, but he saw the theory as much
less useful in the short run. Keynes pointed out that a theory that only explains the long run is
not very useful. For example, the velocity of money (and therefore k) was especially unstable
during the Great Depression. Between 1929 and 1933, V fell sharply and k increased. (Recall
that k = 1/V.) A rise in the value of k meant that the amount of money people wanted to hold,
relative to GDP, had increased. The quantity theory of money offered no explanation for the
sudden increase in the demand for money implied by the sharp drop in V.
Keynes reasoned that in addition to demanding money for making transactions, people also
want to hold money as a safeguard against changes in interest rates on bonds and other financial assets. If interest rates are low, people will avoid buying bonds and hold more of their
wealth in the form of money while waiting for interest rates to rise. When interest rates are
low, the opportunity cost of holding money is also low. Thus, very little is sacrificed by holding
money instead of bonds or other securities. In addition, people who buy bonds when interest
rates are low run a risk of locking in those rates and being stuck with low-yield assets when
the rates rise.
When market interest rates are high, people will prefer to hold more of their wealth in
interest-earning securities and less in money because the opportunity cost of holding
money is high. Much interest is lost by holding money, which earns little or no interest,
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The Keynesian Alternative
Section 7.5
instead of interest-earning assets. Keynes called the motive for holding money as an asset
the “speculative demand for money.” Today many economists prefer the term asset demand
for money, which is the demand for money to hold in order to protect oneself against losses
due to changes in interest rates. The asset demand for money is negatively related to interest rates. The motive for holding money identified by Marshall is called the transactions
demand for money—the demand for money in order to make purchases and carry out
other day-to-day market transactions. Transactions demand is positively related to income.
Keynes added a third source of demand for money, called the precautionary demand for
money, which is cash for a rainy-day or emergency fund. Since this demand is also related
to the level of income, later economists combined it with transactions demand. In sum, the
interest rate could strongly influence the demand for money.
Key Ideas: Keynesian Criticisms of the Classical Model
• Say’s law is not necessarily valid. Just because income is created does not mean it
will be spent.
• Self-regulating markets do not guarantee full employment.
• In the credit market, saving and investment are influenced by more than interest
rate.
• In the labor market, unions and other influences can make it difficult to adjust wages
downward. If wages do fall, that will also reduce demand. In the product market,
large corporations may cut output rather than prices.
• Instead, in the Keynesian model, employment is determined by output.
7.5 The Keynesian Alternative
Keynes criticized the quantity theory because it neglects the role of interest rates and fails
to explain short-run changes in V and k. He argued that Say’s law was not valid and that long
periods of overproduction and unemployment were possible. Without Say’s law and selfregulating markets, no automatic forces would bring the economy back to equilibrium during
a recession. Without a stable velocity of money, even an increase in the money supply might
not work. Having criticized the classical view of the way the macroeconomy worked, Keynes
offered a different model. In his view, only government intervention could bring the economy
out of a downturn as severe and prolonged as the Great Depression.
During the Great Depression, the U.S. economy experienced severe and lasting unemployment, along with falling prices and a sharp decline in real output. Table 7.1 shows some of
the dramatic changes in spending, output, and unemployment from 1929 to 1941. Classical
theory could not account for such conditions. In developing an alternative theory, Keynes and
his followers focused on the question “What determines the level of employment in a market
economy?” They knew that if they could explain employment, the same model would explain
unemployment.
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The Keynesian Alternative
Section 7.5
Table 7.1: Consumption and investment expenditures during the Great
Depression (in billions of dollars)
Year
Consumption
expenditures
Investment
expenditures
Total GDP
Unemployment rate
1929
79.0
16.2
103.9
3.2%
1931
61.3
5.5
75.8
15.9%
55.6
24.9%
1930
1932
1933
1934
1935
1936
1937
1938
1939
1940
1941
71.0
49.3
46.4
51.9
56.3
62.6
10.3
0.9
1.4
2.9
6.3
8.4
67.3
11.7
67.6
9.3
64.6
71.9
81.9
6.7
13.2
18.1
90.4
58.0
65.1
72.2
82.5
90.4
84.7
90.5
100.4
125.5
8.7%
23.6%
21.7%
20.1%
16.9%
14.3%
19.0%
17.2%
14.6%
9.9%
From “Economic Report of the President,” by Council of Economic Advisors, 2012, Washington, DC: U.S. Government Printing Office.
The Building Blocks of the Keynesian Model
In attempting to explain changes in employment, Keynes reasoned as follows:
1. The level of employment is directly related to the level of production, or output (Y).
2. In a market economy, planned spending on the output of the business sector will
determine the level of production. Firms adjust their levels of production to meet
demand for their products. Put simply: Supply adjusts to demand. (In contrast, Say’s
law states that supply creates its own demand.)
3. Because employment depends on production and production responds to spending,
the level of employment in a market economy depends on the level of planned spending in the economy.
Note how Keynes reversed the sequence of events from the classical model. In the classical
model, the labor market determined employment, and employment determined the level of
output. Therefore, the position of the AS curve is vertical. Recall from Chapter 6 that the AS
curve can be very flat, or even horizontal, if many resources are unemployed (the economy is
operating inside its production possibilities curve). The Keynesian model of the Depression
economy has ample unemployed resources and a horizontal AS curve. If aggregate supply is
constant (horizontal), then aggregate demand determines the level of output. In turn, the level
of output determines the level of employment. Aggregate demand, which determined only the
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The Keynesian Alternative
Section 7.5
price level in the classical model, has the starring role in Keynes’s model. It determines the
level of real output. In Figure 7.6 the price level is given at P1, and aggregate demand determines the level of output, Y1.
Figure 7.6: A Keynesian view of aggregate supply and aggregate demand
When there are unemployed resources, the AS curve is horizontal. Aggregate demand determines the
level of real output (Y1). An increase in aggregate demand shifts the curve to the right (AD2). The price
level (P1) is not affected by the change in demand.
P
P1
AS
AD2
AD1
0
Y1
Y*
Y
Keynes and Policy Solutions to Unemployment
Consider how this model might apply to the situation in the 1930s. Unemployment was high
because planned spending was too low to generate the level of output that would result in
full employment. Thus, too little spending was identified as the cause of unemployment. To
reduce unemployment, planned spending had to increase. In the language of aggregate supply and aggregate demand (a model developed after Keynes), aggregate demand had to shift
to the right.
How could aggregate demand be shifted to ensure a level of output that would result in higher
employment and lower unemployment? Keynes’s answer goes back to the circular flow
model. He identified the groups of purchasers (households, firms, government, and the foreign sector) in the spending stream and considered what determines the amount of planned
spending by each group. Keynes was very interested in determinants of planned consumption
spending and planned investment spending. (If Keynes were still alive today, he would have
added net export spending.) He concluded that sometimes these two sources of spending
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The Keynesian Alternative
Section 7.5
would be inadequate to lead the economy to the full-employment level of output. At such
times, the government, as a third major spending sector, should step in and boost planned
spending (and aggregate demand) to the desired level.
What determines planned consumption and investment spending? According to Keynes, consumer spending (and saving) depends primarily on the level of income. Keynes believed that
household spending habits are relatively stable and that households will spend a specific fraction of any increase in income. Investment demand, or planned investment spending, however, is much less stable. Investment depends on factors such as expectations, interest rates,
and changes in final consumer demand. Expectations are especially prone to sharp swings.
Thus, Keynes believed that investment spending would shift a great deal and would be the
major source of changes in output and employment. Government can offset those changes by
increasing its spending when investment demand is low and by cutting it back when investment demand is high.
This emphasis on determinants of planned spending highlights a basic difference between the
Keynesian and classical models. In the classical model, investment and saving both depend on
the interest rate, which ensures that saving is equal to investment in the circular flow. In the
Keynesian model, however, the interest rate plays a much smaller role. Because investment
and saving are determined by different forces, there is no reason to expect that planned saving will be equal to planned investment. Therefore, there is no reason to expect the economy
to move automatically toward equilibrium at a full-employment level of output.
The Keynesian Explanation of the Great Depression
Since the Great Depression, many economists have looked for explanations and key causes.
These causes include the Smoot–Hawley Tariff of 1930, international monetary problems
relating to the collapse of the gold standard, long-wave business cycles, and the Federal
Reserve’s mismanagement of the money supply. At the time, however, economists trained in
the classical tradition could not explain what was happening. Keynes was able to offer a direct
and plausible explanation of why planned spending by consumers and investment by firms
fell so dramatically from 1929 to 1933, as was shown in Table 7.1. He also explained why the
economy did not recover automatically, as classical macroeconomics predicted.
Keynes observed that, after several years of rising consumption and investment spending
during the 1920s, the rate of expansion began to slow. With enough factories and equipment
to meet current demand, firms reduced their levels of investment spending, leading to a
decline in output and employment. When employment declined, household income declined.
Consumption spending also declined. Falling consumption further discouraged investment
spending because of firms’ expectations of poor future sales. Investment spending fell further, causing more declines in employment, income, and consumption spending. The spiral
continued, and output and sales plummeted. To many people, it seemed as though the whole
system had broken down.
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The Keynesian Alternative
This view of what was happening also suggested
that the way to end the Great Depression was simple: The government should intervene in the market economy by using its power to tax and spend to
increase aggregate demand. That is, the government
should spend more, reduce taxes, or both. Keynes’s
prescription was followed to a very limited extent
until World War II. Table 7.1 shows that the process
of recovery was very slow, especially in employment. Consumption, investment, and total GDP did
not reach the pre-Depression levels of 1929 until
12 years later, in 1941. Unemployment remained
high until the war was fully underway in 1942.
Section 7.5
Everett Collection/Superstock
Keynes’s prescription for fixing the
Great Depression was more government
spending and lower taxes.
Preparations for war forced the U.S. government to
increase its defense spending. Congress chose to
raise taxes, but by less than the amount needed to pay for the war. By 1943 the unemployment rate in the United States had fallen to 1.9%. Keynesian economic policy of increasing
spending more than taxes had finally ended the Great Depression, but not as Keynes expected.
The massive increase in government spending in the 1940s was not simply an exercise in
Keynesian macroeconomic policy. It occurred in order to pay for World War II.
How would Keynes explain the Great Recession of 2007–2009? Would Keynesian theory provide a solution for 8.2% unemployment, a 0.3% decrease in prices, and a 1.9% growth rate of
GDP (Bureau of Economic Analysis, 2012)? The next chapter provides the foundation for the
Keynesian model before the theory can be tested with more recent economic data.
Key Ideas: The Keynesian View of the Great Depression
• According to Keynes, government intervention was necessary to bring the economy
out of a downturn as severe and prolonged as the Great Depression.
• Unemployment was high because planned spending was too low to generate the
level of output that would result in full employment.
∘∘ Therefore, too little spending was the cause of unemployment.
∘∘ To reduce unemployment, planned spending had to increase.
∘∘ In the model of aggregate demand and aggregate supply, this means that aggregate demand needed to shift to the right.
• Keynes explained that the government should have intervened in the market economy by using its power to tax and spend to increase aggregate demand.
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Conclusion
Conclusion
Looking back, the 2007–2009 recession had a somewhat happier ending than the one that
began in 1929. Although the 2007–2009 recession was a serious economic wake-up call
to the United States, the government stimulus package and the Federal Reserve’s ability
to manipulate interest rates likely helped end it sooner rather than later. Compared to the
experience of the Great Depression, the 2007–2009 recession was much shorter and far less
severe. Was this the result of following Keynesian policies? How would the economy have
fared under a classical “wait and see” prescription? Although it would be ideal to observe the
counterfactual—the economy of today, for example, with or without any of the government
bailouts in 2009—we will never know how severe the recession could have been. A 2010
study determined that the Troubled Asset Relief Program helped prevent an even worse
recession (Blinder & Zandi, 2010), but what was the total cost of that program, and did it
really prevent a global depression? We will never know, but many believe the answer is yes.
Key Ideas
1. The view of the classical school was that the economy always tends toward the fullemployment level of output. The classical AS curve is vertical. Changes in aggregate
demand affect only the price level. Deviations from the full-employment level of output are temporary and self-correcting because of Say’s law, which states that enough
income will be created in the process of production to purchase all that is produced.
2. Any temporary overproduction or unemployment will be corrected through price
adjustments in the self-regulating product, resource, and credit markets. The interest rate ensures that planned saving is equal to planned investment.
3. The quantity theory of money explains how changes in the money supply are translated through household behavior into changes in the price level or real output.
In the classical model, the velocity of money (V) and real output (Y) are constant.
According to the equation of exchange, M × V = P × Y, changes in the money supply
lead to proportional changes in the price level.
4. Keynes criticized the three central elements of classical theory: Say’s law, the quantity theory of money, and self-regulating markets. He argued that factors other than
interest rates determine saving and investment, that prices and wages can be sticky
downward, and that the demand for money is unstable.
5. Keynes stressed the role of planned spending in determining the levels of output and
employment. He argued for government intervention to deal with persistent recession and unemployment.
Critical-Thinking Questions
1. Why is the classical AS curve vertical? Why is the Keynesian AS curve horizontal?
2. What was revolutionary about Keynes’s ideas?
3. According to classical economists, how do interest rates help ensure that the economy will always return to the full-employment level of output?
4. What reason did Keynes give for the instability of money velocity?
5. Sometimes the Keynesian revolution is described as a switch from “supply creates its
own demand” to “demand creates its own supply.” Explain this statement.
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Conclusion
6. Why, according to Keynes, do self-regulating markets not solve the problem of falling
output?
7. In the equation of exchange, suppose V is stable (constant) with a value of 4, and the
money supply is $200 billion. What combinations of P and Y are possible? Identify
about a dozen combinations, and plot them on a graph. Does your graph look like an
AD curve? Why or why not?
8. Suppose the money supply in Question 7 increases to $300 billion. Identify some
new possible combinations of P and Y. Plot the new combinations. Which way has
the curve shifted?
9. Marshall’s form of the equation of exchange is Md = k × P × Y. Let k = ¼. Suppose the
money national income is $3,000. What must the money supply be in order to be
equal to the money demand? Suppose the money supply increases to $1,000. What
must the value of total output be? What are some possible divisions of that total
between P and Y?
10. Keynes argued that k was not stable, especially in the short run. Suppose when
you increase the money supply to $1,000 in Question 9, k rises from ¼ to ⅓—that
is, people decide to hold a larger fraction of their money income in cash balances.
What happens to P × Y when Ms increases in this case? What does that imply for
monetary policy?
11. The variables V and k are not calculated directly but are inferred from the values
of Ms and P × Y (nominal GDP). Given the following data on money supply and GDP
(both in billions of dollars), compute Y and k for the United States for the years
shown:
Year
Money supply
GDP
2000
1,138.3
9,951.5
2008
1,370.2
14,291.5
2010
1,711.7
14,526.5
2009
2011
2012
2013
2014
2015
2016
2017
1,633.4
1,852.3
2,200.4
2,460.2
2,666.9
2,931.9
3,172.7
3,342.7
13,939.0
15,094.0
16,155.3
16,691.5
17,393.1
18,120.7
18,624.5
19,390.6
Source: Federal Reserve Bank of St. Louis, 2018b; World Bank, 2018d (Licensed under CC-BY 4.0).
12. Using the data from Table 7.1, compute the ratio of consumption to GDP and the
ratio of investment to GDP for each year. Present the data as a graph. What conclusions can you draw about which form of spending is more stable?
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Conclusion
13. Indicate whether each of the following statements about the Great Depression would
be likely to be made by a business cycle theorist, a classical economist, or a Keynesian.
a. “Left alone, the economy would have corrected itself.”
b. “Unequal distribution of income meant that the rich bought too little and the
poor could not buy the rest, leaving a glut of unsold goods.”
c. “Instability of investment means that the government has to step in to stabilize
demand.”
14. If you expect interest rates to rise, will you hold money in cash or buy bonds? Why?
What if you expect interest rates to fall?
15. Suppose there are 100 million workers in the economy, and full employment is
defined as 96% of them being employed. Also suppose that, given current technology,
each $10 billion in output employs a million workers. What is the full-employment
level of output? If actual output is $850 billion, what would you expect the unemployment rate to be?
16. Suppose an economy has suffered 2 years of falling output and rising unemployment.
How would this be explained by an economist in the classical tradition? A Keynesian? What would each recommend doing?
17. Suppose that in the past 6 months, real output has fallen by 3%, with a sharp rise in
unemployment. What would a classical economist recommend as policy? Why? What
would a Keynesian recommend?
Key Terms
asset demand for money Demand for
money to hold in order to protect the value
of one’s assets against changes in interest
rates. The asset demand for money is negatively related to the interest rate.
demand for money The amount of money
that people want to hold in currency or
checking accounts.
equation of exchange An identity based
on the quantity theory of money that states
that the money supply times the velocity of
money is equal to the price level times the
level of real output.
hyperinflation A situation in which prices
increase rapidly as a currency loses its value
and inflation hits very high rates.
Keynesian revolution The change in macroeconomic theory and policy that occurred
when Keynes’s ideas displaced the classical
theory of how output and employment are
determined.
macroeconomic equilibrium The level
of output at which there is no tendency to
change. The amount that buyers wish to buy
is exactly equal to what is being produced.
precautionary demand for money Cash
that households may wish to hold for a rainy
day, like an emergency fund.
quantity theory of money The theory that
changes in the price level will be proportional to changes in the money supply.
Say’s law An economic law that states that
aggregate production necessarily creates an
equal quantity of aggregate demand.
self-regulating markets Markets that
quickly resolve problems of shortage and
surplus through price changes, quantity
adjustments, or a combination of the two.
transactions demand for money Demand
for money in order to make purchases and
carry out other day-to-day market activities. The transactions demand for money is
positively related to income.
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8
The Keynesian Model
Archive Photos/Stringer/Getty Images
Learning Outcomes
After reading this chapter, you should be able to
• Explain why the AS curve could be horizontal at points in time.
• Understand the consumption function and investment demand in the two-sector aggregate expenditure
model.
• Describe how the addition of government and the foreign sector to the aggregate expenditure function
enhances the Keynesian model.
• Use the expenditure multiplier to calculate the change in equilibrium that results from a change in any
component of aggregate expenditure.
• Comprehend the primary foundations of the Keynesian model.
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Key Aspects of the Keynesian View
Section 8.1
Introduction
By the time Sharon Tirabassi turned 18 in Hamilton, Ontario, she had already been in and out
of many shelters. Growing up on welfare had caused her to be frugal and cherish any money
she had. But in 2004, at the age of 26, her life changed dramatically. She was a single mom
with three kids and no car who was living in an apartment in East Hamilton, and she had just
taken a job as a personal care provider. Then in April she matched all seven lottery numbers
and won over 10 million dollars.1 Her life was turned upside down.
In this chapter, we discuss consumption, and people’s propensity (tendency) to consume.
Keynes proposed that people’s propensity to consume changes as their income levels change.
Tirabassi’s example is an interesting way to illustrate this principle at work.
What would this influx of income do to Tirabassi’s consumption? Unfortunately, research has
shown that lottery winners are more likely to file bankruptcy within five years of winning the
lottery than the average American who hasn’t won the lottery.2 In short, when a person wins
the lottery, the propensity for that person to consume increases, as Keynes predicted. But
what about the tendency to save? Not so much.
After Tirabassi’s win, she took her friends on exotic trips: the Caribbean, Florida, Mexico,
and Las Vegas. She got married and bought a large $500,000 home along with an Escalade,
a Hummer, and two other fancy cars. Just four years after winning, Sharon Tirabassi and her
husband Vinny lost their house and were back to being poor. Today she rents her house and
takes the bus to work, similar to before the lottery and all of the consumption that ensued.
In other words, when her income decreased, her propensity to consume likewise decreased.
1
Hayes, M. (2013, March 21). Hamilton lottery winner fritters away $10 million. The Star. Retrieved from https://www.thestar.com
/news/gta/2013/03/21/hamilton_lottery_winner_fritters_away_10_million.html
2
Hess, A. (2017, August 25). Here’s why lottery winners go broke. CNBC. Retrieved from https://www.cnbc.com/2017/08/25/heres-why
-lottery-winners-go-broke.html
8.1 Key Aspects of the Keynesian View
Aggregate Demand
Keynes argued that supply adjusts to demand. That is, businesses will adjust their level of
output to meet the demand as long as there are idle resources to expand production. The
key to determining the level of output, then, is the factors that determine the spending plans
of households and firms. Keynes believed that expenditures, especially consumption expenditures, or spending by individuals and households, are strongly influenced by the level of
income. All income (wages, salaries, rent, interest, and profit) is received by the owners of
resources. There is a continuous flow from income to demand to output and back to income.
Planned spending by households and firms determines the level of national, or aggregate,
income and output, but planned spending itself is influenced by national income. The levels
of planned spending and national income are jointly determined.
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Key Aspects of the Keynesian View
Section 8.1
Aggregate Supply
In the language of aggregate supply and demand, the Keynesian model has a downward-sloping AD curve and a horizontal AS curve, as shown in Figure 8.1. Remember, the AS curve can
be horizontal when there are unemployed resources, which make it possible to expand output without driving up wages and prices. With a horizontal AS curve, the position of the AD
curve determines the equilibrium level of national income and output. Unlike equilibrium in
the classical model, the equilibrium level of real output (Y) in this model does not necessarily
ensure full employment.
Figure 8.1: Horizontal AS curve
The Keynesian AS curve, which assumes that there are enough unemployed resources so that real output
can increase without driving the price level above 120.
P
AS
120
AD
0
$18 trillion
Y
Consumption, Investment, and Aggregate Expenditures
Keynes, however, did not use the terms aggregate supply and aggregate demand, at least not
in the way they are used today. When Keynes wrote about demand, he was looking at factors
that underlie the AD curve that we have been using. In his model, the central focus was on the
relationship between consumption expenditures and disposable income. This relationship is
known as the consumption function (which will be discussed in Section 8.2).
Investment demand also plays an important role in the Keynesian model. In a two-sector
economy, with just households and business firms, the sum of the two sources of planned
spending—consumption and investment—is the aggregate expenditure function. This
function determines the equilibrium level of national income and output. The addition of government purchases and export and import spending provides a complete Keynesian model of
the macroeconomy.
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The Aggregate Expenditure Function
Section 8.2
Simplifying Assumptions
In this chapter and the next, we make a few simplifying assumptions. First, we initially ignore
the distinctions among GDP, GNP, net national product, national income, and personal income.
We treat these output measures as though they were all equivalent to Y, or real income and
output. The only important distinction we will need to make later on is between before-tax
income and after-tax, or disposable, income (Yd). Second, we assume that the price level
is fixed. When the price level does not change, then consumption, investment, output, and
income have the same values whether they are expressed in current market terms or in real
(price-adjusted) terms. For periods of high unemployment when there is little upward pressure on prices, a fixed price level is a convenient and plausible assumption. (This second
assumption will be relaxed toward the end of this chapter.)
Third, we initially ignore government and the foreign sector to concentrate on a simple twosector economy with just households and business firms. Once we have built a working model
of this simple economy, we can relax each assumption and bring the model closer to the real
world.
Key Ideas: The Basics of the Keynesian Model
• In the model of aggregate demand and aggregate supply, the Keynesian alternative
would assume a downward-sloping AD curve and a horizontal AS curve.
• With a horizontal AS curve, the position of the AD curve determines the equilibrium
level of national income and output.
• In Keynes’s model, the central focus was on the relationship between consumption
expenditures and disposable income.
• Investment demand and consumption make up aggregate expenditure.
• The aggregate expenditure function determines the equilibrium level of national
income and output.
• Government purchases and export and import spending complete the Keynesian
model of the macroeconomy.
8.2 The Aggregate Expenditure Function
Aggregate expenditure (AE) is defined as total planned spending by all sectors for an economy’s total output. Planned expenditures are distinguished from actual expenditures because
sometimes households or firms will find that actual spending does not equal what was initially planned; for example, if households spend a different amount on goods and services
than what firms anticipate, there will be unplanned changes in inventories that can lead to
unplanned spending.
In the circular flow, there are four sectors in the economy: households, business firms, government, and the foreign sector. In the upper half of the circular flow, the business sector sells
output to each of the four sectors, including business firms that are making investment purchases. In a complete model, the components of aggregate expenditure are C (consumption
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The Aggregate Expenditure Function
Section 8.2
expenditures), I (investment spending), G (government purchases of goods and services), and
X and M (exports and imports). Aggregate expenditure for a four-sector economy is the sum
of the purchases of all sectors:
AE = C + I + G + (X – M)
These four purchasers of output correspond to the four categories of purchasers used in
national income accounting and to the four sectors in the circular flow model. Without government and foreign trade, planned expenditures have just two components: consumption
and investment. It is useful to start with these two expenditures to develop a model of income
determination and then add the others to make the model more realistic.
The Consumption Function
The largest component of spending is consumption; thus, Keynes began building his model
by examining the behavior of households. He argued that the amount consumers choose to
spend depends mainly on their disposable income, or the amount of income available after
taxes. Keynes called this relationship the consumption function and made it a key part of
his theory.
The consumption function is any equation, table, or graph that shows the relationship
between the disposable income of consumers and the amount they plan to spend on currently
produced final output. The equation for the consumption function is
C = C0 + bYd
where C is total consumption expenditures and Yd is disposable income. This expression says
that consumption is positively related to income. That is, consumption rises when income
rises and falls when income falls. The expression also indicates that there is a component of
consumption (C0) that is not related to the level of income. In the simple Keynesian model, any
variable that is not dependent on income is said to be autonomous, or determined by other
variables not included in the model. On a graph, the consumption function is a positively
sloped straight line that crosses the vertical axis at C0. The slope of this line is b.
As an example, assume that the consumption expenditures for a simple economy can be
expressed as
C = $200 + 0.8Yd
with values in billions of dollars. Table 8.1 shows some specific values for this consumption function. Column 1 lists different levels of national income (Y = Yd). The values for
planned consumption spending (C) are then obtained by substituting the values of Yd into
the equation. That is, the table answers the question “If disposable income is equal to Yd,
then how much will households spend out of that income on consumption?” For example,
if Yd = $1,200 billion, then
C = $200 billion + 0.8($1,200 billion) = $1,160 billion
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The Aggregate Expenditure Function
Section 8.2
Subtracting consumption from income in each row of Table 8.1 gives the values for planned
saving (column 5). Remember, saving is that part of income that is not spent. Note that saving
is often negative at very low levels of income. Households will draw on their past savings or
borrow in order to maintain some minimum level of consumption.
Table 8.1: Planned consumption expenditures (C ) and planned saving (S ) at
various levels of national income (Y), in billions of dollars
(1) National
income
(disposable
income),
Y = Yd
(2) Change
in disposable
income, ∆Yd
(3) Planned
consumption
spending, C
(4) Change in
consumption
spending, ∆C
(5) Planned
saving, S
(6) Change in
saving, ∆S
0
—
200
—
–200
—
200
520
160
–120
200
200
600
200
400
800
200
360
160
680
160
840
160
–160
40
–80
40
40
–40
1,000
200
1,000
160
0
1,400
200
1,320
160
80
1,200
1,600
1,800
200
200
200
1,160
160
1,480
160
1,640
160
40
120
160
40
40
40
40
40
40
Marginal Propensities to Consume and to Save
The values in Table 8.1 show a consistent relationship among income, consumption, and saving. In the table, every time income increases by $200 billion, consumption increases by $160
billion and saving by $40 billion. Keynes believed that consumers were creatures of habit.
When disposable income changed, he expected consumer spending to change by a constant
fraction of the change in income.
Keynes called this ratio of the change in consumption or spending levels to the change in
income the marginal propensity to consume (MPC). It corresponds to b in the equation
for the consumption function. The MPC means that people are more likely to increase spending when they earn an extra dollar, but they are not likely to increase it by the whole dollar.
The MPC is the ratio of the change, represented by the Greek letter delta (Δ), in consumption
spending (thus, ΔC) to the change in disposable income (which would be ΔYd), where MPC is
thus
MPC =
ΔC
ΔY
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The Aggregate Expenditure Function
Section 8.2
Once you have calculated the MPC, it is very easy to compute its parallel, the marginal
propensity to save (MPS), which describes how saving responds to income changes. The
MPS is the ratio of the change in saving (ΔS) to the change in disposable income (ΔYd):
MPS =
ΔS
ΔY
In other words, the extra dollar that a worker earns is not really a dollar. For example, let us
say 90 cents of that dollar is consumed and the rest is saved; thus, MPS = 1 – 0.90 = 0.10. The
10 cents that is saved contributes to investment, which means that the MPS could be indicative of an economy’s potential for investment and growth.
Values of MPC and MPS are not shown in Table 8.1 but can be calculated easily from the
values given there. For instance, when Yd increases from $1,000 billion to $1,200 billion, C
increases from $1,000 billion to $1,160 billion, and S increases from $0 to $40 billion. Thus,
ΔY = $200 billion, ΔC = $160 billion, and ΔS = $40 billion. The values of MPC and MPS are
and
MPC =
ΔC $160 billion 4
=
= = 0.8
ΔY $200 billion 5
MPS =
ΔS
$40 billion 1
=
= = 0.2
ΔY $200 billion 5
If you calculate MPC and MPS from other values in Table 8.1, you will get the same values each
time because Table 8.1 was created using Keynes’s assumption that the MPC is constant.
In this example, MPC is 4⁄5 and MPS is 1⁄5 of the change in income, and their sum equals 1.
In an economy with no taxes, MPC and MPS will always add up to 1 because all consumer
income that is not spent on final goods and services must be saved. (If MPC and MPS are
computed as fractions of changes in disposable, or after-tax, income, then they will sum to 1
even if taxes are included in the model.) When income rises by $500 billion and MPC is 0.8,
consumption spending rises by $400 billion. The amount not spent on consumption (that
is, the amount saved) is (1 – MPC) times $500 billion, or $100 billion. Thus, when income
rises by $500 billion, the change in saving is equal to MPS times $500 billion. Because all the
added income must be either spent or saved, we can conclude that
or
MPS = 1 – MPC
MPC + MPS = 1
For example, if MPC is 0.9, then MPS must be 0.1. If MPC is 0.6, then MPS must be 0.4.
Figure 8.2 is a graphical presentation of the numbers in Table 8.1 with the consumption
function
C = $200 + 0.8Yd
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The Aggregate Expenditure Function
Section 8.2
and the corresponding savings function
S = Yd – C = Yd – $200 – 0.8Yd = –$200 + 0.2Yd
The MPC is equal to b, the slope of the consumption function. Recall that the slope of a line is
the ratio of the change in the variable on the vertical axis to the change in the variable on the
horizontal axis, moving from left to right along the horizontal axis. In Figure 8.2 the slope is
the ratio of the change in C to the change in Y. In symbols, b = ΔC/ΔY = MPC. When consumers
receive more income, a much larger share of it normally goes to consumption than to saving.
Thus, the slope of the consumption function is much steeper than the slope of the saving function in Figure 8.2.
Figure 8.2: Planned consumption and planned saving schedules
The consumption function shows the relationship between planned consumption and national income,
and the saving function shows the relationship between planned saving and national income. The slope
of the consumption function is the MPC; the slope of the saving function is the MPS.
C, S (billions
of constant
dollars)
C
1,060
∆C=160
1,000
∆Y=200
500
∆S=40
200
0
–200
500
S
1,000 1,200 1,500
Y
(billions of constant dollars)
–500
Keynes believed that the MPC would be relatively constant, at least over a modest range
of values of income and output. That is, he expected that a rise in disposable income from
$1,000 billion to $1,200 billion would lead to the same increase in consumption as a rise in
disposable income from $1,200 billion to $1,400 billion.
The Constant Term in the Consumption Function
It is easy to understand why consumption would rise as income rises. But where does that
constant term, C0, come from in the equation for the consumption function? If we insert a
value of 0 for Yd into the consumption function C = C0 + bYd, this equation seems to say that
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The Aggregate Expenditure Function
Section 8.2
there is a positive level of consumption, C0, even when no output is currently being produced
and no income is being earned. For Table 8.1, C0 has a value of $200 billion, which is shown
as the intercept of the consumption function. This value indicates that consumers would buy
$200 billion worth of goods and services even if there were no production taking place and
no income coming into households.
The constant term in the consumption function reflects two important facts. One is that it is
possible to consume for a short while even with no current production. An economy could
consume inventories and deplete its stock of capital for short time periods. This process is
known as dissaving. No economy ever comes to a complete standstill. However, during the
revolutionary changes in Eastern Europe from 1989 to 1991, for example, some economies
came very close to a complete shutdown. What does happen fairly often is that, during wartime, economies temporarily consume more than they produce by drawing on inventories
and wearing out capital without replacing it.
There are also other influences on consumption besides income. The most important of these
influences are
1.
2.
3.
4.
wealth (consumers’ assets such as stocks, bonds, houses, cars, and savings deposits);
interest rates (which affect the cost of consumer borrowing);
the price level (discussed in Chapter 6 in connection with the AD curve); and
expectations (including expectations about future prices, income, and employment).
If one of these influences changes, consumers may choose to purchase more goods and services at every income level. For example, if consumers acquired more wealth and assets over
time and thus felt they did not need to save as much out of any level of income, they would
increase their consumption at every possible value of Yd. The value of C0 might increase from
$200 billion to $250 billion, and the entire consumption function would shift upward.
Key Ideas: Basic Features of the Keynesian Consumption
Function
• Consumption (C) depends on the level of disposable income (Yd).
• Part of consumption is independent of the level of income. This constant term (C0)
changes in response to changes in other influences such as wealth, interest rates, the
price level, and expectations.
• The rest of consumption (bYd) is positively related to income. The marginal propensity to consume (MPC = b) is the fraction of an additional dollar of income that will
be spent on consumption: 0 < b < 1.
Investment Expenditures
Remember that planned investment is the anticipated capital outlay or spending by businesses for income, profit, or the purchase of something of value. This can include purchasing
machinery, land, or infrastructure such as an office building.
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The Aggregate Expenditure Function
Section 8.2
Investment has three components: fixed investment in business plants and equipment, residential construction, and inventories. All three of these components are responsive to changes
in both expectations and interest rates, but to different degrees. Buildings and equipment
have a long useful lifetime. Thus, there may be a large existing stock to be used up before there
will be much replacement. The same is true of residential construction. Because inventories
are very sensitive to actual and expected final sales, they tend to fluctuate more in the short
run than other types of investment. Unplanned changes in inventories, in fact, play a very
important role in moving an economy toward equilibrium. Sudden increases or decreases in
inventories may signal to producers that they need to change their level of output.
In general, all three types of investment fluctuate much more than consumption. Because
inventories are more likely than other types of investment spending to exceed or fall short of
desired levels, we assume that any gap between planned and actual spending will consist of
unplanned changes in inventories. This is not always the case, however. For example, prior
to the fall of communism, actual consumption in Eastern European countries frequently fell
short of planned consumption because of food and
supply shortages. Stores’ shelves were empty, and
there were no inventories on which to draw.
Classical economists believed that the most important determinant of planned investment spending
was the interest rate. Keynes thought that profit
expectations were a much more important influence on investment. Keynes assumed that the
investment demand curve would shift so frequently
that the relationship between planned investment
spending and the level of income or the rate of
interest would not be as important as the causes of
its shifts. For this reason, we will treat investment
demand as an exogenous variable, or a given value
that is determined by factors outside of the model.
SVF2/Contributor/Getty Images
Actual consumption can be less than
planned consumption if goods are
literally not available for purchase at
that time, as in Eastern Europe prior to
the fall of communism.
Equilibrium in a Two-Sector Model
The consumption function and investment demand are the basic elements of a two-sector
model that determines the equilibrium value of national income and output (Y). Along with
the consumption function from Table 8.1, there is now an investment demand of $160 billion,
which is independent of the level of income. The sum of consumption and investment demand
is shown in Table 8.2. Figure 8.3 graphs the data in Table 8.2 and adds a reference line with a
slope of 45°. This reference line locates those points where the value measured on the horizontal axis (total output or income) is equal to the value on the vertical axis (aggregate planned
expenditure, or C + I). Where the AE (or C + I) curve crosses the 45° line, aggregate expenditure
is equal to total output. This value of output is the equilibrium level. In Figure 8.3 equilibrium
occurs at Ye = $1,800 billion = C + I.
An output level of $1,800 billion is equilibrium because unplanned changes in inventory
would occur at any other level. These changes direct firms to adjust production levels in order
to make output equal to aggregate planned expenditure.
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The Aggregate Expenditure Function
Section 8.2
Table 8.2: Aggregate expenditure schedule (in billions of dollars)
(1) National income, Y
(2) Consumption, C
(3) Business
investment, I
(4) Aggregate
expenditure, AE = C + I
0
200
160
360
400
520
160
680
200
360
600
160
680
800
160
840
1,000
1,960
160
2,120
2,600
1,800
160
1,960
2,400
1,640
160
1,800
2,200
1,480
160
1,640
2,000
1,320
160
1,480
1,800
1,160
160
1,320
1,600
1,000
160
1,160
1,400
840
160
1,000
1,200
520
2,120
160
2,280
2,280
160
2,440
Figure 8.3: The aggregate expenditure line and the equilibrium output
Adding investment to the consumption function gives aggregate expenditure (AE = C + I) at every possible
level of output. The 45° reference line shows the points where total expenditure (measured on the
vertical axis) equals total output (measured on the horizontal axis). The total expenditure (C + I) line
crosses the 45° line at the equilibrium level of output (Ye = $1,800 billion).
AE = Y
C+ I
C
160
C, I (billions
of dollars)
1,800
1,200
600
45 degrees
0
600
Ye
1,200
1,800
Y (billions
of dollars)
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The Aggregate Expenditure Function
Section 8.2
Table 8.3 shows the important role played by unplanned inventory changes, using a few of
the values from Table 8.2. For example, if Y were $1,400 billion, aggregate planned expenditure (AE) would be $1,480 billion. Planned spending would exceed current production by
$80 billion. As firms tried to fill orders, their inventories would begin to decline. Firms would
respond to unplanned declines in inventories by increasing their levels of output. The expansion in output to rebuild inventories would increase the level of output to the equilibrium
level of $1,800 billion.
Table 8.3: Unintended inventory changes and the equilibrium level of national
income (in billions of dollars)
(1) National
income, Y
(2) Aggregate
expenditure, AE
(3) Unintended
inventory
changes, Y – AE
(4) Business
response
(5) Effect on
national income
1,400
1,480
–80
Increase output
Increase
1,800
1,800
0
Maintain output
No change
2,120
80
1,600
2,000
2,200
1,640
1,960
–40
40
Increase output
Decrease output
Decrease output
Increase
Decrease
Decrease
On the other hand, if Y were equal to $2,200 billion, AE would be only $2,120 billion. In this
case, current production would exceed aggregate planned expenditure by $80 billion, resulting in an unplanned buildup of inventories. Firms would reduce output in order to bring
inventories back to the desired levels. The level of output would fall steadily until the equilibrium level of $1,800 billion was reached.
Adjustments Through Inventories and Layoffs
Firms maintain inventories because they do not want to risk losing sales to competitors by
not having a desired item in stock. What did you do the last time you tried to purchase an item
in a store and that item was sold out? You went to a competitor. Not only did the first store
lose a sale, it may also have lost a customer for future sales.
Most firms choose a desired level of inventory that is related in some way to expected sales.
For instance, a firm may plan to maintain an inventory of goods equal to twice the amount
usually sold in a month. Inventories act as a safety cushion or buffer between production
and sales. When the actual level of inventory is different from the level desired by the firm,
unplanned inventory changes have occurred. Such changes are a signal that the amount being
produced is not equal to the amount that purchasers want to buy.
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Adding Government and the Foreign Sector
Section 8.3
Two important changes in the past 25 years have modified the role of inventories in the
Keynesian model. The first is the advent of the just-in-time production and quick-response
manufacturing strategies. Both of these strategies attempt to minimize inventory of not only
final goods but also raw materials, parts, and semifinished goods while still trying to respond
quickly to consumer demand. These new methods have been made possible by technological
innovations such as computerized inventory management and overnight delivery services.
Although inventories are smaller, changes in inventories are still an important adjustment
factor between expected and actual sales and between planned and realized spending.
The second important change is the shift from manufacturing to services as the major source
of new jobs and output. Service firms do not maintain much inventory of goods. Instead,
they maintain an inventory of workers. For example, a call center maintains a staff of phone
operators so that customers can be served as needed. If sales are below expectations, the
unplanned inventory adjustment applies not to extra goods on the shelves but rather to workers with nothing to do. Initially, the firm may use those workers on other related projects or
use the slack time to encourage workers to upgrade their skills. Eventually, however, firms
will respond to reduced demand by laying off workers, reducing worker hours, or relying on
temporary workers to fill in during periods of peak demand.
8.3 Adding Government and the Foreign Sector
A more complete Keynesian model includes all four sectors from the circular flow and the
national income accounts. Adding government and the foreign sector makes the model more
realistic.
Government Spending and Taxes
Government adds a leakage from the circular flow in the form of taxes (T) and an injection of
spending in the form of government expenditures (G). Government expenditures are assumed
to be determined by factors other than income; that is, they are autonomous. There may be
some relationship between levels of income and output, but government spending is determined through the political process. Thus, we treat its value (G) as a constant. When we add
government expenditures, aggregate planned expenditure becomes
AE = C + I + G
Taken by itself, the addition of government expenditures to planned aggregate expenditure
would increase the equilibrium level of income and output. However, there is a downside to
this addition. Government purchases must be paid for, at least in part, by collecting taxes. For
simplicity, we assume that taxes are independent of the level of income and that all taxes are
paid by consumers. (In practice, tax collections are definitely linked to the level of income. We
will explore this complication in Chapters 9 and 10.)
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Adding Government and the Foreign S...
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