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The slope of the consumption function is

Â the marginal propensity to consume. Do you remember that key detail?

Â Now, in our closed economy model where we leave out net exports,

Â we also have other curves that,

Â by Keynesian assumptions, are horizontal lines.

Â These are the investment expenditure and the government expenditure functions.

Â So, here is a very key point.

Â If we vertically sum these curves,

Â we arrive at the aggregate expenditures function and,

Â because the investment and government expenditure functions are both horizontal lines,

Â that means that the slope of

Â the aggregate expenditures function will be the same as the consumption function.

Â Let me repeat that. The slope of

Â the aggregate expenditures function has the same slope as

Â the consumption function because the investment expenditures and

Â government expenditures functions are both horizontal lines.

Â Now, this complete aggregate expenditures curve is illustrated in this figure.

Â In this example, the full employment output is $900 billion.

Â However, the economy is stuck at a recessionary output

Â of $800 billion where the aggregate expenditures curve,

Â AE, crosses the 45-degree line of the aggregate production curve, AP.

Â In other words, this figure shows us a recessionary gap,

Â and the beauty of the Keynesian model is that it

Â helps us determine how fiscal policy can,

Â quite precisely, close that recessionary gap.

Â Before I demonstrate that, however,

Â we first need to master one more key concept,

Â that of so-called Keynesian expenditure multiplier or

Â the Keynesian multiplier for short.

Â In this key definition,

Â the Keynesian expenditure multiplier is the number by which a change in

Â aggregate expenditures must be multiplied

Â in order to determine the resulting change in total output.

Â Let me repeat that because it is so important.

Â The Keynesian expenditure multiplier is the number by which a change in

Â aggregate expenditures must be multiplied in

Â order to determine the resulting change in total output.

Â So, for example, if you want to change total output by

Â $200 billion and the Keynesian multiplier is 4,

Â you will need to increase aggregate expenditures by $50 billion.

Â And that's the simple arithmetic the Keynesian fiscal policy is based on.

Â Now, as a general observation,

Â we can say that the Keynesian expenditure multiplier is always greater than 1.

Â This is because income is respent,

Â and not just once, but many times after the initial increase.

Â This figure shows, in very fine detail,

Â how the multiplier process can thereby deepen a recession.

Â Please study this figure carefully before we move on to an explanation.

Â Looking at the figure,

Â here, we see that in Step 1,

Â there is an aggregate demand shock which leads to $100 billion

Â in unsold goods from a reduction in aggregate demand.

Â Now, in Step 2,

Â firms respond by cutting back on employment or wages.

Â This in turn leads, in Step 3,

Â to a reduction in income followed by a reduction in consumption in Step 4.

Â Of course, this reduction in consumption triggers a cutback in sales

Â and further cutbacks in employment and the process continues.

Â Now, here's the key point and it relates directly

Â to the idea of the Keynesian multiplier.

Â The ultimate impact of this initial aggregate demand shock on total spending can be

Â determined by computing the change in income and

Â consumption at each step of the circular flow.

Â So, how do we make what appears to be such a complex calculation in a simple way?

Â Well, in the Keynesian model,

Â it can be easily shown mathematically that

Â the Keynesian expenditure multiplier is

Â simply the reciprocal marginal propensity to save.

Â Let me repeat this key formula and do commit it to memory now.

Â The Keynesian multiplier is calculated simply by dividing 1

Â by the marginal propensity to save or MPS.

Â Now, take a minute to figure out how we may

Â rewrite this formula for the Keynesian multiplier in terms

Â not of the marginal propensity to save but

Â rather the marginal propensity to consume or MPC.

Â Do give this a try now while we pause the presentation.

Â So, if the Keynesian multiplier is simply 1 divided by the MPS,

Â we can also express the Keynesian multiplier as 1 divided by 1 minus the MPC.

Â Do you see that?

Â If so, let's move on now.

Â But if not, please go back in the presentation and review the math and logic of this.

Â Okay, let's work out some examples to really nail this.

Â So, please calculate the Keynesian multiplier for

Â the following values of the marginal propensity to consume: 0.5,

Â 0.75, 0.8, and 0.9.

Â And, as you do so,

Â please also note the relationship between

Â the calculated multiplier and the size of the MPC itself.

Â In particular, does the multiplier rise as

Â the MPC rises or does it move in the opposite direction?

Â Think about why this relationship may be so

Â and write down a few thoughts now before moving on.

Â This exhibit provides the multiplier for MPCs of 0.5,

Â 0.75, 0.8, and 0.9 while illustrating the first five steps of the multiplier.

Â You can see that the bigger the MPC,

Â and the less people are saving,

Â the larger will be the multiplier and the more effective fiscal policy will be.

Â That should be very intuitive and this is also an observation that is consistent with

Â our earlier discussion of leakages from

Â an economy where savings represent a major leakage.

Â In this case, the more thrifty a society is,

Â the less effective fiscal policy may be.

Â It's a well-known paradox in macroeconomics known as the paradox of thrift.

Â It's the idea that in attempting to save more individually,

Â individuals wind up saving less because

Â their collective savings behavior results in a slower economy,

Â reduced income, and, therefore, lower savings.

Â And with that startling paradox,

Â this module now comes to a close.

Â So, take a well-deserved rest and,

Â when you're ready, let's move on to the next module.

Â