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The Keynesian Total Expenditures Model

What determines how much output our economy will produce and how many people will be employed? For Keynes, the answer was total spending—total demand for goods and services. When total spending increases, businesses produce more output and hire more people. That's the central idea in Keynesian macroeconomic theory: Total spending is the critical determinant of the overall level of economic activity.

Today, we know that Keynes ignored an important determinant of the economy's performance—aggregate supply. But there is much to be learned by examining the Keynesian total expenditures model. It will allow us to take a closer look at the factors that influence total spending (aggregate demand) and to consider why total spending tends to fluctuate. It also allows us to introduce an important concept known as the multiplier, which will be useful in understanding how changes in spending can have a magnified impact on the overall level of spending and output in the economy.

We begin this chapter by confining our analysis to a two-sector economy—households and businesses. We assume that there is no government and no foreign trade. We also assume that all saving is done by households and all investment by businesses. Further, we assume that the price level remains constant until full employment is reached. (Keynes believed that prices and wages tend to be rigid, not flexible as the classical economists assumed.)

Our first step is to explore the determinants of consumption and investment spending. Then we consider the way in which consumption, investment, and saving interact to determine the level of equilibrium income and output. Finally, we investigate the possibility of an unemployment or an inflationary equilibrium. The appendix to the chapter introduces government spending and taxation and examines the appropriate Keynesian fiscal policy for combating unemployment or inflation.

 
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