A Closed Economy
In the Standard Model of Macroeconomics, a
national economy is driven by the demand for goods & services. Internally
this demand is made by households (consumption and savings), business enterprise
or firms (investment) and government (tax & spend) - national, regional & local.
Externally, demand is made for domestic goods & services by foreign governments,
firms and households in the form of exports.
For the moment we assume a closed economy, i.e.,
no imports or exports (MKM Fig. 5.1).
of the three domestic economic actors has an objective function, i.e.,
they strive to maximize something subject to constraint. In introduction
the nature and objective function of each will be examined within the framework
of the Circular Flow of National Income.
i - Households
It is assumed that households are the basic unit
of consumption and savings. In a household individuals share capital
assets like appliances, cars, entertainment centres, housing, etc.
It is also assumed that households own all factors of production including
capital, labour and natural resources. Households earn income by
selling these factors to firms and receive, in return,
dividends/interest/profits, wages & salaries and rents. The total income
earned by households from the sale of factors of production constitutes Gross
Domestic Income (GDI).
In what follows it is assumed that the dollar
value of GDI, Consumption (C), Investment (I) and Government (G) spending are
expressed in real not nominal terms. As was seen
under 2.0 National Accounts, inflation reduces the value of a dollar. This
means a dollar in the past bought more than a dollar today or tomorrow.
Economists are concerned with what was really bought and sold, e.g., the
number of cars, houses, labour, TVs, etc. Inflation adjusting
dollars of yesterday yields their real value today. Measuring in a
past year's dollars yields their nominal value. As a consequence,
inflation eats away at real household income over time.
Some household income is also taxed away by
government leaving households with disposable income. Some of this
is spent (consumption) and some saved. At the macroeconomic level it
is important to note that how much is spent and saved depends on national income
Thus consumption and saving are dependent variables induced by changes in
The objective function of households is to
maximize their well-being, happiness or, as in microeconomics, their utility.
They are constrained, however, by the demand for factors of production,
especially labour, and the price of goods & services as well as government
ii - Firms
It is assumed that business enterprise or firms
are the sole source of goods & services to satisfy the demand of households,
other firms and governments. Firms buy factors of production from
households. They combine them to produce goods & services. The value
of all final goods & services produced by all firms constitutes Gross
Domestic Product (GDP). A more detailed explanation of both GDI and
GDP is provided in 4.0 National Accounts. As will be seen, GDI
≡ GDP where the symbol (≡) represents an accounting
identity meaning that GDI must equal GDP. What is earned by
households selling factors of production to firms must, allowing for government
taxes and transfers, equal how much households spend buying goods & services
Assuming households pay all taxes, after paying
for factors of production firms use residual revenue to invest in capital plant
& equipment to produce the same output or produce more in the next year.
Thus investment consists of two parts. The first is depreciation of
exiting plant & equipment that wears down and must be renewed to maintain the
same output next year. The second part is spent on new plant & equipment
to expand production. Thus net new investment is total investment less
depreciation. It is important to note that the decision to invest is not
dependent on national income but rather on the expectation of profit. Thus
investment is an autonomous variable, independent of national income.
The objective function of firms is to maximize
profits constrained by the cost of factors of production, available technology
and government policies.
iii - Government
It is assumed that governments produce nothing.
Thus in Fig 5.1 (above) there is no government. They tax households
reducing gross to disposable income. They then redistribute tax revenue to
buy both private and public goods & services from firms.
The objective function of government is
re-election constrained by satisfaction of a majority of households with how
their taxes are spent. It is important to note that government spending is
thus autonomous of national income.; it is dependent on political forces.
For those interested in such forces, please see
Observation #2: The
Economics of Democracy.
iv - Expectations/Futurity
(MKM C4/73 & 78)
In what follows it is important to distinguish
between planned and actual expenditures by each of the three
economic actors. Decisions today about what to buy, or to save,
depends on what one expects to happen tomorrow. If one expects
prices to fall tomorrow one holds off spending today and vice versa.
If one expects to lose one's job tomorrow one reduces spending today and vice
versa. If a firm expects demand for its goods & services to increase
tomorrow then it invests today and vice versa. If a government
expects to be defeated in an upcoming election it spends 'to buy votes' to
improve its chances and vice versa. This is Futurity: One
lives in the Future but acts in the Present. What happens if one is wrong?
What if demand does not increase but one has made an investment to produce more
goods & services? To sell the surplus one must lower one's price.
There is thus an inherent tension between planned and actual expenditures by
one, two or even all three actors. We will later examine how the model
adjusts to differences between planned and actual expenditures.
When it comes to spending price plays a critical
role. In the Standard Model of Market Economics the
determining variable is
the market price of a good or service . In macroeconomics, however. it is the overall or
Level of millions of different goods & services. The
Aggregate Price Level is measured by a 'price index' of all goods
& services. This is possible because, as will be seen in 5.2 Monetary
Policy, money serves as a unit of account for apples and oranges and all other goods &
services. More will be said about price indices in 4.0 National Accounts.
Given the critical role of price we begin to
construct the Standard Model of Macroeconomics with the assumption that all
economic actors - households, firms and governments - share the same
expectations about the Aggregate Price Level. For a given price level each
plans its expenditures. Change the price level and spending changes.
We assume, for the moment, that the Aggregate Price Level is, in effect, fixed.
Taken together, spending by households (C),
firms (I) and governments (G) constitutes Aggregate Expenditure or:
(1) AE = C
+ I + G
AE = Aggregate Expenditure
Consumption by households;
Investment by firms in plant, equipment and inventories including
Government spending derived from taxes on households or borrowing.
As previously noted:
GDI = gross domestic income earned by domestic factors of production including capital, labour and natural resources; and,
GDP = gross domestic product of final goods & services produced by
To simplify the terminology:
(3) Y ≡
GDI ≡ GDP
≡ AE or, more simply,
(4) Y =
In this section we examine each component of AE.
We begin in a closed economy with the Aggregate Price Level (P) fixed and equilibrium
where AE =
Y. Graphically this is represented
by a locus of points
45 degree line drawn from the origin of Y
represented as the X-axis and AE by the Y-axis. AE
Y at every point on the 45
i - Consumption & Savings - Induced Expenditures
(MKM C5/107, C8/177)
Consumption (C) is the final use of
goods and services by households to satisfy human wants, needs and desires. Savings
(S) is the
difference between income and consumption. In a sense savings is deferred
The primary factor affecting consumption and
savings is disposable
income (Yd) which equals gross household income less taxes plus government transfers.
This means that changes in taxes to and transfers from governments such as
unemployment insurance, welfare, etc., changes Yd. As disposable income increases,
consumption and savings increase and vice versa. Thus C & S are induced by changes
a) Consumption Function
The relationship between disposable income and consumer spending is the Consumption
Function. If we plot income (Y) on the x-axis and consumption (C) on the y-axis then
point 'w' on the 45 degree line shows where
consumption equals disposable income (P&B
7th Ed. Fig. 27.1;
R&L 13th Ed
The Consumption Function is expressed as:
(5) C = a + bYd
a = non-discretionary or survival level of consumption
when income is zero;
b = the marginal propensity to consume (b); and
Yd = disposable income, i.e., gross income
minus net taxes (taxes minus transfers).
Non-discretionary or autonomous consumption (a)
varies between countries and over time. Thus in Saskatoon winter heating
is essentially non-discretionary for survival. In Trinidad there is no
need for winter heating. Similarly, once upon a time a telephone was a
luxury and 'party lines' common. Today a smart phone is a near necessity.
In the figure the area between the
Consumption Function and the 45 degree line ending at point 'w' consumption
is greater than income. To support consumption households
must 'dis-save', i.e., sell off assets accumulated in the past or
rely upon charity, family, friends or government transfers. After
point 'w' disposable income is greater than consumption. This
means households are able to save part of their disposable income.
Such savings then become available for investment purposes.
marginal propensity to consume (MPC or b in the figure above) is the slope of
the Consumption Function. It measures how much of each additional dollar
in income is spent on consumption (P&B
7th Ed Fig. 27.2;
R&L 13th Ed
Fig. 21-2). The MPC also varies between countries and over time.
For example, the MPC is much higher in North America and western Europe than in
East Asia. This means there is a higher level of savings in East Asia.
Similarly, before the Great (sometimes called 'the Long') Recession of 2008 the MPC in the United States was arguably greater than 1. This meant
households spent more than they earned. Essentially they borrowed from
East Asian savers. After the Great Recession the MPC has fallen below 1 as
Americans pay off their debts.
One factor affecting MPC is progressive income tax
- the higher the income, the higher the rate of taxation.
The percentage of each additional dollar of income taken by government
is the marginal tax rate (MTR).
Under progressive income tax the MRT rises with income. Accordingly the
Consumption Function bends lower as it passes from a lower to a higher MTR.
Thus, in effect, the MPC changes as disposable income is reduced by a higher
MTR. Therefore, under progressive taxation,
the slope of the
Consumption Function becomes MPC and the MTR. In effect, taxes are a
leakage from the system reducing the disposable income of households.
Savings (S) is the difference between disposable
income (Yd) minus consumption (C)
In the figure above dis-saving occurs from point 'a' to point 'w'.
At point 'w' savings are zero. Above point 'w' disposable income is
greater than consumption and savings occur. Given that disposable income
is split between consumption and savings the Marginal Propensity to Save (MPS)
is (1-b) where 'b' is the MPC (P&B
7th Ed Fig. 27.2;
R&L 13th Ed
). Other influences on savings
include changes in: the interest rates (r); the value of net assets, i.e., changes in the
aggregate price level (P); and, expected future
income. Such changes shift the consumption and savings functions.
ii - Investment & Government Expenditure
- Autonomous Expenditures
Each firm has a list of investment projects that can be rank ordered according
to their expected
rate of return or profit (π). Their ordering is then compared to the
opportunity cost of money, i.e., the interest rate (r). What could
be earned with the same money buying a financial asset with a guaranteed rate of
return. Below is an example of the 'marginal efficiency of
capital schedule' introduced by Keynes.
Marginal Efficiency of Capital Schedule
In the example Projects 1-4 are all expected to
earn a higher profit than the current 9% interest rate. They are
undertaken. Project 5 promises a profit rate equal to the interest rate
but with risks. A bond will return a fixed interest rate but an investment has
risks (economic, legal or political). Why take the chance? Projects
5-10 will not be undertaken.
What happens, however, if the interest rate drops
to 5%? Projects 5-8 are now profitable. What happens if the interest
rate goes up to 10%? Then only Projects 1-3 will be undertaken. What
is important is that if the interest rate falls then investment increases and
vice versa. As will be seen in 5.2 Monetary Policy it is by raising
and lowering the interest rate that the central bank can reduce or increase
investment and thereby affect GDP.
Investment is some
function of the expected rate of return or profit (
and the interest rate (r), or
I = (π, r)
I = the level of investment;
π = the expect rate of return or profit;
r = the interest rate or the cost of money.
In this sense, investment is autonomous to Y.
Being autonomous firms independently
determine which projects to undertake, i.e., how much to invest, without
regard to Y. The Investment Function is a straight line with a slope of 0 beginning at I1
the figure below.
While mainstream economists stress rationality in
calculating the Marginal Efficiency of Capital Schedule, Keynes stressed its
Chapter 12: The State of Long-Run Expectations
of his 1936 The General Theory of Employment, Interest and Money.
Among other things he noted three things.
First, there are two types of investment. The first is to build an Enterprise (investing for the long-run); the second
(playing the market). For Keynes the stock market was a 'beauty contests'
in which one tries to anticipate what the crowd will considers the best looking investment
tomorrow. Similarly, at the beginning of the Great Recession
of 2008 another meme emerged -
Second, there is simply ignorance, not just
uncertainty about the future. With an investment spreading over many
years, e.g., a dam, power station, integrated chip factory, it is simply
impossible to know what the price of copper may be in 10 years time let alone
the overall state of the economy. Probabilistic estimates can be made for
uncertainty but not for ignorance, the lack of knowledge.
Third, Keynes believed that investment
involved the 'animal spirits' of the
entrepreneur. He summed it up this way:
It is safe to say that enterprise which depends on
hopes stretching into the future benefits the community as a whole. But
individual initiative will only be adequate when reasonable calculation is
supplemented and supported by animal spirits, so that the thought of ultimate
loss which often overtakes pioneers, as experience undoubtedly tells us and
them, is put aside as a healthy man puts aside the expectation of death (Keynes,
There is a cycle to such 'animal spirits'
fuelled by greed as the market soars and fear when it dives. They
are bi-polar. According to
Keynes, this is what fuels the business cycle. Years later another
economist summed it up this way:
Keynes’s whole theory of unemployment is ultimately the simple
statement that rational expectation being unattainable, we substitute for it
first one and then another kind of irrational expectation: and the shift from
one arbitrary basis to another gives us from time to time a moment of truth,
when our artificial confidence is for the time being dissolved, and we, as
business men are afraid to invest, and so fail to provide enough demand to match
our society’s desire to produce. Keynes in the General Theory
attempted a rational theory of a field of conduct which by the nature of its
terms could be only semi-rational. But sober economists gravely upholding a
faith in the calculability of human affairs could not bring themselves to
acknowledge that this could be his purpose.
Shackle, G.L.S., The
Years of High Theory: Invention and Tradition in Economic Thought 1926-1939,
Chapter 11 - To the 'QJE' from Chapter 12 of the "General Theory': Keynes's
Cambridge at the
University Press, 1967
Government spending is funded by taxes on household income and/or borrowing on financial markets. It is determined politically,
that is government spending influences Y but Y does not influence government
spending. Government spending is a political, not an economic decision. In this sense, government expenditure is autonomous of real GDP.
The Government spending Function is expressed as:
(7) G =
G = spending by governments; and,
(politics) = maximizing the probability of
For those interested in the nature of such
decisions, please see
Observation #2: The Economics of Democracy
The Government Spending Function is a straight line with a slope of 0 beginning
the figure below.
Aggregate Expenditure Curve
To plot the AE curve we must add, vertically, C +
I + G at each level of Y. Given that the slope of I & G is zero the slope
of the final AE curve as shown in the figure below is the same as the
Consumption Function (b) or the marginal propensity to consume (MPC).
It is important to note that AE is determined by
first assuming that: the Aggregate Price Level (P) is fixed; it is a
closed economy meaning there are no imports or exports; and the Marginal Tax
Rate (MTR) is zero. The economy is in a state of autarky,
Equilibrium occurs at point 'v'.
Actual aggregate expenditure is always equal to
real GDP. Planned and actual aggregate expenditures or real GDP, however, can
diverge. How? It is assumed that C, G, X & M planned expenditures will be
fulfilled. That leaves Investment (I) as the component that may vary. This is
due to inventories. When aggregate planned expenditure is less than
actual, inventories increase; if actual is greater than planned, inventories
shrink. This sets up a dynamic in the next time period. Keynes's introduction
of inventory adjustment suggested recessions or downturns in the economy
averaging about half a year. Once inventories are run down, production starts
We now change our assumption and open the
economy to world trade. Why we should do so is explained in 6.0 The Global
Exports: Autonomous Expenditure
Exports are goods and services sold to
persons (Legal or Natural) of another
country plus services involved in shipping, financing and facilitating exports.
Their level is determined by international price (exchange rate) of the $Cdn, the real GDP
of foreign countries (GDPf) and trade agreements.
things being equal: the lower the Canadian dollar, the higher the real GDP of foreign countries
and the more liberal trading agreements and the higher will be exports.
The Export Function is expressed as:
(7) X = ($Cdn,
$Cdn = the foreign exchange value of the Canadian
(GDPf) = the real GDP of foreign countries.
are autonomous of Y.
Export Function is a straight line with a slope of 0 beginning at X0 in
- Induced Expenditure (MKM
Imports are goods and services bought by
Canadians (Legal or Natural) from another
country plus services involved in shipping, financing and facilitating exports.
Their level is induced by Canadian real GDP (Y) and affected by the exchange
rate for the $Cdn and trading agreements.
The Import Function is
the relationship between Y and imports, assuming all other
factors are held constant. Imports are induced by changes in Y. The Marginal Propensity to Import (MPM) measure
the change in imports divided by the change in Y, i.e.,
MPM = change in imports/change in income
7th Ed Fig. 27.3;
R&L 13th Ed
Fig. 21-6). Accordingly, of every additional dollar in disposable
income some is saved (MPS) but the rest is spent consuming both domestic and
imported goods & services.
This means that the slope of the Consumption Function and hence the AE
curve will be reduced depending on the value of MPM.
- Net Exports (MKM C5/106-7)
Net exports is equal to actual exports
minus imports (R&L 13th Ed Fig. 22-1