The general idea behind the Keynesian approach is that natural forces cause our output of goods and services (i.e., aggregate supply, our national income) to match the level of aggregate demand for our goods and services. This match is called an equilibrium because at such a position there are no pressures for change. (Further discussion of the equilibrium concept can be found in appendix A at the end of this book.) The automatic movement of income to match aggregate demand has two implications. First, to predict the level of national income, we should look at what is happening to the level of aggregate demand for our goods and services. Second, to influence the level of national income, we can change any component of domestic aggregate demand over which we have control—by changing government spending, for example, we can influence the economy and thereby achieve desired ends such as avoiding unemployment.
Keynes viewed aggregate demand for goods and services as comprising four major types of demand: demand by consumers for things such as toys and haircuts, referred to as C for consumption demand; demand by business firms for things such as factories, machinery, and delivery tracks, referred to as I for investment demand; demand by the government for things such as hospitals, accountants, and armies, referred to as G for government demand; and demand by foreigners for goods we send abroad, such as wheat and lumber, referred to as x for exports. Demand in each of these sectors includes demand for imported as well as domestic goods and services. To obtain what is important for the Keynesian view, aggregate demand for domestically produced goods and services, imports must be subtracted from the sum of C, I, G, and X. Textbooks often use a circular-flow diagram to illustrate how these components of aggregate demand contribute to equilibrium. For those interested, this diagram (figure 4A.1) is presented in appendix 4.2 at the end of this chapter.
Keynes split demand up into these different categories for a good reason. He believed that it would be easier for economists to analyze these categories of demand separately rather than as an aggregate. For example, the factors that determine the level of consumption demand are different from those determining investment demand; recognizing this difference should provide better insight into the operation of the economy and how it might respond to policy. Much of the historical development of the Keynesian approach has taken the form of investigating in detail the economic forces that determine demand in one of these sectors and then seeing the implications that this analysis has for the operation of the economy as a whole.
One of the simplest of Keynes’s insights is that the level of consumption demand is affected by the level of income. As income increases, so does consumption, but not by as much because income earners save some income and set some aside to pay taxes. Economists usually capture this relationship by specifying that consumption is a function of after-tax (or disposable) income. As disposable income increases by, say, a thousand dollars, consumption demand increases by some fraction of the thousand dollars, say by $800. This fraction (0.8 in this example) is called the the marginal propensity to consume (MPC). The MPC tells us what fraction of an additional dollar of disposable income will be spent on consumption. The fraction not spent on consumption is called the marginal propensity to save. This consumption function, as it is known, is a major ingredient in the Keynesian explanation of the determination of income. Much more complicated variants of the consumption function have been developed, involving additional explanatory variables, but this simple version suffices to illustrate the Keynesian approach. The other categories of aggregate demand also have functions explaining their levels, but for now we ignore these functions and assume the categories are fixed at constant levels.