1 The Keynesian Model in Action Key Concepts Key Concepts Summary Summary ©2005 South-Western College Publishing.

1

The Keynesian Model in Action

• Key Concepts• Summary

©2005 South-Western College Publishing

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

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

1.000.750.500.25

1 2 3 4

1.251.501.752.00

5 6 7 8 9 10

Real GDPTrillions of $ per year

Government SpendingR

eal

Go

vern

men

t sp

end

ing

Tri

llio

ns

of

$ p

er y

ear

Government Spending

G1

G2

Autonomous Government Spending

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

1.000.750.500.25

1 2 3 4

1.251.501.752.00

5 6 7 8 9

Autonomous Net Exports

10

Real GDPTrillions of $ per year

Positive Net ExportsR

eal

Net

Exp

ort

sT

rill

ion

s o

f $

per

yea

r

Negative Net Exports

(X-M)2

(X-M)1

(X-M)Zero Net Exports

7

What does the term equilibrium mean?

In the Keynesian model, the equilibrium is the point toward which the economy tends

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

What can pull aggregate expenditures higher or

lower in Keynesian economics?

Aggregate expendituresC + I + G + (X-M)

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

What causes a decrease in real GDP

and employment?Unplanned inventory investment accumulation

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

What causes an increase in real

GDP and employment?

Unplanned inventory investment depletion

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

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

4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures-Output

Model AE = Y

AE

Real GDPRea

l Ag

gre

gat

e E

xpen

dit

ure

s

Inventory Depletion

C + I + G + )X-M)

Inventory Accumulation

E

Full employment

GDP gap

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

4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures-Output Model

AE1

Real GDP

Full employment

AE2 R

eal A

gg

reg

ate

Exp

end

itu

res

Less than Full employment

19

What is theKeynesian multiplier?Any initial increase in spending will lead to a multiple increase in GDP

20

4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures-Output

Model

AE1

Real GDP

1 trillion dollars

AE2 .5 trillion dollars

Rea

l Ag

gre

gat

e E

xpen

dit

ure

s

21

Initial increase in government

spending

Operates through a multiplier

Larger increase in aggregate

expenditures

22

How does themultiplier work?

Any initial change in spending by the government, households, or firms creates a chain reaction of further spending

23

4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures-Output Model

AE

Real GDP

Rea

l Ag

gre

gat

e E

xpen

dit

ure

s

2

4

MPC = .5

24

What is the Marginal Propensity to

Consume?MPC is the change in consumption spending resulting form a given change in income

25

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

26

How does the multiplier work?

27

Spending Multiplier Effect

Round

1

2

Spending

$500$250$125

$63...

$1,000

3

4

All other rounds

Total spending

28

What is the relationship between

MPC and MPS?MPC + MPS = 1

29

What is the formula for the multiplier?1 / (1 – MPC)

(or)

1 / MPS

30

If the MPS is 1/2, what is the multiplier?

1 / MPS = 1 / 1/2 = 2

31

Relationship between MPC, MPS, and the Spending Multiplier

MPC

105

MPS

4

3

2

1.5

Spending Multiplier

.90

.80

.75

.67

.50

.33

.10

.20

.25

.33

.50

.67

32

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

33

What is therecessionary gap?

The amount by which aggregate expenditures fall short of the amount required to achieve full employment equilibrium

34

4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures - Output Model

AE1

Real GDP

AE2

GDP gap

Rea

l Ag

gre

gat

e E

xpen

dit

ure

s

E1

E2

Recessionary gap

Full employment

35

What is the Keynesian remedy for a

recessionary gap?Increase autonomous spending by the amount of the recessionary gap

36

What can the government do to close

a recessionary gap?• Increase government spending

• Lower taxes• Raise transfer payments

37

What is an inflationary gap?

The amount by which aggregate expenditures exceed the amount required to achieve full employment equilibrium

38

4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures - Output Model

AE2

Real GDP

AE1

GDP gap

Rea

l Ag

gre

gat

e E

xpen

dit

ure

s

E2

E1

Inflationary gap

Full employment

39

What is the Keynesian remedy for an

inflationary gap?Reduce autonomous spending by the amount of the inflationary gap

40

How can the government close an

inflationary gap?• Cut government spending• Increase taxes• Reduce transfer payments

41

Key Concepts

42

• Why is government spending considered an autonomous expenditure?

• What does the term equilibrium mean?• In the Keynesian model, where is the equilibri

um level of GDP?• What can pull aggregate expenditures higher

or lower in Keynesian economics?• What causes a decrease in real GDP and em

ployment?

43

• 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?

44

• 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?

45

Summary

46

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

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

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

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

1.000.750.500.25

1 2 3 4

1.251.501.752.00

5 6 7 8 9 10

Real GDPTrillions of $ per year

Government SpendingR

eal

Go

vern

men

t sp

end

ing

Tri

llio

ns

of

$ p

er y

ear

Government Spending

G1

G2

Autonomous Government Spending

51

1.000.750.500.25

1 2 3 4

1.251.501.752.00

5 6 7 8 9

Autonomous Net Exports

10

Real GDPTrillions of $ per year

Positive Net ExportsR

eal

Net

Exp

ort

sT

rill

ion

s o

f $

per

yea

r

Negative Net Exports

(X-M)2

(X-M)1

(X-M)Zero Net Exports

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

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

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

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

4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures-Output

Model AE = Y

AE

Real GDPRea

l Ag

gre

gat

e E

xpen

dit

ure

s

Inventory Depletion

C + I + G + )X-M)

Inventory Accumulation

E

Full employment

GDP gap

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

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

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

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

4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures - Output Model

AE1

Real GDP

AE2

GDP gap

Rea

l Ag

gre

gat

e E

xpen

dit

ure

s

E1

E2

Recessionary gap

full employment

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

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

4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures - Output Model

AE2

Real GDP

AE1

GDP gap

Rea

l Ag

gre

gat

e E

xpen

dit

ure

s

E2

E1

Inflationary gap

full employment

65

END