MODULE 3

KEYNESIAN THEORY OF BUSINESS FLUCTUATION

INTRODUCTION

According to Keynesian Theory, the government should play the key role in
economic development, particularly in less developed countries, or those with
depressed economic conditions. This theory contends that during economic
depression, the government should put up massive public works, like construction of
roads and bridges, and other labor intensive projects. These generates large scale
employment resulting to more incomes for more people. Such situation increases the
demand for goods and services. This means more production, and this enhances
economic development.
Keynes’s Theory contained an idea that a market economy might settle at an
underemployment equilibrium with no tendency to return to full employment. The
government would have to take responsibility for adjusting its taxes and spending to
keep the economy at full employment. Keynes’s view of the role of government
merely had to offset fluctuations in the private economy through changes in taxes and
government spending. The state needs to guide the private economy but not to take
it over.

COURSE LEARNING OUTCOMES

At the end of the module, students are expected to understand consumption

and saving functions and apply some Keynes analysis to explain the largest single
component of GNP of the business cycle.

A. THE CONSUMPTION FUNCTION

The structure of Macro economy explained how consumption patterns have

changed over the years. Here we want to concentrate on a different issue: how do
households decide how much to consume in total? What determines the amount of
your consumption and the amount of your saving? Remember that your saving can be
negative - you might borrow to finance consumption above your income. To study
what determines how much you consume, you have to figure out what determines
your income and what determines the amount that you either save out of your income
or borrow. Think of income as including all your spendable resources - earnings and gift
receipts, minus taxes.
Consumption Function is the relationship between consumption and income.

How did Keynes view the consumption function? From the fundamental psychological
law, is that men are disposed, as a rule and on the average, to increase their
consumption as their income increases but not by as much as the increase in their
income. And that a household’s consumption should depend systematically on its
income.
 To apply some Keynes’s analysis, consider the period between the business cycle
peal in July of 1987 and the cycle trough in November 1987. the number of people
unemployed in the Philippines rose by about 2 million. A pre-Keynesian economist might
have argued that these people reduced their consumption because their preference
for work versus leisure changed and they decided to reduce their hours of work.
Keynesians would argue that such a view is silly. Many of these unemployed people
wanted work, as one could see by their efforts to find jobs. These people were forced to
reduce their consumption when their incomes fell because of job losses beyond their
control. If unemployment can be involuntary, then income and consumption are not
always a function of work preferences and market wage rates. The important
relationship is expressed in the Keynesian consumption function, which specifies hte
relationship between consumption and income.

Figure 1: The Aggregate Consumption Function

Real
Consumption B
Per C2
Year

X Consumption
C1 function
C0 A

450

YD0 YD1 YD2

Real Disposable Personal Income per year

The aggregate consumption function shows how real consumption per year for
the total economy depends on the economy’s real disposable personal income per
year. Real personal disposable income is households’ income after taxes. The 450 line
shows all points for which consumption equals income. At a low level of income such as
YD0 , consumption of C0 exceeds income, and so household is dis-saving. At income YD1,
consumption equals income, and so saving is 0. at income YD2 , consumption is less than
income, and so saving is positive. In the real world, the consumption function seems to
be linear, or close to it, throughout its entire length.

B. THE AVERAGE PROPENSITY TO CONSUME

Economists use several different concepts in describing the characteristics of the

consumption function. The average propensity to consume (APC) is the ratio of
consumption to income. If your income is ₱10,000 and your consumption is ₱8,000. then
your average propensity to consume is ₱8,000/₱10,000, which is equal to 0.8. The
average propensity to consume may be the same for different households with the
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 same income and maybe the same for different households with different incomes. A
given household may change its average propensity to consume from one year to the
next. For example, a household with a steady income of ₱250,000 per year might have
consumption of ₱200,000 one year and ₱220,000 the next year. That household has an
average propensity to consume of 0.8 in the first year and 0.88 in the second year.
Because we are now studying the aggregate consumption function, we will be
concerned with the average propensity to consume for the economy as a whole. For
example, in 2016 disposable personal income for all households in the Philippines taken
together was ₱1,778.8 billion and personal outlays were ₱1,574.4 billion, for an average
propensity to consume of 0.89.
The Average Propensity to Consume (APC) is the ratio of consumption to income.

C. THE MARGINAL PROPENSITY TO CONSUME

The marginal propensity to consume (MPC) is the ratio of the change in

consumption to the change in income. It measures the peso change in consumption
for a ₱1 change in income. For example, suppose your income increases from ₱10,000
to ₱10,001 and as a result your consumption increases by ₱0.80. Then your marginal
propensity to consume at an income level of ₱10,000 is ₱0.80/₱1.00 is 0.8. The marginal
propensity to consume may differ from one income level to another, from one
household to another, and for any particular household from one year to another.
The marginal propensity to consume (MPC) is the slope of the consumption
function. It measures the peso change in consumption for a ₱1 change in income.

D. DISTINCTION BETWEEN APC AND MPC

The distinction between the APC and the MPC has an immediate practical
application. Suppose the government were to raise taxes on higher-income people like
professors, and distribute the proceeds to lower-income people like students. Our
intuitive reaction is that such a policy would raise consumption for the economy as a
whole because higher-income people consume a smaller fraction of their income than
do lower-income people. But the “smaller fraction” refers to the APC and what matters
for this problem is the MPC. If the consumption function is linear - a straight line - over its
entire length, then the MPC is the same at every income level. Reducing the after-tax
income of a rich professor by ₱1,000 would reduce that person’s consumption by, say
₱900. If the poor student who receives ₱1,000 has the same MPC of 0.9 - an implication
of a linear consumption function, then the student’s consumption would rise by ₱900,
and consumption for the economy as a whole would be unaffected.
Making use of some simple algebra is often convenient when discussing
consumption behavior. Most often, economists use a linear consumption function
because it is approximately correct as a description of the data and perfectly
adequate to the task of putting key ideas into algebraic form. A linear consumption
function looks like this:

C = a + bYD

We can relate this equation to a graph of the consumption function; for example,
see the linear section of the consumption function in Figure 1. In this linear function, a is
the intercept - it represents the point at which the straight line representing the
consumption function intersects the vertical axis. If the disposable income were 0,
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 consumption would equal a. The coefficient b shows how much consumption will
change for a ₱1 change in disposable income, and so b indicates the marginal
propensity to consume.

E. THE SAVING FUNCTION

Disposable income not consumed is, by definition, income saved. Thus,

explaining saving is the same subject as explaining consumption. However, sometimes
we find it convenient to look at the consumption/saving subject in terms of saving
rather than in terms of consumption, and so we need to employ a saving function
rather than a consumption function.
The saving function is related to the consumption function in a simple way. Figure
2 explains this relationship. In Panel A, which contains a consumption function , saving
and dis-saving are shown by comparing the consumption function with the 450 line. The
relation of saving to income derived from the consumption function is plotted in Panel B
of the figure. For example, in Panel A, the level of saving is S1 at income Y1 , and that
level of saving is plotted as a point on the saving function in Panel B.
We can obtain the saving function in algebraic form from the consumption
function through the following steps:

YD = YD

C = a + bYD , this is the linear consumption function.

By Subtracting, we obtain;

YD - C = YD - a - bYD

S = -a + (1 - b)YD , this is the saving function derived from the linear

consumption function.

In Figure 2, Panel A shows the consumption function; Panel B shows the saving
function derived from the consumption function. At point X in Panel A, the consumption
function crosses the 450 line, so we know that saving is 0 at YD0 , as shown in Panel B. At
YD1 , Panel A shows that saving is S1 ; Panel B reports the same information.

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 Figure 2: Relationship of the Saving Function to the Consumption Function

CONSUMPTION

YD1
Saving
S1

C1

X
Consumption
Dis-saving function

450

YD
Panel A

SAVING

S1

Saving
function

YD0 YD1 YD

Panel B

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F. THE AVERAGE PROPENSITY TO SAVE and MARGINAL PROPENSITY TO SAVE

The average propensity to save (APS) is the ratio of saving to income. The
marginal propensity to save (MPS) is the amount save out of one additional peso of
income. Referring to Figure 2, if saving S1 at income YD1 , then the average propensity to
save is S1/YD1 . As you can see from the saving function immediately above, the MPS is
(1 - b) which is an increase of ₱1 in YD increases saving by (1 - b). Because saving is
income not consumed, the APS is 1 minus the APC and the MPS is 1 minus the MPC. If
for example, a household with income of ₱10,000 consumes ₱8,000, it is saving ₱2,000.
The household’s APC is 0.8 and its APS is 0.2. If the household consumes ₱0.7 of an extra
₱1.00 of income, it saves ₱0.30; its MPC is 0.7 and MPS is 0.3.

The Average Propensity to Save (APS) is the ratio of saving to income.

The Marginal Propensity to Save (MPS) is the amount saved out of ₱1 additional
income.

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Learning Activities: (Assignment)

Suppose that a Keynesian consumption function has the equation,

C = a + bYD

Where C is consumption and YD is disposable income.

1. Show that the APC has the equation

APC = b + (a/YD)

And that the MPC has the equation

MPC = b

Sketch graphs of the APC and MPC for a = 100 and b = 0.75 with YD on the
horizontal axis. Describe these graphs and interpret them.

2. Determine the equation of the saving function and show that the APS has the
equation

APS = 1 - b - (a/YD)

And that the MPS has the equation

MPS = 1 - b

Sketch graphs of the APS and MPS for a = 100 and b = 0.75 with YD on the
horizontal axis. Describe these graphs and interpret them.

3.

Table A

INCOME (Millions of Pesos) CONSUMPTION (Millions of Pesos)

₱0 ₱ 25

50 50

100 75

150 100

Calculate the saving schedule and then calculate APS, APC, MPS, MPC.

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 ________________________________________________________________________________

REFERENCES:
Fajardo, Feliciano R. ECONOMIC DEVELOPMENT, Manila, National Bookstore,
2004

Henderson, Vernon J. PRINCIPLES OF ECONOMICS, Heath and Company, 2008

Lauron, Maria Theresa N. ECONOMICS, Manila, Ibon Foundation, Inc., 2009

Medina, Roberto G. PRINCIPLES OF ECONOMICS, Rex Bookstore Inc., 2013

Zaida, Sonia LIVING ECONOMICS, 2nd ed., All National Publishing Co.,
Inc. Philippines, 2002

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