Keynesian Foundations of Modern Macroeconomics

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Slides to Accompany “Economics: Public and Private Choice 9th ed.”


James Gwartney, Richard Stroup, and Russell Sobel

Keynesian Foundations

of Modern Macroeconomics

Chapter 11

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“ I believe myself to be writing a book on


economic theory which will largely


revolutionize

not, I suppose, at once


but in the course of the next ten years



the way the world thinks about economic


problems. ”

--

John Maynard Keynes

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1.
Keynesian Explanations


of the Great Depression

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Keynesian Explanations


of the Great Depression


Keynesian economics 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.

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Keynesian Explanations


of the Great Depression


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.


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2.
The Basic


Keynesian Model

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Aggregate
Expenditures

=

The Basic Keynesian Model


In the Keynesian model

Planned

Net

Exports

Planned

Consumption

+

Planned

Investment

+

Planned

Government

Expenditures

+


as income expands,
consumption

increases,
but by a lesser amount than the increase in
income,


both
planned investment

and
government

expenditures are independent of income, and,


planned net exports
decline as income
increases.

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3

6

9

P
lanned
C
onsumption

E
xpenditures

(trillions of dollars)

R
eal

D
isposable
I
ncome

(trillions of dollars)

6

9

12

3

12


The Keynesian model assumes that there is a positive relationship
between consumption and income.

Aggregate Consumption Function


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

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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

850

850

850

$7,600

$650

7,900

700

8,200

750

8,500

800

8,800

850

$200

150

100

50

0


Because exports are determined by income abroad,
they are constant at $850 billion.

Income and

Net Exports


Imports increase as domestic income expands.


Thus, planned net exports fall as domestic income
increases.

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3.
Keynesian


Equilibrium

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Keynesian Equilibrium


In the Keynesian view,
equilibrium
occurs when:


When this is the case:

Planned Aggregate

Expenditures

=

Current

Output


businesses are able to sell the total
amount of goods & services that they
produce, and,


there are no unexpected changes in
inventories, so,


producers have no reason to either
expand or contract their output during
the next period.


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Keynesian Equilibrium


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.


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.

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Keynes believed that weak aggregate
demand was the cause of the Great
Depression.

Keynesian Equilibrium


Keynesian equilibrium can occur at
less than full employment.


Aggregate Demand is key to the
Keynesian model.


When it does, the high rate of
unemployment will persist into the
future.


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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
P
lanned
A
ggregate
E
xpenditures equals the sum of
P
lanned
C
onsumption,
P
lanned
I
nvestment,
P
lanned
G
overnment
E
xpenditures, and
P
lanned
N
et
E
xports.

$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

1,700

1,700

1,700

Expand

Expand

Equilibrium

Contract

Contract


When planned aggregate expenditures
equal

Total Output, there
is Keynesian macroeconomic
equilibrium
.


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


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

8,200

6,400

100

1,700

Equilibrium

<

<


>


>


=

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O
utput

(Real GDP
--


trillions of $)

P
lanned
A
ggregate

E
xpenditures

(trillions of dollars)



45º

E
quilibrium

(
AE

= GDP)


Aggregate Expenditures (
AE
)


The 45
°

line maps out potential equilibrium levels
of output for the Keynesian model.


Aggregate expenditures will be equal to total output
for all points along the 45
°

line from the origin.

7.9

7.9

8.5

8.5

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7.9

8.5

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


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.


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
P
lanned

A
ggregate
E
xpenditures

data is introduced.

8.5

E
quilibrium

(
AE

= GDP)

Aggregate Expenditures

and Keynesian Equilibrium

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7.9

8.5

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

8.2


At that level of income where planned expenditures just equal
actual output, the Keynesian equilibrium exists. Here that
equilibrium exists at $8.2 trillion.


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

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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

8.5

8.2

8.2

8.8

8.5

Full Employment

(Potential Output)


When equilibrium output is less than the economy’s capacity only an
increase in expenditures (a shift in
AE
) will lead to full employment output.


If consumers, investors, governments, or foreigners would spend more and
thereby shift
AE

to
AE
2
, output would reach its
full employment
potential.


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

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4. The
Keynesian View


Can be Illustrated


Within the AD/AS


Framework

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The Keynesian View Illustrated


within the AD/AS Framework


When output is less the
full
-

employment
, the primary impact of an
increase in aggregate demand will be
an increase in output.


When output is at or beyond the
full
-

employment
level, the primary impact of
an increase in demand will be higher
prices.

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P
rice

L
evel


G
oods
&

S
ervices

(real GDP)

Y

F

LRAS

Full Employment

(Potential Output)

Keynesian Aggregate Supply Curve


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.


This flat range is often referred to as the
Keynesian range
. Output
here is entirely dependent on the level of
aggregate demand
.


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

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P
rice

L
evel


G
oods
&

S
ervices

(real GDP)

LRAS

SRAS

AD
1

Y

F

AD / AS Presentation of the Keynesian Model


The diagram above illustrates the
Polar implications

of the

Keynesian model.


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

e
3

e
2

e
1

Y

F


But, increases in demand beyond
AD
2
, such as a shift to
AD
3
, lead
only to a higher price level (
P
3
)
.

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P
rice

L
evel


G
oods
&

S
ervices

(real GDP)

LRAS

SRAS

AD
1

Y

F


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.


Now an unanticipated increase in
AD
would lead:

AD
3

AD
2

Y

1

P

1

P

3

P

2

e
3

e
1


Primarily to increases in output when output is below capacity (for
example beginning at
AD
1

with output
Y
1
).

Y

3

e
2


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

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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?




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5.
The Multiplier

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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, an
increase in spending can expand output by

a much larger amount.


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
).

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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.

The Multiplier

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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

3/4

3/4

3/4

3/4

3/4

3/4

3/4

3/4

3/4

3/4

Total

4,000,000

3,000,000

3/4

All Others

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).


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.

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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


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
MPC
s, higher multipliers result, specifically
the relationship follows this equation:

M =


1

1
-

MPC

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6.
The Keynesian view


of the Business Cycle

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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.


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 principle to propel the economy to an
inflationary boom.


The theory suggests that a market
-
directed economy,
left to its own devices, will tend to fluctuate between
economic recession and inflationary boom.

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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.

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7.
Evolution of Modern


Macroeconomics

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Evolution of


Modern Macroeconomics


Major Insights of Keynesian Economics:



Changes in output, as well as in prices, play
a role in the macroeconomic adjustment
process, particularly in the short run.


The responsiveness of aggregate supply to
changes in demand will be directly related to
the availability of unemployed resources.


Fluctuations in aggregate demand are an
important potential source of business
instability.


Modern macroeconomics is a hybrid,
reflecting elements of both classical and
Keynesian analysis as well as some insights
drawn from other areas of economics.


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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?

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End

Chapter 11