The Keynesian Perspective

This is Unit Nine of Principles of Macroeconomics, part one of two: the Keynesian perspective. Unit eight built the diagram; this unit builds the apparatus underneath its demand side. Carry one idea through. In the short run, spending decides output, and because part of every dollar leaks away, a change in spending moves output by more than itself. How much more depends entirely on the leakages. By the end you will build consumption and saving schedules, sort a component as autonomous or induced, find equilibrium from a schedule and by algebra, compute the multiplier from the slope, and say how each leakage changes its size.

Two entries on where Keynes started, and the claim the rest of the unit rests on.

What firms actually do.

MAC 0801 Firms Produce What They Expect to Sell

Keynes started from what firms do: they produce what they expect to sell. In the short run, spending decides output; potential GDP sets the ceiling, but output can sit below it. A factory with idle machines and idle workers produces less because orders fell, not because anything else changed. This reverses unit five's logic, where supply sets output, and both hold on different horizons.

Why demand can stay too low.

MAC 0802 Aggregate Demand May Be Too Low

The first building block is that total spending can be too low to employ everyone who wants work. The claim is not that resources vanished, but that nobody is buying. Between nineteen twenty-nine and nineteen thirty-three the factories, workers and technology were much as before, yet output collapsed. That is evidence, not proof, and unit ten disputes the conclusion drawn from it.

Three entries on why adjustment is slow, and what slowness does to the whole economy.

The second building block.

MAC 0803 Sticky Wages and Sticky Prices

The second building block is that wages and prices adjust slowly. When demand falls, quantities move before prices do, so firms cut production and employment rather than pay and price tags. Unit five gave five reasons wages resist falling, and this unit adds the coordination problem and menu costs. Sticky does not mean fixed: it means slow enough that output moves first.

The coordination problem.

MAC 0804 The Coordination Problem and Menu Costs

Workers might accept lower pay if every worker did, but no decentralised economy can arrange that promise. Firms change prices infrequently because changing them costs analysis, relabelling, reprinting and customer goodwill — menu costs, named for the printed menu a restaurant would have to replace. Both are arguments about why adjustment is slow, not about why it never happens.

What stickiness does to everyone.

MAC 0805 The Macroeconomic Externality

A single firm facing weak demand should cut its price and win customers. When every firm's price is sticky at once, no such reallocation happens, and the economy's output falls instead of its prices. What is true of one firm is not true of all firms together. This repeats unit eight's part-and-whole warning, now applied to prices.

Five entries on what households spend, and on building the two schedules.

The spending households decide.

MAC 0806 The Consumption Function

Consumption depends on disposable income, meaning income after taxes, and the relationship is the consumption function. It has two pieces: a part that happens at any income, and a part that rises with income. Written out, consumption equals autonomous consumption plus a fraction of disposable income. Disposable personal income is not GDP: it is what households have left to spend.

That fraction.

MAC 0807 The Marginal Propensity to Consume

The marginal propensity to consume is the share of an extra dollar of disposable income that gets spent, and it is the slope of the consumption function. With a propensity of nought point seven five, an extra thousand dollars of disposable income raises spending by seven hundred and fifty. The propensity is about the next dollar, not the dollars already spent.

The mistake that guards against.

MAC 0808 Marginal, Not Average

The propensity is the change in consumption divided by the change in disposable income, not consumption divided by income. The two differ, and at low incomes they differ sharply. A household spending twelve hundred and fifty out of a thousand has a ratio above one, though its propensity stays at nought point seven five. Spending more than income is possible, from past saving, sold assets or borrowing.

What happens to the rest.

MAC 0809 Saving, and the Two Propensities

Disposable income is consumed or saved, so the two propensities sum to one. The marginal propensity to save is the share of an extra dollar not spent, and its function mirrors the consumption function. A propensity to consume of nought point seven five means a propensity to save of nought point two five. This is personal saving alone; firms and governments save too.

Building both schedules.

MAC 0810 Building Consumption and Saving Schedules

Take the course's household sector: autonomous consumption of five hundred billion and a propensity of nought point seven five, so consumption is five hundred plus three quarters of disposable income, and saving is income minus consumption. At zero income, saving is negative five hundred. At two thousand, consumption is two thousand and saving is zero. At four thousand, saving is five hundred. The break-even income is two thousand, where the function crosses the forty-five-degree line. Check two things on any schedule: the columns must add to disposable income at every row, and consumption must rise by the same amount at every step.

Four entries on what moves the function, which income households respond to, and how far the estimates disagree.

What moves the whole function.

MAC 0811 What Shifts the Consumption Function

A change in disposable income moves along the function. Two things move the function itself: real wealth, and expectations, and either raises spending at every income level. A sustained rise in house and share prices makes owners wealthier and lifts consumption at each income. Expectations can be self-confirming: if households expect bad times and cut spending, times get worse.

Which income they respond to.

MAC 0812 Current Income or Permanent Income

Two hypotheses compete. The current income hypothesis says consumption follows this period's income. The permanent income hypothesis says it follows the average income households expect over a lifetime. A medical student with low income now and high income expected may save nothing and still spend freely. The two predict differently about temporary income changes, which is what makes them testable.

What happened when they were tested.

MAC 0813 Testing the Two Hypotheses

A temporary income change is the test case. The current income hypothesis predicts consumption rises with it; the permanent income hypothesis predicts almost no response. Surveys of a nineteen ninety-two withholding change found households planning to spend about forty-three percent of the temporary gain. That result sits between the two predictions and refutes the strong form of each.

How far the estimates disagree.

MAC 0814 How Large Is the Propensity to Consume

The propensity is estimated, not observed. Rebate cheques sent in two thousand and one in randomly timed batches gave a natural experiment, and three teams reached three different answers: about one third, forty percent over nine months, and two thirds. All three found the effect was not negligible. The course's nought point seven five is an example, not a measurement.

Four entries building the model these propensities feed.

Output is also income.

MAC 0815 Output Is Also Income

The expenditure-output model puts real GDP on the horizontal axis and total planned spending on the vertical. Because every dollar of output becomes someone's income, the horizontal axis measures national income as well: the same axis answers how much was produced and how much was earned. Everything later in this unit depends on that identity, so it is stated first.

The line that defines equilibrium.

MAC 0816 The 45-Degree Line

A forty-five-degree line from the origin marks every point where planned spending equals output, and equilibrium lies on it, because GDP is the value of what is spent. At any point on the line, the vertical and horizontal readings are the same number. The line is not a behavioural relationship but a definition drawn as a graph.

Which spending rises with income.

MAC 0817 Autonomous and Induced Spending

Spending that does not vary with real GDP is autonomous and draws as a horizontal line. Spending induced by real GDP rises with it and draws as an upward slope. Consumption contains both: autonomous consumption is the part that happens at zero income, and the rest is induced. Autonomous does not mean unchanging, only not changing because of this year's output.

Sorting the components.

MAC 0818 Sorting the Components

Classify each component as autonomous or induced. The test is one question: does this component change because real GDP changed? If not, it is autonomous and sets the intercept. If it does, it is induced and contributes to the slope. Investment turns on expected returns, interest rates and technology, none of which is on the horizontal axis. Government purchases are set politically, and exports by foreign income. Consumption is partly induced, through the propensity to consume. Taxes and imports both rise with income, and imports enter negatively, because spending on foreign output is not spending on domestic output. Autonomous components shift the line; induced components tilt it.

Five entries stacking the line, finding the one point that settles, and two ways of locating it.

Stacking the line.

MAC 0819 Stacking the AE Line

Aggregate expenditure sums consumption, investment, government purchases and exports, minus imports. The intercept comes from everything autonomous, and the slope from the propensity to consume, the tax rate and the propensity to import. Raising any of those three flattens the line, because less of each extra dollar returns as spending. Imports come out of after-tax income throughout this course, matching consumption.

Why one point is special.

MAC 0820 Why That Point and No Other

Equilibrium is where the expenditure line crosses the forty-five-degree line. Above it, spending falls short of output, goods pile up unsold and firms cut production. Below it, spending exceeds output, shelves empty and firms expand. Only at the crossing is there no pressure in either direction. Spending exceeding output is what makes firms produce more, not an impossibility.

The inventories doing that work.

MAC 0821 Planned and Unplanned Investment

Unsold goods count as investment in inventories. Goods piling up unsold are unplanned investment; goods sold from stock are negative unplanned investment. Equilibrium is where unplanned investment is zero. Inventories are the signal firms read before changing production. The two sources differ on how sharply to draw this, and the course keeps it, because it explains the adjustment.

Building the schedule.

MAC 0822 Building an AE Schedule and Finding Equilibrium

Use the course's economy: autonomous consumption five hundred, propensity nought point seven five, a tax rate of twenty percent, investment eight hundred, government purchases one thousand and exports four hundred, in billions. Disposable income is eighty percent of GDP, so the autonomous total is two thousand seven hundred and the slope is nought point six. At GDP of five thousand, expenditure is five thousand seven hundred, so production rises. At six thousand seven hundred and fifty the two are equal. At seven thousand, expenditure falls short, so unsold goods accumulate. Equilibrium is six thousand seven hundred and fifty, with arrows on either side pointing toward it. Check that row by substitution rather than by reading the graph.

Doing it with algebra.

MAC 0823 Solving for Equilibrium Algebraically

The schedule finds equilibrium by search; algebra finds it directly. Set output equal to expenditure, substitute the line, collect the output terms and solve. Any parameter can then be changed without rebuilding a table. Set GDP equal to two thousand seven hundred plus nought point six of GDP: that leaves nought point four of GDP equal to two thousand seven hundred, so GDP is six thousand seven hundred and fifty. Raise government purchases by one hundred and GDP becomes seven thousand, so a change of one hundred moved equilibrium by two hundred and fifty. The dividing figure is one minus the slope, not the slope, and that error is wrong in a plausible-looking direction.

Four entries on why output moved by more than spending did, and what decides how much more.

Why output moved by more.

MAC 0824 The Multiplier, Round by Round

An initial change in spending circulates. Households buy from firms, firms pay workers and suppliers, who spend again. Each round is smaller, because some of every dollar leaks away, and the rounds become negligible after roughly ten passes. The rounds sum to more than the change, and the total is finite: an endless shrinking series adds to a definite number.

The formula that sums it.

MAC 0825 The Multiplier Formula

The multiplier is one divided by one minus the slope of the expenditure line. State it that way first, because the slope is visible and already contains every leakage. With a slope of nought point six, the multiplier is one divided by nought point four, which is two point five. With no taxes and no imports the slope is the propensity to consume alone.

What the leakages do.

MAC 0826 Leakages Set the Size

Three leakages stop the circulation: saving, taxes and imports, each a share of an extra dollar that does not return as spending on domestic output. Add them one at a time and watch the multiplier fall. With the propensity at nought point seven five and no other leakage, the multiplier is four. Add a twenty percent income tax and the slope becomes nought point six, so the multiplier falls to two point five. Add imports at ten percent and the slope falls to nought point five two, with the multiplier at about two point one. It fell by nearly half, and the propensity to consume never changed. Quoting a multiplier without its leakages says almost nothing.

A change that works through taxes.

MAC 0827 The Tax Multiplier

A tax cut does not raise spending by its full amount. Households consume only a fraction of it, so the line shifts by the propensity to consume times the tax change, and output moves less than an equal increase in government purchases would move it. Neither source names this multiplier; both derive it, and the course supplies the name.

Look at what you can now do. You can build consumption and saving schedules, find the break-even income, and check every row two ways. You can sort a component as autonomous or induced by asking whether real GDP moves it, and say whether it shifts the line or tilts it. You can find equilibrium from a schedule and by algebra, dividing by one minus the slope. You can compute the multiplier from the slope, because the slope already contains every leakage. And you can say how saving, taxes and imports each cut it down. Part two works the gaps and the policy that closes them.