“ I believe myself to be writing a book on
economic theory which will largely
revolutionize—not, I suppose, at once
but in the course of the next ten years—
the way the world thinks about economic
problems. ”
-- John Maynard Keynes
The book, The General Theory of Employment, Interest, and Money ,
systematically analyzed the relationship between changes in aggregate
expenditure and changes in GDP.
In any particular year, the level of GDP is determined
mainly by the level of aggregate expenditure.
Real
GDP
370
390
C
375
390
410
430
450
470
S
Ig
C + Ig
______
______
20
______
______
______
Unplanned
Inventory
______
______
405
420
435
450
______
______
______
______
______
______
______
______
______
______
______
______
______
______
______
______
490
510
530
465
480
495
______
______
______
______
______
______
______
______
______
______
______
______
550
510
______
______
______
______
GDP - C
Real
GDP
370
390
C
375
390
410
430
450
470
S
Ig
C + Ig
-5
0
20
20
395
410
Unplanned
Inventory
25
20
405
420
435
450
5
10
15
20
20
20
20
20
425
440
455
470
15
10
5
0
490
510
530
465
480
495
25
30
35
20
20
20
485
500
515
-5
-10
-15
550
510
40
20
530
-20
GDP - C
C
0
GDP
Real
Consumption
A smooth, upward trend, interrupted infrequently by brief recessions.
After taxes (-) and transfers (+)
Every $1 increase increases consumption by 4-5 cents
Doesn’t seem to have much affect up or down
Price levels affect real wealth more than total consumption
Higher rates - more savings, lower rates - more consumption
GDP
C
S
1500
1540
____
1600
1620
____
1700
1700
____
1800
1780
____
1900
1860
____
2000
1940
____
2100
2020
____
2200
2100
____
Planned consumption
(trillions of $)
45º line
12
Saving
C
9
Dis-saving
6
3
45º
3
6
9
12
Real disposable
income
(trillions of dollars)
Savings
Consumption
The Relationship between Consumption and
Income, 1960–2010
The line, which represents the relationship between
consumption and disposable income, is called the
consumption function.
The slope of the consumption function is the marginal
propensity to consume.
Marginal propensity to
consume (MPC)
The slope of the consumption function: The amount by
which consumption spending changes when
disposable income changes.
MPC 
Change in consumptio
Change in disposable
n
income

C
 YD
Between 2006 and 2007, disposable income increased
by $228 billion and consumption spending increased
by $208 billion.
C
 YD

$208 billion
$228 billion
 0 . 91
Marginal propensity to save
(MPS)
The amount by which saving changes when disposable
income changes.
Between 2006 and 2007, disposable income increased
by $228 billion and if consumption spending increased
by $208 billion, then savings increased by $20 billion.
S
 YD

$20 billion
$228 billion
1 = MPC + MPS
 0 . 09
Calculating the MPC and
MPS
Real GDP
Consumption
$9,000
$8,000
10,000
8,600
11,000
9,200
12,000
9,800
13,000
10,400
Calculating the MPC and
MPS
Real GDP
Consumption
Saving
$9,000
$8,000
1000
10,000
8,600
1400
11,000
9,200
1800
12,000
9,800
2200
13,000
10,400
2600
Calculating the MPC and
MPS
Real GDP
Consumption
Saving
MPC
MPS
$9,000
$8,000
1000
.60
.40
10,000
8,600
1400
.60
.40
11,000
9,200
1800
.60
.40
12,000
9,800
2200
.60
.40
13,000
10,400
2600
.60
.40
MPC 
MPS 
C
Y
S
Y


$ 8 , 600  $ 8 , 000
$ 10 , 000  $ 9 , 000
$ 1, 400  $ 1, 000
$ 10 , 000  $ 9 , 000

$ 600
 0 .6
$ 1, 000

$ 400
$ 1, 000
 0 .4
Real
Investment
Planned Investment
Higher rates - more savings, lower rates - more consumption
Corporate taxes (-)
Investment tax credits (+)
The more profitable a firm is, the greater its cash flow and the greater its
ability to finance investment.
Unplanned
Inventory
Reduction
Planned consumption
(trillions of $)
45º line
12
Saving
C
9
Dis-saving
6
Unplanned
Increases in
Inventory
3
45º
3
6
9
12
Real disposable
income
(trillions of dollars)
Lower inflation rates attract more consumption
Higher incomes increase consumption
Appreciating currency increases import consumption, but decreases
export consumption.
Planned aggregate
expenditures
Equilibrium
(trillions of $)
Keynesian
equilibrium
10.3
10.0
9.7
(AE = GDP)
AE = C + I + G + NX
AE = C + I + G
AE = C + I
AE = C
Full Employment
(potential GDP)
45º
Output
9.4 10.0 10.6
(Real GDP -trillions of $)
Planned aggregate
expenditures
(trillions of $)
(AE = GDP)
AE = C + I + G + NX,P1
AE = C + I + G + NX,P2
AE = C + I + G + NX, P3
10.6
10.0
9.4
Output
(Real GDP -trillions of $)
45º
9.4 10.0 10.6
P3
P2
P1
AD
9.4 10.0 10.6
• The Multiplier:
A change in an spending (e.g. investment) leads to an
even larger change in output and employment.
• The multiplier is the number by which the
initial change in spending is multiplied to
obtain the total increase.
• The size of the multiplier depends on
how much is spent of each increase.
• The greater this %, the greater the effect
•injections will increase the size
of the multiplier;
•leakages will decrease the size of
the multiplier,
Expenditure
stage
Additional income
Additional consumption
Marginal propensity
to consume
(dollars)
(dollars)
Round 1
Round 2
Round 3
Round 4
Round 5
All others
1,000,000
750,000
562,500
421,875
316,406
949,219
750,000
562,500
3/4
3/4
421,875
316,406
237,305
711,914
3/4
3/4
3/4
3/4
Total
4,000,000
3,000,000
3/4
For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.
• The multiplier concept is based upon the proportion of additional income
that households choose to spend (here assumed to be 75% = 3/4).
Assume the people will spend .8 (80%) of a change in
their income and the change in business investment is
$10 (billion). Complete the table below. How much
will they save? ______
change in
income
change in
consumption
change in
savings
+ $10
______
______
2nd round
______
______
______
3rd round
______
______
______
4th round
______
______
______
5th round
______
______
______
16.38
13.10
3.28
______
______
______
increase in investment
of $10 billion
all other rounds
Totals
Higher Spending
Means a Larger Multiplier
MPC
Size of
multiplier
9/10
4/5
3/4
2/3
1/2
1/3
10.0
5.0
4.0
3.0
2.0
1.5
• As the spending % increases more and more money of every
injection is spent (and so received as payment and then spent
again, received as payment and spent again, etc.).
• The effect is that for higher spending, higher multipliers
result, specifically the relationship follows this equation:
1
M = 1 - %spent
Calculating the effect of the multiplier:
change in the injection
% not spent (saved)
Change in investment
% saved
multiplier effect
$10
20%
________
$10
10%
________
$10
25%
________
$20
20%
________
Total Output (Real GDP)
Planned Aggregate Expenditures
$5,000
$5,250
5,500
5,500
6,000
5,750
6,500
6,000
7,000
6,250
a. If the current output rate is $5,000, what will tend to happen to business
inventories, future output, and employment?
b. If the current output rate is $6,500, what will tend to happen to business
inventories, future output and employment?
c. What is the equilibrium rate of income of this economy?
d. If the economy’s full employment rate of output is $6,000, will the rate of
unemployment be high, low, or normal, assuming the current planned
demand persisted into the future?
e. What would happen if there was an increase in investment of $250?
Keynesian View
of the Business Cycle
During a downturn, business pessimism,
declining investment, and the multiplier
principle combine to plunge the economy
further toward recession.
During an economic upswing, business and
consumer optimism and expanding
investment interact with the multiplier to
propel the economy to an inflationary boom.
• The theory suggests that a market-directed
economy, left to its own devices, will tend to
fluctuate between economic recession and
inflationary boom.
Keynesian View
of the Business Cycle
• Regulation of aggregate expenditures is
the crux of sound macroeconomic policy
according to the Keynesian view.
• If we could assure aggregate expenditures
large enough to achieve capacity output, but
not so large as to result in inflation, the
Keynesian view implies that maximum output,
full employment, and price stability would be
attained.