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Keynesian Economics
CHAPTER 3
OUTPUT AND AGGREGATE
DEMAND 1. Keynesian Economics focuses on using active government
policy to manage aggregate demand in order to address or
prevent economic recessions.
2. Keynes developed his theories in response to the Great
Depression, and was highly critical of classical economic
arguments that natural economic forces and incentives
would be sufficient to help the economy recover.
3. Activist fiscal and monetary policy are the primary tools
recommended by Keynesian economists to manage the
economy and fight unemployment.
The General Theory of Employment, Interest, and Money

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By the end of this chapter, you 1. COMPONENTS OF AGGREGATE DEMAND.

should be able to…
•Aggregate demand is created by four secter:
1. Determine components of aggregate demand Households, firms, the government and the
2. Analyse consumption and investment foreign sector.
demand
•Without a government or a foreign sector, there
3. Define the marginal propensity to consume C are two sources of demand: consumption
4. Show how aggregate demand determines demand by households and investment demand
equilibrium output by firms.
5. Calculate the multiplier
•Consumption demand and investment demand
6. Aggregate demand and multiplier effect in an are chosen by different economic groups and
open economy depend on different things

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1. COMPONENTS OF AGGREGATE DEMAND.
CONSUMPTION DEMAND.
•Households buy goods and services from car to
cinema tickets.
•These consumption purchases account for most
of personal disposable income
•Given its disposable income, each household
plans how much to spend and to save.
•In the aggregate, households’consumption
demand rises with aggregate personal
disposable income.
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1. COMPONENTS OF AGGREGATE DEMAND.
INVESTMENT SPENDING
•Investment is expenditure on capital goods –
for example, new machines, offices, new
technology.
•Investment is a component of Aggregate
Demand (AD) and also influences the capital
stock and productive capacity of the economy
(long-run aggregate supply)
•Firms’investment demand depends on
firms’current guesses about how fast the
demand for their output will increase.
•Which factors determining the investment
decision by firms?
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1. COMPONENTS OF AGGREGATE DEMAND.
THE CONSUMPTION FUNCTION
•The positive relation between income
and consumption demand is called the
consumption function
•The consumption function shows
aggregate consumption demand at each
level of income
consumtion phu thuoc vao DI
C = f(Yd)
1. COMPONENTS OF AGGREGATE DEMAND.
INVESTMENT SPENDING
Main factors influencing investment by firms:
Economic growth
•Firms invest to meet future demand.
• If demand is falling, then firms will cut back on
investment.
•If economic prospects improve, then firms will
increase investment as they expect future
demand to rise.
•There is strong empirical evidence that
investment is cyclical. In a recession, investment
falls, and recover with economic growth.
•I = f(Y)
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1. COMPONENTS OF AGGREGATE DEMAND. 1. COMPONENTS OF AGGREGATE DEMAND.

INVESTMENT SPENDING INVESTMENT SPENDING

Accelerator theory Interest rates

The accelerator theory states that investment depends on the
rate of change of economic growth.
In other words, if the rate of economic growth increases from
1.5% a year to 2.5% a year, then this increase in the growth rate
will cause an increase in investment spending as the economy is
on an up-turn.
The accelerator theory states that investment is highly dependent
on the economic cycle.
I = f(Y)
Investment is financed either out of current savings or by
borrowing.
Therefore investment is strongly influenced by interest rates.
High interest rates make it more expensive to borrow.
High interest rates also give a better rate of return from keeping
money in the bank.
With higher interest rates, investment has a higher opportunity
cost because you lose out the interest payments.

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Interest rates 1. COMPONENTS OF AGGREGATE DEMAND.

GOVERNMENT
•Government spending G on goods and services
adds directly to aggregate demand.
•The government also levies taxes and pays out
transfer benefits.
•Net taxes are taxes minus transfer benefits.
•T= Tx - Tr
•Disposable income (Yd, DI) is gross income
minus taxes plus benefits, that is , the net income
available to spend or save.
•Yd =Y – Tx + Tr = Y – (Tx – Tr) = Y – T
•Yd = Y - T

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1. COMPONENTS OF AGGREGATE DEMAND.
GOVERNMENT
•Unlike consumption and investment, G is
determined directly by government
spending decisions
•G is a constant
• G = Go
hang so
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1. COMPONENTS OF AGGREGATE DEMAND.
FOREIGN TRADE: NET EXPORT
•Demand for imports rises when domestic
income and output rise.
•M = f(Y)
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1. COMPONENTS OF AGGREGATE DEMAND.
FOREIGN TRADE: NET EXPORT
•Exports X are goods and services made at
home but sold abroad.
•Imports M are goods and services made
abroad but bought by domestic residents.
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1. COMPONENTS OF AGGREGATE DEMAND.
FOREIGN TRADE: NET EXPORT
•Export demand depends mainly on what is
happening abroad.
•Foreign income and foreign demand are
largely unrelated to domestic output, we
can treat the demand for exports as
autonomous.
•It does not depend on the level of domestic
demand.
•X = Xo
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2. AGGREGATE DEMAND AND BASIC
MULTIPLIER
2.1. Consumption and Saving.
w Consumption function: Y = f(Yd)
C= Co + Cm.Yd tieu dung tu dinh
• Co – Autonomous consumption demand
(When Yd = 0): Households wish to consume
Co even if Yd is zero – reflecting the minimum
consumption needed for survival.
• Cm (MPC): Marginal Propensity to consume –
the fraction of each extra pound of disposable
income that households wish to consume)
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2. AGGREGATE DEMAND AND BASIC
MULTIPLIER
2.1. Consumption and Saving.
w Consumption function:
C= Co + Cm.Yd
• Billionaires may already be consuming
everything they could possibly want. For them,
any extra income is largely unspent: Cm is
close to 0.
• In macroeconomics, we are interested in
aggregate behaviour => 0< Cm <1
• The aggregate consumption reflects average
behaviour for the population as a whole.
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2. AGGREGATE DEMAND AND BASIC
MULTIPLIER
2.1. Consumption and Saving.
w Consumption function:
C= Co + Cm.Yd
• Different people may exhibit different
marginal propensities to consume.
• Poor people, with many unmet needs, are
likely to spend immediately any extra income
that they receive => Cm close to 1.
2. AGGREGATE DEMAND AND BASIC
MULTIPLIER
2.1. Consumption and Saving.
w Consumption function: Cm la he so goc
C= Co + Cm.Yd
rC
Cm(MPC) =
rYd
0 < Cm < 1: the slope of the
consumption functions
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2.1 Consumption and Saving.

2.1 Consumption and Saving.
The following data on the payment of Yd (DI) and the
economic performance of an economy:
• Consumption C
function:
Yd 0 300 600 900 1200 1500 1800 C=200+ 2/3 Yd
(DI) C=200+ 2/3 Yd
C 200 400 600 800 1000 1200 1400

600

Co = 200
Cm = 200/300 = 2/3
C = 200 + 2/3Yd 200

Yd
600

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2. AGGREGATE DEMAND AND BASIC

MULTIPLIER 2.1 Consumption and Saving
2.1. Consumption and Saving.
• Saving
w Saving is income not consumed.
w Since a fraction Cm of each pound of extra Yd 0 300 600 900 1200 1500 1800
income is consumed, a fraction (1 – Cm) of (DI)

each extra pound of income is saved

C 200 400 600 800 1000 1200 1400
w The marginal propensity to save Sm (MPS) is
(1 - Cm)
w Cm + Sm = 1 or MPC + MPS = 1 S -200 -100 0 100 200 300 400

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2.1 Consumption and Saving 2.1. Consumption and Saving

Saving: S= So + Sm.Yd
•So – Autonomous saving (When Yd = 0)
•Sm (MPS): Marginal Propensity to Saving • Saving function:
S=-200+ 1/3 Yd S

rS
Sm: slope of the
saving function
Sm(MPS) = 0< Sm <1
rYd S=-200+ 1/3 Yd

600 Yd
-200

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2.1. Consumption and Saving 2.2. INVESTMENT SPENDING

vThe relationship
between C function • Investment function:
and S function:
I = Io + ImY
Because: Yd = C + S C
aS = Yd – C.
aS = - Co + (1 – v Io – Autonomous investment
Cm)Yd
C=200+ 2/3 Yd
Im: Marginal investment
a So = - Co 600
a Sm = 1 - Cm S=-200+ 1/3 Yd rI
a Cm + Sm = 1
Im = (0 < Im <1)
For example above: 200 rY
C = 200 + 2/3 Yd
Yd
S = -200 + 1/3 Yd 600
- 200

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2.2. INVESTMENT
• I function: I

• Ex:
I = 50 + 1/6 Y C
C+I
S
I

I = 50 + 1/6 Y
150 HOUSEHOLDS FIRMS

I = Io
50

Y Injection = Withdraw
600

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cach tinh khi kh co thu nhap G va nuoc ngoai

2.3 DETERMINING AGGREGATE DEMAND 2.3 DETERMINING AGGREGATE DEMAND
• Without a government or a foreign sector, there Ex:
are two sources of demand: consumption demand
by households and investment demand by firms. C = 200 + 2/3 Yd The aggregate demand function: Y = AD
• Aggregate demand AD is the sum of consumption I = 50 + 1/6 Y AD AD = 250+5/6 Y
demand C and investment demand I (simple aAD = 250+5/6 Y
model)
1500
AD = C + I
O

• Yd = Y – T = Y vi kh co G nen T=0 Equilibrium output:

• AD = Co + Cm.Yd + Io + Im.Y = Co + Cm.Y +
Io + Im.Y Y = AD
Equilibrium output: : Y = AD a Y = 1500
250
Co + Io
Y = 450 Y, Yd
1 - Cm - Im 1500

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2.3 DETERMINING AGGREGATE DEMAND

v Adjustment towards equilibrium

AD Y = AD
ó Yd = C + I
AD = C + I
óC+S=C+I
B
AD3 => I = S I, S
A
AD2 Equilibrium output: I = S
C
AD1 O
S =- 200 + 1/3 Yd I = 50+1/6 Y
I = 50 + 1/6 Y 50 Y, Yd
50+1/6 Y =-200+1/3 600 1500
45 0 Y Yd -200 S = -200+1/3 Yd
a Y = 1500
Y1 Y2 Y3

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3. Basic Multiplier Model

In economics, a multiplier broadly refers to an
economic factor that, when increased or changed,
causes increases or changes in many other related
economic variables.
I, S
In terms of gross domestic product, the multiplier AD
effect causes gains in total output to be greater than AD2 = C + I2
the change in spending that caused it.
AD1 = C + I1 S
rY = k. rAD
C = Co + Cm . Yd (Cm or MPC)
I = Io (Im = 0) rAD I2
rY
450
I1
1
k= 1 – MPC Y1 Y2 Y Y1 Y2
1
Or k=
MPS

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4.3. Determining Ye when AD changes

4.3. Determining Ye when AD changes
The initial effect of a unit fall in investment
The multiplier tells us how much output demand is to cut output and income by a
changes after a shift in aggregate demand. unit.
If the MPC is large, this fall in income
The multiplier exceeds 1 because a change in leads to a large fall in consumption and
autonomous demand sets off further changes in the multiplier is big.
consumption demand.
If the MPC is small, a given change in
investment demand and output induces
The size of the multiplier depends on the
small changes in consumption demand
marginal propensity to consume.
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and the multiplier is small 38

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OPEN ECONOMY 3.1 The effect of Net Taxes on output

3.1 The effect of Net Taxes on output • T function:
§ Positive relation between Y and T.
v T = Tx – Tr T = f (Y) = To + Tm.Y
In an open economy: § To: Autonomous tax
Yd = Y – Tx + Tr = Y – T Tm: Marginal propensity to tax
ð rYd = - rT T
=> Negative relation between disposable income of
households and net tax T = To + TmY

rT
Tm =
rY To

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3.1 The government budget

3.1 The effect of government spending on output
• A budget is the spending and revenue plan of an
• G function individual, a firm or a government.
G = f(Y) = Go •The government budget describes what goods and
services the government will buy during the
coming year, what transfer payments is will make
and how it will pay for them.
G •Most of its spending is financed by taxes.

G = Go
Go

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3.1 The combined effects of

3.1 The government budget governement spending and taxation
• When spending exceeds taxes, there is a budget deficit. ¿ AD = C + I + G
• When taxes exceed spending, there is a budget surplus. C = Co + Cm.Yd AD
• Government budget deficit = G - T Yd = Y – T
Budget surplus = Y – To – Tm.Y AD

= (1 – Tm).Y – To
T, G
Budget deficit
ÞC = Co + Cm.Y –
T = To + TmY Cm.Tm.Y-Cm.To
Go
G = Go
ÞC= Cm.Y(1-Tm) - Cm.To
To
+Co
450
Yo Y
Yt Y

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3.2 Foreign trade and income determination 3.2 Net export and equilibrium income
• Export and Import fuction AD = C + I + G + X – M
¿ Export function:
qEquilibrium output:
X = Xo Y = AD
¿ Import function: aY = C + I + G + X – M
M = Mo + MmY Trade deficit)

Mo : Autonomous Import X,M [Co + Io + Go + Xo – Mo – Cm.To]

Trade surplus
Mm : Marginal propensity to import Y=
• Balance of Trade M = Mo + MmY [1 – Cm(1 – Tm) - Im + Mm]
• NX: positive - Trade surplus Xo
X = Xo
• NX: negative - Trade deficit Mo

NX = X - M Yo Y

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4.1 Determining equilibrium output (Ye)

•AS = AD
•While: AS = Y
AD AD = C + I + G + X – M
èY = C + I + G + X – M (1)
AD

AD = C + I + G + X - M èEquilibrium output (Ye) must satisfy:

Aggregate Supply equal Aggregate Demand

450

Ycb Yp

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4.3 Determining equilibrium output (Ye)

4.2 Determining equilibrium output (Ye)
Besides: Yd = Y - T
Y = AD
aY = C + I + G + X – M => Y = Yd + T (*)
Put (*) into (1) we have:
Yd + T = C+I+G+X–M
[Co + Io + Go + Xo – Mo – Cm.To]
Or :Yd – C + T + M = I + G + X
Y= ÞS + T + M = I + G + X (2)
[1 – Cm(1 – Tm) - Im + Mm]
Þ(2) shows: to get equilibrium output, the
withdraw must equal injection

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Equilibrium output: Y = AD 4.3. Determining Ye when AD changes

ó I+G+X=S+T+M
•When the output
I increases rAD, the
AD AD2
M equilibrium increases
S FOREIGN
C+I+G in the amount of rY
C G X AD1

HOLDHOUSES FIRMS r Y = k. r AD
GOVERNMENT
(Yd = Y – T) (Y) 1
k= rAD
1 – Cm (1-Tm) – Im + Mm
T

k : the multiplier 450 rY Y

(injection) = (withdrawal)
Yt Yp

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