ECO 102

LECTURE NOTES

TOPIC 3

THE AGGREGATE EXPENDITURE (KEYNESIAN) MODEL

➢ The Classical Versus the Keynesian View of the

Economy
➢ Income Determination in a Closed Economy (The
Aggregate Expenditure Model)
➢ The Consumption & Savings Functions
➢ The Investment Function
➢ The Multiplier Effect

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TOPIC 3: THE AGGREGATE EXPENDITURE (KEYNESIAN) MODEL

3.1. THE CLASSICAL VERSUS KEYNESIAN VIEW OF THE ECONOMY

3.1.1. The Classical View of the Economy:
• The classical school of economics thought emanated in the 18th century and
it was spearheaded by economists such as Adam Smith & Irvin Fisher who
were later followed by Robert Malthus & David Ricardo amongst others.
• The main idea of the classical school of thought was that markets work best
when they are left to work on their own; and there is zero government
intervention.
• The classical theory believed in a perfect market system that would self-
correct itself when there are deviations from full employment or equilibrium
in the economy.
• The classical theory acknowledge that some occurances in the economy such
as; drought, floods, wars, etc. could move the economy away from its
equilibrium state/full employment. The classical school believed that the
economy will adjust automatically (self-correct) so that it restores itself back
to the equilibrium position.
• The classical economists strongly believed in Say’s law; which says that,
“Supply creates its own demand”. For example: A medical doctor supplies
medical services as a means of buying other goods that he demands; such as
clothing, food etc. Therefore, the doctor’s supply of medical services
provides income that the doctor will use/spend of the other goods that he
demands. Hence, his demand for the goods & services must be equal to the
supply; and this ensures that all markets attain equilibrium/ full employment
position.
• The classical theory was the dominant economic theory up until the onset of
the Great Depression in the early 1930’s.

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3.1.2. The Keynesian View of the Economy:
• The great depression of the 1930’s affected most economies in such a way
that economies experienced escalating levels of unemployment and national
incomes of most economies fell drastically. The economy failed to self-
correct itself back to equilibrium as the classical economists had postulated.
• John Maynard Keynes in his book entitled, “The general theory of
employment, interest and money”, criticized the classical school of thought
proposition that the economy will automatically adjust back to equilibrium
during a crisis.
• Keynes criticized, in particular, Say’s law; and he pointed out that not all
income earned in any one period is all spent on the output produced in that
period. Keynes said that, there is a possibility of under-spending (saving) in
one period; therefore, not all the output produced/supplied is purchased
/demanded/consumed. Thus, stocks produced begin to rise, because of
excess supply, and this indicates that firms should cut back/down on
production. When that happens, then some firms will lay-off workers and
this will exacerbate the level of unemployment in the economy.
• The Classical economists believed Say’s law that says that, “supply creates its
own demand”, which basically implies that the supply side (production
process) is the most important feature of the macro economy.
• However, Keynes argued that it is the demand side that is actually important,
and not the supply side as the classical theorists postulated. In a nutshell,
Keynes is saying the opposite of the classical theory. Keynes is saying, it is,
“demand that creates supply”.
• For example: Keynes is saying that an increase in demand leads to a fall in
stocks, which sends a signal to firms to increase production (output), and
firms need to hire more people (increase employment).
• Keynes also criticized the classical theory proposition that says that ‘markets
are perfect’. Keynes instead, postulated that markets were imperfect,
because in times of crises, the markets fail to produce efficient outcomes.
• Keynes, therefore, recommended that there is need for government
intervention to play an active role in ensuring that the economy maintains a
full employment/ equilibrium position.

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 • Therefore, Keynes is the originator/founder of the central idea underlying
the aggregate expenditure model.

3.2. THE INCOME DETERMINATION IN A CLOSED ECONOMY

3.2.1. The Simple Aggregate Expenditure Model:

• The main aim of the Keynesian model is to explain how national income is
determined.
• The aggregate expenditure model developed in this topic is based on
Keynesian ideas that the level of economic activity is determined by
aggregate (total) spending.
3.2.2. Assumptions of the Aggregate Expenditure Model:
i) The economy consists solely of households & firms. This means that total
spending includes only consumption by households and investment by
firms.
ii) Prices & wages are given; implying that the model cannot be used to study
inflation, nor can it be used to study the workings of the labor market.
iii) The money supply & interest rate are also determined outside the model
(i.e. they are exogenous variables in the model).
iv) Spending is the driving force solely responsible for the determination of
the level of economic activity; i.e. supply passively responds to changes
in demand, and not the other way round as postulated by the classical
theory.
3.2.3. Components of the Simple Aggregate Expenditure Model:
• We will study the aggregate expenditure model using equations that
describe each of the components of aggregate expenditure. The
components are: The consumption function; the savings function and the
investment function. i.e.
AD = C(Y) + I(Y,i)

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 3.3. THE CONSUMPTION FUNCTION AND SAVINGS FUNCTION

3.3.1. THE CONSUMPTION FUNCTION

• Consumption is defined as that part of disposable income (Yd) that is not

saved:

Disposable Income (Yd) = Consumption (C) + Savings (S)

Yd = C + S………………………………………………………………………………………………(1)

• In equation (1), make C the subject and get a consumption function as

follows:

C = Yd – S……………………………………………………………………………………………….(2)

• Recall that factors that influence the level of consumption spending are:
i) Tastes & preferences
ii) Disposable income (Yd)
iii) Savings (S)
• The consumption function in equation (2), therefore, describes the
relationship between private consumption expenditure and the disposable
income.
• Note, that when the household income is zero, the household will still spend
on some minimal amounts of consumption that includes: shelter, food &
clothing (basic needs).
• The household will use handouts, beg, borrow and even draw down their
savings to cover for these basic needs.
• Thus, the consumption that occurs when income for the household is zero is
called the, “AUTONOMOUS CONSUMPTION”.
• We can now represent the consumption function in a linear form as follows:

C = c0 + c1Yd……………………………………………………………………………………………(3)

Where: c0 is the autonomous consumption

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 c1 is the marginal propensity to consume and it lies between 0 & 1
i.e. 0 < c1 < 1
• Note: that the autonomous consumption (c0) does not depend on the
disposable income (Yd). It could be financed out of past accumulation of
wealth.
• The marginal propensity to consume (c1), describes how much consumption
spending increases in response to each unit increase in disposable income.
We note that the c1 is a positive fraction.

3.3.2. THE SAVINGS FUNCTION

• Because saving is defined as the disposable income that is not consumed, we
can present it as follows:

From Yd = C + S in equation (1), make S the subject and get:

S = Yd – C………………………………………………………………………………………………(4)

• Substituting the linear consumption function (equation 3) into the savings

function (equation 4) yields:

S = Yd – [c0 + c1Yd]………………………………………………………………………………..(5)

• Open up the brackets in equation (5) and collect like terms and get:
S = Yd – c0 – c1Yd collect like terms

S = - c0 + [1-c1]Yd……………………………………………………………………………………(6)

Where: c0 is the autonomous consumption spending and

[1-c1] is the marginal propensity to save.
• Note:
i) The marginal propensity to save [1-c1] measures how much of each E1
of disposable income is saved.

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 ii) Because saving is defined as the disposable income that is not
consumed, then the consumption function implicitly defines a savings
function.
3.3.3. THE AVERAGE PROPENSITIES TO CONSUME & SAVE
• Recall that the marginal propensities look at a change in one value in terms
of another. They actually measure the slopes of the various functions (i.e.
consumption & savings function).
• The average propensities, on the other hand, measure the total expenditures
divided by the total disposable incomes.
• Hence, the average propensity to consume (APC), refers to the total
consumption expenditure divided by the total disposable income:

APC = C/Yd……………………………………………………………………………………………(7)

• Likewise, the average propensity to save (APS), refers to the total savings
divided by the total disposable income:

APS = S/Yd……………………………………………………………………………..……………(8)

3.3.4. NON-INCOME DETERMINANTS OF CONSUMPTION AND SAVINGS

Other factors affecting consumption, besides the disposable income are:
i) WEALTH:
• Wealthier households that have accumulated wealth over time in real assets
such as: houses, motor vehicles, household goods etc. are more likely to
consume a larger amount at any current income. Therefore, an increase in
wealth will shift the saving function downwards, and the consumption
functions will shift upwards.

ii) HOUSEHOLD DEBT:

• When households have easy access to credit, they are able to increase their
current consumption at each level of their disposable income. Therefore, the

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 consumption function will shift upwards if households increase their debt.
That means that there is a positive relationship between the household debt
and the consumption spending.
• If households reach a point where they have accumulated debt, then they
may decide to reduce their consumption to pay off their debt. This will shift
the consumption downwards.

iii) EXPECTATIONS:
• Household expectations can also affect the current
consumption/spending patterns.
• If households expect a rise in prices or a shortage of goods & services in
the next few days; then this may trigger more spending today and less
saving for the future.
• As households spend on goods & services today, they will utilize more of
their disposable income today. This will result in a shift in the
consumption function upwards, while the savings curve will shift
downwards.

iv) TAXATION:
• An increase in taxes will shift both the consumption and savings curves
downwards, because the increase in tax means that households consume
less and save less. There is therefore, a negative relationship between
taxes and the saving & consumption spending.

v) INCOME DISTRIBUTION:
• Low income households have a higher propensity to spend than high
income households.
• This means that low income households actually spend a larger portion of
their incomes than do the higher income households.
• Thus, the total level of consumption is also dependent on the distribution
of total income in the economy.

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 • Changes in income distribution (i.e. through grants) will also trigger
changes in consumption patterns. Therefore, this will shift the
consumption curve upwards.

3.4. THE INVESTMENT FUNCTION

3.4.1. Types of Investments:
• Investment is another component of the aggregate expenditure model.
• Investment spending takes three main forms in practice, which are:
i) Spending by businesses on new plant & equipment (Business Fixed
Investment).
ii) Spending by households on new residential housing (Residential Fixed
Investment).
iii) Changes in inventories (Inventory Investment).

3.4.2. Investment & Interest Rate:

• Any investment spending responds to changes in interest rates.
• Examples:
i) In the residential fixed investment; households are reluctant to build
new houses when the mortgage interest rates are high. This means
that there is a negative relationship between investment spending and
the level of interest rate.
ii) In the business fixed investments, on the other hand, interest rates
represent the cost of funding for projects they are investing in. Thus,
businesses regard the interest rate as an opportunity cost of the funds
used for that investment project.

3.4.3. Investment & Income:

• Investment spending also responds to changes in income.
Examples:
i) Households whose incomes have increased are better able to afford
new houses.

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 ii) Businesses that enjoy high profits have more funds available to finance
new projects.
• From the examples above we learn/conclude that there is a positive
relationship between investment spending and income.
• We can present the investment function in a general form as follows:

I = I (Y, i)……………………………………………………………………………………….……..(9)

Where: i represents the interest rate; Y is the income level.

• We can also present equation (9) in a linear form as follows:

I = b0 + b1Y – b2i…………………………………………………………………………………..(10)

Where: b0 is the autonomous investment; b1 is the marginal propensity to

invest and it is a positive fraction (0<b1<1); b2 is the interest sensitivity of
investment.
• Note:
i) That the autonomous investment spending b0, is that investment
spending that does not depend on income or credit conditions.
ii) Since the Keynesian model of aggregate spending is regarded as
‘Simple’, we will impose two assumptions on the investment function,
which are:
i) We assume that there is a constant interest rate ( 𝑖̅ ), in order to
eliminate any variations in investment.
ii) We assume that b1, the marginal propensity to invest is zero, so
that our investment function is constant as follows:

̅𝑰 = 𝒃𝟎 − 𝒃𝟐 𝒊̅……………………………………………..……………………..(11)

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3.5. THE AGGREGATE EXPENDITURE MODEL:
• The aggregate demand is the sum of consumption spending and investment
spending in the simple Keynesian model. The general form of the aggregate
expenditure model is represented as follows:

AD = C(Y) + I(Y,i) which is the same as;

AD = C + I……………………………………………………………………………………………(12)
• Since both components of the aggregate demand function (C & I) are direct
functions of income; we expect aggregate demand to be positively/directly
related to the level of income.
• To derive the linear aggregate demand function, we substitute the linear
consumption function (equation 3) and the constant the constant level of
investment (𝐼 )̅ , so that the aggregate demand/expenditure model in linear
form becomes:
𝑨𝑫 = 𝑪 + ̅𝑰

𝑨𝑫 = 𝒄𝟎 + 𝒄𝟏 𝒀𝒅 + ̅𝑰……………………………………………………………………….(13)

• Recall that the disposable income is the income less taxes:

𝒀𝒅 = 𝒀 − 𝑻…………………………………………………………………………………………(14)

• Substitute (14) into (13) and get:

𝑨𝑫 = 𝒄𝟎 + 𝒄𝟏 [𝒀 − 𝑻) + ̅𝑰 open up the brackets yields:

𝑨𝑫 = 𝒄𝟎 + 𝒄𝟏 𝒀 − 𝒄𝟏 𝑻 + ̅𝑰 put all constants together and get:

𝑨𝑫 = [𝒄𝟎 − 𝒄𝟏 𝑻 + ̅𝑰] + 𝒄𝟏 𝒀…………………………………………………………….(15)

• Note that the aggregate demand function (equation 15) is linear because it
has an intercept [𝒄𝟎 − 𝒄𝟏 𝑻 + 𝑰̅]and a slope 𝒄𝟏 .
• We also note that the slope of the aggregate demand function
(𝒄𝟏 ) is the marginal propensity to consume. This makes good sense

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 because consumption spending is the only kind of spending that responds to
the changes in the level of income if we assume that the marginal propensity
to invest is zero.
• Graphically the aggregate expenditure/demand function for a simple
Keynesian model (equation 15) is presented as follows:

Figure 3.1: The Simple Keynesian Aggregate Expenditure Function

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 3.6. DETERMINATION OF THE EQUILIBRIUM IN THE PRODUCT MARKET

• The aggregate expenditure function expresses total planned spending as a

function of the level of income or output.
• The economy will be at equilibrium when the firms have collectively chosen
to produce the level of output that exactly equals to the level of demand
(AD = Y).
• Mathematically, the equilibrium condition in the product market, is
attained where final goods & services are bought and sold. The equilibrium
condition is therefore; expressed as follows :+

AD = Y……………………………………………………………………………………………….(16)

• If we substitute the linear aggregate demand function (equation 15), into

the equilibrium condition (equation 16) we get:

AD = Y

[𝒄𝟎 − 𝒄𝟏 𝑻 + ̅𝑰] + 𝒄𝟏 𝒀 = Y collect like terms and get:

𝒀 − 𝒄𝟏 𝒀 = 𝒄𝟎 − 𝒄𝟏 𝑻 + ̅𝑰 factor out Y and get:

𝒀(𝟏−𝒄𝟏 ) 𝒄𝟎 −𝒄𝟏 𝑻+ 𝑰̅
= simplify and get:
𝟏− 𝒄𝟏 𝟏− 𝒄𝟏

𝟏
𝒀∗ = [𝒄𝟎 − 𝒄𝟏 𝑻 + 𝑰̅]…………………………………………………………………(17)
𝟏− 𝒄𝟏

𝟏
Where: represents/ is called the, “MULTIPLIER”.
𝟏− 𝒄𝟏

• We can represent the multiplier using a symbol ‘m’, where :

𝟏
𝒎= ………………………………………………………………………………………………(18)
𝟏− 𝒄𝟏
• The parameters in brackets in equation 17, represent all the spending that
is independent of the level of income (Autonomous spending).

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 • In a nutshell, equation 17, tells us that in the Keynesian theory the
economy achieves an equilibrium level of income (Y*) equals to the
𝟏
autonomous spending [𝒄𝟎 − 𝒄𝟏 𝑻 + 𝑰̅] multiplied by the multiplier( ).
𝟏− 𝒄𝟏

3.7. THE MULTIPLIER

• The multiplier tells us the extent to which the rate of total spending will
change in response to an initial change in the flow expenditure.
• The multiplier is a measure of the magnitude of changes in income.
• It is the ration of the change in income due to the change in expenditure;
i.e, the change in national income, divided by the change in autonomous
expenditure.
𝟏
• Mathematically, it is represented as 𝑚 = for a simple Keynesian
𝟏− 𝒄𝟏
model.

**************************GOOD LUCK****************************

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