The Keynesian System I:

The Role of Aggregate Demand

Chapter 6

Professor Steve Cunningham

Intermediate Macroeconomics
ECON 219
Great Depression (1)
Year U.S. Unemployment Rate
1929 3.2%
1930 8.7%
1931 15.9%
1932 23.6%
1933 24.9%
↓ ↓
1939 17.2%
2
Great Depression (2)
 General Conditions
– GNP fell 30% from 1929-1933
– Gov’t Tax Revenues fell 50%
• Hoover raised highest marg. tax rates from 25% to
63%, making the 2.5 times higher!
– By 1933, machine tool orders were 1/8 their
1929 level
– More than 9,000 banks closed
– Factories and mines were closed down, towns
went bankrupt and were abandoned
3
Great Depression (3)
 Prices
– GNP Deflator fell 24% from 1929-1933
– Farm Product Prices fell 50%
– Crude oil was 5 cents per barrel
 Financial Markets
– Interest Rates fell
– Equivalent Dow Jones Average = 300

4
Keynes

“ 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

5
The Early J. M. Keynes
 Born in 1883 in Cambridge, England
 Son of John Neville Keynes
– Neville was a professor of Economics and Logic at Cambridge
Univ., and wrote on Economic Methodology
 Won a scholarship to Eton
 Boy Genius
– Won prizes for his work in the classics, mathematics, history,
English essays
– Wrote papers on contemporary social problems, participated
in crew and debate, acted, read everything
– Became an expert in medieval latin poetry
 Part of Eton’s social elite
 Won a scholarship to King’s College, Cambridge

6
Keynes as a College Student
 President of the Student Union
 President of the University Liberal Club
 Rowed, studied philosophy, played bridge,
visited art galleries, collected rare books,
went to the theatre
 Became a member of the “Apostles”, a
secret and highly exclusive Cambridge
intellectual society

7
After Graduation
 Briefly studied economics, but did poorly on his
exams.
 Took a civil service exam and took a job at the
India Office.
 1908, his father managed to get him a job as a
lecturer at King’s College. Later he became a
Fellow.
 1911, he became editor of the Economic Journal.
 Worked at the Treasury during WWI.
 1921, he published A Treatise on Probability.
8
After WWI
 Keynes wrote the Economic Consequences of the
Peace, regarding reparation payments
– Best Seller
– Made him a public celebrity
 1923 Tract on Monetary Reform (against returning
to the pre-war gold standard)
 Economic Consequences of Mr Churchill (warned
of depression)
 1930 Treatise On Money
 1936 General Theory of Employment, Interest and
Money
 1937, he has a serious heart attack
9
Comment by Samuelson
“It is a badly written book, poorly organized; any layman who,
beguiled by the author’s previous reputation, bought the book
was cheated of his 5 shillings. It is not well suited for classroom
use. It is arrogant, bad-tempered, polemical, and not overly-
generous in its acknowledgements... In it the Keynesian system
stands out indistinctly, as if the author were hardly aware of its
existence or cognizant of its properties; and certainly he is at his
worst when expounding on its relations to its predecessors.
Flashes of insight and intuition intersperse tedious algebra. An
awkward definition gives way to an unforgettable cadenza. When
it is finally mastered, we find its analysis to be obvious and at the
same time new. In short, it is the work of genius.”
10
Keynes’ Vision (1)
1. If the consumer is an economic optimizer,
he/she must be unable to buy the goods they
planned to buy because of some kind of
constraint—risk, convention, social institutions,
cash, or ...?
a) According to the classical model, the consumer has
insatiable wants.
b) The consumer sells his/her labor in exchange for
enough income to buy the goods.
c) The money value of the incomes received must be
equal to the value of the output produced.
d) So how can unsold goods pile up in warehouses,
causing firms to lay off workers?
11
Keynes’ Vision (2)
2. Say’s Law cannot hold. (“Supply
creates its own demand.”)
a) If spending constraints are in effect,
then there will be a difference between
(unlimited) demand and “effective
demand”.
b) Actual (effective) demand will usually
be “deficient” to purchase total
output.

12
Keynes’ Vision (3)
3. Microeconomics and macroeconomics do
not operate on the same basis. One
cannot assume that what is true for the
economic agent at the level of the
individual consumer or firm is true in
aggregate. This amounts to the fallacy of
composition.
– In microeconomics, relative price effects
dominate. This is not true in macroeconomics.
In macroeconomics, income effects dominate,
making income more important in determining
aggregate economic behavior. 13
Keynes’ Vision (4)
4. Therefore, consumption depends
primarily upon income, not interest
rates.
– C ≠ C(r), but rather C = C(Y)
– “People don’t change their standard of
living simply because the interest rate
changes a few points.”

14
Keynes’ Vision (5)
5. Saving occurs as the result of a habit,
convention, or social norm. People on
average set aside a certain percentage of
their income. Saving is not a function of
interest rates.
 S ≠ S(r), but rather S = S(Y)
5. Investment is related to interest rates,
but also to businesspeople’s
expectations for the future.
 That is, I = I(r,E).
15
Keynes’ Vision (6)
7. If S = S(Y) and I = I(r,E), then there is no
coordinating variable to bring supply and demand
together in the loanable funds (capital) market.
– There is no reason to assume that supply equals
demand in this market.
– There is no reason to believe that there will be adequate
funds available to provide adequate investment demand.
– Since AD = C + I + G + NX, if investment demand is
deficient, then AD < AS, and inventories may pile up,
with unemployment a natural outcome.
– Without the coordinating variable, this will be the normal
outcome, with AD = AS only happening accidentally.

16
Keynes’ Vision (7)
8. Investment is a large and long-term
commitment, and is based on weakly
supported expectations about the future.
This makes investment very different
from consumption. Investment decisions
will be erratic and emotional, and the
risks associated with investment are very
high. As a result, business decision
makers will tend to under-invest, further
worsening the problem of deficient
investment.
17
Keynes’ Vision (8)
9. It may be a natural outcome of the
organization and institutions of modern
economies that prices and wages may
not be fully flexible. This would result in
markets (like the labor and goods
markets) being unable to clear, leading
to unemployment and aggregate supply
exceeding demand.

18
Keynes’ Vision (9)
10. Money plays a key role in the economy. The
use of money leads to uncertainty, and makes
“piercing the veil” impossible. A money
economy is fundamentally different from a
barter economy. The classical dichotomy
cannot hold.
– Interest rates are established in the money market.
– People may rationally hoard money, holding money
for purposes other then making transactions.
11. Equilibrium is not AD = AS. It is a state that
persist.

19
Some Accounting
Assume a closed economy:
Output = Aggregate Expenditure = National Product
Y = E = C + I + G = C + Ir + G
But Y is also income, and from income we purchase
consumer goods (C), save (S), or pay taxes (T), so
Y=C+S+T
So that
C+S+T=C+I+G
Or
S+T=I+G
Which means that saving and taxes paid by the public must
finance investment and government spending. 20
More Accounting

Similarly,
C + Ir + G = Y = C + I + G
Or, by canceling terms,
Ir = I
This gives us three equivalent conditions for equilibrium in the
Keynesian model:
(1) Y = C + I + G
(2) S + T = I + G
(3) Ir = I
21
Keynes’ Initial Assumptions
 On the short run, quantity adjustments are more
important than price adjustments.
 Quantities demanded can change more rapidly
than prices, which is why you can have
temporary shortages of goods.
 So aggregate expenditure (demand) determines
the volume of goods that firms sell.
 Producers, government, and consumers all make
plans that may or may not be achieved.
– In the short run, all plans are fixed, except for planned
consumption expenditure because it alone varies with
income.
22
Is C related to Income?

7000
6000
5000
Consumption

4000
3000
2000
1000
0
0 2000 4000 6000 8000 10000
Real GDP
U.S. Annual Data, 1929 - 2001
23
Regression Results
 Over 99% of the variation in consumption
expenditures is explained by GDP. (R2 =
99%)
 Slope is 0.67.
– Roughly 67¢ out of every dollar of new income
(GDP) is spent on consumption goods.
 This
gives us good reason to suspect that
Consumptions follows a relationship like:
C = C0 + cY or C = C0 + cYd
24
Consumption Function
c = mpc = ∆ C/∆ Yd = marginal propensity to consume
C

C = C0 + mpc x Yd
∆C Or
∆ Yd C = C0 + cYd
C0

Yd

25
Saving and Dissaving
Planned C
Yd (if C = Yd)

Dissaving C
C > Yd

Saving
Yd > C

Yd1 Yd* Yd2 Yd

26
Saving Function
 Since Y = C + S + T
and
Yd = Y – T
 Yd = C + S
 So, if C = C0 + cYd, then
S = -C0 + (1-c)Yd, or
 S = S0 + sYd, or equivalently
S = S0 + mps x Yd,
where mps = marginal propensity to save
 Note that: mps + mpc = 1
27
Note
 In the classical model:
 C = C(r)
 S = S(r)
 In the Keynesian model:
 C = C(Yd)
 S = S(Yd)

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Investment
 Capital goods have a long life.
 Capital goods take time to build.
 Large expenditure.
 Value of investment is related to the income
stream it can generate over a very long time
horizon.
– This requires business people to form expectations
about future business conditions and profitability.
– Investment is inherently risky.
 As a result of these things, the investment
expenditure tends to be erratic.

29
Present Value and MEC
In the classical model, the business decision maker compared the
interest rate to the current marginal productivity of capital:
∆Y
r=
∆K
Keynes reminds us of the long life and income stream available from
capital, and compares the interest rate to the present value of the future
profit stream of the capital. He does this by finding the discount factor
d that makes the value of the investment equal to the future stream of
income:
π2 π3 πn
I = π1 + + ++
1 + d (1 + d ) 2
(1 + d ) n−1
He then compares d to the interest rate. If d > r, then investment is
profitable. The variable d is called the marginal efficiency of capital.
30
Investment and the MEC
 The MEC is essentially the modern finance
concept called the internal rate of return.
 The businessperson’s formation of expectations
about the future profit stream is pure speculation,
and tends to make investment erratic.
 Although this is a more sophisticated look at
investment than the classicals, still we have that
investment depends upon interest rates (and
expectations). I = I(r)
 Note that I ≠ I(Y) and I ≠ I(Yd)

31
 o
Real GDP exceeds 45 line

(trillions of 1992 dollars/year)

Aggregate planned expenditure
planned expenditure
10.0
Total Expenditure
C+I+G
8.0
f

d e
6.0

4.0
b c Equilibrium
expenditure

a Planned
C0 expenditure
exceeds
G real GDP
I
0 2 4 6 8 10
Real GDP (trillions of 1992 dollars32
per year)
 Stability of the Equlibrium o
45 line

(trillions of 1992 dollars/year)

Aggregate planned expenditure 10.0
Total Expenditure
C+I+G
8.0
f
Increase Output,
increase Employment d e
6.0 Reduce Output,
c Reduce Employment
b
4.0

0 2 4 6 8 10
Real GDP (trillions of 1992 dollars33
per year)
Algebra of the Model

Y=C+I+G But this means that

1
but C = C0 + c(Y-T), so ∆Y = ∆G
1− c
Y = C0 + c(Y-T) + I + G 1
∆Y = ∆I
Y = C0 + cY – cT + I + G 1− c
1
Y – cY = C0 + I + G – cT ∆Y = ∆C
1− c
but
Y(1-c) 1= C0 + I + G – cT
Y* = [C0 + I + G − cT ] −c
∆Y = ∆T
1− c 1− c
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Multipliers (1)
 Thus 1/(1-c) is called the aggregate expenditure
multiplier or autonomous expenditure multiplier.
– It is positive.
– An increase in autonomous spending has a amplified
impact on GDP.
 But –c/(1-c) is the tax multiplier.
– It is negative.
– An increase in taxes reduces GDP.
 This implies that deficit spending can have a
powerful effect for stimulating the economy.

35
Multipliers (2)
 Clearly taxes slow an economy, having a negative
effect on GDP and therefore employment.
 Note that if ∆G= ∆T, a balanced budget :
1 −c
∆Y = ∆G + ∆G
1− c 1− c
1− c
∆Y = ∆G
1− c
∆Y = ∆G
 Thus the balanced budget multiplier is 1.
36
Multipliers (3)
 As an example, if the mpc = 0.9, then
1/(1 – 0.9) = 1/(0.1) = 10 !
 For every $1 increase in government
spending, GDP will increase by $10 !
 But also for every $1 that taxes are
increased, GDP falls by $9 !
 With a balanced budget (G=T), every $1
increase in G will increase GDP by only
$1.

37
 Fiscal Policy
Planned
Expenditures
E1

E0

∆G

Y0 Yf Y

38
Adding the Foreign Sector
 The demand for imports is
Z = Z0 + zY, Z0>0, 0<z<1
 Little
“z” is the marginal propensity to
import.
 Exports are thought to be exogenously
determined—they don’t depend on
conditions in our economy, but rather the
conditions in the economy of the buyer
nation.
39
Adapting the Multiplier
 Now we have some new components to the
multipliers:

1
Y= [C0 + I + G + X − Z0 ]
1− c + z

 Note that we leave out taxes for the moment.

 Because the marginal propensity to import is
greater than one, the multiplier is now smaller.

40