A. Consumption and Saving
1. Average Propensity to Consume
(APC) is consumption (C) divided by income (Y).
a. APC = C/Y
b. APC decreases as income increases as people can afford to save.
2. Marginal Propensity to Consume
(MPC) is the change in consumption divided by the change in income.
a. MPC decreases as income increases.
b. This makes sense because when an average is falling,
what is happening on the margin must be less.
1) If a test average drops, it was pulled down by a lower number.
3. Saving (S) is income minus
consumption. S = Y - C
Propensity to Save is change in saving divided by change
expectations about personal needs and future economic activity, and concerns
about consumer, business, and government debt.
B. Investment is business
spending on capital goods, inventory, and
C. Government Spending is assumed to be constant.
D. Net Exports equal exports minus
imports, are also assumed to be constant
One problem with this simplified assumption is it assumes investment
Low Investment Generally Means Slow Growth
Keynes Requires an Extraordinary Workout
II. Aggregate Demand and Equilibrium
A. Equilibrium (E) is where planned and actual AD and AS are equal.
1. Equilibrium is where all goods produced for sale are sold.
2. At points below equilibrium, AD < AS, inventories are building and
business activity is contracting. This level of economic activity was
depicted by the horizontal (Keynesian) range of AS explained in the
3. At points above equilibrium AD > AS, inventories are decreasing and
business activity is expanding
as depicted by the intermediate range and eventually the classical
range of AS.
4. Economic activity (Real GDP) will be wherever AD intersects AS.
Equilibrium seldom exists as
economic activity is usually in one stage or another of the business
B. If economic activity is not in balance, a dynamic situation exists and
will continue until equilibrium is reached.
C. Keynes believed that E could settle at a level of economic activity with
large amounts of unemployment.
1. If potential Real GDP is greater than what actual AD yields, a reces-
sionary gap exists and may persist indefinitely. The solution to this
unacceptable equilibrium is to increase AD.
2. If potential Real GDP is less than what actual AD yields, an inflationary
gap exists and the inflation may persist indefinitely. The solution to this
unacceptable level of economic activity is to decrease AD.
3. Inflationary and Recessionary Gaps- ACDC Economics in 60 Seconds
D. Multiplier Affect (K) is important to determining the change in AD needed
to reach equilibrium E.
1. Changes in AD will result in larger changes in NNP as increases are not
spent and respent.
2. Decreases in AD have a similar but opposite affect.
3. K = 1/MPS = 1?(1-MPC) Note: As MPS increases, K decreases.
4. A MPS is 20%, Multiplier is 5 as 1/20% = 1/(1/5) = 1X 5 = 5
5. Fiscal policy and the multiplier... is an 9 minute video from YouTube
III. Fine Tuning Economic Activity
US Government Spending About 10% Lower Than Western Europe.
V. Additional Material