ECS 1601

Learning Unit 6
Income determination in a
simple Keynesian
macroeconomic model

Take out your text book. Keep

it next to you!
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speech bubble that says
READ section so-and-so, hit
pause, read the section
and watch the slide
thereafter!

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Content
In this learning unit you will learn more
about:
Production, income and spending
The basic assumptions of the Keynesian model
Consumption spending
Investment spending
Keynesian model in a closed economy with no
government
Algebraic version of the Keynesian model
The multiplier
A brief summary of the Keynesian model

Please note:
According to the proposed
timetable in your tutorial
letter, you have two weeks
to complete this learning
unit!
Take your time and make
sure you understand each
concept as you go along.

Read section
17.1 in
textbook
pp 314-316

6.1 Production, income

and spending

Watch the 1601

DVD, for more on
production,
income and
spending.

Remember this from learning unit 1:

In theory these three should be equal but
in reality it is not necessarily the case.
Consumers may save some of Producti
on
their money or buy on credit,
meaning spending and income
is not equal.
Remember, these are flow
variables that could
Spendin
Income
g
change constantly.

6.1 Production, income

and spending
What happens when production and spending
are not equal?
If production is MORE than spending,
inventories will increase. Producers are making
more stuff than consumers are buying.
Increasing inventories is a signal
to producers to produce less.
If producers decrease
production, then
inventories will decrease.

6.1 Continue
Production can also be LESS than
spending; then inventories will
decrease. Producers are not making
enough stuff for consumers to buy.
A decrease in inventories is a signal
to producers to produce more.
If producers increase
production, then
inventories will increase.

6.1 Continue
Spending (A) and production (Y) could be:
A=Y (in equilibrium)
A>Y
A<Y

Jean Baptiste Say formulated a law that

production and spending will always be
equal.
Says law: supply creates its own demand (YA)
During the Great Depression, it seemed that Says
Law was incorrect. John Maynard Keynes had a
new theory that spending caused production (AY)

Study Box
17-1 in
textbook
pp 315

Box 17-1 (words that mean the

same in macro-economics)
Spending
(A)
Aggregat
e
spending

Total
expendit
ure

Aggregat
e
expendit
ure

Income or
production
(Y)
Total output

National
output

Aggregate
output

Aggregate
production

Aggregate
income

National
product

National
income

Read section
17.2 in
textbook
pp 316-317

6.2 Basic assumptions

Watch the
1601 DVD, for
more on the
basic
assumptions.

This learning unit starts with the most basic Keynesian model.
This model only has households and firms. In the next learning
units we will introduce the government and foreign sector.
In this simple Keynesian model, spending (A) consists of:
What consumers buy: CONSUMPTION SPENDING (C)
What firms buy: INVESTMENT SPENDING (I)

If equilibrium is where A=Y

and A=C+I (in the simple model with no
government and foreign sector)
then equilibrium is Y=C+I

The model is used to explain how

variables in the economy will react to a
change (ex ante) and not record what
happened already (ex post).

Study box
17-2 in
textbook
p 317

Box 17-2
Assumption

Implication

There are only households &

firms.

There are only consumption and

investment spending. A = C + I.

For now, there is no government

(will be added in following
learning units).

At this time, the model cannot be

used to analyse the government
expenditure or taxes.

For now, there is no foreign sector At this time, the model cannot be
(will be added in following
used to analyse the exports,
learning units).
imports, trade policy, etc.
Prices are given.

At this time, the model cannot be

used to analyse inflation.

Wages are given.

At this time, the model cannot be

used to analyse the labour
market.

Spending drives economic

activity.

Supply has a passive role in the

model

Read section
17.3 in
textbook
pp 317-322

Watch the 1601

DVD, for more
on consumer
spending.

6.3 Consumption spending

Consumers buy different types of things.

Consumer spending is a large and relatively stable part of
total spending.
The relationship between consumer spending and income
is called the CONSUMPTION FUNCTION.
There are 3 important characteristics of the consumption
function you have to know:
1. Consumption is positive even if income is zero. (If David loses
his job and has no income, he is still going to consume goodshe has to eat and wear clothes.)
2. Consumption is going to increase if income increase (if
It is important to
David gets a raise, he is going to spend
more)
understand the
3. When income increases, consumption increases
but by
consumption
less than the increase in income. (For example,
if you
his
function; so
income increases by R100, his consumption
have to concentrate!
will increase by less than R100, e.g. R90.
He saves R10.)

To show the
relationship between
two variables, like
between consumer
spending and income,
it is easy to draw a
graph and put the two
variables on the axes.
Let's first think about
an individual person's
consumption..

Total consumption spending (C)

The consumption function

0
Total income (Y)

Remember the first

characteristic you have to
know about the
consumption function?
If income is zero (if David
has no job and no income),
consumption is NOT zero.
David will beg, borrow or
steal, but he will still get
money in order to consume
vital goods and services.
Therefore, the first point on
our graph is here.

Consumption spending by David

Lets look at Davids consumption:

0
Davids income

This is Davids autonomous

consumption. That is the
amount David will spend if he
had no income!
Autonomous consumption is
that PART of your consumption
spending that is not influenced
by your income. No matter
what your income, the
autonomous consumption
stays the same.

This is David's
autonomous
consumption.

Consumption spending by David

Lets look at Davids consumption:

0
Davids income

Lets look at Davids consumption:

Consumption spending
by David

What is the second

characteristic you have to
know?
If income increases, total
consumption increases.
What is the third characteristic
you have to know?
If income increases, total
consumption will increase by
less than the increase in income.
This is David's induced
consumption - that part
of consumption which
increases when income
increases.
The increase in
consumption (C) is
less than the increase
in income. (Y).

Y
Y1

Davids income
increases from
Davids
0 to Y1

income

Now we look at the

consumption function for
the economy as a whole,
i.e. all the consumption in
the economy added
together.

Total consumption spending (C)

The consumption function

C

Autonomous
consumption is
that part of
consumption that

does not dependAutonomous

incomeby consumption
on
It isthe
depicted
0
level.
Total income (Y)

When the income level in the

economy increases to Y1,
consumption increases to C1

The increase in
consumption is induced
consumption.

Total consumption spending (C)

The consumption function

C

C1

The increase in consumption

(C) is smaller than the

increase in income (Y).
Y
Total consumption is now
0
Y1
equal
to:
Autonomous consumption + Induced
consumption.

Total income (Y)

The
relationship between the
increase in consumption and
the increase in income: is
called the marginal propensity
to consume (MPC).
It is also indicated by a small c.
The MPC is smaller than one.
For example:
if MPC = 0,5 it means that
for every R1,00 increase in
Y, consumption will increase
by 0,5 x R1,00 = 50 cents.
Induced consumption is
therefore equal to MPC x Y or
cY.

Total consumption spending (C)

The consumption function

C

C1
C
Y
0

Y1
Total income (Y)

Note
the following:
This is the consumption function
graphically .
It does not start from the origin
(remember first characteristic).
This part is the total autonomous
spending ().
This part is the total induced
spending (cY) .
Total consumption is equal to:
+ cY.
This is the equation.

The slope of this line shows how

much spending will increase if
income increases with 1 unit.
This is also know as the MPC,
shown by the small letter c
Remember this ? will be
smaller than one (due to

Total consumption spending (C)

Thr consumption function

? =c
1

0
Total income (Y)

TAKE NOTE:
All types of spending (in this learning unit
and the next) will be divided into two groups:
Autonomous
Induced

Autonomous spending:
Are not affected by income in any way
Determines the intercept of the expenditure line

Induced spending:
Is directly influenced by income
Determines the slope of the expenditure line

Study box
17-4 in
textbook
pp 321-322

Box 17-4

Households can either spend their money or

save it. There are no other options.
If they do not spend their money, they save it,
therefore, saving is also called not spending.
Lets say a household's income increase by R10.
Consumption will increase but by less than R10, eg
by R8. This means their marginal propensity to
consume (MPC) is 0,8 - out every one rand they earn
more, they spend 80 cents.
This means they save 20 cents from every rand they
earn more. Their marginal propensity to save (MPS)
is 0,2.
Thus: MPC + MPS = 1.

The savings function

Total consumption spending (C)

Now
we are going to show
C, S
consumption and saving on
the diagram:
When income is 0,
consumption is equal to
This consumption has to be
financed in some way.
It is financed by a decrease
in saving, depicted by

is always equal to minus

The slope of the savings
function is s and this is thus
0
the savings function.
Note that has a negative

value.

C=+cY

c
1

S=+sY
s
1

Income can only be spent or

Derivation of the saved.
savings function
* Note that you only have to understand the derivation if you
Take the S to the left and the
are interested. But all students have to know the savings
Y to the right (shuffle).
equation.

Remember the consumption
function?
Put the consumption function
in the equation.
Multiply the brackets out.
Reshuffle the equation.
Take out a common Y.
Remember that saving is
equal to NOT spending .
Substitute to get the final
equation.
Graphically shown in Box 174.

Read section
17.4 in
textbook
pp 322-324

Watch the
1601
DVD, for more
on investment
spending.

6.4 Investment spending .

Investment spending is highly volatile.

Investment by firms depends on various factors,
such as cost of capital goods, interest rate and
the expected return on the investment.
With a high interest rate investment spending will be
low (it is expensive to borrow funds) and with a low
interest rate investment will be high (see figure 17-3).

Investment spending is not influenced by

income, therefore, investment spending is part
of autonomous spending.
Meaning there is no relationship between income
and investment spending as shown in figure 17-4.

Read section
17.5 in
textbook
pp 324-327

Watch the 1601

DVD, for more
on the simple
Keynesian
model.

6.5 Simple Keynesian model:

closed economy, no government

In order to draw the simple Keynesian model

without a government and a foreign sector
(which will be introduced in learning unit 7),
we have to recall the following:

Equilibrium is where A (spending) is equal to Y

(production). Inventories are constant.
In this learning unit total spending is equal to
consumption spending plus investment
spending
Consumption spending has an autonomous part and
a induced part ()
Investment spending is totally autonomous. ()

A=Y

Aggregate spending (A)

Lets draw the total

expenditure line. First
the axes.
Lets map out all the
possible equilibrium
points, meaning
everywhere were A=Y.
Connect the dots.
This is a 45 line and it
shows all the possible
equilibrium points. It is
not a real line; it will
just help us to identify
equilibrium where A=Y.

45

Total production, income (Y

Aggregate Spending (A)

The consumption
function will look
something like this:
And the investment
function will look
something like this
But remember, A = C
+ I, in order to get
the total expenditure
line, we have to add
investment to
consumption.

45

Total production, income (Y

Aggregate Spending (A)

Equilibrium is here:
Where the expenditure
line intersects with the
equilibrium 45 line.
Indicate equilibrium
spending and equilibrium
production.
To the left of equilibrium,
spending is more than
production and there is a
excess demand:
To the right of
equilibrium spending is
less than production and
there is a excess supply:

AE

45

YE

Total production, income (Y

Other ways to express equilibrium

income
Using words
If there is an excess supply, inventories increase,
and production will decrease until aggregate
demand is equal to production (ie until equilibrium
is reached again). If there is an excess demand,
inventories decrease, and production will increase
until aggregate demand is equal to production (ie
until equilibrium is reached again).

Using symbols
Using numbers
Using graphs

Carefully study the

examples in the
textbook and ask
your e-tutor if you
do not understand

Read section
17.6
in textbook pp
327-328 and
box 17-7
on pp 330

6.6 Algebraic version

Lets explain this with the aid

of an example:
If
C = 50 + 0,9Y
I = 45
What is the equilibrium
income?
Start with the equilibrium
condition:
We know A = C + I, therefore
at equilibrium:
Y = C + I.
Substitute the consumption
and the investment functions.

Read section
17.6
in textbook pp
327-328 and
box 17-7
on pp 330

6.6 Algebraic version

At
equilibrium:

Simplify the equation.

Carry the 0,9Y over to
the left-hand side
Simplify:
Divide both sides by
0.1 to get Y alone
That is how it is done:
equilibrium income is

6.6 Algebraic version

Hit pause and do the following example:
What is the equilibrium income if:
C = 870 + 0.85Y
I = 1 500
The answer is: Y0 = 15 800
Couldnt get the right answer? Ask your
e-tutor how.

Read section
17.7 in
textbook
pp 328-333

6.7 The multiplier

I am
investing
R10
million

Jason has a
Jason
MPCisofa
0.8.
Spends
R800
builder
and
Meaning
of
at
the local
received
the R1000
butcher,
Ian.he
R saves
1 000 R200
in
salaries
and to
help build
the new
office
Steve
is a teacher and
building
gets the R640 from
Ian. He has a MPC of
0.8. Meaning he saves
R128 and

Watch the
1601 DVD, for
more on the
multiplier.

When firms invest, the investment has

a ripple effect in the economy. For
Ian receives
Sp
example,
when
a
business
man
invests
en
the R800
.
d
s
from RJason.
Cin building a new office block,
money
T
64
E
Ian 0has
a
pa to
MPC
the following happens.
fo y of 0.8.
Spends R512
at the local
hairdresser

scMeaning
r
of
ho
o the R800 he
fe l
es saves R160
and

 Like in the previous

example, a
businessman invests
R10 million.
Therefore, aggregate
spending increases
with R10 million.
But now we are not
in equilibrium, so
production increases.

Aggregate spending (A)

6.7 The multiplier: graphically

20
10
45

10

20

Total production, income (Y

Aggregate spending (A)

But now we are not on

the new A2 line anymore,
so spending increases.
Again, we are not in
equilibrium. so production
has to increase.
This continues until we
reach the point that is
both in equilibrium and on
the new A2 expenditure
line.
Can you see the multiplier
effect working in this
graph, how the effect of
the R10 million is much
larger than the initial
investment?

27
25
20
10
45

10

20 2527

Total production, income (Y

6.7 The multiplier

It is clear that the initial investment had a larger
impact on the economy than just the amount of
the investment.
Did you see that the MPC had an vital impact on
the amount each person would spend?
The size of the multiplier depends on the amount
each person spend of the additional income
generated he received, meaning the MPC.
Thus, we can calculate the value of the multiplier
if we have the value of the MPC. Lets have a
look!

6.7 The multiplier

We
use the Greek letter
Alfa () to symbolise the
multiplier.
The equation to calculate
the multiplier is:
Lets calculate the
multiplier if the MPC is
equal to 0,8. like in the
previous example.
Very important, in the
consumption function ,
the small letter c is a
synonym for MPC!

This means that the increase in total

income will be 5 times larger than the
initial increase in spending!

 Remember
our example

where a businessman
increased investment by
R10 million?
If the multiplier is 5, the
effect on income will be:
Y =
= 5 x R10 m
= R50m
We can show it on the
graph:
Equilibrium moves from E0
to E1.
Equilibrium income will
now be R10m + R50m =
R60m.

Aggregate spending (A)

6.7 The multiplier

E1

20
10

E0

45

=R10m

Y=R50m

10m

60 m

Total production, income (Y

Study box
17-9 in
textbook
p 335

The paradox of thrift

Remember the metaphor of the economy being a car?

When the car (economy) is moving slow (small
economic growth rates)..
people are scared to spend a lot during bad economic
times and would rather save more.
However saving more will make the car move even
slower
Why? Because consumption is a big part of total
income, and saving more means spending less (which
means less petrol for the car)

Read section
17.8 in
textbook
pp 333-334

6.8 Summary

This simple Keynesian model consists of

households and firms.
Thus A = C + I.
Consumption has a autonomous part (not
influenced by income) and a induced part.
Investment is only autonomous.
Equilibrium is where Y=A (inventories stay
constant).
The multiplier is the ratio between change in
income and change in autonomous spending.

Are you able to

Define Says Law?
List the basic assumptions of the Keynesian model?
Define the multiplier?
Explain the implications of the assumptions?
Explain the relationship between savings and
consumption?
Name the three characteristics of the consumption
function?
Explain the relationship between income and consumption?
Explain the relationship between investment and the
interest rate?
Explain the relationship between investment and income?
Where equilibrium exists on a diagram?
Explain the difference between autonomous and induced
spending?
Explain what the multiplier is?

Now you
know more
about Keynes,
like every
economist
should!

That is the end of learning

unit 6.
A quiz on this work will be
available soon; make sure
you do it and discuss it
with your e-tutor!