Classical economic thought was widely accepted prior to the 1930’s Classical economists believed the economy always tended toward a full employment equilibrium Say’s Law: Supply creates its own demand Full Employment theory: Producers produce goods consumers want and consumers have the money to buy because of the wages they were paid unemployment is possible, but it is a short-lived adjustment period in which wages and prices decline or people voluntarily choose not to work

Keynesian Model (John Maynard Keynes) A British economist (1883-1946) who offered an explanation of the Great Depression of the 1930’s Keynes wrote “The General Theory of Employment, Interest and Money” Keynes’ theory suggest demand can be forever inadequate for an economy to achieve full employment The Great Depression and Keynesian Economics The economy could tend toward a less than full employment equilibrium Disposable income determines demand for goods and services

Savings: Money earned but not spent Consumption Function: A graph that shows the amount households spend for goods and services at different levels of disposable income Savings: Money earned but not spent Dissaving: The amount by which personal spending exceeds disposable income People dissave by taking money from personal savings Autonomous Consumption is independent of the level of disposable income When disposable income is zero spending will equal autonomous consumption because households will dissave for basic needs

Marginal Propensity to Consume (MPC) is the change in consumption resulting from a change in real disposable income MPC= ∆C ∆ Y d Marginal Propensity to Save (MPS) is the change in saving resulting from a change in real disposable income MPS= ∆S ∆ Y d where MPC+MPS=1

Real Disposable Income The Consumption Function 8 C 7 6 5 C Real Consumption 4 3 Yd 2 1 1 2 3 4 5 6 7 8 9 10 Real Disposable Income

Real Disposable Income The Consumption Function C = Yd 8 C 7 Real Consumption 6 Dissaving 5 4 Saving 3 2 1 45° 1 2 3 4 5 6 7 8 9 10 Real Disposable Income

Nonincome determinants of consumption There is a direct relationship between changes in real disposable income and changes in consumption When other factors than income change, there is a shift in the consumption schedule Nonincome determinants of consumption Expectations Wealth Interest rates Stock of durable goods Causes a shift in the consumption function

 nonincome determinant Shifts in the Consumption Function 8 7 C2 6 C1 5  nonincome determinant Real Consumption 4 3 2 1 1 2 3 4 5 6 7 8 9 10 Real Disposable Income

Consumer Function There is a direct relationship between a change in wealth and a change in consumption Consumers expectations of things to happen in the future will affect their spending decisions today There is an indirect relationship between a change in prices and a change in consumption There is an indirect relationship between a change in interest rates and a change in consumption When durable goods were suppressed, during WWII, afterwards there was an increase in the demand for goods not previously made available Consumption is more stable than investment

Classical economists consider the interest rate the primary determinant investment Keynesians believe expectations of future profits is the primary factor, along with the level of interest rates, in determining the level of investment

Investment Demand Curve Investment Demand Curve shows the amount businesses invest at different possible rates of interest 16% Interest rate Investment Demand Curve 12% 8% 4% 5 10 15 20 Real investment

Shift in the Firm’s Investment Demand Curve Interest rate 16% 12% 8% I2 4% I1 5 10 15 20 Real investment

Investment demand is generally unstable Expectations Investors are susceptible to moods of optimism and pessimism Technological change New products and new ways of doing things have a big impact on investment decisions Capacity utilization For low utilization firms can meet an increase in demand without expanding For high utilization firms must increase investment to meet an increase in demand Business taxes Business decisions depend on the expected after-tax rate of profit Autonomous reasons Spending that does not vary with the current level of disposable income

Autonomous investment Aggregate Investment Demand Curve 16% 14% 12% 10% Interest Rate 8% 6% Autonomous investment 4% I 2% .2 .4 .6 .8 1.0 1.2 1.4 1.6 Real Investment

I Aggregate Autonomous Demand Curve 1.6 1.4 1.2 1.0 .8 .6 Autonomous investment .4 .2 1 2 3 4 5 6 7 8 Real Disposable Income trillions of dollars per year

The Aggregate Expenditure Function represents total spending in an economy at a given level of real disposable income 8 7 AE = C + I C 6 5 4 3 2 1 1 2 3 4 5 6 7 8 Real Disposable Income