The Keynesian model applies to the very short run in which firms have fixed the prices of their goods and services. As a result, the price level is fixed and so aggregate demand determines real GDP.
Expenditure Plans
Aggregate planned expenditure is equal to planned consumption expenditure plus planned investment plus planned government expenditure on goods and services plus planned exports minus planned imports.
In the very short term, planned investment, planned government expenditure, and planned exports are fixed. Planned consumption expenditure and planned imports are not fixed, but depend on aggregate income. An increase in real GDP increases aggregate expenditure and an increase in aggregate expenditure increases real GDP.
Consumption Function and Saving Function
Consumption expenditure and saving depend on the real interest rate, disposable income, wealth, and expected future income. Disposable income is aggregate income minus taxes plus transfer payments. The relationship between consumption expenditure and disposable income, other things remaining the same, is called the consumption function. The relationship between saving and disposable income, other things remaining the same, is called the saving function.
The figure shows a consumption function. Along the 45 degree line, consumption equals disposable income. When the consumption function is above the 45 degree line, there is dissaving. When the consumption function is below the 45 degree line, there is saving.
The consumption expenditure when disposable income is zero, $4 trillion in the figure, is autonomous consumption. Consumption expenditure in excess of this amount is induced consumption.
Marginal Propensities to Consume and Save
The marginal propensity to consume (MPC) is the fraction of a change in disposable income that is consumed, DC/DYD. The MPC is the slope of the consumption function, which is 0.67 in the figure.
The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved, DS/DYD. The MPS is the slope of the saving function.
The sum of the MPC plus the MPS equals 1.0.
Other Influences on Consumption Expenditure and Saving
A change in any other factor influencing consumption and saving besides disposable income (such as the real interest rate, wealth, and expected future income) shifts the consumption function and the saving function. An increase in wealth or expected future income and a decrease in the real interest rate increases consumption—and shifts the consumption function upward—and decreases saving—and shifts the saving function downward.
The U.S. MPC is about 0.9. Since the 1960s, increases in expected future income and wealth have shifted the consumption function upward.
Consumption as a Function of Real GDP and the Import Function
For a given level of taxes and transfers, disposable income changes when real GDP changes, so consumption also is a function of real GDP. We use this observation when we derive the aggregate expenditure function.
Just as consumption of domestically produced goods and services depends on real GDP, so do imports. The marginal propensity to import is the fraction of an increase in real GDP that is spent on imports.
The figure shows a consumption function. Along the 45 degree line, consumption equals disposable income. When the consumption function is above the 45 degree line, there is dissaving. When the consumption function is below the 45 degree line, there is saving.