Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. The Great Depression and the Keynesian View

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Macroeconomics Prior to the Great Depression Classical economists believed that markets would adjust quickly and direct the economy toward full employment.

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Keynesian Explanation of the Great Depression Keynesian economics was developed during the Great Depression (1930s). Keynesian theory provided an explanation for the severe and prolonged unemployment of the 1930s. 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.

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Keynesian Explanation of the Great Depression Keynes argued that spending induced business firms to supply goods & services. Hence, if total spending fell, then firms would respond by cutting back production. Less spending would lead to less output.

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. The Basic Keynesian Model

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Aggregate expenditures = Planned Net Exports Planned consumption + Planned investment + Planned government expenditures + The Basic Keynesian Model In the Keynesian model: As Y , consumption ,, but by a lesser amount than the increase in income, Planned I, G and X are independent of income

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Aggregate Consumption Function 369 Planned consumption (trillions of £) Real disposable income (trillions of £s) º 45º line C Dis-saving Saving The Keynesian model assumes as Y  D  However, as Y  D  by a smaller amount. Thus, the slope of the consumption function (line C) is <than the slope of the 45° line).

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Keynesian Equilibrium

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. When this is the case businesses are able to sell the total amount of goods & services that they produce, and, there are no unexpected  in inventories, so, producers have no reason to either output during the next period. Planned aggregate expenditures = Current output Keynesian Equilibrium According to the Keynesian viewpoint, equilibrium occurs when:

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Total aggregate expenditures < Current output Keynesian Equilibrium Firms  stocks,  output,  employment When Total aggregate expenditures > Current output Firms  output,  employment in an effort to restore stocks to their normal levels. When

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Keynesian Equilibrium Keynesian equilibrium can occur at less than the full employment output level. When it does, the high rate of unemployment will persist into the future. Aggregate demand is key to the Keynesian macroeconomic model. Keynes believed that weak aggregate demand was the cause of the Great Depression.

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. AS (real GDP) AD C Net Exports Tendency of output I + G Recall: Planned Aggregate Expenditures = Planned Consumption plus Planned Investment plus Planned Government Expenditures plus Planned Net Exports. £ £ £ £ £ Expand Equilibrium Contract > An Example of Keynesian Equilibrium > = < < o/p < AD, expand their output to rebuild their inventories to regular levels. o/p > AD, and inventories accumulate. Firms reduce output in order to reduce this build-up of excessive inventories. AD = AS there is Keynesian macroeconomic equilibrium.

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Aggregate Expenditures Output (Real GDP -- trillions of £) 45º Equilibrium (AD = GDP) Aggregate expenditures will be equal to total output for all points along the 45° line from the origin. The 45° line maps out potential equilibrium levels of output for the Keynesian model Planned aggregate expenditures (trillions of £)

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Keynesian Equilibrium Output (Real GDP -- trillions of £) 45º Equilibrium (AD = GDP) At output levels below £10.0 trillion (for example 9.7) AD is above the 45° line – expenditures exceed output and thus businesses sell more than they currently produce, diminishing inventories. Businesses expand output. 9.7 AD = C + I + G + X 9.85 Unplanned reduction in inventories Planned aggregate expenditures (trillions of £)

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Keynesian Equilibrium Output (Real GDP -- trillions of £) 45º Equilibrium (AD = GDP) At output levels above £10.0 trillion (for example 10.3) AD is below the 45° line – output exceeds expenditures and thus businesses sell less than they currently produce, increasing inventories. Businesses reduce output AD = C + I + G X Unplanned increase in inventories Unplanned reduction in inventories Planned aggregate expenditures (trillions of £)

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Keynesian Equilibrium Output (Real GDP -- trillions of £) 45º Equilibrium (AD = GDP) Keynesian equilibrium exists where planned expenditures just equal actual output. Here that point is at £10.0 trillion AD = C + I + G + X Full-employment for this example exists at £10.3 trillion. In the Keynesian model, macroeconomic equilibrium does not necessarily coincide with full-employment. Keynesian equilibrium Full Employment (potential GDP) Planned aggregate expenditures (trillions of £)

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Keynesian Equilibrium Output (Real GDP -- trillions of £) 45º AD = GDP If equilibrium is less than its capacity, only an increase in expenditures (shift AD) can lead to full employment output If consumers, investors, governments, or foreigners spend more and thereby shift AD to AD 2, output would reach its full employment potential. Full Employment (potential GDP) AD AD Planned aggregate expenditures (trillions of £)

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Keynesian Equilibrium Planned aggregate expenditures (trillions of £) Output (Real GDP -- trillions of £) 45º AD = GDP Once full employment is reached, further increases in AD, such as to AD 3, lead only to higher prices – nominal output expands along the black segment of AD (those points beyond the full employment output level at £10.3 trillion) while real output does not Full Employment (potential GDP) AD 1 AD AD 3 AS

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Questions for Thought: 1.What determines the equilibrium rate of output in the Keynesian model? What did Keynes think was the cause of the prolonged, high unemployment during the Great Depression?

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Questions for Thought: 2.According to the Keynesian view, which of the following is true? a)Businesses will produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buy. b)If planned aggregate expenditures are less than full employment output, output will fall short of its potential. c)Equilibrium can only occur at the full employment rate of output.

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Questions for Thought: 3.Within the framework of the Keynesian model, if the planned expenditures on goods and services were less than current output, a. business firms would reduce their output and lay off workers in the near future. b. the wage rates of workers would decline and thereby help to direct the economy to full employment.

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Questions for Thought: 4.According to the Keynesian view, which of the following is true? a)Businesses will produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buy. b)If planned aggregate expenditures are less than full employment output, output will fall short of its potential. c)Equilibrium can only occur at the full employment rate of output.

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Questions for Thought: 5.Which of the following is the primary source of changes in output within the framework of the Keynesian model? a. changes in aggregate expenditures b. changes in interest rates c. changes in wage rates

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. The Multiplier

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. The Multiplier The Multiplier: The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate income. An increase in spending by one party increases the income of others. Thus, growth in spending can expand output by a multiple of the original increase. The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income. The size of the multiplier increases with the marginal propensity to consume (MPC).

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. effectively, $4 million is spent in the economy. Here, a £1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until … Expenditure stage Additional income (Pounds) Marginal propensity to consume Additional consumption (Pounds) For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. 1,000, , , , , , , , , , , ,914 Round 1 Round 2 Round 3 Round 4 Round 5 Total 4,000,0003,000,000 All others 3/4 The Multiplier Principle 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).

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. MPC Size of multiplier 9/10 4/5 3/4 2/3 1/2 1/ M =M = MPC A Higher MPC Means a Larger Multiplier 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.). The effect is that for higher MPCs, higher multipliers result. Specifically the relationship follows this equation:

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Real-World Significance of The Multiplier In evaluating the importance of the multiplier, one should remember: taxes and spending on imports will dampen the size of the multiplier; it takes time for the multiplier to work; and the amplified effect on real output will be valid only when the additional spending brings idle resources into production without price changes.

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Keynesian View of the Business Cycle Keynesians argue that a market economy, if left to its own devices, is unstable and likely to experience prolonged periods of recession.

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. According to the Keynesian view of the business cycle, upswings and downswings tend to feed on themselves: During a downturn, business pessimism, declining investment, and the multiplier principle combine to plunge the economy further toward recession. During an economic upswing, business and consumer optimism and expanding investment interact with the multiplier to propel the economy to an inflationary boom. Keynesian View of the Business Cycle

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. The Keynesian view argues that wide fluctuations in private investment are a major source of economic instability. The theory suggests that a market-directed economy, left to its own devices, will tend to fluctuate between economic recession and inflationary boom. Keynesian View of the Business Cycle

Jump to first page Copyright ©2006 Thomson Business and Economics. All rights reserved. Keynesian View of the Business Cycle Regulation of aggregate expenditures is the crux of sound macroeconomic policy according to the Keynesian view. 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.