ECON102: Principles of Macroeconomics (2021.A.01)

The fundamental equation of the Keynesian system is:

aggregate income = aggregate expenditures

This means that the only way any individual can receive any income in the form of money is for some other individual to spend an equal sum. Conversely, every act of expenditure by an individual results in an equivalent monetary income for someone else. In every case, expenditures, and only expenditures, can create monetary income.

Aggregate expenditures are classified into two basic types:

• Final expenditure for goods and services that have been produced during the period, which equals consumption.
• Expenditure on the means of production of these goods, which equals investment.

Thus, monetary income is created by decisions to spend, consisting of consumption decisions and investment decisions.

This relationship between aggregate income and consumption is considered to be stable, fixed by the habits of consumers. In the mathematics of Keynesian theory, aggregate consumption (and therefore aggregate savings) is a stable, passive function of income. This is known as the consumption function.

For example, according to the consumption function, we can say consumption equals 90 percent of income. Thus, savings would be equal to 10 percent of income.

Thus:

income = independent expenditures (private investment + government deficit) + passive consumption expenditures.

Using our illustrative consumption function, income = independent expenditures + 90 percent of income, then income equals ten times independent expenditures.

Similarly, a decrease in independent expenditures will lead to a ten-fold drop in income.

This "multiplier" effect on income will be achieved by any type of independent expenditure – whether private investment or government deficit (such as foreign trade problems). Therefore, government deficits and private investment have the same economic effect.

The consumption function (and therefore the savings function) is assumed to be constant throughout while the level of investment is constant at least until equilibrium is reached. This assumption implies that:

From this it follows that for every level of national income, there corresponds a unique, definite volume of employment. The higher the national income, the greater will be the volume of employment, until a state of "full employment" is reached. After the full-employment level is reached, a higher money income will represent only a rise in prices, with no rise in physical output (real income) and employment.

Also, income below this "full-employment" level will signify large-scale unemployment; an income above will mean high price inflation.

There is no reason whatsoever to assume that this equilibrium level of income determined in the free market will coincide with the "full-employment" income level. It may be more or less. Thus, the government must be involved. If the system it is below the "full-employment" level, the state can engage in deficit spending until the desired income level is reached.

Keynes argued that the solution to depression was to stimulate the economy ("inducement to invest") through some combination of two approaches:

• A reduction in interest rates.
• Government investment in infrastructure.

The injection of income results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.