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About this Lesson
 Type: Video Tutorial
 Length: 17:58
 Media: Video/mp4
 Use: Watch Online & Download
 Access Period: Unrestricted
 Download: MP4 (iPod compatible)
 Size: 193 MB
 Posted: 03/30/2010
This lesson is part of the following series:
Economics: Full Course (269 lessons, $198.00)
Economics: The Aggregate Expenditures Model (13 lessons, $26.73)
In this video lesson on economics, you'll learn about both the Expenditures Approach and the Saving Approach. Taught by Professor Tomlinson, this lesson was selected from a broader, comprehensive course, Economics. This course and others are available from Thinkwell, Inc. The full course can be found at http://www.thinkwell.com/student/product/economics. The full course covers economic thinking, markets, consumer choice, household behavior, production, costs, perfect competition, market models, resource markets, market failures, market outcomes, macroeconomics, macroeconomic measurements, economic fluctuations, unemployment, inflation, the aggregate expenditures model, banking, spending, saving, investing, aggregate demand and aggregate supply model, monetary policy, fiscal policy, productivity and growth, and international examples.
Steven Tomlinson teaches economics at the Acton School of Business in Austin, Texas. He graduated with highest honors from the University of Oklahoma and earned a Ph.D. in economics at Stanford University. Prof. Tomlinson's academic awards include the prestigious Texas Excellence Teaching Award given by the University of Texas Alumni Association and being named "Outstanding Core Faculty in the MBA Program" several times. He has developed several instructional guides and computerized educational programs for economics.
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Now we are ready to analyze the equilibrium in the Keynesian model of the macroeconomy. Pay close attention because once you have mastered this, you will have a very powerful tool for understanding and explaining how the economy works. Remember that Keynes' view is based on demand, and at the heart of the circular flow of goods and services in the economy, is the relationship between consumers and businesses. So, we're going to start by thinking about the balance between consumers and businesses, between consumption and income. Here's the flow of resources: consumers send their labor and capital to the factory markets, where firms buy them and transform them into goods and services that flow back to the households as consumption spending. Households then pay for these goods and services, providing revenue to businesses that allows the businesses to hire for the factor of production, putting income in the pockets of consumers. So if this is the only flow in the economy; if we start with this simplest possible model of the macro economy, it must be true that the top half of this flow has exactly the same magnitude, the same size, the same number as the bottom half of this flow.
Where do businesses get the money that they pay consumers as income? They get it when consumers buy goods and services. So in this simple model, the equilibriumthe stable outcome, the balanceis when consumption spending is exactly equal to real income. That's the notion here that gives us balance. If that's the case, then the economy is stable. If that's not the case, if consumption spending is greater than income; if consumers are trying to buy more stuff than the factories are actually creating, it's because what the factories are actually creating determines this. It's the goods and services that the companies have produced that allow them to earn the money that they are paying to the households as income. So if consumers are trying to spend more than they are getting in income, the economy is out of balance, factories are not producing enough and they might have to scramble to produce more. In the short run their inventories are going to be drawn down, and they are going to be forced into a position of unintended inventory reduction. So the only way we have a stable or balanced outcome is when consumer spending is equal to real income.
Let's look at a numerical example now, and see how this would work. Let's go back to our consumption function. This tells you what consumers are planning to spend as a function of their real income. At any given level of real income, consumers are going to spend A, the autonomous consumption plus B, the marginal propensity to consume multiplied by real income. So in our example, let's suppose that autonomous consumption is equal to 10, and let's further suppose that the marginal propensity to consume is equal to 0.8, or 8/10; consumers spend 80 cents out of each additional dollar that they are paid in income. Well if that's the caseif income is 40, and autonomous consumption is 10then consumers are going to spend eighttenths times 40, or 32 plus 10.The autonomous consumption (10) plus 32 gives total consumer spending of 42. In that case, consumers are spending more than their income so savings is going to be negative, we could go ahead and put that in our table.
Suppose now that income is higher, at 50. In this case, autonomous consumption plus the marginal propensity to consume multiplied by 50 (.8 times 50) is 40; plus 10 gives us total consumer spending of 50which in this case, is exactly equal to income, so savings is equal to zero. If income were highersay 9090 multiplied by .8 is 72; plus 10 is total consumer spending of 82. In this case, since income is greater than consumption we find that total savings is going to be equal to 8, a positive number, and finally if income is 100, 100 multiplied by .8 is equal to 80; plus autonomous consumption of 10 gives total consumption of 90, leaving savings to total 10.
Now, right now there is nowhere for savings to go in this economy. That is, if consumers put money in the bank, if they take some of their income and don't spend it, then there will be goods left on the store shelves that are not purchased, so that can't be an equilibrium. Businesses are accumulating inventory against their will, unplanned inventory investment. So in this simple model where our only circular flow is with household spending and income coming in, it must be true that consumption and income are equal in equilibrium. Therefore, our stable outcome is going to involve an income of 50 and a consumption of 50 and a savings of zerothat's the outcome that gives us stability.
Lets go and look at that outcome now in the picture that we have drawn, called the Aggregate Expenditure Diagram. In this case, we are going to have a consumption function with an intercept of A, (which in our case is 10) and a marginal propensity to consume of B (which in our case is .8), so here is the consumption function C as a function of Y, income. Now look at this point where the consumption function crosses the aggregate expenditures equal income line right here. Here we have microeconomic equilibrium. That is, at this level of output, Y, which in our story we have calculated to be 50, something very interesting happens. At this level of output we have consumers getting an income of 50, planning to do consumption of 50, so that total consumer spendingwhich, in this story, is the very sum of aggregate expenditures since consumers are the only people we have got in our model so faraggregate expenditure is equal to income. Consumers are planning to spend an amount of money (50) that generates an income (50) on which these spending plans are based. That's the notion of macroeconomic equilibrium: when people are planning to spend an amount of money that generates the income on which the spending plans are based. The top of the circular flow, balances the bottom of the circular flow; consumption expenditures are equal to income. If income were higher, say income were up here at some higher level like 100, then we would have the situation of consumption spending only being 90, as we calculated in our table, but income is 100, so we have unintended inventory investment. Businesses are producing more goods and services than consumers are planning to buy at an income of 100. Therefore, we don't have equilibrium, inventories accumulate, and businesses are going to cut back production in response to this excess supply of goods and services until finally we get back to an equilibrium, at which planned investment is equal to zero, in this case in which planned spending, consumer spending is equal to income.
On the other hand if income were lower, say it were somewhere down here, at 40, then consumers are planning to spend 42, but income is only 40, there is not enough stuff to satisfy consumer demand. In that case inventories are being drawn down; and businesses have to produce more goods and services to satisfy consumer demand, and as they increase their production of goods and services, income will increase until we will return to 50, the stable income, the equilibrium in this model.
Now that's an approach that focuses on consumer spending, one way of describing macroeconomic equilibrium is consumer spending equals income: consumers are planning to spend an amount of money that creates the income on which the plans are created. Now there is another way of explaining this, we have seen that when you have a consumption function, you can also draw a savings function. And the savings function has an intercept that has the same magnitude but the opposite sign. So the intercept of the savings function is negative 10, and the slope of our savings function is one minus the marginal propensity to consume, or the marginal propensity to save. Which in this caseas we have seen beforeis 0.2. Now the savings function in this case has an intercept right here, savings is to equal to zero when income is equal to 50. That isas we saw from the table a moment agowhen income is 50, people are planning to spend all of their income on consumer goods and services, leaving savings equal to zero. So, one way of explaining equilibrium in this case, is if there is nowhere for savings to go, if businesses don't want to borrow it, the government doesn't want to borrow it, if there is no one else in the model who might use your savings, then at equilibrium savings has to be zero. Consumers have to be spending all of the income that they get; otherwise either stuff is piling up on the shelves at the stores, or businesses have to take stuff out of their inventories to satisfy extra consumer demand. So one way of seeing the equilibrium here, is saying that if consumers are the only players in the market, savings has to be equal to zero; because there is no one else to use the savings.
Well let's now introduce savings more deliberately into the model and think about how savings really work in the macroeconomy. We will go back to our circular flow diagram and introduce savings into the picture, so here is my icon for savings. Savings are a leakage out of the system; that is money that consumers could be spending on goods and services, but instead they are choosing to put this into the bank as savings. Now who is going to use this savings? See, if the savings were here, if there were a positive amount of savings, as we saw in our table a minute ago and no one to use it, then we will have disequilibrium because consumers are getting income, but they are not spending on goods and services in our wheel: our circular flow is out of balance. But suppose we introduce businesses, and suppose businesses acquire consumer savings, and then spend it on plant and equipment, that is so called investment spending. If businesses acquire savings and then use them to buy the stuff in the market that consumers aren't buying, that can restore balance to the circular flow. Here is how it works: savings are a leakage out of the circular flow; but business spending, investment spending, is an injection back into the circular flow. So we label this investment spending and the way it works in our model is: investment spending balances the reduction and consumption that created the savings. So if there is 10 worth of savings and business spending is equal to 10, then the circular flow balances once again. The stuff that consumers don't buy when they divert some of their income into their savings account is purchased by businesses when they borrow that savings and use it to acquire plant, equipment and other capital goods. So, one way of thinking about an equilibrium condition when you have savingswhen you have this leakageis that in equilibrium, it must be true that what leaks out, flows back in. In equilibrium, savings has to equal investment. Well, there you have it, another way of describing macroeconomic equilibrium. In our simple story, we had zero savings: that is everything was spent; therefore, in equilibrium since savings was zero, investment spending would have to be equal to zero for everything to balance.
Let's go back to our numbers now, and suppose that we have savings in the economy. If we have savings in the economy, then we have something for businesses to borrow, to conduct their investment purchases. So let's suppose that businesses want to spend 10. That is the investment spending that they are planning to do is 10 at any level of income. If that is the case, the only equilibrium that we can have is one where consumers are willing to reduce their consumption spending relative to their income by enough to create savings for businesses to use. If the businesses want 10 worth of investment spending, there has to be 10 worth of savings to give us balance. Now our equilibrium is going to be 100. An equilibrium income level of 100, because only when equilibrium income is 100 is there enough of a gap between planned consumption and income to create the savings that satisfy businesses' demand for investment spending. That is when businesses increase their investment spending by 10; they will generate enough income so that consumers will do the savings that will satisfy their need for capital.
Here's another way of seeing the equilibrium condition: if you take investment spending and add it to consumer spending, 90 plus 10 is 100. Aggregate expenditure is equal to income; or equivalently, we can say we have equilibrium because the amount of money that people are saving is equal to the amount of investment spending that businesses want to do. Lets go over and look at that in the diagram. Here we have it in the diagram. Right now we only have consumption spending, but now were going to add on investment spending, so suppose we increase aggregate expenditure by the amount of investmentand in this case that is equal to 10so I shift my line upwards by 10 and now I have aggregate expenditure as a function out of income and it is 10 higher that my consumption function, same slope because investment spending is independent of the level of income. Well look, now my equilibrium point, the point at which the red line crosses the black dotted line has shifted way up here. That is, now, we have a balance between total planned spending and total income at an income level of 100, much higher that our original equilibrium income level.
Another way to see this is if we look in the diagram downstairs and I put investment spending in this picture, investorsthat is, businesses buying capital goodsare planning to spend a total of 10. Well, that means that at an income level of 100, we get enough savings generated by this highincome level to satisfy businesses' need to borrow money. That is only when the income level is 100, are consumers willing to save enough money, that gap between the dotted black line and the consumption function. Only when that gap has risen to a level of 10 is there enough extra money being saved by people so that businesses can go to the bank, borrow it, and do the 10 worth of investment spending that they are planning to do. Only whenever savings equals investment do we have macroeconomic equilibrium.
See, it is kind of interesting there are two ways of describing equilibrium in that circular flow, one is to say that spending equals incomethat is, the sum of consumer spending plus business spending is equal to the total income that is created. A second way, and equally good way, is to say that what leaks out, has to flow back in, that is savings is equal to investment spending. Notice, as you look at this picture that both pictures are telling the same story, just from different perspectives.
Let me summarize by writing this out in an equation, and I think this equation will help make it clear how the spending approach is exactly equal to the savings approach in explaining macroeconomic equilibrium. In our simplest model, it must be true that output is equal to consumption. Well you know that income is equal to what you save plus what you spend. Remember that there are only two uses of your income: and that is consumption and savings; and what it is you don't spend; you must be saving. Well if that is the case, then in the simplest version, if we set income equal to each other in these two equations, we get consumptions equals S plus C, or savings must equal zero. If your only spenders are households then it must be in equilibrium that savings is equal to zero.
Now if we add another set of spenders, that is if we add business spenders to our equation then aggregate expenditure and equilibrium has to equal income. So consumption plus investment spendingour aggregate expenditureset that equal to income, that is your condition for equilibrium. But it still has to be true that the total income that is received in the economy is equal to savings plus consumption. So if you set Y equal to Y you get C+I is equal to C+S or savings equals investment. They have to be equal in equilibrium. You heard the story intuitively and have seen it in the circular flow diagram; I've given you a simple numerical example; and then I drew diagrams to show you how the spending approach is equal to the savings approach; and finally we used this simple algebra. The idea here is: there are two ways of describing macroeconomic equilibrium. In one, you focus on the flow of spending and you say, what consumers are spending has to be equal to their income. In the second approach, you focus on what is leaking out of that wheel, and you say that everything that leaks out has to go back in at some point. The spending approach the savings approach: two ways of talking about when the economy is in balance.
Aggregate Expenditures Model
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He brings pure clarity to the problem of understanding equilibrium. Particularly with savings and investment and how they act with one another.