1. 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

2. Keynesian Model (John Maynard Keynes)
A British economist ( ) 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

3. 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

4. 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

5. 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

6. 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

7. 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

8.  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

9. 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

10. 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

11. 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

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

13. 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

14. 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

15. 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

16. 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