1. 1 Chapter 19 The Keynesian Model in Action Key Concepts Key Concepts Summary Summary Practice Quiz Internet Exercises Internet Exercises ©2002 South-Western College Publishing

2. 2 What is the purpose of this chapter? To complete the Keynesian model by adding the government and the foreign sector to our analysis

3. 3 Why is government spending considered an autonomous expenditure? Government spending is primarily the result of a political decision made independent of the level of national output

4. 4 1.00 0.75 0.50 0.25 1234 1.25 1.50 1.75 2.00 5678910 Real GDP Trillions of $ per year Government Spending Real Government spending Trillions of $ per year Government Spending G1G1 G2G2 Autonomous Government Spending

5. 5 Why is net exports assumed to be negative? For many years our spending for imports has exceeded the value of exports we have sold to foreigners.

6. 6 1.00 0.75 0.50 0.25 1234 1.25 1.50 1.75 2.00 56789 Autonomous Net Exports 10 Real GDP Trillions of $ per year Positive Net Exports Real Net Exports Trillions of $ per year Negative Net Exports (X-M) 2 (X-M) 1 (X-M) Zero Net Exports

7. 7 What does the term equilibrium mean? In the Keynesian model, the equilibrium is the point toward which the economy tends

8. 8 In the Keynesian model, where is the equilibrium level of GDP? It is where the total value of goods and services produced is precisely equal to the total spending for these goods and services

9. 9 What can pull aggregate expenditures higher or lower in Keynesian economics? Aggregate expenditures C + I + G + (X-M)

10. 10 What affect do aggregate expenditures have on the economy? Aggregate expenditures in Keynesian economics pull aggregate output either higher or lower toward equilibrium

11. 11 What causes a decrease in real GDP and employment? Unplanned inventory investment accumulation

12. 12 Why does unplanned inventory investment accumulation cause unemployment? Business firms will cut back production and lay off workers when they find themselves with surpluses

13. 13 What causes an increase in real GDP and employment? Unplanned inventory investment depletion

14. 14 Why does unplanned inventory depletion cause economic growth? Business firms will increase production and higher more workers to meet the level of demand for their product

15. 15 What is the aggregate expenditures-output model? The model that determines the equilibrium level of real GDP by the intersection of aggregate expenditures and aggregate output

16. 16 4 3 2 1 1 2 3 4 5 6 7 8 5 6 78 The Keynesian Aggregate Expenditures-Output Model AE = Y AE Real GDP Real Aggregate Expenditures Inventory Depletion C + I + G + )X-M) Inventory Accumulation E Full employment GDP gap

17. 17 How can full employment be reached in the previous graph? The aggregate expenditure curve must be shifted upward until the full- capacity output of $6 trillion is reached

18. 18 4 3 2 1 1 2 3 4 5 6 7 8 5 6 78 The Keynesian Aggregate Expenditures-Output Model AE 1 Real GDP Full employment AE 2 Real Aggregate Expenditures Less than Full employment

19. 19 What is the Keynesian multiplier? Any initial increase in spending will lead to a multiple increase in GDP

20. 20 4 3 2 1 1234 5 6 7 8 5678 The Keynesian Aggregate Expenditures-Output Model AE 1 Real GDP  1 trillion dollars AE 2 .5 trillion dollars Real Aggregate Expenditures

21. 21 Initial increase in government spending Operates through a multiplier Larger increase in aggregate expenditures

22. 22 How does the multiplier work? Any initial change in spending by the government, households, or firms creates a chain reaction of further spending

23. 23 4 3 2 1 1234 5 6 7 8 5678 The Keynesian Aggregate Expenditures-Output Model AE Real GDP Real Aggregate Expenditures  2  4 MPC =.5

24. 24 What is the Marginal Propensity to Consume? MPC is the change in consumption spending resulting form a given change in income

25. 25 What is the Marginal Propensity to Save? MPS is the fraction of any change in real disposable income that households save

26. 26 How does the multiplier work?

27. 27 Spending Multiplier Effect Round 1 2  Spending $500 $250 $125 $63... $1,000 3 4 All other rounds Total spending

28. 28 What is the relationship between MPC and MPS? MPC + MPS = 1

29. 29 What is the formula for the multiplier? 1 / (1 – MPC) (or) 1 / MPS

30. 30 If the MPS is 1/2, what is the multiplier? 1 / MPS = 1 / 1/2 = 2

31. 31 Relationship between MPC, MPS, and the Spending Multiplier MPC 10 5 MPS 4 3 2 1.5 Spending Multiplier.90.80.75.67.50.33.10.20.25.33.50.67

32. 32 What is the GDP gap? The difference between full employment real GDP and actual real GDP

33. 33 What is the recessionary gap? The amount by which aggregate expenditures fall short of the amount required to achieve full employment equilibrium

34. 34 4 3 2 1 1234 5 6 7 8 5 6 7 8 The Keynesian Aggregate Expenditures - Output Model AE 1 Real GDP AE 2 GDP gap Real Aggregate Expenditures E1E1 E2E2 Recessionary gap Full employment

35. 35 What is the Keynesian remedy for a recessionary gap? Increase autonomous spending by the amount of the recessionary gap

36. 36 What can the government do to close a recessionary gap? Increase government spending Lower taxes Raise transfer payments

37. 37 What is an inflationary gap? The amount by which aggregate expenditures exceed the amount required to achieve full employment equilibrium

38. 38 4 3 2 1 1 2 3 4 5 6 7 8 5 6 7 8 The Keynesian Aggregate Expenditures - Output Model AE 2 Real GDP AE 1  GDP gap Real Aggregate Expenditures E2E2 E1E1 Inflationary gap Full employment

39. 39 What is the Keynesian remedy for an inflationary gap? Reduce autonomous spending by the amount of the inflationary gap

40. 40 How can the government close an inflationary gap? Cut government spending Increase taxes Reduce transfer payments

41. 41 Key Concepts

42. 42 Key Concepts Why is government spending considered an autonomous expenditure?Why is government spending considered an autonomous expenditure? What does the term equilibrium mean? In the Keynesian model, where is the equilibrium level of GDP?In the Keynesian model, where is the equilibrium level of GDP? What can pull aggregate expenditures higher or lower in Keynesian economics?What can pull aggregate expenditures higher or lower in Keynesian economics? What causes a decrease in real GDP and employment?What causes a decrease in real GDP and employment?

43. 43 Key Concepts cont. What causes an increase in real GDP and employment?What causes an increase in real GDP and employment? What is the aggregate expenditures-output model?What is the aggregate expenditures-output model? What is the Keynesian multiplier? What is the Marginal Propensity to Consume?What is the Marginal Propensity to Consume? What is the Marginal Propensity to Save?

44. 44 Key Concepts cont. What is the relationship between MPC and MPS?What is the relationship between MPC and MPS? What is the formula for the multiplier? What is the GDP gap? What is the recessionary gap? What is the Keynesian remedy for a recessionary gap?What is the Keynesian remedy for a recessionary gap? What is an inflationary gap? What is the Keynesian remedy for an inflationary gap?What is the Keynesian remedy for an inflationary gap?

45. 45 Summary

46. 46 The Keynesian argues that the economy is inherently unstable and may require government intervention to control aggregate expenditures and restore full employment.

47. 47 If we assume that real disposable income remains the same high proportion of real GDP, then we can substitute real GDP for real disposable income in the Keynesian model.

48. 48 Government spending and net exports can be treated as autonomous expenditures in the Keynesian model.

49. 49 Net exports are the only component of aggregate expenditures that changes from a positive to a negative value as real GDP rises. Both exports and imports are determined by foreign or domestic income, tastes, trade restrictions, and exchange rates.

50. 50 1.00 0.75 0.50 0.25 1234 1.25 1.50 1.75 2.00 5678910 Real GDP Trillions of $ per year Government Spending Real Government spending Trillions of $ per year Government Spending G1G1 G2G2 Autonomous Government Spending

51. 51 1.00 0.75 0.50 0.25 1234 1.25 1.50 1.75 2.00 56789 Autonomous Net Exports 10 Real GDP Trillions of $ per year Positive Net Exports Real Net Exports Trillions of $ per year Negative Net Exports (X-M) 2 (X-M) 1 (X-M) Zero Net Exports

52. 52 The Keynesian aggregate expenditures-output model determines the equilibrium level of real GDP by the intersection of the aggregate expenditures and the aggregate output and income schedules.

53. 53 Each equilibrium level in the economy is associated with a level of employment and corresponding unemployment rate.

54. 54 At any output greater or less than the equilibrium real GDP, unintended inventory investment pressures businesses to alter aggregate output and income until equilibrium at full-employment real GDP is restored.

55. 55 At any output greater or less than the equilibrium real GDP, unintended inventory investment pressures businesses to alter aggregate output and income until equilibrium at full-employment real GDP is restored.

56. 56 4 3 2 1 1 2 3 4 5 6 7 8 5 6 78 The Keynesian Aggregate Expenditures-Output Model AE = Y AE Real GDP Real Aggregate Expenditures Inventory Depletion C + I + G + )X-M) Inventory Accumulation E Full employment GDP gap

57. 57 The spending multiplier is the ratio of the change in equilibrium output to the initial change in any of the components of aggregate expenditures.

58. 58 Algebraically, the multiplier is the reciprocal of the marginal propensity to save. The multiplier effect causes the equilibrium level of real GDP to change by several times the initial change in spending.

59. 59 To eliminate a positive GDP gap, the Keynesian solution is to increase autonomous spending by an amount equal to the recessionary gap and operate through the multiplier to increase equilibrium output and income.

60. 60 To eliminate a positive GDP gap, the Keynesian solution is to increase autonomous spending by an amount equal to the recessionary gap and operate through the multiplier to increase equilibrium output and income.

61. 61 4 3 2 1 1234 5 6 7 8 5 6 7 8 The Keynesian Aggregate Expenditures - Output Model AE 1 Real GDP AE 2 GDP gap Real Aggregate Expenditures E1E1 E2E2 Recessionary gap full employment

62. 62 An inflationary gap is the amount by which aggregate expenditures exceed the amount necessary to establish full-employment equilibrium and indicates upward pressure on prices.

63. 63 To eliminate a negative GDP gap, the Keynesian solution is to decrease autonomous spending by an amount equal to the inflationary gap and operate through the multiplier to decrease equilibrium output and income.

64. 64 4 3 2 1 1 2 3 4 5 6 7 8 5 6 7 8 The Keynesian Aggregate Expenditures - Output Model AE 2 Real GDP AE 1  GDP gap Real Aggregate Expenditures E2E2 E1E1 Inflationary gap full employment

65. 65 END