1. Explain the basics of the classical view that the economy would generally provide full employment levels of output.
2. Recognize, construct, and explain the consumption, saving, and investment schedules.
3. Identify the determinants of the location of the consumption and saving schedules.
4. Differentiate between the average and marginal propensities to consume (and save).
5. Identify the immediate determinants of investment and construct an investment demand curve.
6. Identify the factors that may cause a shift in the investment-demand curve or schedule.
7. Describe the reasons for the instability in investment spending.
8. Explain verbally and graphically the equilibrium level of GDP.
9. Explain why above-equilibrium or below-equilibrium GDP levels will not persist.
10. Describe the leakages-injections approach to determining equilibrium GDP.
11. Trace the changes in GDP that will occur when there is a discrepancy between saving and planned investment.
12. Define and identify terms and concepts at the end of the chapter.

1. 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.
2. 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.
3. Data to update Figure 9-1 may be found in the most recent issue of Survey of Current Business or Economic Indicators.
4. 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 different?

1. 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.
2. 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.
3. 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.
4. 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.

• 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 upheavals.
• 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.

• 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 recession.

• 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 floods.

• 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 these assumptions.

1. 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.
2. Without government and foreign trade, we can treat GDP as being equal to national income (NI), personal income (PI), and disposable income (DI).

• 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 aggregate expenditures.
• Consumption and saving:

• The consumption schedule:

• Average and marginal propensities to consume and save:

• There are nonincome determinants of consumption and saving, which can cause people to spend or save more or less at various income levels.

• Shifts and stability:

• Investment is the second component of private spending.

• 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.

• Investment demand schedule, or curve, shows an inverse relationship between the interest rate and amount of investment.

• Causes of shifts in investment demand: (See Figure 9-6)

• The investment schedule shows the amounts business firms collectively intend to invest at each possible level of GDP.

• Investment is a very unstable type of spending. (See Figure 9-8)

• 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 + I_g) forthcoming at each output level.

• 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.

• Figure 9-9 (Key Graph) is a graphical representation of this information. At $470 billion it shows the C + I_g schedule intersecting the 45-degree line which is where output = aggregate expenditures, or the equilibrium position.

• 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 (I_g).

• Planned vs. actual investment

• Achieving equilibrium:

• 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:

• Prolific scholarship is his most important contribution.

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 employment.

• 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.

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 student's situation.

• 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 rate
• A sharp decline in stock prices
• An increase in the rate of population growth
• 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 orders.
  • 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.

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.

• Show the consumption and saving schedules graphically.

• Locate the break-even level of income. How is it possible for households to dissave at very low income levels?

• If the proportion of total income consumed decreases and the proportion saved increases as income rises, explain both verbally and graphically how the MPC and MPS can be constant at various levels of income.

  Level of Output and income (GDP = DI)	Consumption	SavingAPC	APS	MPC	MPS
  $240 260 280 300 320 340 360 380 400	$_____ _____ _____ _____ _____ _____ _____ _____ _____	$-4 0 4 8 12 16 20 24 28

• Data for completing the table (top to bottom). Consumption: $244; $260; $276; $292; $308; $324; $340; $356; $372. APC: 1.02; 1.00; .99; .97; .96; .95; .94; .94; .93. APS: -.02; .00; .01; .03; .04; .05; .06; .06; .07. MPC: 80 throughout. MPS: 20 throughout.
  • See the graphs.
  • Break-even income = $260. Households dissave borrowing or using past savings.
  • Technically, the APC diminishes and the APS increases because the consumption and saving schedules have positive and negative vertical intercepts respectively. (Appendix to Chapter 1). MPC and MPS measure changes in consumption and saving as income changes; they are the slopes of the consumption and saving schedules. For straight-line consumption and saving schedules, these slopes do not change as the level of income changes; the slopes and thus the MPC and MPS remain constant.

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 much.

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.

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.

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 (I_g). If there is no government or foreign sector, then the level of income is the same as the level of output. In equilibrium, I_gmakes 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 I_gso at equilibrium the value of S must be equal to I_g. 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 + I_g, so S = I_g.

Alternatively, one could explain why there would not be an equilibrium if (a) S were greater than I_gor (b) S were less than I_g. In case (a), we would find that aggregate spending is less than output and output would contract; in (b) we would find that C + I_gwould be greater than output and output would expand. Therefore, when S and I_gare 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.

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 saving.

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.

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 economy.

• 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.

• MPC is .8
• MPS is (1 - .8) = .2
• C = $40 + .8($400) = $40 + $320 = $360
• APC = $360/$400 = .9
• S = Y - C = $400 - $360 = $40
• APS = $40/$400 = .1 or 1 - APC

Y = 500, C= 460, I_g= 40, S= 40

To obtain these results, recognize that at equilibrium aggregate demand (C + I_g) 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= 500

From this we can find C= 10 + .9 (500), which is 460

Since saving equals Investment at equilibrium, S = 40

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 macroeconomics.