Aggregate

Expenditures
Keynesianism

Keynes and the Depression

Says Law says that producing goods generates

an amount of income equal to the value of the
goods produced

Great Depression

Keynes theorizes that not all income is spent

leaving surpluses
In other words, the economy is not self-adjusting and
that external forces not always the cause of recession,
there are also internal forces caused by failure of
certain fundamental economic decisions (savings and
investing)

Disposable Income (DI)

Consumption

Income after taxes or net income

DI=Gross Income Taxes

2 Choices with disposable income

Consume or Save

Average Propensity to Consume

APC = consumption/income

Average Propensity to Save

APS = saving/income

APC + APS = 1

Marginal Propensity to
Consume (MPC)
The

fraction of any change in

disposable income that is
consumed.

MPC=

Change in Consumption
Change in Disposable Income
MPC = C/
DI

Marginal Propensity to Save

(MPS)
The

fraction of any change in

disposable income that is saved.

MPS=

Change in Savings
Change in Disposable Income

MPS

/DI

Marginal Propensities
MPC

+ MPS = 1

.: MPC = 1 MPS
.: MPS = 1 MPC
Remember,

people do two
things with their disposable
income, consume it or save
it!

The Spending Multiplier

Effect
An

initial change in spending (C,

IG, G, XN) causes a larger change
in aggregate spending, or
Aggregate Demand (AD).

Multiplier

= Change in AD
Change in Spending
Multiplier = AD/
C, I, G, or X

The Spending Multiplier

Effect

Why

does this happen?

Expenditures and income

flow continuously which sets
off a spending increase in the
economy.

Calculating the Spending

Multiplier
The

Spending Multiplier can be

calculated from the MPC or the
MPS.
1
Multiplier = 1/
or
/MPS
1-MPC
Multipliers

are (+) when there is

an increase in spending and ()
when there is a decrease

MPS, MPC, & Multipliers

Ex. Assume U.S. citizens spend 90 for every extra $1

they earn. Further assume that the real interest rate (r
%) decreases, causing a $50 billion increase in gross
private investment. Calculate the effect of a $50 billion
increase in IG on U.S. Aggregate Demand (AD).
Step 1: Calculate the MPC and MPS
MPC = C/DI = .9/1 = .9
MPS = 1 MPC = .10
Step 2: Determine which multiplier to use, and whether its + or
The problem mentions an increase in IG .: use a (+) spending
multiplier
Step 3: Calculate the Spending and/or Tax Multiplier
1/MPS = 1/.10 = 10
Step 4: Calculate the Change in AD
( C, IG, G, or XN) * Spending Multiplier
($50 billion IG) * (10) = $500 billion AD

Calculating the Tax

Multiplier
When

the government taxes, the multiplier works

in reverse
Why?
Because now money is leaving the circular flow

Tax

Multiplier (note: its negative)

= -MPC/1-MPC
If

or

/MPS

-MPC

there is a tax-CUT, then the multiplier is +,

because there is now more money in the circular
flow

MPS, MPC, & Multipliers

Ex. Assume U.S. citizens spend 90 for every extra $1

they earn. Further assume that the real interest rate (r
%) decreases, causing a $50 billion increase in gross
private investment. Calculate the effect of a $50 billion
increase in IG on U.S. Aggregate Demand (AD).
Step 1: Calculate the MPC and MPS
MPC = C/DI = .9/1 = .9
MPS = 1 MPC = .10
Step 2: Determine which multiplier to use, and whether its + or
The problem mentions an increase in IG .: use a (+) spending
multiplier
Step 3: Calculate the Spending and/or Tax Multiplier
1/MPS = 1/.10 = 10
Step 4: Calculate the Change in AD
( C, IG, G, or XN) * Spending Multiplier
($50 billion IG) * (10) = $500 billion AD

MPS, MPC, & Multipliers

Ex. Assume Germany raises taxes on its citizens by

200 billion . Furthermore, assume that Germans save
25% of the change in their disposable income.
Calculate the effect the 200 billion change in taxes on
the German economy.
Step 1: Calculate the MPC and MPS
MPS = 25%(given in the problem) = .25
MPC = 1 MPS = 1 - .25 = .75
Step 2: Determine which multiplier to use, and whether its + or
The problem mentions an increase in T .: use (-) tax multiplier
Step 3: Calculate the Spending and/or Tax Multiplier
-MPC/MPS = -.75/.25 = -3
Step 4: Calculate the Change in AD
( Tax) * Tax Multiplier
(200 billion T) * (-3) = -600 billion in AD

MPS, MPC, & Multipliers

Ex. Assume the Japanese spend 4/5 of their disposable income.

Furthermore, assume that the Japanese government increases its
spending by 50 trillion and in order to maintain a balanced
budget simultaneously increases taxes by 50 trillion. Calculate
the effect the 50 trillion change in government spending and 50
trillion change in taxes on Japanese Aggregate Demand.
Step 1: Calculate the MPC and MPS
MPC = 4/5 (given in the problem) = .80
MPS = 1 MPC = 1 - .80 = .20
Step 2: Determine which multiplier to use, and whether its + or The problem mentions an increase in G and an increase in T .:
combine a (+) spending with a () tax multiplier
Step 3: Calculate the Spending and Tax Multipliers
Spending Multiplier = 1/MPS = 1/.20 = 5
Tax Multiplier = -MPC/MPS = -.80/.20 = -4
Step 4: Calculate the Change in AD
[ G * Spending Multiplier] + [ T * Tax Multiplier]
[(50 trillion G) * 5] + [(50 trillion T) * -4]
[
250 trillion
]+[
- 200 trillion
] = 50 trillion AD

What is Investment?
Money

spent or
expenditures on:

New plants (factories)

Capital equipment (machinery)
Technology (hardware & software)
New Homes
Inventories (goods sold by
producers)

Expected Rates of Return

How does business make investment

decisions?
Cost / Benefit Analysis

How does business determine the

benefits?
Expected rate of return

How does business count the cost?

Interest costs

How does business determine the amount

of investment they undertake?
Compare expected rate of return to interest cost
If expected return > interest cost, then invest
If expected return < interest cost, then do not invest

Real (r%) v. Nominal (i%)

Whats

the difference?

Nominal is the observable rate of interest. Real

subtracts out inflation (%)and is only known ex post
facto.

How

do you compute the real interest rate

(r%)?
r% = i% - %
What then, determines the cost of an
investment decision?
The real interest rate (r%)

Investment Demand Curve

(ID)
What is the shape of the Investment
demand curve?

Downward sloping

Why?

When interest rates are high, fewer investments are

profitable; when interest rates are low, more
investments are profitable
Conversely, there are few investments that yield high
rates of return, and many that yield low rates of
return

The Investment Demand

Curve
Changes in r%

cause changes in IG.

Factors other than r
% may shift the
entire ID curve

r
%
5%

3%

ID

$2
trillion

$3
trillion

IG

Shifts in Investment Demand (ID)

Cost of Production
Lower costs shift ID
Higher costs shift ID

Business Taxes

Lower business taxes shift ID

Higher business taxes shift ID

Technological Change

New technology shifts ID

Lack of technological change shifts ID

Stock of Capital

If an economy is low on capital, then ID

If an economy has much capital, then ID

Expectations

Positive expectations shift ID

Negative expectations shift ID

Shifts in Investment
When investment demand shifts,
Demand
different levels of gross private
r
%

investment occur even while r%

remains constant

4%

ID1

ID
$2.5
trillion

$3.25
trillion

IG

Instability of Investment
Durability

Capital has a long life-span, therefore once it is built

there is no immediate need for further investment

Irregularity

of Innovation

Innovation does not proceed in a smooth linear

fashion, instead there are bursts of innovation
followed by periods of relative stability

Variability

of Profits

Variability

of Expectations

Profitability is subject to the forces of competition,

cyclical changes in the economy, and human
management decisions
Political, social and natural phenomenon shape our
positive and negative expectations of the future

Instability of Investment

Many economists believe that investment

instability is the chief cause of the business
cycle.

Loanable Funds Market

The market where savers and borrowers
exchange funds (QLF) at the real rate of interest
(r%).
The demand for loanable funds, or borrowing
comes from households, firms, government and
the foreign sector. The demand for loanable
funds is in fact the supply of bonds.
The supply of loanable funds, or savings comes
from households, firms, government and the
foreign sector. The supply of loanable funds is
also the demand for bonds.

Loanable Funds Market in

Equilibrium
r%
SLF &
DBonds

DLF &
SBonds
q

QLF

Changes in the Demand for

Loanable Funds
Remember that demand for loanable funds =
borrowing (i.e. supplying bonds)
More borrowing = more demand for loanable
funds ()
Less borrowing = less demand for loanable
funds ()
Examples

Government deficit spending = more borrowing

= more demand for loanable funds
.: DLF .: r%
Less investment demand = less borrowing
= less demand for loanable funds
.: DLF .: r%

Increase in the Demand

for
Loanable
Funds
r%
SL
F

r1
r

DLF
q

q1

QL
F

DLF .: r% & QLF

DLF
1

Decrease in the Demand

for
Loanable
Funds
r%
SL
F

r
r1

DLF
1

q1 q
DLF .: r% & QLF

QLF

DL
F

Changes in the Supply of

Loanable Funds
Remember that supply of loanable funds =
saving (i.e. demand for bonds)
More saving = more supply of loanable
funds()
Less saving = less supply of loanable funds ()
Examples

Government budget surplus = more saving

= more supply of loanable funds
.: SLF .: r%
Decrease in consumers MPS = less saving
= less supply of loanable funds
.: SLF .: r%

Increase in the Supply

of
Loanable
Funds
r%
SL

SLF 1

r
r1
DLF
q

q1

QL
F

SLF .: r% & QLF

Decrease in the Supply of

Loanable
Funds
S
r%
LF 1

SL
F

r1
r

DL
F

q1

QL
F

SLF .: r% & QLF

Final thoughts on Loanable Funds

Loanable funds market determines the real
interest rate (r%).
Loanable funds market relates saving and
borrowing.
Changes in saving and borrowing create
changes in loanable funds and therefore the r%
changes.
When government does fiscal policy it will
affect the loanable funds market.
Changes in the real interest rate (r%) will affect
Gross Private Investment

ffect of Expansionary Fiscal Polic

on Loanable Funds & Investment
SLF

r%

r%

r1
r

DLF
DLF
q

q1

ID

QL

I1 I

G and/or T .: Government deficit

F spends .: D LF .: r% .:
IG

IG