Okay, let's start this phase of our analysis of the Keynesian Model by looking at Aggregate Production. In this key definition, Aggregate Production is defined as the total amount of goods and services produced in the economy. By definition, such production creates an equal amount of income. This means the aggregate production curve can quite conveniently be represented by a 45-degree line, as illustrated in this figure. Here, production in dollars is represented on the vertical axis. Real Income or GDP is represented on the horizontal axis, and the vertical line at Q superscript P, represents the economy's potential full employment income or GDP. Note, that the upward sloping 45-degree line representing the aggregate production curve, means that at any point along this curve production equals income. For example, at point A, where the 45-degree line crosses the full employment vertical line, production and income are both at Q superscript P. In contrast, at point E, both production and income are at Q. In this case, the economy's so-called recessionary gap is equal to the difference between Q superscript P and Q. Take a minute to study this figure before we move on to aggregate expenditures. As an exercise, turn away from the presentation and try to draw the figure correctly from memory. Were you able to draw the figure correctly? That kind of exercise is a good exercise to help you better visualize macroeconomic interactions. So, when you are reviewing the material for this course, always try to recall and draw the models we use. In the Keynesian model, total spending or aggregate expenditures, may be represented algebraically by the GDP forecasting equation we first introduced in Lesson 1. To reprise, Aggregate Expenditures, AE = consumption + investment + government expenditures + net exports. And now, note this key concept the aggregate expenditures curve is simply the vertical summation of these four components. Let me repeat that. The aggregate expenditures curve is simply the vertical summation of these four components. This figure illustrates how these aggregate expenditures appear as a curve in the basic Keynesian multiplier model. In the figure, expenditures are measured on the vertical axis. Real income or GDP is measured on the horizontal axis and the aggregate expenditures curve slopes upward. Now, let's laser focus in on two key points about the aggregate expenditures curve. First, the aggregate expenditures curve has a flatter slope than the 45-degree line that represents the aggregate production curve. Second, the aggregate expenditures curve intersects the vertical axis at a level above zero. Taken literally, this means that even if income is zero, people will spend a certain amount of money on consumption. In this key definition, such expenditures are called autonomous consumption. This is because they happen independently of the level of income. To fully understand how the Keynesian multiplier model works, we not only have to understand the mystery of autonomous consumption, we also have to understand why the aggregate expenditures curve is flatter than the aggregate production curve. The best way to do this is to sequentially examine the four major components of the Keynesian expenditure function, consumption, investment, government expenditures and exports. But before we do that, let's now pause as you think a little bit about this two-part puzzle. Why does the Aggregate Expenditures curve have a flatter slope in the 45-degree Aggregate Production curve? And how can Autonomous Consumption even exist when the income is zero? And thereby lead to the aggregate expenditures curve intersecting the vertical axis above zero. So, jots out some ideas before moving on. Consumption is the largest component of aggregate expenditures in many developed economies, like that of Europe and the United States. For example, in the U.S. economy, consumption accounts for almost 70% of total aggregate expenditures. This table, divides consumption into its three basic categories. The first is called durable goods, like autos and household equipment that have a long lifespan. The second is non-durable goods, like food and clothing, which have a lifespan of a few years or less. Third, there are services like transportation and medical care. So, how can consumers still spend even if their income falls to zero? That's the real mystery behind autonomous consumption. But it's not really a mystery at all, when you consider that even if a person loses his or her job and income falls to zero, this person will still be able to consume by dipping into his or her savings. Now in addition to Autonomous Consumption, there is also what Keynes called "induced consumption". In this key definition, induced consumption is that level of consumption that depends on an individual's disposable income. Just what do I mean exactly by disposable income? In this additional key definition, disposable income is simply the amount of money you have left after paying taxes to the government. Let me repeat that, disposable income is the amount of money that you have left after paying taxes. Besides the concepts of autonomous and induced consumption, there is a third element that John Maynard Keynes used to describe consumption behavior known as a person's marginal propensity to consume, also called the marginal propensity to expend. Here's the key definition, the marginal propensity to consume is simply the extra amount that people consume when they receive an extra dollar of disposable income. At the same time, there is a companion concept known as the marginal propensity to save or marginal propensity to withdraw. It measures the extra amount people save when they receive an extra dollar of disposable income. To see the relationship between the marginal propensity to consume and the marginal propensity to save. Suppose people spend 90 cents of every dollar of their disposable income. In this case, what is the marginal propensity to consume or MPC? And what, by implication is the marginal propensity to save or MPS? So please, jot down your answers before moving on. In this case, the MPC will be 0.90, while the MPS must necessarily be 0.10. Now, what if people save 25 cents of every dollar of disposable income? What's the MPS and what must be the MPC? Again, please jot down your answers before moving on. In this case, the marginal propensity to save is 0.25 and a marginal propensity to consume is 0.75, As to why this simple math is very important to know, take a look at this figure, it illustrates a critical characteristic of the Keynesian model, namely that the slope of the consumption function is actually equal to the marginal propensity to consume. In this case, assuming an MPC of 0.75. By the same token, the slope of the savings function is equal to the MPS in the bottom part of the figure. In fact, with these observations we have just solved the mystery of why the aggregate expenditures curve is flatter than the 45-degree line in the Keynesian model. It is precisely because the marginal propensity to consume is less than one. Algebraically, we can represent the Keynesian consumption function simply as follows, total consumption, C = Autonomous Consumption C knot + Induced Consumption, where induced consumption equals the marginal propensity to consume or MPC x Disposable Income Y sub D. Typical example of such a consumption function is represented in this figure. Assuming, a marginal propensity to consume of 0.75. Note that this consumption function intersects the vertical axis at the level of autonomous consumption at $50 or point A, while the slope of the consumption function is simply the MPC or 0.75. You can see now, how this consumption function relates back to the problem that Thomas Malthus originally identified with sales law in the classical model. People won't necessarily spend everything they earn, therefore, aggregate expenditures need not equal aggregate production. That is, supply need not always create its own demand. Okay, that's the end of this module. Take a breather now and when you're ready, let's move on to the next module and finish building the Keynesian aggregate expenditure side of the model by discussing business investment, government spending, and net exports.
