Chapter 19 The Keynesian Model in Action Key Concepts Summary Practice Quiz Internet Exercises ©2000 South-Western College Publishing

In this chapter, you will learn to solve these economic puzzles: Why does Keynes argue that the government should adopt active policies, rather than allowing the price system to prevail? Why did Keynes reject the classical theory that “supply creates its own demand”? Can the Keynesian Model explain an ice cream war?

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

What percent of GDP is Government and the Foreign sector? About 17% of GDP

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

Autonomous Government Spending 2.00 1.75 Government Spending 1.50 G1 Real Government spending Trillions of $ per year 1.25 1.00 0.75 0.50 G2 Government Spending 0.25 Real GDP Trillions of $ per year 1 2 3 4 5 6 7 8 9 10

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.

2.00 Autonomous Net Exports 1.75 Positive Net Exports 1.50 (X-M)2 Real Net Exports Trillions of $ per year 1.25 1.00 (X-M) Zero Net Exports 0.75 0.50 (X-M)1 Negative Net Exports 0.25 Real GDP Trillions of $ per year 1 2 3 4 5 6 7 8 9 10

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

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

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

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

What causes a decrease in Real GDP and Employment? Unplanned inventory investment accumulation

Why does Unplanned Inventory Investment Accumulation cause Unemployment? Business firms will cut back production and lay off workers when they find themselves with surpluses

What causes an increase in Real GDP and Employment? Unplanned inventory investment depletion

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

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

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

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

The Keynesian Aggregate Expenditures-Output Model 8 7 Less than Full employment AE2 6 AE1 5 4 Real Aggregate Expenditures Full employment 3 2 1 Real GDP 1 2 3 4 5 6 7 8

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

The Keynesian Aggregate Expenditures-Output Model 8 7  .5 trillion dollars AE2 6 AE1 5  1 trillion dollars Real Aggregate Expenditures 4 3 2 1 1 2 3 4 5 6 7 8 Real GDP

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

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

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

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

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

How does the Multiplier work?

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

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

What is the formula for the Multiplier? 1 / (1 – MPC) (or) 1 / MPS

If the MPS is , what is the Multiplier?

Relationship between MPC, MPS, and the Spending Multiplier .90 .10 10 5 .80 .20 4 .75 .25 .67 3 .33 .50 .50 2 .33 .67 1.5

What is the GDP Gap? The difference between full employment real GDP and actual real GDP

What is the Recessionary Gap? The amount by which aggregate expenditures fall short of the amount required to achieve full employment equilibrium

The Keynesian Aggregate Expenditures - Output Model 8 7 AE2 E2 6 AE1 5 E1 Real Aggregate Expenditures 4 Recessionary gap 3 Full employment 2 + GDP gap 1 1 2 3 4 5 6 7 8 Real GDP

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

What can the Government do to close a Recessionary Gap? Increase government spending Lower taxes Raise transfer payments

What is an Inflationary Gap? The amount by which aggregate expenditures exceed the amount required to achieve full employment equilibrium

The Keynesian Aggregate Expenditures - Output Model 8 7 AE1 E1 6 AE2 5 E2 Real Aggregate Expenditures 4 Inflationary gap 3 Full employment 2  GDP gap 1 1 2 3 4 5 6 7 8 Real GDP

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

How can the Government close an Inflationary Gap? Cut government spending Increase taxes Reduce transfer payments

Key Concepts

Key Concepts 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? What can pull Aggregate Expenditures higher or lower in Keynesian economics? What causes a decrease in Real GDP and Employment?

Key Concepts cont. What causes an increase in Real GDP and Employment? 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 Save?

Key Concepts cont. 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 an Inflationary Gap? What is the Keynesian remedy for an Inflationary Gap?

Summary

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

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

Autonomous Government Spending 2.00 1.75 Government Spending 1.50 G1 Real Government spending Trillions of $ per year 1.25 1.00 0.75 0.50 G2 Government Spending 0.25 Real GDP Trillions of $ per year 1 2 3 4 5 6 7 8 9 10

2.00 Autonomous Net Exports 1.75 Positive Net Exports 1.50 (X-M)2 Real Net Exports Trillions of $ per year 1.25 1.00 (X-M) Zero Net Exports 0.75 0.50 (X-M)1 Negative Net Exports 0.25 Real GDP Trillions of $ per year 1 2 3 4 5 6 7 8 9 10

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

Aggregate expenditures and real GDP are equal, graphically, where the AE = C + I + G + (X-M) line intersects the 45-degree line. 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.

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

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

A recessionary gap is the amount by which aggregate expenditures fall short of the amount necessary for the economy to operate at full-employment real GDP. 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.

The Keynesian Aggregate Expenditures - Output Model 8 7 AE2 E2 6 AE1 5 E1 Real Aggregate Expenditures 4 Recessionary gap 3 Full employment 2 + GDP gap 1 1 2 3 4 5 6 7 8 Real GDP

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. 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 .

The Keynesian Aggregate Expenditures - Output Model 8 7 AE1 E1 6 AE2 5 E2 Real Aggregate Expenditures 4 Inflationary gap 3 Full employment 2  GDP gap 1 1 2 3 4 5 6 7 8 Real GDP

©2000 South-Western College Publishing Chapter 19 Quiz ©2000 South-Western College Publishing

1. The net exports line can be a. positive. b. negative. c. zero. d. any of the above. D. Because net exports equals exports minus imports (X-M), the sign of net exports depends on the values of X and M.

B. 2. There will be unplanned inventory investment accumulation when a. aggregate output (real GDP) equals aggregate expenditures. b. aggregate output (real GDP) exceeds aggregate expenditures. c. aggregate expenditures exceed aggregate output (real GDP). d. firms increase output. B.

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

3. John Maynard Keynes proposed that the multiplier effect can correct an economic depression. Based on this theory, an increase in equilibrium output would be created by an initial a. increase in investment. b. increase in government spending. c. decrease in government spending. d. both (a) and (b). e. both (a) an (c) . D. A decrease in government spending is multiplied times the spending multiplier and decreases equilibrium output.

4. The spending multiplier is defined as a. 1/(1 - marginal propensity to consume). b. 1/(marginal propensity to consume). c. 1/(1 - marginal propensity to save). d. 1/(marginal propensity to consume + marginal propensity to save). A. The spending multiplier is also defined as 1/MPS.

5. If the value of the marginal propensity to consume (MPC) is 0 5. If the value of the marginal propensity to consume (MPC) is 0.50, the value of the spending multiplier is a. .5. b. 1. c. 2. d. 5. C. Spending multiplier = 1/(1-MPC) = 1/(1-0.5) = 1/0.50 = 1/50/100 = 2.

6. If the marginal propensity to consume (MPC) is 0 6. If the marginal propensity to consume (MPC) is 0.80, the value of the spending multiplier is a. 2. b. 5. c. 8. d. 10. B. Spending multiplier = 1/(1-MPC = 1/(1-0.80) = 1/20/100 = 5.

7. If the marginal propensity to consume (MPC) is 0 7. If the marginal propensity to consume (MPC) is 0.75, a $50 billion decrease in government spending would cause equilibrium output to a. increase by $50 billion. b. decrease by $50 billion. c. increase by $200 billion. d. decrease by $200 billion. D. Change in equilibrium output (Y) = spending multiplier x change in government spending. Rewritten, Y = 1/(1-0.75) x -$50 billion = $200 billion = 4 x - $50 billion.

8. If the marginal propensity to consume (MPC) is 0 8. If the marginal propensity to consume (MPC) is 0.90, a $100 billion increase in planned investment expenditure, other things being equal, will cause an increase in equilibrium output of a. $90 billion. b. $100 billion. c. $900 billion. d. $1,000 billion. D. Change in equilibrium output (Y) = spending multiplier x change in government. Rewritten, Y = 1/(1-0.90) x $100 billion = 10 x $100 billion.

The Keynesian Aggregate Expenditures-Output Model 8 7 Less than Full employment AE2 6 AE1 5 4 Real Aggregate Expenditures Full employment 3 2 1 Real GDP 1 2 3 4 5 6 7 8

9. Keynes’ criticism of the classical theory was that the Great Depression would not correct itself. The multiplier effect would restore an economy to full employment if a. government would follow a “least government is the best government” policy. b. government taxes were increased. c. government spending were increased. d. government spending were decreased. C. Keynes’ prescription to cure the Great Depression was for government to play an active role rather than depend on the classical theory that the price system will eventually restore full employment.

10. The equilibrium level of real GDP is $1,000 billion, the full employment level of real GDP is $1,250 billion, and the marginal propensity to consume (MPC) is 0.60. The full-employment target can be reached if government spending is a. increased by $60 billion. b. increased by $100 billion. c. increased by $250 billion. d. held constant. B. Change in real GDP required = spending multiplier x change in government spending (G). Rewritten, G = 1/(1 - 0.60) x ($1,250 - $1,000) G x 2.5 = $250 G = $100 billion.

The Keynesian Aggregate Expenditures-Output Model 8 7 AE MPC = .66 6 5  2 4 Real Aggregate Expenditures 3 2 Full Employment  3 1 Real GDP 1 2 3 4 5 6 7 8

11. In Exhibit 9, the spending multiplier for this economy is equal to B. 1/(1-MPC) = 1/(1-3/5) = 1/2/5 = 5/2 = 2 1/2

C. Change in taxes (T) x tax multiplier = change in real GDP (Y) 12. To close the recessionary gap and achieve full-employment real GDP as shown in Exhibit 9, the government should cut taxes by a. $3/5 trillion. b. $ 1 trillion. c. $2 trillion. d. $3 trillion. C. Change in taxes (T) x tax multiplier = change in real GDP (Y) spending multiplier (SM) = 1/(1-MPC) = 1/(1-3/5) = 1/2/5 = 5/2 tax multiplier = (1-SM) = (1-5/2) = -3/2 T x -3/2 = $3 trillion T = -2/3 x $3 trillion T = $2 trillion

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