Keynesian foundations of modern macroeconomics - BG

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Oct 28, 2013 (3 years and 5 months ago)

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To Accompany “Economics: Private and Public Choice 10th ed.”


James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson

Slides authored and animated by:


James Gwartney, David Macpherson, & Charles Skipton

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Text




Macro Only

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Keynesian Foundations

of Modern Macroeconomics

3

11

3

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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The Great Depression

and the Keynesian View

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Macroeconomics

Prior to the Great Depression


Prior

to

the

Great

Depression

of

the

1930
s,

economists

(they

are

now

called

classical

economists)

stressed

the

importance

of

production

and

paid

little

heed

to

aggregate

demand
.

Say’s

Law

(named

for

nineteenth
-
century

French

economist

J
.

B
.

Say)

was

central

to

their

analysis
.



Say’s

Law
:




The

p
roduction

(supply)

of

goods

creates

the

purchasing

power

(demand)

required

to

purchase

the

goods
.

Hence,

general

overproduction

is

impossible

because

“supply

creates

its

own

demand
.



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Macroeconomics

Prior to the Great Depression


Classical

economists

believed

that

markets

would

adjust

quickly

and

direct

the

economy

toward

full

employment
.

The

huge

decline

in

output,

prolonged

unemployment,

and

lengthy

duration

of

the

Great

Depression

undermined

the

classical

view

and

provided

the

foundation

for

Keynesian

economics
.


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Keynesian Explanation

of the Great Depression


Keynesian

economics

developed

during

the


Great

Depression

(
1930
s)
.



Keynesian

theory

provided

an

explanation

for

the

severe

and

prolonged

unemployment

of

the

1930
s
.



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 Explanation

of the Great Depression


Keynesian View

of spending and
output:


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
.


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The Basic Keynesian Model

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Aggregate
expenditures

=

Planned

Net

Exports

Planned

consumption

+

Planned

investment

+

Planned

government

expenditures

+

The Basic Keynesian Model


In the
Keynesian model
:


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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Aggregate Consumption Function

3

6

9

Planned consumption

(trillions of $)

Real disposable
income

(trillions of dollars)

6

9

12

3

12

45º

45º line

C

Dis
-
saving

Saving


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


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).

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Total output

(real GDP in trillions)


Planned exports

(trillions)


Planned imports

(trillions)


Planned net exports

(trillions)


$1.2

1.2

1.2

1.2

1.2


$9.4

$1.00


9.7

1.05


10.0

1.10


10.3

1.15


10.6

1.20

$0.20

0.15

0.10

0.05

0.00

Income and Net Exports


Because exports are determined by income
abroad, they are constant at $1.2 trillion.


Imports increase as domestic income expands.


Thus, planned net exports fall as domestic
income increases.

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Keynesian Equilibrium

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When this is the case:


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.

Planned aggregate

expenditures

=

Current

output

Keynesian Equilibrium


According to the Keynesian viewpoint,
equilibrium occurs when:

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Total aggregate

expenditures

<

Current

output

Keynesian Equilibrium


firms accumulate unplanned additions to
inventories that will cause them to cut back on
future output and employment.


When

Total aggregate

expenditures

>

Current

output


inventories fall and businesses respond with
an expansion in output in an effort to restore
inventories to their normal levels.


When

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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.

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Total Output

(real GDP)

Planned aggregate

expenditures

Planned

consumption

Planned

Net Exports

Tendency

of output

Planned investment
plus

government expenditures

Recall:

Planned Aggregate Expenditures = Planned Consumption
plus

Planned Investment


plus

Planned Government Expenditures
plus

Planned Net Exports.


$ 9.4


9.7

10.0

10.3

10.6


$ 9.70


9.85

10.00

10.15

10.30


$7.1


7.3


7.5


7.7


7.9


$0.20


0.15


0.10

0.05

0.00


$2.4


2.4


2.4


2.4


2.4

Expand

Expand

Equilibrium

Contract

Contract


>

An Example of Keynesian 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.


When
output

is more than
planned aggregate expenditures
,
output exceeds purchases, and inventories accumulate. Firms
reduce

output to slow the accumulation of further inventory.


When
planned aggregate expenditures

equal
total output
,
there is Keynesian macroeconomic
equilibrium
.

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Aggregate Expenditures

Output

(Real GDP
--


trillions of $)

45º

Equilibrium

(
AE

= 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.

9.4

9.4

10.6

10.6

Planned aggregate

expenditures

(trillions of $)

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Keynesian Equilibrium

Output

(Real GDP
--


trillions of $)

45º

Equilibrium

(
AE

= GDP
)


At output levels below $10.0 trillion (for example 9.4)
AE

is
above the 45
°

line


expenditures exceed output and thus
businesses sell more than they currently produce,
diminishing inventories.
Businesses expand output
.

9.4

AE

= C + I + G + NX

9.7

Unplanned

reduction

in inventories

Planned aggregate

expenditures

(trillions of $)

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Keynesian Equilibrium

Output

(Real GDP
--


trillions of $)

45º

Equilibrium

(
AE

= GDP
)


At output levels above $10.0 trillion (for example 10.6)
AE

is below the 45
°

line


output exceeds expenditures and thus
businesses sell less than they currently produce, increasing
inventories.
Businesses reduce output
.

10.6

AE

= C + I + G + NX

10.3

Unplanned

increase

in inventories

9.4


9.7

Unplanned

reduction

in inventories

Planned aggregate

expenditures

(trillions of $)

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Keynesian Equilibrium

Output

(Real GDP
--


trillions of $)

45º

Equilibrium

(
AE

= GDP
)


Keynesian equilibrium exists where
planned expenditures

just equals actual output. Here that point is at $10.0 trillion.

10.6

AE

= C + I + G + NX

10.3

9.4


9.7

10.0

10.0


Full
-
employment for this example exists at $10.6 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 $)

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Keynesian Equilibrium

Output

(Real GDP
--


trillions of $)

45º

AE

= GDP


If equilibrium is less than its capacity, only an increase in
expenditures (shift
AE
) can lead to full employment output.

10.0

10.0


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

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

Full Employment

(potential GDP)

AE
1

10.6

AS

AE
2

10.6

Planned aggregate

expenditures

(trillions of $)

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Keynesian Equilibrium

Planned aggregate

expenditures

(trillions of $)

Output

(Real GDP
--


trillions of $)

45º

AE

= GDP


Once full employment is reached, further increases in
AE
,
such as to
AE
3
, lead only to higher prices


nominal output
expands along the black segment of AE (those points beyond
the full employment output level at $10.6 trillion) while real
output does not.

10.0

10.0

Full Employment

(potential GDP)

AE
1

AE
2

10.6

AS

AE
3

11.2

10.6

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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?

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.

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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.


4.

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

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The Keynesian View Within

the AD/AS Framework

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Keynesian Equilibrium

Within the AD/AS Framework


When

output

is

less

than

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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The Keynesian model implies a 90
°
, angle
-
shaped
SRAS

curve that is flat for outputs less than potential GDP
Y
F



due

to downward wage and price inflexibility.

Keynesian Aggregate Supply Curve

Price

Level

LRAS

Y
F

P
1

SRAS


Goods & Services

(real GDP)

Full Employment

(potential GDP)

Keynesian range


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

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Keynesian Aggregate Supply Curve

Price

Level

LRAS

Y
F

P
1

SRAS


Goods & Services

(real GDP)

Full Employment

(potential GDP)

Keynesian range


The Keynesian model implies that real output rates beyond
full employment are unattainable, both the
SRAS

and
LRAS

curves are vertical at full employment
-

potential output.

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AD/AS Presentation of the

Keynesian Model:
Polar Case

Price

Level

LRAS

Y
F

P
1

SRAS


Goods & Services

(real GDP)


Above are the
polar implications

of the Keynesian model.


When output is less than capacity (e.g.
Y
1
) …

AD
1

P
2
=

e
1

Y
1

AD
2

e
2










an increase in
AD

(like from
AD
1

to
AD
2
) expands output without an
increase in the price level (
P
2

=

P
1
).

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AD/AS Presentation of the

Keynesian Model:
Polar Case

Price

Level

LRAS

Y
F

P
1

SRAS


Goods & Services

(real GDP)


Increases in demand beyond
AD
2

(like from
AD
2

to
AD
3
)
lead to higher price level
P
3
, but real output remains
constant.

AD
2

AD
1

e
2

e
1

P
2
=

P
3

Y
1

AD
3

e
3

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LRAS

AD/AS Presentation of the

Keynesian Model:
Relaxed Case

Price

Level

P
1

SRAS


Goods & Services

(real GDP)


This Keynesian model relaxes the assumptions regarding
complete short
-
run price and output inflexibility beyond
Y
F
.

AD
1

e
1

Y
1

AD
2

P
2

Relaxed assumptions
:

SRAS

now turns from

horizontal to vertical

more gradually.

Y
F


An unanticipated increase in
AD

with output below capacity
leads
mainly

to increases in output (e.g. from
AD
1

to
AD
2
).


e
2

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LRAS

AD/AS Presentation of the

Keynesian Model:
Relaxed Case

Price

Level

Y
F

P
1


Goods & Services

(real GDP)


An unanticipated increase in
AD

with output at or beyond
capacity leads
mainly

to increases in price level (e.g. from
AD
2

to
AD
3
).

AD
2

AD
1

e
2

e
1

P
2

Y
1

AD
3

P
3

Y
3

SRAS

e
3

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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, 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
).


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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.

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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

(dollars)


Marginal propensity

to consume

Additional consumption

(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

949,219

750,000

562,500

421,875

316,406

237,305

711,914

Round 1

Round 2

Round 3

Round 4

Round 5

Total

4,000,000

3,000,000

All others

3/4

3/4

3/4

3/4

3/4

3/4

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).

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MPC

Size of

multiplier

9/10

4/5

3/4

2/3

1/2

1/3

10.0

5.0

4.0

3.0

2.0

1.5

M

=


1

1
-

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

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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.

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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.


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

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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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Evolution of

Modern Macroeconomics

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The 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 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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Questions for Thought:

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.

2.

The multiplier principle indicates that if
businesses increase their investment
expenditures by $5 billion, real GDP will
increase by


a. more than $5 billion if the economy was


initially operating well below capacity.


b. more than $5 billion if the economy was


initially operating at full employment capacity.

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Questions for Thought:

3.
According to the Keynesian view, market
economies are relatively unstable because of


a.
errors on the part of policymakers.



b.
instability in the rate of private investment.



c.
fluctuations in the real rate of interest.


4. (a)
Widespread acceptance of the Keynesian


aggregate expenditure (
AE
) model took


place during and immediately following


the Great Depression. Explain why.



(b) The
AE

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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Questions for Thought:

5.
The proponents of government subsidies for
sports stadiums often argue that they generate
multiplier effects that expand local employment
and output. Is this view correct? Who is
helped and who is hurt by these subsidies?


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