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Home arrow Economics arrow Keynes and the Classical Economists
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SUMMARY

According to Keynesian theory, the primary determinant of the level of total output and total employment is the level of total spending. The greater the level of total spending, the more output businesses will want to produce and the more employees they will hire. In a simplified economy with no government sector and no foreign trade, the level of output and employment would be determined by the level of consumption and investment spending.

The most important factor influencing the amount of consumption spending is the level of disposable income, or income after taxes. The relationship between disposable income and consumption spending is called the consumption function. In Keynesian theory, a positive relationship exists between disposable income and consumption spending; the more people earn, the more they spend.

The way households react to changes in income depends on their marginal propensity to consume (MPC). The MPC is the fraction of each additional earned dollar that households spend on consumption. The marginal propensity to save (MPS) is the fraction of each additional earned dollar that is saved. The MPC and MPS must add to 1.00, or 100 percent: If MPC is 0.80, MPS is 0.20.

Profit expectations are the overriding motivation in all investment-spending plans. These expectations are based on a comparison of costs (including the cost of the capital equipment and the cost of borrowing the money to buy that equipment) and revenues (the revenues the investment project is expected to generate). If the investment is expected to generate revenues that exceed all anticipated costs, the investment should be made; if not, the investment should not be made.

In deciding how much output to produce, businesses attempt to estimate the spending plans of consumers and investors. If they estimate demand correctly, they will be able to sell exactly what they produced; hence they will tend to produce the same amount in the next period. If not, they will alter their production plans in order to match demand more closely.

The level of output at which the economy stabilizes is the equilibrium output. The equilibrium output is one that is neither expanding nor contracting and that tends to be maintained. It can be identified by finding the level of output at which total spending (consumption plus investment) is equal to total output. The equilibrium output can be determined graphically by finding the output at which the total expenditures function (C + I) intersects the 45-degree line.

Once the equilibrium output has been established, it will be maintained until there is some change in the spending plans of consumers or investors. To determine the ultimate impact on equilibrium of any change in spending, it is necessary to know the value of the multiplier (M), the number by which any initial change in spending is multiplied to get the ultimate change in equilibrium income and output. The multiplier can be calculated by using either of the following formulas:

Perhaps the most important contribution Keynes made was to demonstrate that a market economy can be in equilibrium at less than full employment. He attributed this occurrence to too little spending. The amount by which the equilibrium GDP falls short of full-employment GDP is called the recessionary gap. When inflation exists, the problem is too much spending; the economy is attempting to produce too much output. The inflationary gap is the amount by which the equilibrium GDP exceeds full-employment GDP.

Key terms

Consumption function. The relationship between disposable income and consumption spending. A consumption function shows the amount that households plan to spend at different levels of income.

Disposable income. Income after taxes. Disposable income is sometimes described as take-home pay.

Dissaving. Taking money out of savings accounts or borrowing in order to finance consumption spending.

Inflationary gap. The amount by which the equilibrium GDP exceeds full-employment, or potential, GDP.

Marginal propensity to consume (MPC). The fraction of any increase in income that is spent on consumption. The formula for the marginal propensity to consume (MPC) is

Marginal propensity to save (MPS). The fraction of any increase in income that households plan to save. The formula for the marginal propensity to save (MPS) is

Multiplier (M). The number by which any initial change in spending is multiplied to get the ultimate change in equilibrium income and output. The formula for the multiplier (M) is

Multiplier effect. The magnified impact on GDP of any initial change in spending.

Recessionary gap. The amount by which the equilibrium GDP falls short of full-employment, or potential, GDP.

Saving. The act of not spending; also, the part of income not spent on goods and services.

 
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