The central purpose of this
chapter is to introduce the basic analytical tools that will help us organize our thinking
about macroeconomic theories and controversies. First, the historical backdrop of the
aggregate expenditures model is established. Next, the focus is on the consumption-income
and saving-income relationships which are part of the model. Third, investment is
examined, and finally, the consumption, saving, and investment concepts are combined to
explain the equilibrium levels of output, income, and employment in a private (no
government), domestic (no foreign sector) economy.
The major changes in this
chapter relate to investment. The "expected rate of net profit" has been changed
to the "expected rate of return" which is the usual way economists express this
idea. This terminology is consistent with the presentation on Research and Development in
the new Chapter 26. The investment-demand curve is now a Key Graph (with Quick Quiz) and
the discussion surrounding it has been rewritten for clarity. There is a new Figure 9-6
which shows the shifts in the investment-demand curve. The discussion of the "stock
capital on hand" has been revised and included as a determinant of investment.
A new Figure 9-7a and b show the
"connection" between the real interest rate, the investment-demand curve and
the economy's investment schedule. The horizontal investment schedule is now the
only one displayed, since it is the only one used throughout the remainder of the macro
The discussion of equilibrium
GDP has been carefully edited throughout to improve the overall flow. Some of the figure
captions have been reworked to remove "text matter" and provide a clearer focus.
After completing this chapter,
students should be able to:
- Explain the basics of the
classical view that the economy would generally provide full employment levels of output.
- Recognize, construct, and explain
the consumption, saving, and investment schedules.
- Identify the determinants of the
location of the consumption and saving schedules.
- Differentiate between the average
and marginal propensities to consume (and save).
- Identify the immediate
determinants of investment and construct an investment demand curve.
- Identify the factors that may
cause a shift in the investment-demand curve or schedule.
- Describe the reasons for the
instability in investment spending.
- Explain verbally and graphically
the equilibrium level of GDP.
- Explain why above-equilibrium or
below-equilibrium GDP levels will not persist.
- Describe the leakages-injections
approach to determining equilibrium GDP.
- Trace the changes in GDP that
will occur when there is a discrepancy between saving and planned investment.
- Define and identify terms and
concepts at the end of the chapter.
COMMENTS AND TEACHING
- For those who feel that it is
important for students to grasp the multiplier concept, it is possible to explain the
multiplier concept without going into the theoretical discussions of Chapters 9 and 10.
One suggestion would be to use the Last Word for Chapter 10 and some simple role-playing
exercises mentioned in this manual for Chapter 10.
- The Last Word for this chapter is
a biographical sketch of John Maynard Keynes. Impress upon students that Keynes developed
the theory that emphasizes the importance of aggregate demand for economic performance.
You may want to point out that his theory changed the way economists viewed the modern
capitalist system and that he has been credited with the development of macroeconomics as
a separate field. Stress the debate that still lingers over whether the system is
self-correcting during periods of unemployment or inflation.
- Data to update Figure 9-1 may be
found in the most recent issue of Survey of Current Business or Economic
- Investment expenditures are the
most volatile segment of aggregate expenditures. Ask students to research a particular
industry to find out what factors are most likely to influence investment decisions for
that industry, or have students interview a local business manager or owner about their
decision to add capital equipment. Make a list of the factors that they consider when
making their decisions. Are they similar to the reasons given in the text? How were they
STUDENT STUMBLING BLOCKS
- The concept of equilibrium GDP
seems to be easy for students to grasp intuitively, but difficult for them to apply. Give
them a lot of practice in finding equilibrium GDP using questions similar to the
quantitative Key Questions at the end of the chapter.
- A bathtub or sink analogy is
helpful in explaining the "leakages-injections" approach. Imagine investment
coming in through a spigot as an injection, and saving going out of the income stream
through the drain. A stable water level represents an equilibrium GDP. Also, you could
draw in the "full-employment" water level to illustrate that the equilibrium
will not necessarily be at this stage.
- Nonbusiness majors may not be
familiar with the term "inventory," or with the idea that business inventories
represent an investment expenditure to businesses. This is key to understanding the
difference between actual and planned investment. Make sure the distinction is emphasized.
- If your class is filled with
struggling students consider using only one "macro model." It is very difficult
for beginning students to switch from one set of assumptions to another. The concept of
equilibrium can be presented using Aggregate Expenditures; Leakage-Injection; or AD-AS
presented in Chapter 11. Pick one and stick with it. The models in this chapter select
income as the main determinant. AD-AS uses the price level. Switching back and forth can
make anyone dizzy.
- This chapter and Chapter 10 focus
on the development of an analytical model called the aggregate expenditures model. We use
the definitions and facts from previous chapters to shift our study to the analysis of the
economy.The aggregate expenditures model is one tool in this analysis.
- The chapter begins with the
historical backdrop to the model.
- The focus is on the relationship
between income and consumption and savings.
- Investment spending, an important
part of aggregate expenditures, is also examined.
- Finally, these spending
categories are combined to explain the equilibrium levels output and employment in a
private (no government), domestic (no foreign sector) economy.
||Classical Economics and
- Until the Great Depression of the
1930, most economists going back to Adam Smith had believed that a market system would
ensure full employment of the economy's resources except for temporary, short-term
- If there were deviations, they
would be self-correcting. A slump in output and employment would reduce prices, which
would increase consumer spending; would lower wages which would increase employment again;
and would lower interest rates which would expand investment spending.
- Say's law, attributed to the
French economist J. B. Say in the early 1800s, summarized the view in a few words:
"Supply creates its own demand."
- Say's law is easiest to
understand in terms of barter. The shoemaker produces shoes in order to trade for other
needed products and services. All the shoes produced would be traded for something, or
else there would be no need to make them. Thus, supply creates its own demand.
- Reformulated versions of these
classical views are still prevalent among some modern economists today.
||The Great Depression and
- A.The Great Depression of the
1930s was worldwide. GDP fell by 40 percent in U.S. and unemployment rate rose to nearly
25 percent (when most families had only one breadwinner). The Depression seemed to refute
the classical idea that markets were self correcting and would provide full employment.
- John Maynard Keynes (see Last
Word) provided an alternative to classical theory, which helped explain periods of
- Not all income is always spent,
contrary to Say's law.
- Producers may respond to unsold
inventories by reducing output rather than cutting prices.
- A recession or depression could
follow this decline in employment and incomes.
- The modern aggregate expenditures
model is based on Keynesian economics or the ideas that have arisen from Keynes and his
followers since. It is based on the idea that saving and investment decisions may not be
coordinated, and prices and wages are not very flexible downward. Internal market forces
can therefore cause depressions without any external events like droughts, wars, and
||Simplifying Assumptions for
- We assume a "closed
economy" with no international trade.
- Government is ignored; focus is
on private sector markets until next chapter.
- Although both households and
businesses save, we assume here that all saving is personal.
- Depreciation and net income
earned abroad are assumed to be zero for simplicity. E.There are two reminders concerning
- They leave out two key components
of aggregate demand (government spending and foreign trade), but these parts of aggregate
demand are affected by other influences outside the market system.
- Without government and foreign
trade, we can treat GDP as being equal to national income (NI), personal income (PI), and
disposable income (DI).
||Tools of Aggregate
Expenditures Theory: Consumption and Saving
- The level of output and
employment depend directly on the level of total or aggregate expenditures. In this
chapter (once again) we will look only at the consumption and investment components of
- Consumption and saving:
- Disposable income is the most
important determinant of consumer spending (See Figure 9-1 in text which presents
- In Figure 9-1 we see a 45-degree
line which represents all points where consumer spending is equal to disposable income.
- If the actual graph of the
relationship between consumption and income is below the 45-degree line, then the
difference must represent the amount of income that is saved.
- Look at 1994 where consumption
was $4627 billion and disposable income was $4959 billion. Hence, saving was $332 billion.
- The graph also indicates that as
disposable income increases the amount of saving also increases.
- Some conclusions can be drawn:
- Households consume a large
portion of their disposable income.
- Both consumption and saving are
directly related to the level of income.
- The consumption schedule:
- Hypothetical consumption schedule
(Table 9-1 and Figure 9-2a ) shows that households spend a larger proportion of a small
income than of a large income.
- Hypothetical saving schedule
(Table 1, column 3) is illustrated in Figure 9-2b.
- Note that "dissaving"
occurs at low levels of disposable income, where consumption exceeds income and households
must borrow or use up some of their wealth.
- Average and marginal propensities
to consume and save:
- Define average propensity to
consume (APC) as a fraction of income consumed or consumer spending divided by income (APC
- Define average propensity to save
(APS) as a fraction of income saved or saving divided by income (APS = saving/income).
- Global Perspective 9-1 shows the
APCs for several nations.
- Marginal propensity to consume
(MPC) is the fraction or proportion of any change in income that is consumed. MPC = change
in consumption/change in income.
- Marginal propensity to save (MPS)
is the fraction or proportion ofany change in income that is saved. MPS = change in
saving/change in income.
- Note that APC + APS = 1 and MPC +
MPS = 1.
- Also, Figure 9-3 illustrates that
MPC is the slope of the consumption schedule, and MPS is the slope of the saving schedule.
- There are nonincome determinants
of consumption and saving, which can cause people to spend or save more or less at various
||Wealth: Increase in wealth
shifts the consumption schedule up and saving schedule down, but since wealth does not
change greatly from year to year, it won't account for large shifts in the schedules.
Expectations: Expected inflation or shortages in future will shift current consumption
schedule up. Consumer debt: Lower debt level shifts consumption schedule up and saving
schedule down. Taxation: Lower taxes will shift both schedules up, if they are originally
plotted against before-tax income and vice versa for higher taxes.
- Terminology: Movement from one
point to another on a given schedule is called a change in amount consumed; a shift in the
schedule is called a change in consumption schedule.
- Schedule shifts: Consumption and
saving schedules will always shift in opposite directions unless a shift is caused by a
- Stability: Economists believe
that consumption and saving schedules are generally stable unless deliberately shifted by
government action. (See Figure 9-4)
- Investment is the second
component of private spending.
- Expected rate of return will be a
- Interest rate will be the other
- Expected rate of return is found
by comparing the expected economic profit (total revenue minus total cost) to investment
cost to get expected rate of return.
- The real interest rate, i
(nominal rate corrected for expected inflation), is the cost of investment.
- Interest rate is cost of borrowed
- Interest rate is also cost of
investing your own funds, since it is income forgone.
- Investment demand schedule, or
curve, shows an inverse relationship between the interest rate and amount of investment.
- Based on expected return (see
Table 9-2 example).
- Rule: Invest up to the point at
which the expected rate of return equals the interest rate.
- Figure 9-5 shows the relationship
when the investment rule is followed. Fewer projects are expected to provide high return,
so less will be invested if interest rates are high. Shifts in investment demand: Any
factor that increases expected net profit will shift investment demand to the right and
vice versa (leftward shift) for any factor that decreases expected net profit.
- Causes of shifts in investment
demand: (See Figure 9-6)
- Acquisition, maintenance, and
operating costs of capital goods may change.
- Business taxes may change.
- Technology may change.
- Stock of capital goods on hand
will affect new investment.
- Expectations can change the view
of expected profits.
- The investment schedule shows the
amounts business firms collectively intend to invest at each possible level of GDP.
- In developing the investment
schedule, it is assumed that investment is independent of the current income. The line Ig(gross
investment) in Figure 9-7b shows this graphically.
- The assumption that investment is
independent of income is a simplification. A higher level of business activity may induce
additional capital spending for two reasons.
- Investment is related to profit
and profits are likely to rise with increases in GDP.
- At low levels of income and
output, excess capacity, idle machinery and equipment discourage additional capital
- Investment is a very unstable
type of spending. (See Figure 9-8)
- Capital goods are durable, so
spending can be postponed or not. This is unpredictable.
- Innovation occurs irregularly.
- Profits vary considerably.
- Expectations can be easily
- Look at Table 9-4, which combines
data of Tables 9-1 and 9-3.
- Real domestic output in column 2
shows ten possible levels that producers are willing to offer, assuming their sales would
meet the output planned. In other words, they will produce $370 billion of output if they
expect to receive $370 billion in revenue.
- Ten levels of aggregate
expenditures are shown in column 6. The column shows the amount of consumption and planned
gross investment spending (C + Ig) forthcoming at each output level.
- Recall that consumption level is
directly related to the level of income and that here income is equal to output level.
- Investment is independent of
income here and is planned or intended regardless of the current income situation.
- D.Equilibrium GDP is the level of
output whose production will create total spending just sufficient to purchase that
output. Otherwise there will be a disequilibrium situation.
- At $410 billion GDP level, total
expenditures (C + Ig) would be $425 = $405(C) + $20 (Ig) and
businesses will adjust to this excess demand by stepping up production. They will expand
production at any level of GDP less than the $470 billion equilibrium.
- At levels of GDP above $470
billion, such as $510 billion, aggregate expenditures will be less than GDP. At $510
billion level, C + Ig= $500 billion. Businesses will have unsold, unplanned
inventory investment and will cut back on the rate of production. As GDP declines, the
number of jobs and total income will also decline, but eventually the GDP and aggregate
spending will be in equilibrium at $470 billion.
- Figure 9-9 (Key Graph) is a
graphical representation of this information. At $470 billion it shows the C + Ig schedule
intersecting the 45-degree line which is where output = aggregate expenditures, or the
- Observe that the aggregate
expenditures line rises with output and income, but not as much as income, due to the
marginal propensity to consume (the slope) being less than 1.
- A part of every increase in
disposable income will not be spent but will be saved.
- Equilibrium GDP can also be
analyzed using another approach, the "leakages-injections" approach. It is less
direct, but it states that equilibrium GDP is where saving (S) = planned gross investment
- Since part of income is saved
rather than spent, saving represents a leakage from the income-expenditures stream.
- Business spending on investment
goods, on the other hand, can be considered an injection into the income-expenditures
stream because it is spending above that from household earnings.
- If the leakage is greater than
the injection, then aggregate spending will be less than GDP and this level of GDP is too
high to be sustained.
- Conversely, if the injection of
investment exceeds the leakage of saving, then aggregate expenditures will exceed planned
GDP and GDP will be driven up.
- To recap: Only where S = planned
Ig, where the leakage of saving is just offset by the injection of investment
will aggregate expenditures equal real output, and this is equilibrium GDP.
- In general, a leakage is any use
of income other than its spending on domestically produced output, which would also
include income "leaks" to import spending and tax payments.
- In general, any supplement to
consumer spending on domestic production is an injection. Injections also include export
earnings and government purchases.
- Looking back at Table 9-4, it can
be seen that at equilibrium GDP of $470 billion, saving and planned investment are equal
at $20 billion.
- Looking at Figure 9-10, this can
also be seen graphically. Only at $470 billion do businesses and households invest and
save at the same rates.
- Planned vs. actual investment
- It is important to note that in
our analysis above we spoke of "planned" investment.
- Actual investment consists of
what is planned plus (or minus) any unplanned changes in inventory investment. The
unplanned investment acts as a balancing item which always equates actual investment to
the actual amounts saved.
- If aggregate spending is less
than equilibrium GDP, then businesses will find themselves with unplanned inventory
investment on top of what was already planned. This unplanned portion is reflected as a
business expenditure, even though the business may not have desired it, because the total
output has a value that belongs to someone--either as a planned purchase or as an
- If aggregate expenditures exceed
GDP, then there will be less inventory investment than businesses planned as businesses
sell more than they expected. This is reflected as a negative amount of unplanned
investment in inventory. For example, at $450 billion GDP, there will be $435 billion of
consumer spending, $20 billion of planned investment, so businesses must have experienced
a $5 billion unplanned decline in inventory because sales exceed that expected.
- Summary: At above-equilibrium
GDP, saving exceeds planned investment, but actual investment will equal actual saving
because there will be unplanned increase in inventories. At below-equilibrium GDP, saving
is less than planned investment, but actual investment will equal actual saving because
there will be an unplanned decrease in inventories.
- A difference between saving and
planned investment causes a difference between the production and spending plans of the
economy as a whole.
- This difference between
production and spending plans leads to unintended inventory investment or unintended
decline in inventories.
- As long as unplanned changes in
inventories occur, businesses will revise their production plans upward or downward until
the investment in inventory is equal to what they planned. This will occur at the point
that household saving is equal to planned investment.
- Only where planned investment and
saving are equal will there be no unintended investment or disinvestment in inventories to
drive the GDP down or up. (Key Question 11)
||LAST WORD: John Maynard
- He is regarded as the originator
of modern macroeconomics.
- His book, The General Theory
of Employment, Interest, and Money (1936), revolutionized economic analysis.
- Personal characteristics:
- Was the son of an eminent English
- Had many diverse roles in
- Amassed a personal fortune
- Was a member of famous British
intellectual "Bloomsbury group".
- Prolific scholarship is his most
- General Theory is his most
important work. He suggested that recessions were not self-correcting.
- His recommendation for government
spending to induce more production was revolutionary at the time.
ANSWERS TO END OF CHAPTER
- Relate Say's law to the
perspective held by classical economists that the economy generally will operate at
aposition on its production possibilities curve (Chapter 2). Use production
possibilities analysis to demonstrate the Keynesian perspective on this matter.
Say's law states that
"supply creates its own demand." The economy operates at full employment
continuously because people engage in production in order to earn spendable income. They
spend the income they earn either directly on consumption or indirectly by channeling
saving into spending on investment goods. Thus, if we let the production possibilities
curve represent the tradeoff between consumption and investment, the economy will operate
on the curve, with the allocation of resources for producing consumption or investment
goods determined by society's choices on how to allocate their incomes.
The Keynesian perspective, on the other hand, suggests that society's savings will not
necessarily all be channeled into investment spending. If this occurs, we have a situation
in which aggregate demand is less than potential production. Because producers cannot sell
all of the output produced at a full employment level, they will reduce output and
employment to meet the aggregate demand (consumption plus investment) and the equilibrium
output will be at a point inside the production possibilities curve at less than full
- 9-2 Explain what relationships
are shown by (a) the consumption schedule, (b) the saving schedule, (c) the
investment-demand curve, and (d) the investment schedule.
- The consumption schedule or curve
shows how much households plan to consume at various levels of disposable income at a
specific point in time, assuming there is no change in the nonincome determinants of
consumption, namely, wealth, the price level, expectations, indebtedness, and taxes. A
change in disposable income causes movement along a given consumption curve. A change in a
nonincome determinant causes the entire schedule or curve to shift.
- The saving schedule or curve
shows how much households plan to save at various levels of disposable income at a
specific point in time, assuming there is no change in the nonincome determinants of
saving, namely, wealth, the price level, expectations, indebtedness, and taxes. A change
in disposable income causes movement along a given saving curve. A change in a nonincome
determinant causes the entire schedule or curve to shift.
- The investment-demand curve shows
how much will be invested at all possible interest rates, given the expected rate of net
profit from the proposed investments, assuming there is no change in the noninterest-rate
determinants of investment, namely, acquisition, maintenance, operating costs, business
taxes, technological change, the stock of capital goods on hand, and expectations. A
change in any of these will affect the expected rate of net profit and shift the curve. A
change in the interest rate will cause movement along a given curve.
- The investment schedule shows how
much businesses plan to invest at each of the possible levels of output or income.
- 9-3 Precisely how are the APC and
the MPC different? Why must the sum of the MPC and the MPS equal 1? What are the basic
determinants of the consumption and saving schedules? Of your own level of consumption?
The APC is an average whereby
total spending on consumption (C) is compared to total income (Y): APC = C/Y. MPC refers
to changes in spending and income at the margin. Here we are comparing a change in
consumer spending to a change in income: MPC = change in C / change in Y.
When your income changes there are only two possible options regarding what to do with it:
You either spend it or you save it. MPC is the fraction of the change in income spent;
therefore, the fraction not spent must be saved and this is the MPS. The change in the
dollars spent or saved will appear in the numerator and together they must add to the
total change in income. Since the denominator is the total change in income, the sum of
the MPC and MPS is one.
The basic determinants of the consumption and saving schedules are the levels of income
and output. Once the schedules are set, the determinants of where the schedules are
located would be the amount of household wealth (the more wealth, the more is spent at
each income level); expectations of future income, prices and product availability; the
relative size of consumer debt; and the amount of taxation.
Chances are that most of us would answer that our income is the basic determinant of our
levels of spending and saving, but a few may have low incomes, but with large family
wealth that determines the level of spending. Likewise, other factors may enter into the
pattern, as listed in the preceding paragraph. Answers will vary depending on the
- 9-4 Explain how each of the
following will affect the consumption and saving schedules or the investment schedule:
- A decline in the amount of
government bonds which consumers are holding
- The threat of limited,
non-nuclear war, leading the public to expect future shortages of consumer durables
- A decline in the real interest
- A sharp decline in stock prices
- An increase in the rate of
- The development of a cheaper
method of manufacturing pig iron from ore
- The announcement that the social
security program is to be restricted in size of benefits
- The expectation that mild
inflation will persist in the next decade
- An increase in the Federal
personal income tax
- If this simply means households
have become less wealthy, then consumption will decline and saving will increase. The
investment schedule will also shift down. However, if what is meant is that households are
cashing in their bonds to spend more, then the consumption schedule will shift up and the
saving schedule will shift down. If the increase in consumption should boost national
income, and if the investment schedule is then upsloping, there will be movement upward
(to the right) along it and investment will increase.
- This threat will lead people to
stock up; the consumption schedule will shift up and the saving schedule down. If this
puts pressure on the consumer goods industry, the investment schedule will shift up. The
investment schedule may shift up again later because of increased military procurement
- The decline in the real interest
rate will increase interest-sensitive consumer spending; the consumption schedule will
shift up and the saving schedule down. Investors will increase investment as they move
down the investment-demand curve; the investment schedule will shift upward.
- Though this did not happen after
October 19, 1987, a sharp decline in stock prices can normally be expected to decrease
consumer spending because of the decrease in wealth; the consumption schedule shifts down
and the saving schedule upwards. Because of the depressed share prices and the number of
speculators forced out of the market, it will be harder to float new issues on the stock
market. Therefore, the investment schedule will shift downward.
- The increase in the rate of
population growth will, over time, increase the rate of income growth. In itself this will
not shift any of the schedules but will lead to movement upward to the right along the
upward sloping investment schedule.
- This innovation will in itself
shift the investment schedule upward. Also, as the innovation starts to lower the costs of
producing everything made of steel, steel prices will decrease leading to increased
quantities demanded. This, again, will shift the investment schedule upward.(g) The
expected decrease in benefits will cause households to save more; the saving schedule will
shift upward, the consumption schedule downward.
- If this is a new expectation, the
consumption schedule will shift upwards and the saving schedule downwards until people
have stocked up enough. After about a year, if the mild inflation is not increasing, the
household schedules will revert to where they were before.
- Because this reduces disposable
income, consumption will decline in proportion to the marginal propensity to consume.
Consumption will be less at each level of real output, and so the curve shifts down. The
saving schedule will also fall because the disposable income has decreased at each level
of output, so less would be saved.
- 9-5 Explain why an upshift in the
consumption schedule typically involves an equal downshift in the saving schedule. What is
If, by definition, all that you
can do with your income is use it for consumption or saving, then if you consume more out
of any given income, you will necessarily save less. And if you consume less, you will
save more. This being so, when your consumption schedule shifts upward (meaning you are
consuming more out of any given income), your saving schedule shifts downward (meaning you
are consuming less out of the same given income).
The exception is a change in personal taxes. When these change, your disposable income
changes, and, therefore, your consumption and saving both change in the same direction and
opposite to the change in taxes. If your MPC, say, is 0.9, then your MPS is 0.1. Now, if
your taxes increase by $100, your consumption will decrease by $90 and your saving will
decrease by $10.
- 9-6 (Key Question)
Complete the accompanying table (top of next page).
- 9-7 What are the basic
determinants of investment? Explain the relationship between the real interest rate and
the level of investment. Why is the investment schedule less stable than the consumption
and saving schedules?
The basic determinants of
investment are the expected rate of net profit that businesses hope to realize from
investment spending and the real rate of interest.
When the real interest rate rises, investment decreases; and when the real interest rate
drops, investment increases--other things equal in both cases. The reason for this
relationship is that it makes sense to borrow money at, say, 10 percent, if the expected
rate of net profit is higher than 10 percent, for then one makes a profit on the borrowed
money. But if the expected rate of net profit is less than 10 percent, borrowing the money
would be expected to result in a negative rate of return on the borrowed money. Even if
the firm has money of its own to invest, the principle still holds: The firm would not be
maximizing profit if it used its own money to carry out an investment returning, say, 9
percent when it could lend the money at an interest rate of 10 percent.
For the great majority of people, their only saving is to buy a house and to make the
mortgage payments on it. Apart from that, practically their entire income is consumed.
Since for the majority of people their incomes are quite stable and since almost all their
income is consumed, the consumption and saving schedules are also quite stable. After all,
most consumption is for the essentials of food, shelter, and clothing. These cannot vary
Investment, on the other hand, is variable because, unlike consumption, it can be put off.
In good times, with demand strong and rising, businesses will bring in more machines and
replace old ones. In times of economic downturn, no new machines will be ordered. A firm
can continue for years with, say, a tenth of the investment it was carrying out in the
boom. Very few families could cut their consumption so drastically.
New business ideas and the innovations that spring from them do not come at a constant
rate. This is another reason for the irregularity of investment. Profits and the
expectations of profits also vary. Since profits, in the absence of easy access to
borrowed money, is essential for investment and since, moreover, the object of investment
is to make a profit, investment, too, must vary.
- 9-8 (Key Question) Assume
there are no investment projects in the economy which yield an expected rate of netprofit
of 25 percent or more. But suppose there are $10 billion of investment projects yielding
expected net profit ofbetween 20 and 25 percent; another $10 billion yielding between 15
and 20 percent; another $10 billion between 10and 15 percent; and so forth. Cumulate these
data and present them graphically, putting the expected rate of net profit on the vertical
axis and the amount of investment on the horizontal axis. What will be the equilibrium
level of aggregate investment if the real interest rate is (a) 15 percent, (b) 10 percent,
and (c) 5 percent? Explain why this curve is the investment-demand curve.
See the graph on previous page.
Aggregate investment: (a) $20 billion; (b) $30 billion; (c) $40 billion. This is the
investment-demand curve because we have applied the rule of undertaking all investment up
to the point where the expected rate of return, r, equals the interest rate, i.
- 9-9 Explain graphically the
determination of the equilibrium GDP by (a) the aggregate expenditures-domestic output
approach and (b) the leakages-injections approach for a private closed economy. Why must
these two approaches always yield the same equilibrium GDP? Explain why the intersection
of the aggregate expenditures schedule and the 45-degree line determines the equilibrium
These two approaches must always
yield the same equilibrium GDP because they are simply two sides of the same coin, so to
speak. Equilibrium GDP is where aggregate expenditures equal real output. Aggregate
expenditures consist of consumer expenditures (C) + planned investment spending (Ig).
If there is no government or foreign sector, then the level of income is the same as the
level of output. In equilibrium, Igmakes up the difference between C and the
value of the output.
If we let Y be the value of the output which is also the value of the real income, then
whatever households have not spent is Y - C = S. But at equilibrium, Y - C also equals Igso
at equilibrium the value of S must be equal to Ig. This is another way of
saying that saving (S) is a leakage from the income stream, and investment is an
injection. If the amount of investment is equal to S, then the leakage from saving is
replenished and all of the output will be purchased which is the definition of
equilibrium. At this GDP, C + S = C + Ig, so S = Ig.
Alternatively, one could explain why there would not be an equilibrium if (a) S were
greater than Igor (b) S were less than Ig. In case (a), we would
find that aggregate spending is less than output and output would contract; in (b) we
would find that C + Igwould be greater than output and output would expand.
Therefore, when S and Igare not equal, output level is not at equilibrium.
The 45-degree line represents all the points at which real output is equal to aggregate
expenditures. Since this is our definition of equilibrium GDP, then wherever aggregate
expenditure schedule coincides (intersects) with the 45-degree line, there is an
equilibrium output level.
- 9-10 (Key Question)
Assuming the level of investment is $16 billion and independent of the level of total
output, complete the following table and determine the equilibrium levels of output and
employment which this private closed economy would provide. What are the sizes of the MPC
of employment (millions)
Saving data for completing the
table (top to bottom): $-4; $0; $4; $8; $12; $16; $20; $24; $28.
Equilibrium GDP = $340 billion,
determined where (1) aggregate expenditures equal GDP (C of $324 billion + Iof $16
billion = GDP of $340 billion); or (2) where planned I= S(Iof $16
billion = Sof $16 billion). Equilibrium level of employment = 65 million; MCP = .8;
MPS = .2.
- 9-11 (Key Question) Using
the consumption and saving data given in question 10 and assuming the level of investment
is $16 billion, what are the levels of saving and planned investment at the $380 billion
level of domestic output? What are the levels of saving and actual investment? What are
saving and planned investment at the $300 billion level of domestic output? What are the
levels of saving and actual investment? Use the concept of unintended investment to
explain adjustments toward equilibrium from both the $380 and $300 billion levels of
At the $380 billion level of
GDP, saving = $24 billion; planned investment = $16 billion (from the question). This
deficiency of $8 billion of planned investment causes an unplanned $8 billion increase in
inventories. Actual investment is $24 billion (= $16 billion of planned investment plus
$8 billion of unplanned inventory investment), matching the $24 billion of actual
At the $300 billion level of GDP, saving = $8 billion; planned investment = $16 billion
(from the question). This excess of $8 billion of planned investment causes an unplanned
$8 billion decline in inventories. Actual investment is $8 billion (= $16 billion
of planned investment minus $8 billion of unplanned inventory disinvestment)
matching the actual of $8 billion.
When unplanned investments in inventories occur, as at the $380 billion level of GDP,
businesses revise their production plans downward and GDP falls. When unintended
disinvestments in inventories occur, as at the $300 billion level of GDP; businesses
revise their production plans upward and GDP rises. Equilibrium GDP--in this case, $340
billion--occurs where planned investment equals saving.
- 9-12 "Planned investment is
equal to saving at all levels of GDP; actual investment equals saving only at the
equilibrium GDP." Do you agree? Explain. Critically evaluate: "The fact that
households may save more than businesses want to invest is of no consequence, because
events will in time force households and businesses to save and invest at the same
You should not agree. The
statement is backward--reverse the placement of the planned investment and actual
investment. Actual investment is always present--it is the amount that actually takes
place at any output level because it includes unintended changes in inventories (a type of
investment) as well as the level of planned investment. If saving is greater than planned
investment, the total level of aggregate spending will not be enough to support the
existing level of output, causing businesses to reduce their output. If saving is less
than planned investment, the total level of aggregate expenditures will be greater than
the existing output level and inventories will drop below the planned level of inventory
investment, causing businesses to increase their output to replenish their inventories.
The only stable output level will be the equilibrium level, at which saving and planned
investment are equal.
The events described in the second quote are predictable, but most would argue that this
is of great consequence. When households save more than businesses want to invest, it
means they are consuming less. This, in turn, means that aggregate spending (consumption
plus investment) will be less than the level of output and current real income. Businesses
will experience unplanned inventory buildup and will cut their output levels, which means
a decline in employment. The resulting unemployment is not inconsequential--especially to
those who lose their jobs, but also in terms of lost potential output for the entire
- 9-13 Advanced analysis: Linear
equations (see appendix to Chapter 1) for the consumption and saving schedules take the
general form C = a + bY and S = - a + (1- b)Y, where C, S, and Yare
consumption, saving, and national income respectively. The constant arepresents the
vertical intercept, and bis the slope of the consumption schedule.
- Use the following data to
substitute specific numerical values into the consumption and saving equations.
- What is the economic meaning of
b? Of (1 - b)?
- Suppose the amount of saving
which occurs at each level of national income falls by $20, but that the values for b and
(1 - b) remain unchanged. Restate the saving and consumption equations for the new
numerical values and cite a factor which might have caused the change.
- C = $80 + 0.6Y S = -$80 + 0.4Y
Since b is the slope of the
consumption function, it is the value of the MPC. (In this case the slope is 6/10, which
means for every $10 increase in income (movement to the right on the horizontal axis of
the graph), consumption will increase by $6 (movement upwards on the vertical axis of the
graph). (1 - b) would be 1 - .6 = .4, which is the MPS.
Since (1 - b) is the slope of
the saving function, it is the value of the MPS. (With the slope of the MPC being 6/10,
the MPS will be 4/10. This means for every $10 increase in income (movement to the right
on the horizontal axis of the graph), saving will increase by $4 (movement upward on the
vertical axis of the graph).
- C = $100 + 0.6Y S = -$100 + 0.4Y
A factor that might have caused
the decrease in saving--the increased consumption--is the belief that inflation will
accelerate. Consumers wish to stock up before prices increase. Other factors might include
a sudden decline in wealth or increase in indebtedness, or an increase in personal taxes.
- 9-14 Advanced analysis: Suppose
that the linear equation for consumption in a hypothetical economy is C = $40 + .8Y.
Also suppose that income (Y) is $400. Determine (a) the marginal propensity to
consume, (b) the marginal propensity to save, (c) the level of consumption, (d) the
average propensity to consume, (e) the level of saving, and (f) the average propensity to
- MPC is .8
- MPS is (1 - .8) = .2
- C = $40 + .8($400) = $40 + $320 =
- APC = $360/$400 = .9
- S = Y - C = $400 - $360 = $40
- APS = $40/$400 = .1 or 1 - APC
- 9-15 Advanced analysis: Assume
that the linear equation for consumption in a hypothetical private closed economy is C=
10 + .9Y, where Yis total real income (output). Also suppose that the
equation for investment isIg= Ig0= 40, meaning that Igis
40 at all levels of real income (output). Using the equation Y = C + Ig,determine
the equilibrium level of Y. What are the total amounts of consumption, saving, and
investment at equilibrium Y?
Y = 500, C= 460, Ig=
40, S= 40
To obtain these results,
recognize that at equilibrium aggregate demand (C + Ig) must equal Ywhich
represents output. Therefore the solution for equilibrium Yis where:
Y = C + 40 = (10 + .9Y)
+ 40 or Y= .9Y+ 50 or Y - .9Y= 50, which means that Y=
From this we can find C=
10 + .9 (500), which is 460
Since saving equals Investment
at equilibrium, S = 40
- 9-16 (Last Word) What is the significance
of John Maynard Keynes book, The General Theory of Employment, Interest, and
Money, published in 1936?
The significance of The General Theory is
that it provided a plausible explanation and theory for long-run unemployment and
recession or depression. Classical theory had no explanation for the existence of such
problems in economics and denied that they could exist, even when it was obvious that
unemployment was often persistent. Keynes suggested that there was no automatic market
mechanism propelling the economy to full employment. His basic policy recommendation was
for government to increase its spending to induce more production and put people back to
work. The General Theory is often credited with originating the study of modern