The questions we need to concern ourselves with is: Where will the economy go if there is no government intervention? What will be the equilibrium level of income? At what income level will AD = Income?
To understand the situation, consider what you would do if you were running a T-shirt shop and you saw your inventories being depleted. You would likely get on the phone / Internet and order additional stock. If many T-shirt shops found themselves in your situation, they would also place orders for more product and the level of production would rise. If we were at an income / output level of 3,000, then you would expect to see income / output rise. The situation would be quite different if inventories were building up - if you were unable to sell all that you were ordering. In this situation you would likely make the call to reduce your orders which would eventually become an order for lower production. If we were at an income level of 18,000, then you would expect to see income fall.
Following this logic through, we would find that there is only one level of income (12,000) at which AD = Income. This will be the equilibrium level of income which the economy will gravitate towards.
Before leaving our simple example there is one additional aspect of the table which we need to examine. If you compare the consumption and income columns you see that they tend to move in the same direction, which is what we would expect. As income rises we find consumption spending also rising. In fact, each time income rises by 1,000, consumption rises by 800. Stated differently, the change in consumption equals 80 percent of the change in income so we would say that the Marginal Propensity to Consume = .8.
To get to the real substance of the Keynesian contribution let's redo the analysis under the assumption that government spending has been increased by 200 [the Government column is now 350]. If you look down the table you will find that the new equilibrium level of income is 13,000. The increase in government spending of 200 brought about an increase in income of 1,000. In this case the multiplier is 1,000/2000 = 5.
The value of the multiplier could also be derived directly from the formula which we will derive in the algebra section. The formula for the multiplier is:
ΔY/ΔG = 1/(1-MPC)
You should think of this as one equation with three unknowns and you could rewrite the equation to help you solve three policy questions.
How much do I need to increase spending to achieve a certain target level of income? You might want to use this policy if you were trying to move the economy out of a recession.
ΔG = ΔY *(1-MPC)
How much will income change if spending changes by this amount? This formulation would be useful if you wanted to get a handle on the impact on the economy of some external spending shock.
ΔY = [1/(1-MPC)]*ΔG
What is the multiplier? If you have data on two output and spending levels, you could use these data to calculate the multiplier.
Multiplier = (ΔY/ ΔG) = 1/(1-MPC)
The Graphical Approach
The situation can be presented with the aid of the simple Keynesian - cross diagram. Although it is not clear in the diagram, the slope of the Consumption and Aggregate Demand curves are equal to the marginal propensity to consume = .8. Furthermore, the intersection of the AD and the 45 degree line occurs at an income of 12,000. The intersection occurs at this level since it is the graphical and the intersection of the C+I+G+X-M line and the 45 degree line is the equilibrium level of income.
To see the impact of an increase in aggregate demand, you can compare the two diagrams which differ only in that the second one describes the situation after a 400 increase in net exports. The equilibrium level of income rises to 14,000 which is what we would expect given our earlier work. In the tabular section, income increased by 1,000 for an increase in G of 200, while here the increase in income is 2,000 when the increase in spending is 400. In both cases the multiplier is 5 = 1/(1-MPC).
Initial Situation
Situation after 400 Increase in Demand
The Algebraic Approach
The algebra of the simple Keynesian model is presented in the set of equations below. The structural model is:
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C = 2000 + .8*Y
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I = 180
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G = 150
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(X - M) = 170
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AD = C + I + G + X - M
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AD = Y
Where:
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C = consumption spending
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I = Investment spending
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G = Government spending
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(X-M) = Net export spending
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AD = aggregate demand
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Y = Aggregate income
Following standard procedures, if we substitute all of the information into the last equation then we can solve for the equilibrium level of income as follows.
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Y = C + I + G + X - M
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Y = 2000 + .8*Y + I + G + X - M
- Y*(1-.8) = I + G + X - M
- .2*Y = I + G + X - M
- Y = [1/(1-.8)]*[I + G + X - M]
Completing the substitution we get:
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Y = 2000 +.8*Y +180 + 150 + 70
- Y-.8Y = 2400
- .2Y = 2400
- Y = [1/.2]*2400
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Y = 12,000
No surprise here - the equilibrium level of income is 12,000
To derive the multiplier all you need to do is redo the problem for a different level of spending (G, I, X, or M) and derive the new equilibrium. If you allow the government spending to increase by 200 so that it is 350 rather than 150, you end up with the equation Y =(1/.2)*2600 = 13,000. This is precisely what we found using the tabular approach.
The multiplier in this problem equals 1000/200 = 5 which is what we get if we plugged a marginal propensity to consume of .8 into the formula: ΔY/ΔG = (1/(1-.8)) = 1/.2 = 5.
