1

The Keynesian Revolution: 1945 - 1970

Basic Keynesian Economics

At the end of Chapter you will be able to answer the following:

1. According to Keynes, consumption depends on (is a function of) what?

2. Define "disposable income" (review) . "average propensity to consume".
"marginal propensity to consume".
3. From a number set, calculate the marginal propensity to consume and the marginal
propensity to save. From this number set, calculate the equilibrium real GDP. First, do
so with only consumption and investment spending. Then, add it government purchases.
Finally, add in net taxes and net exports. (Relate to the circular flow model.)
4. If real GDP is below (or above) equilibrium real GDP, why will it rise (fall) to
equilibrium? (That is, why can these other levels of real GDP NOT be equilibrium?)
What is meant by "unintended inventory investment"?
5. What is a recessionary? an inflationary (expansionary) gap? Show these on the
aggregate demand - aggregate supply graph. (Review)
6. Explain why a change in investment spending (or government purchases) causes
equilibrium real GDP to change by more than the change in investment spending (or
government purchases).
7. What is meant by the “multiplier"?
8. How is the expenditures multiplier calculated? Why is the real expenditures multiplier
lower than indicated by the multiplier formula?
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Basic Keynesian Economics

Introduction

John Maynard Keynes, arguably the most influential economist of the 20th century,
was introduced in the previous chapter. The Great Depression of the 1930s had called
into question the Classical View of Economics, a view that had prevailed for over 150
years. Remember that the basic conclusion of the Classical View was that cyclical
unemployment would not last very long. Since unemployment rates would fall
automatically, there was no need for any government action to lower them. But rates of
cyclical unemployment had been very high from 1929 until the beginning of World
War II in 1941. In the previous chapter, Keynes’ criticisms of the Classical View were
discussed. In this chapter, we will examine the economic theory that Keynes developed to
replace the Classical view. This theory is known as Keynesian Economics. It became
somewhat influential after World War II and then became very influential in the 1960s.
We can break this theory into just a few components: (1) consumption, (2) Equilibrium
Real GDP, (3) inflationary and recessionary gaps, (4) multipliers, and (5) fiscal
policy. Fiscal policy will not be discussed until Chapter 18.

(1) Consumption

Let us begin to understand Keynesian economics by examining its analysis of

consumer spending. According to Keynes, consumer spending depends upon
disposable income. This relationship is known as the consumption function. We
described disposable income earlier. Disposable income is calculated as the National
Income minus Taxes Paid plus Transfers. Let us examine the following consumption
function:

Disposable Income Consumption Savings

0 $1000 -$1000
$1000 $1800 -$ 800
$2000 $2600 -$ 600
$3000 $3400 -$ 400
$4000 $4200 -$ 200
$5000 $5000 0
$6000 $5800 $200
$7000 $6600 $400
$8000 $7400 $600
$9000 $8200 $800
$10,000 $9000 $1000

Notice that there are only two things one can do with disposable income: spend it or
save it. The amount spent on consumption plus the amount saved must equal the
amount of disposable income. Notice also that savings can be negative. What does this
mean? It means that the person has either borrowed or has used previous savings to pay
for the consumption.
 3

Keynes made two assertions about consumption. First, as disposable income rises,
the amount spent by consumers also rises. This is shown clearly in the table on the
previous page. Second, as disposable income rises, the percent of disposable income
spent on consumer goods falls. Notice in the table that, if disposable income is $5000,
consumers spend $5000. This is 100% of disposable income. But if disposable income
is $10,000, consumers spend $9000. This is only 90% of disposable income.
This second point needs some illustration. Assume there are two people: Joe and Bill.
Each is married with five children. Joe has an income of $10,000 per year. How much
will Joe spend on consumer goods? Surely, Joe will spend all $10,000, and probably
more. The need for shelter, food, and transportation will likely absorb all of Joe’s income
(100%). Bill has an income of $100,000,000. How much will Bill spend on consumer
goods? Let’s say Bill can get by on $10,000,000. This would only represent 10% of
Bill’s income. What happens to the other $90,000,000? The answer is that it goes into
some form of saving. Bill spends a smaller percent of his income because Bill can afford
to save. Joe cannot afford to save at all.
Keynes gave a name to the percent of disposable income spent on consumer goods.
He called it the “average propensity to consume”. So, as disposable income rises,
consumption rises and the average propensity to consume falls. Keynes also named
another important concept: the marginal propensity to consume. This is defined as the
change in consumption that results from a given change in disposable income.

Average Propensity to Consume = Consumption

Disposable Income

Marginal Propensity to Consume = Change in Consumption

Change in Disposable Income

Notice that the marginal propensity to consume must be a number between zero and
one. A number of zero tells you that if disposable income rises by $1, consumption will
not rise at all. The entire additional dollar will be saved. A number of one tells you that
if disposable income rises by $1, consumption will rise by the entire additional dollar.
None of the increase will be saved. Go back to the table on the previous page. What is
the marginal propensity to consume? Notice that, as you read down the table, disposable
income always changes by $1000 (0 to 1000, 1000 to 2000, etc.). As it does,
consumption always changes by $800 (1000 to 1800, 1800 to 2600, etc.). So the
marginal propensity to consume is $800 divided by $1000, which equals 0.8 or 4/5. This
tells us that every time disposable income rises by $1, an extra $0.80 will be spent and an
extra $0.20 will be saved.
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Test Your Understanding

(1) Fill in the following consumption function:
Disposable Income Consumption Savings
0 1000
1000 1900 - 900
2000 2800 - 800
3000 3700
4000 - 600
5000 5500
6000 - 400
7000 7300
8000 - 200
9000 9100
10,000 0
11,000 10,900
12,000 11,800
13,000 300
14,000 13,600
15,000 500
16,000 15,400
17,000 16,300
18,000 800
19,000 18,100
20,000 1000
21,000 19,900
22,000 20,800
23,000 21,700
24,000 22,600
25,000 1500

(2) Calculate the marginal propensity to consume. ________________

Calculate the marginal propensity to save. _____________________

(3) If disposable income is 10,000, what is the average propensity to consume?

_________________
If disposable income is 20,000, what is the average propensity to consume?
_________________
Therefore, as disposable income rises from 10,000 to 20,000, consumption _______
And the average propensity to consume _____________ (answer “rises” or “falls”).

(2A) Equilibrium Real GDP with only Consumption and Investment

Equilibrium Real GDP is a concept we have discussed several times before. The
equilibrium Real GDP occurs when the amount that buyers desire to buy (aggregate
demand) is equal to the amount that sellers wish to sell (aggregate supply). The amount
that buyers wish to buy (aggregate demand) has been divided into four categories:
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consumer spending, business investment spending, government purchases, and net

exports. We have already considered consumption. As we did with the circular flow
model, let us bring in the other spenders one at a time.
First, let us bring in business investment spending. For simplicity, we will assume that
business investment spending does not depend on Real GDP. Business investment
spending depends on other variables (such as real interest rates or business expectations).
These other variables will be considered in Chapter 15. For now, assume business
investment spending to be a constant $400.

Real GDP (= Income) Consumption + Business Investment = Aggregate

Spending Demand
0 $1000 $400 $1400
$1000 $1800 $400 $2200
$2000 $2600 $400 $3000
$3000 $3400 $400 $3800
$4000 $4200 $400 $4600
$5000 $5000 $400 $5400
$6000 $5800 $400 $6200
$7000 $6600 $400 $7000
$8000 $7400 $400 $7800
$9000 $8200 $400 $8600
$10,000 $9000 $400 $9400
$11,000 $9800 $400 $10,200
$12,000 $10,600 $400 $11,000
$13,000 $11,400 $400 $11,800
$14,000 $12,200 $400 $12,600
$15,000 $13,000 $400 $13,400

The column labeled Aggregate Demand is calculated as the sum of consumption plus
business investment spending.

What is the Equilibrium Real GDP? The column on the left represents production
(Real GDP). Remember that production (Real GDP) is equal to National Income. The
column on the right represents Aggregate Demand. Equilibrium occurs where aggregate
demand equals aggregate supply. This occurs when Real GDP is equal to $7000. If
$7000 worth of goods and services were produced, consumers would buy $6600 and
businesses will buy $400. All $7000 worth of goods and services would be bought.
No other number can be equilibrium. To show this, let us pick one number below
$7000 and one number above $7000. Assume that Real GDP were $1000. Consumers
want to buy $1800 worth of goods and services while businesses want to buy $400 worth
of capital goods. Thus, buyers want to buy $2200. But there is only $1000 worth of
goods and services produced. As a result, there is a shortage equal to $1200 worth of
goods and services. In Keynesian language, unintended inventory investment falls.
(Inventories are the stock of goods on hand. They are considered as part of investment
spending. They have declined in a manner that was not planned.) When companies notice
that their inventories have declined, they will order more goods and services from
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manufacturers. Manufacturers will respond to the new orders by producing more. As

they produce more, Real GDP rises from $1000. Therefore, $1000 cannot be
equilibrium. (Changes in Inventories and New Orders from Manufacturers are
important statistics that people monitor closely. They predict future changes in Real
GDP.)
Now assume that Real GDP were $15,000. Consumers want to buy $13,000 worth of
goods and services while businesses want to buy $400 worth of capital goods. Thus,
buyers want to buy $13,400. But there is $15,000 worth of goods and services produced.
As a result, there is a surplus equal to $1600 worth of goods and services. In Keynesian
language, unintended inventory investment rises. When companies notice that their
inventories have risen, they will order fewer goods and services from manufacturers.
Manufacturers will respond to the reduction in orders by producing less. As they produce
less, Real GDP falls from $15,000. Therefore, $15,000 cannot be equilibrium. Only
$7,000 can be equilibrium because, if this amount is produced, there will be no shortages
and no surpluses.

Test Your Understanding

1. Go back to the circular flow model in Chapter 10. Put in the numbers to show what would
occur if Real GDP were $7000.
2. The consumption function from the previous Test Your Understanding is repeated below.
Business Investment Spending of 200 is added in. First, calculate the Equilibrium Real GDP.
Second, explain why $1000 cannot be the Equilibrium Real GDP.
Third, explain why $25,000 also cannot be the Equilibrium Real GDP.
Real GDP (=Income) Consumption Business Investment Spending
0 1000 200
1000 1900 200
2000 2800 200
3000 3700 200
4000 4600 200
5000 5500 200
6000 6400 200
7000 7300 200
8000 8200 200
9000 9100 200
10,000 10,000 200
11,000 10,900 200
12,000 11,800 200
13,000 12,700 200
14,000 13,600 200
15,000 14,500 200
16,000 15,400 200
17,000 16,300 200
18,000 17,200 200
19,000 18,100 200
20,000 19,000 200
21,000 19,900 200
22,000 20,800 200
23,000 21,700 200
24,000 22,600 200
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25,000 23,500 200

(2B) Equilibrium Real GDP with Consumption, Investment, and Government

Bringing government into the picture does not change anything significantly. There is
simply another spender. The basic principles of Section 2A are the same. The table on
the next page reproduces the previous table. However, in this table, it is assumed that the
government taxes $1000 and that the government also spends $1000. There are no
transfers. Equilibrium Real GDP occurs where Aggregate Demand (Consumption plus
Business Investment Spending plus Government Purchases) is equal to Real GDP.
From the table below, you can see that this occurs when Real GDP is equal to $8,000.

Real GDP Taxes Disposable Income Consumption Investment Government Aggregate Demand
2000 1000 1000 1800 400 1000 3200
3000 1000 2000 2600 400 1000 4000
4000 1000 3000 3400 400 1000 4800
5000 1000 4000 4200 400 1000 5600
6000 1000 5000 5000 400 1000 6400
7000 1000 6000 5800 400 1000 7200
8000 1000 7000 6600 400 1000 8000
9000 1000 8000 7400 400 1000 8800
10,000 1000 9000 8200 400 1000 9600
11,000 1000 10,000 9100 400 1000 10,400
12,000 1000 11,000 10,000 400 1000 11,200
13,000 1000 12,000 10,800 400 1000 12,000
14,000 1000 13,000 11,600 400 1000 12,800
15,000 1000 14,000 12,400 400 1000 13,600
16,000 1000 15,000 13,200 400 1000 14,400

Test Your Understanding

1. Explain why $2000 cannot be the Equilibrium Real GDP. Then, explain why $16,000 cannot
be the Equilibrium Real GDP.
2. Go back to the Circular Flow Model of Chapter 10. Plug in the numbers when Real GDP is
$13,000.
3. Go to the number set in the earlier Test Your Understanding. This is repeated below. Now
assume that the government spends $1000 and also taxes $1000. There are no transfers. What is
the new Equilibrium Real GDP?

Real GDP Taxes Disposable Income Consumption Investment Government Aggregate Demand
1000 1000 0 1000 200 1000
2000 1000 1000 1900 200 1000
3000 1000 2000 2800 200 1000
4000 1000 3000 3700 200 1000
5000 1000 4000 4600 200 1000
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6000 1000 5000 5500 200 1000

7000 1000 6000 6400 200 1000
8000 1000 7000 7300 200 1000
9000 1000 8000 8200 200 1000
10,000 1000 9000 9100 200 1000
11,000 1000 10,000 10,000 200 1000
12,000 1000 11,000 10,900 200 1000
13,000 1000 12,000 11,800 200 1000
14,000 1000 13,000 12,700 200 1000
15,000 1000 14,000 13,600 200 1000
16,000 1000 15,000 14,500 200 1000
17,000 1000 16,000 15,400 200 1000
18,000 1000 17,000 16,300 200 1000
19,000 1000 18,000 17,200 200 1000
20,000 1000 19,000 18,100 200 1000

(2C) Equilibrium Real GDP with Consumption, Investment, Government, and Net
Exports

When we bring in the rest of the world, we have the complete model. There is yet
another spender -- foreigners. The basic principles of Section 2A are the same. The table
below reproduces the previous table. However, in this table, it is assumed that exports
are equal to $1000 and that imports are also equal to$1000. Equilibrium Real GDP
occurs where Aggregate Demand (Consumption plus Business Investment Spending
plus Government Purchases plus Exports minus Imports) is equal to Real GDP. From
the table below, you can see that this occurs again when real GDP is equal to $8,000.
Real GDP Taxes Disposable Consumption Investment Government Exports Imports Aggregate
Income Demand
2000 1000 1000 1800 400 1000 1000 1000 3200
3000 1000 2000 2600 400 1000 1000 1000 4000
4000 1000 3000 3400 400 1000 1000 1000 4800
5000 1000 4000 4200 400 1000 1000 1000 5600
6000 1000 5000 5000 400 1000 1000 1000 6400
7000 1000 6000 5800 400 1000 1000 1000 7200
8000 1000 7000 6600 400 1000 1000 1000 8000
9000 1000 8000 7400 400 1000 1000 1000 8800
10,000 1000 9,000 8200 400 1000 1000 1000 9600
11,000 1000 10,000 9100 400 1000 1000 1000 10,400
12,000 1000 11,000 10,000 400 1000 1000 1000 11,200
13,000 1000 12,000 10,800 400 1000 1000 1000 12,000
14,000 1000 13,000 11,600 400 1000 1000 1000 12,800
15,000 1000 14,000 12,400 400 1000 1000 1000 13,600
16,000 1000 15,000 13,200 400 1000 1000 1000 14,400
Test Your Understanding
1. Using the new numbers above, explain why $2000 cannot be the Equilibrium Real GDP.
Then, explain why $16,000 cannot be the Equilibrium Real GDP.
2. Go back to the Circular Flow Model. Plug in the numbers when Real GDP is $13,000.
 9

3. Go to the number set in the Test Your Understanding above. These are repeated below. Now
assume that exports equal $1000 and also that imports equal $1000. What is the new equilibrium
Real GDP?
Real GDP Taxes Disposable Consumption Investment Government Exports Imports Aggregate
Income Demand
1000 1000 0 1000 200 1000 1000 1000
2000 1000 1000 1900 200 1000 1000 1000
3000 1000 2000 2800 200 1000 1000 1000
4000 1000 3000 3700 200 1000 1000 1000
5000 1000 4000 4600 200 1000 1000 1000
6000 1000 5000 5500 200 1000 1000 1000
7000 1000 6000 6400 200 1000 1000 1000
8000 1000 7000 7300 200 1000 1000 1000
9000 1000 8000 8200 200 1000 1000 1000
10,000 1000 9000 9100 200 1000 1000 1000
11,000 1000 10,000 10,000 200 1000 1000 1000
12,000 1000 11,000 10,900 200 1000 1000 1000
13,000 1000 12,000 11,800 200 1000 1000 1000
14,000 1000 13,000 12,700 200 1000 1000 1000
15,000 1000 14,000 13,600 200 1000 1000 1000
16,000 1000 15,000 14,500 200 1000 1000 1000
17,000 1000 16,000 15,400 200 1000 1000 1000
18,000 1000 17,000 16,300 200 1000 1000 1000
19,000 1000 18,000 17,200 200 1000 1000 1000
20,000 1000 19,000 18,100 200 1000 1000 1000
21,000 1000 20,000 19,000 200 1000 1000 1000

(3) Gaps

The concept of the gap has been discussed before. The gap is the difference between
the Equilibrium Real GDP ( the amount of production that will actually occur) and the
Potential Real GDP (the amount of production necessary to have full employment). If
the Equilibrium Real GDP is below the Potential Real GDP, the gap is called a
recessionary gap. If the Equilibrium Real GDP is above the Potential Real GDP, the
gap is called an inflationary gap.
Go back to the earlier table. The equilibrium Real GDP was calculated as $8,000.
Assume that the Potential Real GDP is equal to $13,000. Then, there is a recessionary
gap of $5,000.
According to Keynes, if nothing is done about it, this gap will continue indefinitely
and perhaps will become larger. Wages and prices will not fall sufficiently to reduce the
gap. Real interest rates will fall, but neither consumer spending nor business investment
spending will rise because of pessimistic expectations. Closing the gap will require
government actions.

Test Your Understanding

Go back to the table at the top of page 9. The involves the Test Your Understanding example you
have been using throughout this chapter. Assume now that the Potential Real GDP is equal to
$10,000. How large is the gap? What kind of gap is it?
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(4) Multipliers

Once again, refer to the table at the bottom of Page 8. The Equilibrium Real GDP was
$8000. Now assume that the government increases its purchases from the 1000 to 2000.
All the other numbers are to remain the same, including taxes. What is the new
Equilibrium Real GDP?

Real GDP Taxes Disposable Consumption Investment Government Exports Imports Aggregate
Income Demand
2000 1000 1000 1800 400 2000 1000 1000 4200
3000 1000 2000 2600 400 2000 1000 1000 5000
4000 1000 3000 3400 400 2000 1000 1000 5800
5000 1000 4000 4200 400 2000 1000 1000 6600
6000 1000 5000 5000 400 2000 1000 1000 7400
7000 1000 6000 5800 400 2000 1000 1000 8200
8000 1000 7000 6600 400 2000 1000 1000 9000
9000 1000 8000 7400 400 2000 1000 1000 9800
10,000 1000 9,000 8200 400 2000 1000 1000 10,600
11,000 1000 10,000 9100 400 2000 1000 1000 11,400
12,000 1000 11,000 10,000 400 2000 1000 1000 12,200
13,000 1000 12,000 10,800 400 2000 1000 1000 13,000
14,000 1000 13,000 11,600 400 2000 1000 1000 13,800
15,000 1000 14,000 12,400 400 2000 1000 1000 14,600
16,000 1000 15,000 13,200 400 2000 1000 1000 15,400

The answer, as you can see, is now $13,000, where the new aggregate demand equals the
Real GDP. What is the new gap? The answer is zero (Equilibrium Real GDP of $13,000
minus Potential Real GDP of $13,000).

We have discovered something that needs to be explained. We increased government

purchases by $1000 (from $1000 to $2000). We did not change anything else. Yet,
Equilibrium Real GDP increased by $5000 (from $8000 to $13,000). Where does the
other $4000 come from?
Before we answer this question, let us define some terminology. Government
purchases increased by $1000. And Equilibrium Real GDP increased by $5000, which is
5 times the increase in government purchases. This number, 5, is called the Multiplier.
A multiplier is just a number that multiplies something to calculate something else. In
this case, the number multiplies the change in government purchases to calculate the
change in Equilibrium Real GDP.

Change in Government Purchases x Multiplier = Change in Equilibrium Real GDP

+1000 x 5 = +5000

Now, let us answer the question as to where the extra $4000 comes from. Suppose the
government spends the $1000 additional money to buy computers from Dell. This gives
Dell $1000 additional income. That additional income goes to the company’s workers,
owners, and suppliers. What do they do with the additional $1000 of income? To answer
this, we need the marginal propensity to consume. We calculated this as 0.8. This means
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that every $1 increase in income will cause consumption to increase by $0.80. There was
an increase in income of $1000. Therefore, consumption will increase in $800 (.8 times
$1000). We called this induced consumption. What happened to the other $200 of
income? The answer is that it was saved.
The workers, owners, and suppliers of Dell spent an additional $800 buying goods at
Sears. This provides an additional $800 of income for the workers, owners, and suppliers
of Sears. What do they do with this additional income? The answer is that they spend
$640 of it (0.8 times $640) and save the other $160. So we have another $640 of induced
consumption.
The workers, owners, and suppliers of Sears have spent $640 of additional income
buying food at Vons. This gives the workers, owners, and suppliers of Vons an additional
$640 of income. What do they do with this additional income? The answer is that they
spend an additional $512 (0.8 times $640) and save the other $128. So we have yet
another $512 of induced consumption.
This $512 will be spent, creating another round. In each succeeding round, consumers
will spend 80% of the addition to their income and save the rest. After four rounds, the
additional total spending now adds to $2952 ($1,000 + $800 + $640 + $512). We know
that, when all rounds are completed, total spending will rise by $5000.

Let us summarize. +1000 Spending by the Government

+ 800 Induced Consumption by Dell
+ 640 Induced Consumption by Sears
+ 512 Induced Consumption by Vons = $2,952
……….
_______
+5000 Increase in Equilibrium Real GDP

The basic principle of the multiplier is that one person’s spending generates another
person’s income. That person spends part of that additional income which generates
income for yet another person. And so on. The effect of an increase in spending
snowballs. But because only part of any increase in income is spent, the process
eventually ends.

Most of the time, we will not have a table by which to make the calculations. And we
will need the multiplier number. To calculate it, there is a formula. You need to
remember this formula:

1___________________
Multiplier = 1 – Marginal Propensity to Consume

Take the marginal propensity to consume, subtract it from 1, and then divide the result
into 1. So take 0.8, subtract it from 1, and the result is 0.2 (the marginal propensity to
save). Take 0.2 and divide it into 1 and the result is 5.
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In reality, the multiplier is likely to be much smaller than is given by this

calculation. In fact, the actual multiplier for government purchases is usually
estimated to be close to 2. The reason the actual multiplier is smaller is that our
calculation does not consider certain facts. First, as spending and income rise,
taxes will rise as well. The increase in taxes will hold back the growth of additional
spending. Second, as spending rises, prices (including interest rates) are likely to
rise as well. The rise in prices will also hold back the growth in additional spending.
And third, as spending rises, some of the increase in spending is likely to flow
out of the country as imports. If we considered the effect of the rise in taxes,
prices, and imports, our calculation would be much more complicated. So we will
keep the calculation simple. But remember that a realistic calculation would
generate a much smaller multiplier.

Test Your Understanding

What is the multiplier is the marginal propensity to consume is 1/2? 2/3? 9/10? 0?

We will use this in one of two ways. One, if government increases its purchases by
$1000, what is the new Equilibrium Real GDP? To answer this, you would solve with
the formula to find that the multiplier is 5. You would multiply the $1000 increase in
government purchases by 5 to get $5000. Then, you would add the $5000 on to the
original equilibrium Real GDP of $8000 to get $13,000. What is the new gap? The
answer is zero ($13,000 - $13,000)
Two, if the government wished to close the gap, what should it do to its spending?
The gap is $5000 ($8000 - $13,000). You would use the formula to calculate the
multiplier as equal to 5. What increase in government purchases, when multiplied by 5,
will increase equilibrium Real GDP by $5000. The answer, of course, is $1000.

Test Your Understanding

Go back to the table in the previous Test Your Understanding sections. Now assume that the
government decreases its purchases from $1000 to $500. There is no change in any other
variable, including taxes. Use the multiplier formula to calculate the new Equilibrium Real
GDP. Now calculate the new gap (Potential Real GDP is still $10,000). What kind of a gap is it?
If the government had desired to eliminate all recessionary and all inflationary gaps, what
should its purchases have been equal to? Again show using the multiplier formula.

(5) Summary

In the Keynesian view of Economics, consumption is related to disposable income.

An economy will generate an Equilibrium Real GDP each year. That Equilibrium Real
GDP occurs when the amount buyers wish to buy (the aggregate demand equal to
consumption plus business investment spending plus government purchases plus net
exports) is just equal to the amount sellers wish to sell (the Real GDP). Or to say the
same thing in different words, the Equilibrium Real GDP occurs where the entire
National Income that is earned is spent by some buyer (a consumer, a business, a
government agency, or a foreigner), no more and no less. That Equilibrium Real GDP
may or may not equal the goal for Real GDP, called Potential Real GDP (the amount of
production needed to have full employment). If the Equilibrium Real GDP is less than
 13

the Potential Real GDP, the difference is called a recessionary gap. If the Equilibrium
Real GDP is greater than the Potential Real GDP, the difference is called an
inflationary gap. In the Keynesian view, these gaps will not be eliminated automatically
in a relatively short time. They may be eliminated automatically eventually, but that is
not good enough. As Keynes put it, “in the long run, we are all dead”. Therefore, there
is a need for government action to eliminate any gap that exists.
Finally, the Keynesian view stresses the concept of the multiplier. Any change in
government purchases (or consumer or business purchases, for that matter) will cause
the Equilibrium Real GDP to change by more than that amount. This is so because a
dollar spent by the government gives someone additional income which will lead to
additional spending by that person, and so forth.
We need to analyze the actions the government can take to eliminate any gap that
might exist. But before we can do that, we need to do a more detailed analysis of the
factors affecting consumer spending and business investment spending. We will do this
in the next two chapters.

Practice Quiz for Chapter 13

Real GDP (National Income) Planned Investment Consumption

$ 500 500 600
1,000 500 1,000
1,500 500 1,400
2,000 500 1,800
2,500 500 2,200
3,000 500 2,600
3,500 500 3,000

1. The marginal propensity to consume is:

a. 400 b. 500 c. 1 d. 0.8 e. 0.75

2. If national income is 1000, what is the average propensity to consume?

a. 1 b. 1000 c. 0.8 d. 0.5 e. 0.75

3. According to Keynes, as disposable income rises, consumption ________ and the average propensity
to consume ____________.
a. rises; rises b. falls; falls c. rises; falls d. falls; rises

4. Using these numbers, the Equilibrium Real GDP is:

a. 1,500 b. 2,000 c. 2,500 d. 3,000 e. 3,500

5. Using these numbers, if Real GDP were 2,500, unintended inventory investment
(the shortage or surplus) would equal:
a. 0 b. 100 c. 200 d. 500

6. Using these numbers , if Potential Real GDP equals 3,000, there would be a/an:
a. inflationary gap of 500 b. gap of zero c. recessionary gap of 500 d. recessionary gap of 100

7. Using these numbers, if planned investment spending were to rise by 1,000

(to 1,500), the new Equilibrium real GDP would be: (hint: use the multiplier formula)
a. 1,500 b. 8,500 c. 5,000 d. 12,500
 14

8. Assume that government spending rises by $1000. The marginal propensity to consume is ¾. (This does
not relate to the numbers above.) In the first round, the amount of induced consumption will be:
a. $1000 b. $750 c. $800 d. $4000

9. Why does an increase in government purchases cause Equilibrium Real GDP to rise by more than the
increase in government purchases (i.e., why is there a multiplier)?
a. an increase in government purchases causes an increase in the money supply
b. an increase in government purchases increases people’s incomes causing them to spend more
c. an increase in government purchases causes an equal increase in taxes
d. an increase in government purchases causes an increase in interest rates

10. The actual multiplier is lower than the simplified multiplier from the formula because the formula does
not consider that, if government purchases increase,
a. taxes will increase c. imports will increase
b. prices will increase d. all of the above

Answers: 1. D 2. A 3. C 4. E 5. C 6. A 7. B 8. B 9. B 10. D