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Example 1: An increase in Total Expenditures to shift the AD curve right would be necessary to
close a recessionary gap, according to Keynesian theory.
Price
Level
Real GDP
SRAS
AD1 AD 2
Q N
Classical theory emphasizes supply, and takes demand for granted. After all, “supply creates its
own demand”. Keynesian theory emphasizes spending as the driving force in the economy.
According to Keynesian theory, the level of Total Expenditures determines the level of total
output. Next, we look at the components of Total Expenditures (consumption, investment,
government purchases, and net exports) and how they are related to total output (Real GDP).
Consumption
Consumption is the largest of the four types of spending that make up Total Expenditures.
Consumption is determined primarily by disposable income.
Example 2A: Assume that the table below shows the relationship between disposable income
and consumption for different levels of disposable income:
Disposable Income Consumption
$5,000 $11,000
10,000 14,000
15,000 17,000
20,000 20,000
25,000 23,000
30,000 26,000
35,000 29,000
Notice from the table above that consumption increases as disposable income increases. Each
time disposable income increases by $5,000, consumption increases by $3,000. When
disposable income is less than $20,000, consumption is greater than disposable income. The
households are dissaving. When disposable income is greater than $20,000, consumption is less
than disposable income. The households are saving. At $20,000 of disposable income,
consumption equals disposable income. At relatively low levels of disposable income, dissaving is
common. Many low income households are headed by young adults at the start of their working
careers or by older adults in retirement. Dissaving allows these households to practice
consumption smoothing; to smooth out the level of their consumption over their lifetimes.
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Keynesian Economic Theory 8 - 2