Classical Macroeconomics and Keynesian Aggregate
Expenditures
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The
Endogeneity of Foreign Trade Balances and Government Outlays |
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Classical Macroeconomics and Keynesian Aggregate Expenditures
Classical Macroeconomics
Bozoian Economics ‑ Explaining Say's Law
Philip J. McLewin,
Explain Say's Law and point out its implications that a capitalist market society is inherently stable at full employment ‑‑ when shocked it will automatically recover. At this stage draw a Bozo figure on the blackboard, the type with a weighted bottom used as a punching bag by young children.
Students already know what happens when Bozo is hit; after a period of adjustment rocking back and forth it fully recovers in the original upright position. It doesn't take much to realize that when the economy is "shocked" with a blow, it also recovers by itself. What gravity is to Bozo's recovery, flexible prices are to the market economy.
As you develop the Classical AD/AS framework, draw a Bozo around the AS curve. The upright Bozo is perfect to help explain why the AS function is vertical.
One Christmas my son gave me a Bozo. Economics seems less stuffy when you walk around campus with a big yellow Bozo in tow, and call yourself a specialist in Bozoian Economics.
Frank Whitesell,
Typically, a student's first introduction to macro‑theory is through the classical model, beginning with Say's Law. I have found that students have a very difficult time learning to think in macro terms. The following example helps in getting started.
Figure 9‑1
Imagine a closed economy consisting of ten people. Each is producing $10,000 worth of consumer goods or services. (You may want to give a few specific examples of occupations here.) Total production is $100,000 worth of goods. But how can we be sure that these people can sell all of the goods they are producing? There must be $100,000 in total spending. This, of course, results from each person's receiving $10,000 in income and spending all of it. This is basically what Say's Law assumes will happen. If everything works neatly, total demand will equal total production, and everyone will be fully employed.
Now ask your students what problem could arise in this economy. Most of them will quickly see that there will be a problem if people save part of their incomes. For example, if everyone saves 10%, only $90,000 will be spent and someone will be out of a job.
Now you need to explain the difference between saving and investment. This distinction is always confusing at first, because these words are often used interchangeably in everyday conversation. Then, with investment considered as another type of spending, you can show how full‑employment equilibrium is assured in the classical model by a flexible interest rate that equates saving and investment.
In the picture, now designate one of the people as a producer of capital goods. Now you have the supply side:
Production of consumer goods
(9 people x $10,000) = $ 90,000
Production of capital goods
(1 person x $10,000) = $ 10,000
Total output, or supply = $100,000
Spending for consumer goods
(10 people x $9,000) = $ 90,000
Saved, and channeled into
investment spending
(10 people x $1,000) = $ 10,000
Total spending, or demand = $100,000
Everyone is selling exactly what he or she produces, and the economy is still in equilibrium at full employment.
You may even take the opportunity here to look ahead and suggest how modern Keynesian theory denies the simple saving = investment linkage and therefore comes to quite different conclusions about the operation of our modern economy.
Wages and Prices During 1929‑33
Ralph T. Byrns
This is a good place to point out that the price level fell by roughly one third during 1929‑33, while average wages only fell by roughly one fourth. Suggest to students that this is a classical explanation for the decline in employment during this period, and ask if this implies that most of the unemployed could have secured jobs by taking wage cuts that were equal to the average of price cuts during this period. If so, does this mean that those who were without jobs were voluntarily unemployed?
Suggest that the classical wage‑bargaining mechanism may not be very smooth, with violence often being meted out to firms that insist on wage cuts (arson, sabotage, the Pullman Strike) and to individual workers who are willing to accept wage cuts so that others will be laid off‑‑mayhem, broken legs, etc.) Student opinion will typically range widely about how much violence or the potential for terrible employee morale might make wages sticky downwards.
Robinson Crusoe, Keynes, and the Classicals
Jim M. Cox, University of
Alabama at
When contrasting the Classical and Keynesian views on the macro-economy I always have occasion to make the point that whereas Classicals held that savings was equal to investment, Keynes believed the two were not necessarily equal. I ask the questions: Which might be greater, savings or investment? In the majority of cases the answer immediately comes back "investment!" This answer is based on the idea of borrowing money to finance investments. In order to deter this mistaken answer, I have instead begun to urge the students to first analyze the question in the setting of Crusoe alone on an island.
The Crusoe setting isolates the essentials--there's no money, no other people, and no credit cards to complicate the essential issue. With the Crusoe approach my students have routinely concluded that it is savings which can be greater than investment. The example I typically give after getting the correct answer from the students is that of Crusoe producing 5 apples today and saving 2, obviously the 2 do not have to be invested in the form of seeds for a future tree and future apples, therefore savings can be greater than investments.
The Crusoe approach has been helpful in analyzing other situations as well, such as deriving the law of diminishing marginal utility, illustrating opportunity costs, explaining roundabout production and (with Friday brought onto the island) the nature of exchange and the law of comparative advantage.
Keynes and the Classics: Using History
By Thomas J. Shea,
It is very difficult to keep student interest in the classical school of thought for two reasons. First they feel that something so long ago is outdated and irrelevant and second, the assumptions of the classical model that Keynes tears down seem too unrealistic when compared to "modern" thought.
I attempt to handle this cynicism by reiterating the distinction between long run and short run. It is very important to note that the classical economists were attempting to explain the long run effects of a "free enterprise" market economy model. They were aware of short run problems but feared that amelioration those problems would lead to even greater difficulties in the long run. As a matter of fact, the classical school is still the benchmark we must return to when we teach contemporary criticism of Keynesian thought. Many of the concepts of "modern" monetarism, supply side economics, rational expectations and the like can find their intellectual ancestors in classical thought.
At the same time, it is important to use the classical school as Keynes' "whipping boy" during the time he was writing. The great depression cried out for a solution and Keynes' maxim of "in the long run we're all dead" was the rallying cry for the beginnings of massive government intervention into the marketplace. Students are woefully ignorant of these times and the incredibly important shift in emphasis in economic thinking that came out of this period. It can be made exciting viewed in this historical framework, just as more recent struggles with inflation, the Vietnam war and budget deficits are in our discussion of post-Keynesian economic theory.
Finally, many of the economic arguments that students read about in newspapers and news magazines lead them to accept the old saw that "if you lined up all the economists in the world from end to end they would not reach a conclusion." Consideration of Keynes and the Classics will lead them to the idea that it is not economists disagreeing but that the opponents are arguing short run vs. long run "solutions" to an economic problem.
Classical See‑Saws and Keynesian Elevators
Erick Lee Erickson, Metropolitan State College‑Denver
Classical faith in the concept of full employment equilibrium can be likened to a seesaw between saving and investment. Keynesian theory can be compared to an elevator, driven by investment alone.
Classical economists explained business cycles as largely reflecting temporary imbalances between the actions of thrifty savers and enterprising investors. Full employment depended on equality between saving and investment, for if saving was not invested, it would be frozen out of the spending flow. But interest flexibility would automatically balance saving with investment. The classical model can be likened to a seesaw hinged on a full employment equilibrium. Saving in excess of investment might pull the economy down, but recovery is automatic because excess saving pushes interest rates down, stimulating investment spending so that this market clears. The economy might temporarily inflate if saving were inadequate to satisfy investors' demands, but shortages of investable funds would bring about higher interest rates and dampen investment. Any inflation or recession must therefore be temporary.
Note the "seesaw cross" between saving and investment in Panel A of Figure 9‑2, which illustrates a classical view of the loanable funds market. This seesaw yields the tendency for the economy to equilibrate in a stabilizing fashion towards full employment GDP, as shown in Panel B of Figure 9‑2.
Keynesian economists view the loanable funds market in a drastically different way, holding that saving is far more influenced by income than by interest rates. (Keynes was personally skeptical that interest rates had any influence on saving.) During a recession, saving dries up because income plummets, and there is feeble pressure, at most, to invest. The question of boom or bust depends on the health of the enterprise, not thrift. This model of the economy, reflected in Figure 9‑3, can be likened to an elevator, capable of stopping on any floor and remaining dormant until the right buttons are pushed. (Suggest that the vertical saving function in Panel A is like an elevator shaft.) Full employment may require a level of investment (or other autonomous spending) that may not be generated in the loanable funds market, leaving the economy to stagnate as shown in Panel B of Figure 9‑3. Unemployment that occurs because of this depressed GDP will not automatically go away.
Figure 9‑2 Classical Saving/Investment Seesaws
Figure 9‑3 The Keynesian Elevator
Classical Saving‑Investment‑Production Linkages
Joseph Williams,
This example emphasizes the importance of saving/investment to production, using a simplified farming operation.
Farmer Brown has one bushel of corn left over from last year, and so has one bushel to use as seed to plant for this year. Had he ground up that last bushel, baked it, and eaten it, he would have had no seed to plant for this year's crop. He then would have no more corn to eat, to feed his animals, or to sell. He would have nothing for the future. Farmer Brown had to save that bushel for planting.
Now, he can plant that bushel of corn and harvest many more bushels this year. Farmer Brown knew that saving a little now can provide him with a lot more later on. Investment goes along with saving. Investment is the using of saved goods in order to make more goods for the future. Farmer Brown invested when he planted that saved bushel of corn so that he could harvest more corn later. Saving makes it possible for investment to occur.
Through saving and investment, Farmer Brown can have even more corn. Let's assume that he harvests 20 bushels this year. If he gives 2 bushels to his farm animals, eats 5 bushels, and sells 12 bushels, he then has 1 bushel left. He could save that bushel and plant it next year, harvesting 20 bushels again. His production provides him with something to save. Saving is possible only when not all income is consumed.
He realizes that 1 bushel saved this year will provide for 20 bushels next year; but if he saves 2 bushels this year, he might harvest 40 bushels next year. Then he could have more corn to eat, to feed his animals, and to sell. By increasing his investment, Farmer Brown can produce more goods and increase his economic well‑being.
A nation's production of goods and services must increase if its people are to enjoy a higher standard of living. This increase in production requires more investment. However, this additional investment will require more savings. Just as Farmer Brown tried to save the second bushel of corn, so must an economy try to save more of its present output in order to provide for more future investment and economic growth.
The Importance of Classical Macro
Ralph T. Byrns
We emphasize classical (pre‑Keynesian) theory for a couple of reasons. One is that it sets the stage for Keynesian analysis and explains the laissez faire approach to macroeconomic policy prior to the 1930s. Another is that classical theory has been modified and restated in the theories of efficient markets and rational expectations, and in the works of modern supply‑siders. These recent innovations in macroeconomic theory are treated later in the text, but a thorough exposition of classical analysis is an important foundation for student understanding of them. NOTE: we use the term classical to refer to most of economic theory prior to Keynes, including early approaches to the quantity theory of money (Chapter 14). The term `neoclassical' may seem more appropriate, but it raises a number of issues (e.g., If this is neoclassical, then what was classical?) that waste class time. Thus, we use the `classical' label that Keynes used to refer to earlier thought.
Classical Economics and Homeostasis
Ralph T. Byrns
The suggestion in the text that classical economics relies on automatic adjustments that are analogous to biological processes called homeostasis (e.g., fevers or chattering teeth to regulate temperature) is one that students enjoy discussing, especially since many will have recently taken a biology course. Ask your students for examples of homeostasis other than those offered in the text. NOTE: A colleague has suggested that this example has an Austrian flavor because Austrians view the economy as an adaptive organism rather than as a repetitive machine based on principles drawn from physics, which is the basis for much of traditional classical modeling (marginalism). Nevertheless, this analogy works well for students, and is worth elaborating.
Involuntary Student Unemployment?
Ralph T. Byrns
One useful classroom technique is to ask students if any of them have ever been involuntarily unemployed. If some respond in the affirmative, ask if they would have been willing to work for the minimum legal wage. If they say "no", see if they will admit that they could easily have found a job at $3.35 per hour, or whatever, in which case they were voluntarily unemployed. If they were willing to take a minimum wage job, ask if they would have worked for, say $1.00 per hour had it been legal to do so. If the answer is yes, then suggest that a law kept them from working, not the market system. The more persuasively you use a classical line of reasoning with your students, the better they will understand the power of classical argument.
Money and the Price Level as "Veils"
Ralph T. Byrns
Introduce students to the classical notion that all `real' behavior is homogeneous of degree zero in money prices (but don't use this terminology). You can do this by asking if their work or spending patterns, etc., would change if we used e.g., euros, yen, pesos, or rubles instead of dollars. Most will intuitively say that this would not affect their behavior. Now ask if the time, wear and tear on the car, gasoline, etc. used to drive from your town to, say, Los Angeles, would be affected if current measurements (gallons and miles) were converted to a metric system (liters and kilometers.) Again, the common response will be negative. Then ask if their behavior would be altered if all prices, including wages, were raised (or lowered) by 10 percent. 20 percent? 100 percent? In all cases, the answer will probably be no, especially from students who fancy themselves ultrarational. Point out that their behavior is consistent with the interpretation of a classical Aggregate Supply curve, as shown in our parallel text chapter.
An interesting diversion is to ask why, if units of measure do not matter, most people change the hours they awaken, eat, and go to school or work when governmental edict moves us from standard time to daylight‑saving time or vice versa. If people are ultrarational about numeraires, they should reset their clocks but then move their activities up or back one nominal hour to correct for this `new' system of time measurement.
Keynesian Aggregate Expenditures
C + I + G + (X ‑ M)
Consumption, Saving and the Invasion of the Killer Bees
Holley Ulbrich,
Students have trouble with the constant term in the consumption function‑‑especially the vertical intercept, which seems to indicate that consumption goes on even when income and output are zero. I point out that it is easy for an individual to consume by dissaving ‑‑ drawing on past savings, or borrowing against future saving. But how do we do it collectively? I remind them of some of the horror movies they have seen such as Invasion of the Killer Bees. Fleeing from disaster, there is no time to produce; income and output temporarily fall to zero. Instead, we see people looting the stores for food, a graphic example of dissaving by drawing down on accumulated inventories. In longer term disasters, they pillage buildings for materials and wear out their capital rapidly without replacing. Bread and circuses in the late Roman empire were made possible by letting the society's rich stock of physical capital, buildings, roads and aqueducts, be used and allowing capital to wear out without replacement. They were eating their capital, or dissaving.
Ralph T. Byrns
Students enjoy discussions of dissaving because so many of them are financing their college educations by borrowing or by drawing down past savings. You can introduce this point by asking if any student has a zero income. Several will normally answer that this is their situation. Ask one of them if he or she is spending any money this year. After the affirmative answer, illustrate this person's situation on the board, showing positive autonomous spending at zero income. Use realistic numbers while you are doing this. Query the student about the source of spent funds. This yields a discussion of sources for dissaving. Then ask if the student would continue to dissave as much if he or she was awarded an additional $1,000 as a scholarship. A little discussion should enable arrival at an estimate of this person's MPC. If you assume that this MPC is constant, you can draw a linear Keynesian consumption function. You might suggest the possibility that the MPC diminishes slightly as people achieve ever higher incomes. Discuss this with the class as you graphically illustrate a nonlinear Keynesian consumption function. Then indicate that to simplify the analysis (per Occam's razor), you will use the linear function as you build a full Keynesian cross model.
Distinguishing the MPC from the APC
Michael Kuehlwein,
After introducing the concept of the marginal propensity to consume and relating it to the slope of the consumption function, I like to test the class on how well they understand the concept. So I tell them there is a hypothetical economy in the world where C is $400 million and DI is $500 million. I then ask them what the MPC is in this economy.
Someone usually suggests .8. To explain why this is wrong, I show then that all you have is one point on our consumption function and you can draw many different lines with different slopes through that point:
Figure 9-4
So we need at least two points to pin down the slope and MPC. We can, however, determine that the average propensity to consume in this economy is .8. For that all we need is one point reflecting total consumption and income.
The Circular Flow As A Teaching Device
Robert Scott Gassler, Vesalius College of the VUB
My only experience as a teaching assistant was with a professor who had me grade 125 assignments on the circular flow diagram. Perhaps that gave me a psychological need to justify my work, but in any event I started thinking about the meaning of such diagrams. A seminar paper on network theory written earlier for Kenneth Boulding gave me an appreciation for the logic and richness of circular flow and similar diagrams. My experience has been that expanded circular flow diagrams helps students connect a large amount of macroeconomic information that otherwise seems fragmentary and disjointed.
The Problem: Every principles textbook has at least one circular‑flow diagram (usually in an introductory chapter or early chapter on macroeconomics), at least a few pages on the national income accounts (with a table indicating how to go from GDP to personal income in several easy steps), and a section devoted to the development of the Keynesian cross. Some texts also try to distinguish behavioral relations from equilibrium conditions. These topics often appear to students as unrelated to each other or to much else.
The Solution: The first year I taught macro principles on my own I bit the bullet and designed my own circular‑flow diagram, as shown in Figure 9‑5. Note that the four sectors of the economy and the Rest‑of‑World "sector" are in boxes and the lines connecting them are flows of income; flows of goods are suppressed for simplicity. The whole diagram can be drawn upside down, but make sure that the Firms and Households boxes are on the outside (not counting Rest‑of‑World). Using the term "Treasuries" instead of "Government" stresses that other parts of the government show up elsewhere, e.g., the Postal Service is in the Firms box and the FED is in the Banks box.
As an exercise, ask the class to fill in the labels for the lines. (Someone will always get the X and M mixed up; that gives you an excuse to explain that these are flows of income, not goods and services.) For "investment," use fixed investment, which includes both net and replacement investment. Make sure you separate out the change in inventories.
Figure 9‑5
Then explain that classical macroeconomics talked only about the outer ring (again not counting Rest‑of‑World); here Say's Law looks trivial. Now explain that one of Keynes' contributions was to emphasize the roles of the two inner boxes and point out that the pipelines to and from the banks box could get clogged. The only way for the government to unclog the system (assuming that the Bank of England would not do what Keynes thought it should) is to run a deficit, thus adding to the flow what the banking sector took away. Thus, a circular flow diagram can be used to highlight a central point for policy of the Keynesian Revolution. Now explain that the circular flow can be measured at any point and, if we remember to make the right adjustments, the number we get will be consistent with whatever we get by measuring it anywhere else in this diagram. Point to the lower left corner, the upper right corner, and the lower right corner. They are, respectively, the Gross Domestic Product, National Income by source, and National Income by disposition. It is now easy to see why we need to subtract some things from GDP to get national income.
Next point out that (according to network theory) the basic principle for each box is that what goes in equals what goes out, and that according to accounting principles there will always be a term for each box that will take up the slack, e.g., "Deficit" should be a term placed right beside "Taxes" on the arrow going into the Treasuries box. Point out the Change in Inventories term as the most important of these.
Take the Firms box and add the terms going in and equate them to the ones going out:
C + I + G + X + (chg inv) = PY + CCA + CS + IBT + M
By convention we subtract M from each side to get:
C + I + G + (X‑M) + (chg inv) = PY + CCA + CS + IBT
The first four terms are aggregate expenditure and the whole thing is GDP as measured in the national income accounts. Now do the same for the Households box:
PY + TR = C + PS + PT
or, PY = C + PS + PT ‑ TR
(By this time even the students with acute math anxiety will be reasonably sure that you will not be going over their heads.)
Now substitute for PY in the second equation for firms above:
C + I + G + (X‑M) + (chg inv) = C + PS + PT ‑ TR + CCA + CS + IBT
Rearranging:
C + I + G + (X‑M) + (chg inv) = C + (PS+CCA+CS) + (PT+IBT‑TR)
or: C + I + G + (X‑M) + (chg inv) = C + S + T
which is the usual formulation of the national‑income identity.
Now you can graph it (see Figure 9‑6). We separate out the part of GDP that is the result of people's deliberate decisions and get:
AE = C + I + G + (X‑M)
We also acknowledge that income can be disposed of in only three ways, by consuming it, saving it, or getting taxed on it:
Y = C + S + T,
which is the equation for the 45‑degree line. This is the best explanation I have for what a 45‑degree line is doing in the middle of an economic model. The distance between them, of course, is the change in inventories.
In one stroke you now have an explanation for the old question of how GDP is always an identity as well as a behavioral description, and you have plausibly set up a Keynesian model. Now the explanation of equilibrium and the behavior of the system out of equilibrium is a piece of cake (pie?).
Figure 9‑6
All of the major NIPA components are in the diagram and, with some simplifying but harmless assumptions, you can explain where others fit. For example, G includes salaries of government workers if we assume that each worker is her or her own firm selling services to the government. Exports and imports go out from the Firms box because we usually buy goods from firms that import them. And so forth. The chances are slim that questions like these will come up and slimmer that students will the explanations as contrived or implausible.
Conclusion: An expanded circular‑flow diagram can help in explaining relationships between: (1) national‑income accounts and the Keynesian cross, (2) GDP and personal income, and (3) classical and Keynesian analysis. It also provides insights into: (4) the significance of the Keynesian Revolution, and (5) the difference between "behavioral relations" and "equilibrium conditions."
When I first tried this approach, it was well received. The next semester I was behind schedule and initially omitted it. Two days into the macro section of the course, students began complaining that they were not sure what all this was about and would I please explain why we were doing this. I gave my expanded circular‑flow session at that point, and the students said they were satisfied.
Permanent Income and Windfalls
Michael Kuehlwein,
An implication of the permanent income hypothesis is that temporary changes in income should have little effect on current consumption. The illustration I like to use comes from an 1989 article in the Wall Street Journal about how the residents of Winston-Salem, North Carolina, enjoyed an unexpected windfall that year. Many of them worked for RJR Nabisco and owned stock in the company. When Kohlberg, Kravis, and Roberts bought the company for about $25 billion, they paid shareholders a substantial premium for their shares (roughly double the old price). For many stockholders, it was almost like winning the lottery. But consumer spending did not significantly increase. "I hear a lot about this money that's out there, but we haven't seen people coming in to buy things that they might not ordinarily buy," said one store manager. This sentiment was echoed by many other local merchants. So we are able to get into a discussion of why spending did not rise commensurately with income this year.
Interestingly enough, the one business reported to be flourishing was the local Cadillac dealer, who nearly doubled his monthly sales: "We're tickled to death." I've been eating steak and lobster each night." That then leads to a discussion of how purchases of consumer durables such as cars go on to the distinction between consumption expenditures and actual consumption.
The Permanent Income Hypothesis
Philip Lesser,
To illustrate that current consumption is a function of future as well as past and present income, I ask my class to imagine a university where the students are very car conscious. (That usually is not very hard for them to do!) I then contend that medical students will, on the average, have more and better cars than philosophy students at this university with equal endowments of assets, present incomes and desires for cars. It stands to reason, I continue, since medical students would be more willing to deplete their savings and/or borrow today because they anticipate greater future income than their counterparts in the philosophy department.
Life Cycles and Permanent Income
Ralph T. Byrns
We hint at the permanent income hypothesis in principles courses, detailing it in more advanced courses. A possible enrichment for your class is to discuss this theory using a graph like Figure 9‑7. Discuss some reasons for the dissaving common among very young or very old families (respectively, accumulation of housing, consumer durables, educations, etc., and spending out of funds previously saved for retirement); then discuss the saving common during the middle years of families' income streams (funds for retirement, children's college tuitions, etc.) This usually persuades students that the income/consumption/saving pattern shown is reasonable.
You can now ask if a person who inherits $50,000 dollars this year is as likely to spend most of it as someone who receives a $50,000 hike in annual pay. Spend a few moments to explain why not, and how this fits into the permanent income hypothesis. Later, when discussing Chapter 11, you may want to address the implications of this hypothesis for the effectiveness of fiscal policy in stimulating consumption spending via Keynesian multiplier processes.
Figure 9‑7
Ralph T. Byrns
One extension of the text's discussion of the effects of expectations on consumption and saving is to raise the issue of expectations of disemployment. Describe how and why expectations of unemployment may cause a family to save more and spend less. This prepares students for the discussion in the next chapter of the paradox of thrift and other Keynesian concepts.
Rationalizing Investment Schedules
Ralph T. Byrns
Many students (especially those who are derelict about assigned readings) will argue that investment is positively related to the interest rate. This view emerges from failure to distinguish between financial investments (which can be viewed as mechanisms for saving) and economic investment. Review the differences between financial and economic investment (described in Chapter 1) to clarify these concepts for students.
Even some conscientious students have difficulty understanding why the rate of return falls when the level of investment rises. You can offer the intuitive argument that everyone knows about a few highly profitable investments and if these are undertaken, then only somewhat less profitable investments remain. After these have been made, still less profitable investments remain. And so on. A slightly more rigorous discussions appeals to the general law of diminishing returns mentioned in Chapter 2 of our text. You need to emphasize that net investment increases the capital stock.
Savings as a Function of the Interest Rate
James A. Kurre, The
Students sometimes are puzzled at the idea in the loanable funds theory of interest rates that savings should depend on the rate of interest. To illustrate the feasibility of the idea, I ask them to consider the hypothetical case in which we meet in the college cafeteria. I'm hungry but broke, and ask for an overnight loan. The student is also hungry, but has only $2 in his pocket. Normally, he would consume the whole $2 at lunch. However, I can bribe him into not consuming some of his funds by offering to pay him interest with the return of principal tomorrow. I then go through increasing amounts to be paid tomorrow ($1.10, $1.25, $1.50, $2.00, $3.00...) and point out that at some level of interest, he'd be willing to give up one of his two dollars today and go hungry. I then point out that this student has an upward‑sloping saving (supply of loanable funds) curve, just as the loanable funds theory suggests.
The Endogeneity of Foreign Trade Balances and Government Outlays
Ralph T. Byrns
While discussing the foreign sector, you might differentiate between balances of trade and payments. Discuss the marginal propensities to export (negligible) and import (MPM = roughly MPC x M/C). Point out that the positive MPM causes rising income to drive a country towards deficits in both trade and payment balances, but that this will be ignored for now to help simplify the analysis.
Similarly, you may discuss the tendency of government purchases to grow when income grows if public goods are income elastic. (Discuss Wagner's Law if you think this will help.) If you also mention that transfer payments tend to fall as income rises, and why, this will help prepare students for the discussion of built‑in stabilizers presented in Chapter 11. Finally, you should again emphasize that all forms of spending other than consumption are treated as strictly autonomous only for reasons of simplification.