• That the employment of labor would be determined by the supply and demand for labor, along with the wage in purchasing power terms.
• The employment of labor, together with the productivity of labor, would determine production as measured by RGDP.

After 1929, it seemed that this is not true, and the time had come for a "new economics" that could explain unemployment.

Supply and demand couldn't do it. If there is unemployment, then employment is not determined by supply and demand, since supply and demand are not in equilibrium. Then what determines employment? >

Some Key Ideas and People

Aggregate Demand

Total demand for goods and services of all sorts.

Malthus

Thought that insufficient "aggregate demand" could lead to unemployment.

Jean Baptiste Say

A French economist, believed that Malthus was wrong, since no-one would supply goods except for the purpose of demanding other goods to the same value. The Great Depression made him look pretty bad.

John Maynard Keynes

He tried to sort all this out. The name rhymes with "brains."

Keynes' Thinking

on the one hand

Malthus must have been basically right -- the facts speak for themselves.

on the other hand

Say had a point -- the logic seems sound.

So Keynes looked to expenditure as the source of aggregate demand. We recall from that chapter that expenditure has just four components:

• Consumption expenditure.
• Investment expenditure.
• Government expenditure.
• Net Exports.

Let us look a little longer at the first and biggest of the four categories: consumption.

Marginal Propensity to Consume -- abbreviation MPC

From one additional dollar of income (after taxes), the Marginal Propensity to Consume is the fraction of the dollar that is spent on consumption. (The rest is saved).

1. C = a + bY

• C is the consumption expenditure, (in billions of 1992 dollars, for example),
• Y the national income (in the same units)
• a and b are constants. The constant b is the Marginal Propensity to Consume.

Figure 1: Income and Consumption

Each x corresponds to the income (on the horizontal axis) and the consumption (on the vertical axis) for one of the years between 1929 and 1982 inclusive.

Autonomous Consumption

Autonomous consumption is the portion of consumption expenditure that does not depend on income.

Examples

C = 500 + 0.7*Y

C = 0.9*Y,

In this example, the marginal propensity to consume is 0.9 and autonomous consumption is zero.

In general, if the consumption function is written as

C = a + b*Y

a is autonomous consumption, and b is the marginal propensity to consume.

The "supply and demand" model does a lot with two interacting relationships. Let's try something like that. Here are the two:

1. Y = C + I + G + NX

2. C = a +b*Y

where

• C is consumption expenditure
• I is investment expenditure
• G is government purchases of goods and services
• NX is net export expenditures

To be more specific, with hypothetical numbers,

1. Y = C + I + G + NX

2. C = 500 + 0.7*Y

To keep things as simple as possible, let's assume that investment is a given constant, I = 1000 (billion dollars), and G and NX are zero, and there are no taxes.

Taking equation 1 and substituting 1000 for I and zero for G and NX, we have

3. Y = C + 1000

In the figure, income is measured on the horizontal axis and components of expenditure are measured on the vertical axis. The 45 degree line, shown in blue, has been put in to make it easier to compare income (horizontal axis) with expenditure (vertical axis).

What if income is 3000?

An income of 3000 leads people to spend 2600 on consumption. Adding that to 1000 of investment we get a total expenditure of 3600 -- expenditure 600 more than income. So 3000 cannot be an equilibrium income.

What if income is 7000?

An income of 7000 leads people to spend 5400 on consumption. Adding that to 1000 of investment we get a total expenditure of 6400 -- expenditure 600 less than income. That's not right, either -- so 7000 cannot be an equilibrium income.

What if income is 5000?

An income of 5000 leads people to spend 4000 on consumption. Adding that to 1000 of investment we get a total expenditure of 5000 -- eureka! Income equals expenditure, and we have found the equilibrium income for the example.

1. C = 500 + 0.7*Y

2. Y = C +1000

3. Y = 500 + 0.7*Y +1000

4. Y - 0.7*Y = 500 +1000

That is

5. Y*(1 - 0.7) = 1500

The next step is to divide both sides by (1 - 0.7):

6. Y = 1500/(1-0.7)

Now, (1 - 0.7) is 0.3, and so, dividing 1500 by 0.3, we get the equilibrium income -- 5000 billion dollars.

7. Y = (a+I)

The term

1/0.3 = 3.333...

Multiplier

The "multiplier," also known as the "autonomous expenditure multiplier," is computed as one divided by one minus the marginal propensity to consume. In a simple Keynesian model, we may obtain the equilibrium income by multiplying the sum of all autonomous spending by "the multiplier."

Inventories

Inventories are stocks of goods held in businesses to bridge the gap between unpredictable sales and scheduled deliveries. For example, in a retail shoe store, the inventories would consist of pairs of shoes available to be sold.

• An increase in inventories is an investment.
• A decrease in inventories is a negative investment.

Table 2: The Multiplier Step By Step