1. Copyright (c) 2000 by Harcourt Inc. All rights reserved. Next page Slides to Accompany Economics: Public and Private Choice 9th ed. James Gwartney, Richard Stroup, and Russell Sobel Keynesian Foundations of Modern Macroeconomics Chapter 11

2. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. I believe myself to be writing a book on economic theory which will largely revolutionizenot, I suppose, at once but in the course of the next ten years the way the world thinks about economic problems. -- John Maynard Keynes

3. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. Keynesian Explanations of the Great Depression

4. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Keynesian Explanations of the Great Depression n Keynesian economics developed during the Great Depression (1930s). n Keynesian theory provided an explanation for the severe and prolonged unemployment of the 1930s. n Keynes argued that wages and prices were highly inflexible, particularly in a downward direction. Thus, he did not think changes in prices and interest rates would direct the economy back to full employment.

5. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Keynesian Explanations of the Great Depression n Keynesian View of Spending and Output: -- Keynes argued that spending induced business firms to supply goods & services. Thus, if total spending fell, then business firms would respond by cutting back production. Less spending would thus lead to less output.

6. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 2. The Basic Keynesian Model

7. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Aggregate Expenditures = The Basic Keynesian Model n In the Keynesian model Planned Net Exports Planned Consumption + Planned Investment + Planned Government Expenditures + n as income expands, consumption increases, but by a lesser amount than the increase in income, n both planned investment and government expenditures are independent of income, and, n planned net exports decline as income increases.

8. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 369 P lanned C onsumption E xpenditures (trillions of dollars) R eal D isposable I ncome (trillions of dollars) 6 9 12 3 n The Keynesian model assumes that there is a positive relationship between consumption and income. Aggregate Consumption Function n However, as income increases, consumption increases by a smaller amount. Thus, the slope of the consumption function (line C) is less than 1 (less than the slope of the 45° line). 45º 45º Line C S aving D is-saving

9. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. T otal O utput ( Real GDP In Billions ) P lanned E xports ( Billions ) P lanned I mports ( Billions ) P lanned N et E xports ( Billions ) $850 850 $7,600$650 7,900700 8,200750 8,500800 8,800850 $200 150 100 50 0 n Because exports are determined by income abroad, they are constant at $850 billion. Income and Net Exports n Imports increase as domestic income expands. n Thus, planned net exports fall as domestic income increases.

10. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 3. Keynesian Equilibrium

11. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Keynesian Equilibrium n In the Keynesian view, equilibrium occurs when: n When this is the case: Planned Aggregate Expenditures = Current Output n businesses are able to sell the total amount of goods & services that they produce, and, n there are no unexpected changes in inventories, so, n producers have no reason to either expand or contract their output during the next period.

12. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Keynesian Equilibrium n When Total Aggregate Expenditures < Current Output business firms will accumulate unplanned additions to inventories that will cause them to cut back on future output and employment. n When Total Aggregate Expenditures > Current Output inventories will fall and businesses will respond with an expansion in output in an effort to restore inventories to their normal levels.

13. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. u Keynes believed that weak aggregate demand was the cause of the Great Depression. Keynesian Equilibrium n Keynesian equilibrium can occur at less than full employment. n Aggregate Demand is key to the Keynesian model. u When it does, the high rate of unemployment will persist into the future.

14. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. T otal O utput ( Real GDP ) (1) P lanned A ggregate E xpenditures (2) P lanned C onsumption (3) P lanned N et E xports (5) T endency Of O utput (6) P lanned I nvestment + G overnment E xpenditures (4) Recall that Planned Aggregate Expenditures equals the sum of Planned Consumption, Planned Investment, Planned Government Expenditures, and Planned Net Exports. $7,600 7,900 8,200 8,500 8,800 $7,900 8,050 8,200 8,350 8,500 $6,000 6,200 6,400 6,600 6,800 $200 150 100 50 0 $1,700 1,700 Expand Equilibrium Contract n When planned aggregate expenditures equal Total Output, there is Keynesian macroeconomic equilibrium. n In the Keynesian system, when total output is less than planned aggregate expenditures, purchases exceed output and inventories are depleted. Firms expand their output to rebuild their inventories to regular levels. An Example of Keynesian Macroeconomic Equilibrium n When actual output is more than planned aggregate expenditures, output exceeds purchases, and inventories accumulate. Firms reduce their output to slow the accumulation of further inventory. 8,200 6,4001001,700Equilibrium < < > > =

15. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. O utput (Real GDP -- trillions of $) P lanned A ggregate E xpenditures (trillions of dollars) 45º E quilibrium (AE = GDP) Aggregate Expenditures (AE) n The 45° line maps out potential equilibrium levels of output for the Keynesian model. n Aggregate expenditures will be equal to total output for all points along the 45° line from the origin. 7.9 8.5

16. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 7.98.5 45º 8.5 7.9 O utput (Real GDP -- trillions of $) P lanned A ggregate E xpenditures (trillions of dollars) 8.05 8.35 AE = C + I + G + NX 7.9 Unplanned Reduction in Inventories Unplanned Increase in Inventories n At output levels below $8.2 trillion (for example 7.9) AE is above the 45° line – expenditures exceed output and thus businesses sell more than they currently produce, diminishing inventories. Businesses expand output. n At output levels above $8.2 trillion (for example 8.5) AE is below the 45° line – output exceeds expenditures and thus businesses sell less than they currently produce, increasing inventories. Businesses expand output. Now the previously presented Planned Aggregate Expenditures data is introduced. 8.5 E quilibrium (AE = GDP) Aggregate Expenditures and Keynesian Equilibrium

17. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 7.98.5 45º 8.5 7.9 O utput (Real GDP -- trillions of $) P lanned A ggregate E xpenditures (trillions of dollars) Keynesian Equilibrium 8.05 8.35 Full Employment (Potential Output) AE = C + I + G + NX 7.9 8.2 n At that level of income where planned expenditures just equal actual output, the Keynesian equilibrium exists. Here that equilibrium exists at $8.2 trillion. n Note that full-employment for this example exists at $8.5 trillion. In the Keynesian model equilibrium does not necessarily coincide with full-employment. E quilibrium (AE = GDP) Aggregate Expenditures and Keynesian Equilibrium

18. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. O utput (Real GDP -- trillions of $) P lanned A ggregate E xpenditures (trillions of dollars) 45º E quilibrium (AE = GDP) Shifts in Aggregate Expenditures and Changes in Equilibrium Output 8.2 7.9 8.5 8.2 8.8 8.5 Full Employment (Potential Output) n When equilibrium output is less than the economys capacity only an increase in expenditures (a shift in AE) will lead to full employment output. n If consumers, investors, governments, or foreigners would spend more and thereby shift AE to AE 2, output would reach its full employment potential. n Once full employment is reached, further increases in AE, such as to AE 3, lead only to higher prices (nominal output expands along the dotted segment of AE, real output will not). 8.5 AE 1 AE 2 AE 3 AS

19. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 4. The Keynesian View Can be Illustrated Within the AD/AS Framework

20. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Keynesian View Illustrated within the AD/AS Framework n When output is less the full- employment, the primary impact of an increase in aggregate demand will be an increase in output. n When output is at or beyond the full- employment level, the primary impact of an increase in demand will be higher prices.

21. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. P rice L evel G oods & S ervices (real GDP) Y F LRAS Full Employment (Potential Output) Keynesian Aggregate Supply Curve n The Keynesian model implies a 90°, angle-shaped SRAS curve that is flat for outputs less than potential GDP (Y F ) -- because of downward wage and price inflexibility. n This flat range is often referred to as the Keynesian range. Output here is entirely dependent on the level of aggregate demand. n As the Keynesian model implies that real output rates beyond full employment are unattainable, both the SRAS and LRAS curve are vertical at potential output. K eynesian R ange P 1 SRAS

22. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. P rice L evel G oods & S ervices (real GDP) LRAS SRAS AD 1 Y F AD / AS Presentation of the Keynesian Model n The diagram above illustrates the Polar implications of the Keynesian model. n When output is less than capacity (for example Y 1 ), an increase in Aggregate Demand such as illustrated by the shift from AD 1 to AD 2 will expand output without increasing the price level (P 2 = P 1 ). AD 3 AD 2 Y 1 P 1 P 3, P 2 e3e3 e2e2 e1e1 Y F n But, increases in demand beyond AD 2, such as a shift to AD 3, lead only to a higher price level (P 3 ).

23. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. P rice L evel G oods & S ervices (real GDP) LRAS SRAS AD 1 Y F n The diagram above relaxes the assumptions of the model regarding complete price and short-run output inflexibility beyond Y F. The SRAS curve now turns from horizontal to vertical more gradually. n Now an unanticipated increase in AD would lead: AD 3 AD 2 Y 1 P 1 P 3 P 2 e3e3 e1e1 n Primarily to increases in output when output is below capacity (for example beginning at AD 1 with output Y 1 ). Y 3 e2e2 n Primarily to increases in the price level when strong demand pushes output beyond capacity (for example demand greater than AD 2 ). AD / AS Presentation of the Keynesian Model

24. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. What determines the equilibrium rate of output in the Keynesian model? What did Keynes think had happened during the prolonged, high level of unemployment of the Great Depression? Questions for Thought: 2. In the Keynesian model, what is the major factor that causes the level of output and employment to change?

25. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 5. The Multiplier

26. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. The Multiplier n The Multiplier: -- The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate income. n An increase in spending by one party increases the income of others. Thus, an increase in spending can expand output by a much larger amount. n The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income. n The size of the multiplier increases with the marginal propensity to consume (MPC).

27. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. n In evaluating the importance of the multiplier, one should remember: n taxes and spending on imports will dampen the size of the multiplier; n it takes time for the multiplier to work; and, n the amplified effect on real output will be valid only when the additional spending brings idle resources into production without price changes. The Multiplier

28. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. E xpenditure S tage A dditional I ncome ( Dollars ) M arginal P ropensity To C onsume A dditional C onsumption ( Dollars ) For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. 1,000,000 750,000 562,500 421,875 316,406 237,305 177,979 133,484 100,113 75,085 225,253 750,000 562,500 421,875 316,406 237,305 177,979 133,484 100,113 75,085 56,314 168,939 Round 1 Round 2 Round 3 Round 4 Round 5 Round 6 Round 7 Round 8 Round 9 Round 10 3/4 Total4,000,0003,000,0003/4 All Others The Multiplier Principle n The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% 3/4). n Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until... effectively, $4 million is spent in the economy.

29. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. MPC S IZE OF M ULTIPLIER 9/10 4/5 3/4 2/3 1/2 1/3 10.0 5.0 4.0 3.0 2.0 1.5 A Higher MPC Means a Larger Multiplier n As the MPC increases more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.). n The effect is that for higher MPCs, higher multipliers result, specifically the relationship follows this equation: M = 1 1 - MPC

30. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 6. The Keynesian view of the Business Cycle

31. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Keynesian View of the Business Cycle n Keynesians argue that a market economy, if left to its own devices, is unstable and likely to experience prolonged periods of recession. n According to the Keynesian view of the business cycle, upswings and downswings tend to feed on themselves. n During a downturn, business pessimism, declining investment, and the multiplier principle combine to plunge the economy further toward recession. n During an economic upswing, business and consumer optimism and expanding investment interact with the multiplier principle to propel the economy to an inflationary boom. n The theory suggests that a market-directed economy, left to its own devices, will tend to fluctuate between economic recession and inflationary boom.

32. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Keynesian View of the Business Cycle n Regulation of aggregate expenditures is the crux of sound macroeconomic policy according to the Keynesian view. n If we could assure aggregate expenditures large enough to achieve capacity output, but not so large as to result in inflation, the Keynesian view implies that maximum output, full employment, and price stability would be attained.

33. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 7. Evolution of Modern Macroeconomics

34. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. Evolution of Modern Macroeconomics n Major Insights of Keynesian Economics: n Changes in output, as well as in prices, play a role in the macroeconomic adjustment process, particularly in the short run. n The responsiveness of aggregate supply to changes in demand will be directly related to the availability of unemployed resources. n Fluctuations in aggregate demand are an important potential source of business instability. n Modern macroeconomics is a hybrid, reflecting elements of both classical and Keynesian analysis as well as some insights drawn from other areas of economics.

35. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. 1. What is the multiplier principle? What determines the size of the multiplier? Does the multiplier principle make it more or less difficult to stabilize the economy? Explain. Questions for Thought: 2. Widespread acceptance of the Keynesian aggregate expenditure (AE) model took place during and immediately following the Great Depression. Can you explain why? The aggregate expenditure model declined in popularity when many economies experienced both high rates of unemployment and inflation during the 1970s. Was this surprising?

36. Jump to first page Copyright (c) 2000 by Harcourt Inc. All rights reserved. End Chapter 11