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Recall that when we discussed measuring gross domestic product (GDP), we concluded that it could be computed by adding up either all spending or all income in the economy. We saw that the expenditures side consists of consumer spending, business investment spending, government spending, and net foreign spending (exports minus imports). Thus, aggregate expenditures are equal to

GDP = AE = C + I + G + (X – M)

In this chapter, we first will focus on a simple model of the private economy that includes only consumers and businesses. Later in the chapter, we will incorporate government spending, taxes, and the foreign sector into our analysis. Second, we will assume that all saving is personal saving as opposed to national saving, which includes business saving and government saving. Third, because Keynes was modeling a depression economy, we follow him in assuming that there is considerable slack in the economy, much like the economy during and in the years following the 2007–2009 recession. Unemployment is high and other resources are sitting idle, which means that if demand were to rise, businesses could quickly increase output without any upward pressure on costs. We will assume therefore that the aggregate price level (the CPI, PPI, or GDP deflator) is fixed. Taking into account these assumptions, which make the analysis easier but do not affect the key points, let us begin by looking at consumption and saving.

Personal consumption expenditures (C) represent about 68% of GDP, and for this reason consumption is a major ingredient in our model. Figure 1 shows personal consumption expenditures for the years since 1980. Notice how closely consumption parallels disposable income.

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The 45° line inserted in the figure represents all points where consumption is equal to disposable income (Y_d). If an economy spends its entire annual income, saving nothing, the 45° line would represent consumption. Consequently, annual saving (S) is equal to the vertical difference between the 45° reference line and annual consumption (S = Y_d − C). After all, what can you do with income except spend it or save it?

Notice that consumption spending increased every year since 1980 except in 2009, when disposable income rose but consumption dropped. This was an important contributor to the depth of the 2007–2009 recession. In fact, the last time annual consumption spending dropped occurred in 1933, during the depth of the Great Depression.

Keynes began his theoretical examination of consumption by noting the following:

The fundamental psychological law, upon which we are entitled to depend with great confidence both a priori from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the change in their income.1

1 John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt Brace Jovanovich), 1936, p. 96.

Consumption spending grows, in other words, as income grows, but not as fast. Therefore, as income grows, saving will grow as a percentage of income. Notice that this approach to analyzing saving differs from the classical approach. Classical economists assumed that the interest rate is the principal determinant of saving and, by extension, one of the principal determinants of consumption. Keynes, in contrast, emphasized income as the main determinant of consumption and saving.

Table 1 portrays a hypothetical consumption function of the sort Keynes envisioned. As income grows from $4,000 to $4,200, consumption increases by $150 ($4,150 − $4,000) and saving grows from $0 to $50. Thus, the change in income of $200 is divided between consumption ($150) and saving ($50). Note that at income levels below $4,000, saving is negative; people are spending more than their current income either by using credit or drawing on existing savings to support consumption.

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Average Propensities to Consume and Save The percentage of income that is consumed is known as the average propensity to consume (APC); it is listed in column (4) of Table 1. It is calculated by dividing consumption spending by income (C ÷Y). For example, when income is $5,000 and consumption is $4,750, APC is 0.95, meaning that 95% of the income is spent.

The average propensity to save (APS) is equal to saving divided by income (S ÷Y); it is the percentage of income saved. Again, if income is $5,000 and saving is $250, APS is 0.05, or 5% is saved. The APS is shown in column (5) of Table 1.

Notice that if you add columns (4) and (5) in Table 1, the answer is always 1. That is because Y = C + S; therefore, all income is either spent or saved. Similar logic dictates that the two percentages spent and saved must total 100%, or that APC + APS = 1.

Marginal Propensities to Consume and Save Average propensities to consume and save represent the proportion of income that is consumed or saved. Marginal propensities measure what part of additional income will be either consumed or saved. This distinction is important because changing policies by government policymakers mean that income changes and consumers’ reactions to their changing incomes are what we will see later drive changes in the economy.

The marginal propensity to consume (MPC) is equal to the change in consumption associated with a given change in income. Denoting change by the delta symbol (Δ), MPC = ΔC÷ ΔY. Thus, for example, when income grows from $5,000 to $5,200 (a $200 change), and consumption rises from $4,750 to $4,900 (a $150 change), MPC is equal to 0.75 ($150÷$200).

Notice that this result is consistent with Keynes’s fundamental psychological law quoted earlier, holding that people “are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the change in their income.” In Table 1, the MPC for all changes in income is 0.75, as shown in column (6).

The marginal propensity to save (MPS) is equal to the change in saving associated with a given change in income; MPS = ΔS÷ΔY. Therefore, when income grows from $5,000 to $5,200, and saving grows from $250 to $300, MPS is equal to 0.25 ($50÷$200). Column (7) lists MPS.

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Note once again that the sum of the MPC and the MPS will always equal 1, because the only thing that can be done with a change in income is to spend or save it. A small word of warning, however: Though APC + APS = 1 and MPC + MPS = 1, most of the time APC +MPS ≠ 1 and APS + MPC ≠ 1. Try adding a few different columns from Table 1 and you will see that this is true.

Figure 2 graphs the consumption and saving schedules from Table 1. The graph in panel A extends the consumption schedule back to zero income, where consumption is equal to $1,000 and saving is equal to −$1,000. (Remember that Y = C + S; therefore, if Y = 0 and C = $1,000, then S must equal −$1,000. With no income, people in this economy would continue to spend, either borrowing money or drawing down their accumulated savings to survive.) The 45° line in panel A is a reference line where Y = C + S. At the point at which the consumption schedule crosses the reference line (point a, Y = $4,000), saving is zero because consumption and income are equal.

The saving schedule in panel B plots the difference between the 45° reference line (Y = C + S) and the consumption schedule in panel A. For example, if income is $4,000, saving is zero (point f in panel B), and when income equals $5,000, saving equals $250 [line (b − c) in panel A, point g in panel B]. Saving is positively sloped, again reflecting Keynes’s fundamental law; the more people earn, the greater percentage of income they will save (the average propensity to save rises as income rises). Make a mental note that the saving schedule shows how much people desire to save at various income levels.

How much people will actually save depends on equilibrium income, or how much income the economy is generating. We are getting a bit ahead of the story here, but planting this seed will help you when we get to the section where we determine equilibrium income in the economy.

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Note finally that the consumption and saving schedules in our example are straight-line functions. This need not be the case, but it simplifies some of the relationships to graph them like this at this point. When the consumption and saving schedules are linear, the MPC is the slope of the consumption function, and the MPS is the slope of the saving schedule. In this case, MPC = 0.75 and MPS = 0.25, which tells us that every time income changes by $1,000, consumption will change by $750 and saving will change by $250.

Other Determinants of Consumption and Saving Income is the principal determinant of consumption and saving, but other factors can shift the saving and consumption schedules. These factors include the wealth of a family, their expectations about the future of prices and income, family debt, and taxation.

When the town of West Point, Georgia, received the news that South Korean automaker Kia Motors was building a $1 billion car manufacturing facility in its town, its residents couldn’t have been happier. Not only was Kia creating thousands of jobs, the spending by its workers would create even more jobs throughout the region. Because Kia’s manufacturing facility was new to the U.S. economy (and not simply a move from another town), it is counted as gross private domestic investment (the “I” in the GDP equation), an important component of the aggregate expenditures model. Investment can come from foreign and domestic sources, for example, when American companies expand their operations by investing in new capital such as building a new factory.

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Unlike consumer spending, which at 68% is the largest component of GDP and until recently held fairly steady from year to year, gross private domestic investment is volatile. Sure, large investment deals like Kia’s new plant in West Point, Georgia, are a huge boost to the economy, but such investments tend to be sporadic. The annual percentage changes in consumption and investment spending from 1980 to 2015 are shown in Figure 3.

Notice that although consumption plodded along with annual increases between 0% and 10%, investment spending has undergone annual fluctuations ranging from −22% to +27%. Investment constitutes about 16% of GDP; therefore, its volatility often accounts for our recessions and booms.

The economic boom of the 1990s, for instance, was fueled by investments in information technology infrastructure, including massive investments in telecommunications. In the 1990s, people believed that Internet traffic would grow by 1,000% a year, doubling every three months or so. This belief led many companies to lay millions of miles of fiber optic cable. When the massive investments made in computer hardware and software over that same decade are taken into account, it is no wonder that the economy grew at a breakneck pace.

But this increase came to a halt in the early 2000s, when businesses—especially the telecoms—discovered that they had built up a massive excess capacity, and thus bandwidth prices plummeted. The resulting plunge in investment between 2000 and 2001 can be seen in Figure 3. Investment recovered by 2003, then collapsed from 2007 to 2009 as the housing and financial crises took their toll.

Investment Demand Investment levels depend mainly on the rate of return on capital. Investments earning a high rate of return are the investments undertaken first (assuming comparable risk), with those projects offering lower returns finding their way into the investment stream later. Interest rate levels also are important in determining how much investment occurs, because much of business investment is financed through debt. As interest rates fall, investment rises, and vice versa.

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Although the rate of return on investments is the main determinant of investment spending, other factors influence investment demand, including expectations, technological change, capital goods on hand, and operating costs.

Aggregate Investment Schedule To simplify our analysis, we will assume that rates of return and interest rates fully determine investment in the short run. But once that level of investment has been determined, it remains independent of income, or autonomous, as economists say. Therefore, unlike consumption, which increases as income rises, we will assume that investment does not vary based on income, but instead on the rates of return that determine how potentially profitable investment will be. Figure 4 shows the resulting aggregate investment schedule that plots investment spending with respect to income.

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Because we have assumed that aggregate investment is I₀ at all income levels, the curve is a horizontal straight line. Investment is unaffected by different levels of income. This is a simplifying assumption that we will change in later chapters when we look at its implications.

Our emphasis in this section has been on two important components of aggregate spending: consumption and investment. Consumption is about 68% and investment is about 16% of aggregate spending. Consumption is relatively stable, but investment is volatile and especially sensitive to expectations about conditions in the economy. We have seen that, on average, some income is spent (APC) and some is saved (APS). But, it is that portion of additional income that is spent (MPC) and saved (MPS) that is most important for where the economy settles or where it reaches equilibrium, as we will see in the next section.