Learning Objectives

Learning Objectives

By the end of this section, you will be able to do the following:
  • Explain real GDP or real output, recessionary gaps, and inflationary gaps
  • Recognize the Keynesian aggregate demand/aggregate supply model
  • Identify the determining factors of both consumption expenditure and investment expenditure
  • Analyze the factors that determine government spending and net exports

The Keynesian perspective focuses on aggregate demand. The idea is simple: Firms produce output only if they expect it to sell. Thus, while the availability of the factors of production determines a nation’s potential GDP, the amount of goods and services actually being sold, known as real GDP or real output, depends on how much demand exists across the economy. This point is illustrated in Figure 11.3.

Keynesian view of the AD/AS model shows that with a horizontal AS, a decrease in demand leads to a decrease in output, but no decrease in prices.
Figure 11.3 The Keynesian AD/AS Model The Keynesian view of the aggregate demand/aggregate supply (AD/AS) model uses an short run aggregate supply (SRAS) curve, which is horizontal at levels of output below potential, and vertical at potential output. Thus, when beginning from potential output, any decrease in AD affects only output, but not prices; any increase in AD affects only prices, not output.

Keynes argued that, for reasons we explain shortly, aggregate demand is not stable; it can change unexpectedly. In the figure, suppose the economy starts where AD intersects SRAS at P0 and Yp. Because Yp is potential output, the economy is at full employment. Because AD is volatile, it can easily fall. Thus, even if we start at Yp, if AD falls, then we find ourselves in what Keynes termed a recessionary gap. The economy is in equilibrium but with less than full employment, as shown at Y1 in Figure 11.3. Keynes believed the economy tends to stay in a recessionary gap, with its attendant unemployment, for a significant period of time.

In the same way—not shown in the figure—if AD increases, the economy could experience an inflationary gap, where demand is attempting to push the economy past potential output. As a consequence, the economy experiences inflation. The key policy implication for either situation is that government needs to step in and close the gap, increasing spending during recessions and decreasing spending during booms to return aggregate demand to match potential output.

Recall from The Aggregate Demand/Aggregate Supply Model that aggregate demand is total spending, economy-wide, on domestic goods and services. AD is actually what economists call total planned expenditure. Read the appendix on The Expenditure-Output Model for more on this. You may also remember that aggregate demand is the sum of four components: consumption expenditure, investment expenditure, government spending, and spending on net exports—exportsg minus imports. In the following sections, we examine each component through the Keynesian perspective.

What Determines Consumption Expenditure?

What Determines Consumption Expenditure?

Consumption expenditure is spending by households and individuals on durable goods, nondurable goods, and services. Durable goods are things that last and provide value over time, such as automobiles. Nondurable goods are things like groceries; once you consume them, they are gone. Recall from The Macroeconomic Perspective that services are intangible things consumers buy, such as healthcare or entertainment.

Keynes identified three factors that affect consumption:

  • Disposable income: For most people, the single most powerful determinant of how much they consume is how much income they have in their take-home pay, also known as disposable income, which is income after taxes.
  • Expected future income: Consumer expectations about future income also are important in determining consumption. If consumers feel optimistic about the future, they are more likely to spend and increase overall aggregate demand. News of recession and troubles in the economy will make them pull back on consumption.
  • Wealth or credit: When households experience a rise in wealth, they may be willing to consume a higher share of their income and to save less. When the U.S. stock market rose dramatically during the late 1990s, for example, U.S. rates of saving declined, probably in part because people felt their wealth had increased and there was less need to save. How do people spend beyond their income when they perceive their wealth increasing? The answer is borrowing. On the other side, when the U.S. stock market declined about 40 percent from March 2008 to March 2009, people felt far greater uncertainty about their economic future, so rates of saving increased while consumption declined.

Finally, Keynes noted that a variety of other factors combine to determine how much people save and spend. If household preferences about saving shift in a way that encourages consumption rather than saving, then AD shifts out to the right.

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What Determines Investment Expenditure?

What Determines Investment Expenditure?

Spending on new capital goods is called investment expenditure. Investment falls into four categories: producer’s durable equipment and software, new nonresidential structures, such as factories, offices, and retail locations, changes in inventories, and residential structures, such as single-family homes, townhouses, and apartment buildings. The first three types of investment are conducted by businesses whereas the last is conducted by households.

Keynes’s treatment of investment focuses on the key role of expectations about the future in influencing business decisions. When a business decides to make an investment in physical assets, such as plants or equipment, or in intangible assets, such as skills or a research and development project, that firm considers both the expected benefits of the investment—expectations of future profits—and the costs of the investment, or interest rates.

  • The clearest driver of the benefits of an investment is expectations for future profits. When an economy is expected to grow, businesses perceive a growing market for their products. Their higher degree of business confidence encourages new investment. For example, during the second half of the 1990s, U.S. investment levels surged from 18 percent of GDP in 1994 to 21 percent in 2000. However, when a recession started in 2001, U.S. investment levels quickly sank back to 18 percent of the GDP by 2002.
  • Interest rates also play a significant role in determining how much investment a firm makes. Just as individuals need to borrow money to purchase homes, so do businesses need financing when they purchase big-ticket items. The cost of investment thus includes the interest rate. Even if the firm has the funds, the interest rate measures the opportunity cost of purchasing business capital. Lower interest rates stimulate investment spending and higher interest rates reduce it.

Many factors can affect the expected profitability on investment. For example, if the price of energy declines, then investments that use energy as an input yields higher profits. If the government offers special incentives for investment, for example, through the tax code, then investment looks more attractive; conversely, if the government removes special investment incentives from the tax code, or increases other business taxes, then investment looks less attractive. As Keynes noted, business investment is the most variable of all the components of aggregate demand.

What Determines Government Spending?

What Determines Government Spending?

The third component of aggregate demand is spending by federal, state, and local governments. Although the United States is usually thought of as a market economy, the government still plays a significant role in the economy. The government provides important public services such as national defense, transportation infrastructure, and education.

Keynes recognized that the government budget offered a powerful tool for influencing aggregate demand. Not only could AD be stimulated by more government spending, or be reduced by less government spending, but also consumption and investment spending could be influenced by lowering or raising tax rates. Indeed, Keynes concluded that during extreme times such as deep recessions, only the government has the power and resources to move aggregate demand.

What Determines Net Exports?

What Determines Net Exports?

Recall that exports are products produced domestically and sold abroad whereas imports are products produced abroad but purchased domestically. Because aggregate demand is defined as spending on domestic goods and services, export expenditures add to aggregate demand whereas import expenditures subtract from aggregate demand.

Two sets of factors can cause shifts in export and import demand: changes in relative growth rates between countries and changes in relative prices between countries. The level of demand for a nation’s exports tends to be affected most heavily by what is happening in the economies of the countries that would be purchasing these exports. For example, if major importers of American-made products, like Canada, Japan, and Germany, have recessions, exports of U.S. products to those countries are likely to decline. Conversely, the quantity of a nation’s imports is affected directly by the amount of income in the domestic economy: more income brings a higher level of imports.

Exports and imports can also be affected by relative prices of goods in domestic and international markets. If U.S. goods are relatively cheaper compared with goods made in other places, perhaps because a group of U.S. producers has mastered certain productivity breakthroughs, then U.S. exports are likely to rise. If U.S. goods become relatively more expensive, perhaps because a change in the exchange rate between the U.S. dollar and other currencies has pushed up the price of inputs to production in the United States, then exports from U.S. producers are likely to decline.

Table 11.1 summarizes the reasons given here for changes in aggregate demand.

Reasons for a Decrease in Aggregate Demand Reasons for an Increase in Aggregate Demand
  • Rise in taxes
  • Fall in income
  • Rise in interest rates
  • Desire to save more
  • Decrease in wealth
  • Fall in future expected income
  • Decrease in taxes
  • Increase in income
  • Fall in interest rates
  • Desire to save less
  • Rise in wealth
  • Rise in future expected income
  • Fall in expected rate of return
  • Rise in interest rates
  • Drop in business confidence
  • Rise in expected rate of return
  • Drop in interest rates
  • Rise in business confidence
  • Reduction in government spending
  • Increase in taxes
  • Increase in government spending
  • Decrease in taxes
Net Exports
  • Decrease in foreign demand
  • Relative price increase of U.S. goods
Net Exports
  • Increase in foreign demand
  • Relative price drop of U.S. goods
Table 11.1 Determinants of Aggregate Demand


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