In the graph, above, the supply curve represents the amount of savings consumers will undertake at any interest rate (price). The demand curve indicates how many dollars investors will borrow at any price (interest rate). The intesection of the demand and supply curve determines the interest rate and the amount of savings and investment undertaken. If the supply of savings were to increase (shift to the right), the interest rate would fall, and the amount of investment would increase until a new equilibrium is reached. If this mechanism actually works, there would never be a situation where we didn't buy up all the goods and services produced, so we'd always be at a stable or equilibrium level of GDP. Problem is, would this level of GDP be high enough so that everyone who wanted was at work? The neo-classicals thought it would.

So long as wages and prices are fully flexible in both the upward and downward directions, the neo-classical economists argued, then the market would always adjust to put everyone to work. Were there unempoyment, wage rates would fall until everyone was employed. If anyone was persistantly out of work, that would be evidence of their unwillingness to work at market determined wages. This person would, in effect, be choosing not to work. That's fine, said the neo-classical economists; everyone is entitled to opt not to work, but you can't call them "unemployed".

If the economy always purchases everything businesses produce, and if no one can be involuntarily unemployed, then the economy must always operate at full employment with everything that is produced being purchased. This is why the neo-classical economists argued that depressions were impossible. Yet, the Great Depression was entirely real. Something was wrong with their analysis. The first mistake has to do with the effectiveness of the interest rate in equating savings and investment. Most savers assess a number of goals, objectives and constraints in making their savings decision. Some savings are to build a fund for emergencies, some is done to achieve a given objective (college, a vacation, some purchase), and some is done, perhaps, to secure one's old age. It's not clear that interest rates affect the motivations underlying these goals. Probably, for most, the available spare income they have determines how much can be devoted to savings. The interest rate may determine where the savings are placed, but it probably doesn't determine the level of savings. After all, if I'm saving for some specific objective (college, a vacation, a digital camera) an increase in the interest rates would mean that I could have enough money for, say, a vacation on a given future date, with less savings today. In that case, higher interest rates would actually reduce the level of savings. The other problem is the role of interest rates in investment decisions.

Intestment is the process wherein one starts or expands a business. The return to investment activity is "chancey". The business is gambling that their new or expanded enterprise will succeed. Because of this, investors tend to look at a variety of factors in assessing whether to go forward: the interest rate is just one of them. Certainly, the business climate is more significant that interest rates. There are many other factors that affect the investment decision, as well. Within a corporation, it is possible that careers will advance or fail on the basis of whose investment ideas prevail (or don't). There's a great deal of power maneuvering going on in business, as well as the rational calculus of the probability of commercial success. The interest rate simply can't carry the weight of "controlling" the level of investment. Finally, there are problems with the flexible wages and prices argument.

Because the interest rate cannot control either savings or investment levels with any predictability, the neo-classical economists' view that demand would always be sufficient to purchase all that businesses intended to produce was incorrect. Further, flexible wages and prices would not guarantee full employement. The very process whereby wages would fall to bring everyone back to work was the depression that the neo-classical economists felt was impossible.

The reality of the Great Depression destroyed the neo-classical arguments, and led to the investigation of the processes by which inflation and depression occur. John Maynard Keynes developed an analysis which argued that there was no guarantee either that all the goods produced would be sold or that everyone who wanted a job would be able to find one. In his view, aggregate demand could equal aggregate supply (everything produced is sold) at virtually any level of employment--from full employment of massive unemployment. If we found ourselves in a macroeconomic equilibrium (everything businesses intend to produce is sold), and this equilibrium is other than the full employment equilibrium we want, then the proper course it to expand demand to the point where we achieve full employment.

If, for example, we found ourselves hovering in a macro equilibirum with 10% unemployment, and with full employment GDP at 1 trillion dollars above current GDP, the goal would be to generate another 1 trillion dollars in aggregate demand which would put all the unemployed to work. Logically, government spending would be the source of the increased aggregate demand. Government would simply buy things: anything from dams to tanks--each would provide the same stimulus. The good new is that it would not take 1 trillion dollars of new, deficit financed, government expenditure to get to full employment. Indeed, the required amount would be much less than that. A dollar of increased spending goes a long way.

Imagine that people spent 80 cents of every additional dollar of income the recieved. If the government were to increase deficit financed spending by 200 billion dollars, this would have the following effect: $200 billion increase in GDP due to government purchases; This would generate $200 billion in new income for the recepients of this expenditure. They would spend 80% of the new income, or $160 billion. This is the second round. That spending is income for others who spend 80% or $128 billion. This 128 billion dollars is income for the next group and they spend 80% or $104 billion. The total of all these cycles of spending is $1,000 billion or 1 trillion dollars. The government generated $1 trillion in new GDP by spending only $200 billion. This is because everyone saw new income from the original $200 billion and spent 80% of what they saw. When the cycles of spending had worn down, the total increase is $1 trillion. Note that the multiple (multiplier) effect equals 1-(1-0.8) or 1/.2 or 5. The 0.8 (or 80%) is the fraction of an additional dollar that a consumer spends. This fraction is called the marginal propensity to consume MPC. The multiplier is equal to 1/(1-MPC) or 1/MPS where the MPS (marginal propensity to save) equals 1-MPC.

We can move the economy to any level of GDP we want either by increasing or decreasing government deficit spending, or increasing or decreasing taxes. A tax decrease is less potent that a deficit spending increase of the same amount. This is because, by giving a tax decrease, you're giving the consumer added income which will cause him to increase spending by the MPC times the tax cut. The first round of spending increase, then, is equal to (using the figuers above) 0.8 times 200 billion dollar tax cut or $160 billion. Note that this is equal to the phase 2 spending increase in the goverment deficit spending increase of 200 billion, above. The tax cut us weaker by $200 billion because that's the first round increase in GDP that the deficit spending gives us. Tax cuts start at level 2, or 160 billion. The tax multiplier is, therefore, always 1 less than the government deficit spending multiplier. So, if in the spending example, above, the multiplier was 5, the corresponding tax multiplier is one less, or 4.

I leave is as an exercise for the reader to determint the following: If full employment GDP is 8 trillion dollars, and we are currently at 6.5 trillion, what change in government spending will get us to full employent assuming the MPC is 0.75. What change in taxes will move us to full employment.

Have fun.