THE MODERN THEORY OF INCOME,

EMPLOYMENT , AND PRICES

In the short run, whether we have depression,prosperity or inflation depends largely on the level of aggregate demand. What determines the level of aggregate demand, is thus an extremely important question. In Chapter 5 we simply assumed different levels of aggregate demand. Now we must add an explanation of demand to cornbine with the aggregate supply curve developed there.

To answer this question, most modern economists use an “income-expenditures” model, which stresses that one big part of aggregate de mand—what people spend on consumption—de pends primarily on the incomes they receive. What businesses and governments spend is de termined mainly by other forces. This analysis focuses attention on the three big components of gross national product from Chapter 4—on pri vate consumption spending, private investment spending, and government spending, on their de terminants, and on their interrelationships. (We shall continue temporarily to ignore international considerations, postponing them to Part Six.)

SIMPLE STATIC G.N.P. MODEL

To simplify, first assume temporarily that there is no government spending or taxation. Thus, aggregate demand is the sum of consump- tion (C) plus private investment spending (I). Since aggregate demand is also equal to gross national product, we can also say that g.n.p. equals C + I. (Economists typically use Y to rep- resent national income or g.n.p., and so will we.)

Second, assume (what many economists consider a reasonable first approximation to reality) that consumption spending depends en- tirely on the incomes that people receive, and not on any other factor. Moreover, the portion of their income households don’t spend on con- sumption, they save. Since saving is simply that amount of income received which is not spent on consumption, savings also depend on the amount of income people receive.

Third, assume temporarily that business in- vestment spending is autonomously determined. That is, businessmen decide how much to invest on the basis of considerations other than con- sumer spending and saving. What this means as a practical matter is that we simply take business investment spending as given for any time period at this stage of the analysis.

Thus, given these assumptions, in this sim- ple income-expenditures model aggregate demand in each year will be the sum of two parts: business investment spending (a given amount determined autonomously), and consumption spending (which is dependent on the incomes that house- holds receive). But income, which determines consumption, is in turn partially made up of consumption spending. Thus it should be clear that g.n.p., consumption, and investment are all interacting in what we may call a simultaneously determined system. Given these assumptions, we can readily show how consumption and invest- ment spending interact to produce an equilibrium level of aggregate demand (and hence g.n.p.) each year. The reasoning can be presented ver- bally, graphically, or algebraically. It’s done all three ways below, because different people find different approaches most helpful. Note therefore that the following sections repeat the same analysis in these different forms.

Algebraic Presentation

We have defined aggregate demand as being
equal to g.n.p., which is equal to consumption
plus investment spending. Let Y stand for ag-
gregate demand and g.n.p. Then:

Y=c+I

Now assume that consumption spending is always
just .75 of income (that is, people spend three-
fourths of their incomes on consumption and
save one-fourth), so that:

C =.75 Y

Saving (S) is the portion of their income that
households don’t spend on consumption. Thus,
S = .25Y. Remember that investment (I) is
autonomous; it is independently determined. That
is, business investment spending depends on ex-
pected profits, on new inventions, or some other
forces, but not on consumption spending or sav-
ing. Suppose, now, that business investment
spending is 100 this year, so:

I =100

Now, substitute the values for C and I in
our original equation, Y = C + I. We get:

Y=.75- y + 100

Using the rules of elementary algebra, move the
.75Y to the left side of the equation. This changes
the sign from plus to minus, and we have:

Y—.75Y=100,or
.25Y = 100, or
100

Y= 100/.25 and

Y = 400

Equilibrium aggregate demand, or g.n.p., will be
400 if investment is 100 and people spend three-
fourths of all the income they receive on con-
sumption.

This is the “equilibrium” level of g.n.p., given our assumptions. That is, it is the level to which aggregate demand and g.n.p. will move, and the level at which they will stay once they get there, unless something new comes along to change them. It is this equilibrium level of g.n.p. (aggregate demand) we are trying to explain in this chapter.