© 2010 Jane Himarios, Ph.D.
Lecture 8
Chapter 8: Keynesian Macroeconomics
The Classical model introduced in chapter 7 focuses on the long run. Full
employment is achieved in the long run (which is defined as after all adjustments
occur).
Keynes developed his theories in response to the Great Depression, when a
number of countries got stuck in situations of high unemployment for extended
periods. He tried to explain how a country can get stuck.
Aggregate Expenditures
GDP = AE = C + I + G + NX
Simplifying Assumptions (for now):
1. Ignore government and the foreign sector
2. Assume that all saving is personal saving
3. Assume excess plant capacity and, therefore, no pressure on the aggregate
price level
There are two things you can do with your disposable income: save it (S) or
spend it (C).
Yd = S + C
Keynes believed that as income increases consumption also increases, but not
by as much as the change in income. The marginal propensity to consume is
equal to the change in consumption associated with a given change in income:
MPC = ΔC/ΔYd.
Similarly, MPS = ΔS/ΔYd
MPC + MPS = 1
Two other important equations: APC = C ÷ Yd, APS = S ÷ Yd
© 2010 Jane Himarios, Ph.D.
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An important concept: the 45° line
In everyday life, the 45° line is a reference line that shows all the points where
the value on the horizontal axis and the value on the vertical axis are equal:
number of treats
45° line
number of trick-or-treaters
We want to be on the 45° line, where the number of treats matches the number
of trick-or-treaters. Points above the line represent too many treats and points
below the line represent not enough treats (too many trick-or-treaters).
In Keynesian economics, the 45° line is a reference line that shows all the points
where income and consumption are equal:
Consumption
45° line
Income
What do points above the 45° line represent? What about below the 45° line?
________________________________________________________________
Consumption
Consumption
C = a + MPC•Yd
a
Income
Where the value of a is determined by wealth, expectations, household debt, and
taxes.
© 2010 Jane Himarios, Ph.D.
________________________________________________________________
Investment
Investment is determined by interest rates, business expectations about the
future, technological change, capital goods on hand, and operating costs. These
determinants affect the rate of return on investment and, therefore, the amount of
investment.
Notice that income does not affect investment.
Investment
I0
Income
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The Simple Keynesian Model
Equilibrium occurs when Y = AE. Notice that this happens when withdrawals of
spending (saving) equals injections of spending (investment).
AE
45° line (all points where Y = AE)
AE = C + I0
Consumption
a + I0
a
I0
Investment
Income (Y)
Saving and
Investment
Saving
I0
Investment
Income (Y)
-a
© 2010 Jane Himarios, Ph.D.
Using the Simple Keynesian Model:
Show what will happen if investment spending increases from I0 to I1.
AE
45° line (all points where Y = AE)
AE = C + I0
a + I0
Y*
Income (Y)
Saving and
Investment
Saving
I0
Investment
Income (Y)
-a
Make sure that you can also show what will happen if investment decreases.
Another important thing about changes in spending: the multiplier effect
“Changes in Spending are Amplified”
Notice from page 198 in your text that a $100 increase in spending causes
income/output to increase by more than $100.
Specifically, the spending multiplier, k, is
k = 1/(1 – MPC)
If MPC = .75 then k = 1/(1 - .75) = 1/.25 = 4.
A multiplier of 4 implies that a $1 increase in spending causes a $4 increase in
output.
© 2010 Jane Himarios, Ph.D.
The Full Keynesian Model
We will assume (for simplicity) that government spending, taxes, and net exports
are all independent of Y.
This means that their graphs look like the investment spending graph:
Government
Spending
G0
Income (Y)
Net Export
Spending
NX0
(X – M)
Income (Y)
Taxes
T0
Income (Y)
We will also assume (for simplicity) that all taxes are paid in a lump sum. Taxes
are subtracted from income, Y, to get disposable income, YD.
© 2010 Jane Himarios, Ph.D.
Therefore, adding these components to the mix, we get:
AE
45° line (all points where Y = AE)
AE = C + I0 + G + NX
a + I0 + G + NX
Y*
Income (Y)
Saving,
I, G, NX
Saving
I0 + G + NX
I + G + (X – M)
Income (Y)
-a
© 2010 Jane Himarios, Ph.D.
The economy will always move to equilibrium
AE
45° line (all points where Y = AE)
AE = C + I0 + G + NX
a + I0
Y*
Income (Y)
Y* is where this economy will automatically go.
Scenario #1
What will happen if income in the economy is currently bigger than Y*, let’s say
equal to Y1? On this graph, show that at Y1, income > AE. When income > AE
the economy will shrink as firms lay off workers and cut production.
AE
45° line (all points where Y = AE)
AE
a + I0
Y*
Y1
Income (Y)
Y* is where this economy will automatically go.
© 2010 Jane Himarios, Ph.D.
Scenario #2
What will happen if income in the economy is currently smaller than Y*, let’s say
equal to Y2? On this graph, show that at Y2, income < AE. When income < AE
the economy will expand as firms hire more workers and boost production.
AE
45° line (all points where Y = AE)
AE
a + I0
Y2
Y*
Income (Y)
Y* is where this economy will automatically go.
Notes about Macroeconomic Equilibrium in the Simple Keynesian Model
Macroeconomic equilibrium occurs at the income level where there are no net
pressures pushing the economy to move to a higher or lower level of income and
output.
In equilibrium, leakages = injections, that is, S + T + IM = I + G + EX.
In equilibrium, Aggregate Expenditures = Income, that is, C + I + G + NX = Y.
Important Keynesian insight: Y* isn’t necessarily where we want to be. That is
macroeconomic equilibrium doesn’t necessarily occur at the full employment
level of output.
We might want to be at Y1, for example. Why won’t we stay there?
Or we might want to be at Y2. Why won’t we stay there?
© 2010 Jane Himarios, Ph.D.
Scenario #1, Revisited: A recessionary gap
Recessionary gaps occur when there is too little spending to maintain full
employment (Yfull)
What will happen if income in the economy is currently bigger than Y*, let’s say
equal to Yfull? On this graph, show that at Yfull, income > AE. When income > AE
the economy will shrink as firms lay off workers and cut production.
AE
45° line (all points where Y = AE)
AE
a + I0
Y*
Yfull
Income (Y)
Y* is where this economy will automatically go, even though we don’t want to go
there!
Scenario #2, Revisited: An inflationary gap
Inflationary gaps occur when there is too much spending to maintain full
employment (Yfull)
What will happen if income in the economy is currently smaller than Y*, let’s say
equal to Yfull? On this graph, show that at Yfull, income < AE. When income < AE
the economy will expand as firms hire more workers and boost production.
AE
45° line (all points where Y = AE)
AE
a + I0
Yfull
Y*
Income (Y)
Y* is where this economy will automatically go, even though we don’t want to go
there!
© 2010 Jane Himarios, Ph.D.
The Great Depression, according to Keynes
AE
45° line (all points where Y = AE)
AE
a + I0
Yfull
Income (Y)
1. In 1929 the economy was at full employment (income = Yfull). We will start at
this equilibrium.
2. Investment spending collapsed by 91% from 1929 to 1933. Show this
graphically.
3. Find the new equilibrium.
4. Explain why the economy was not able to stay at full employment, that is, why
it got stuck in a recessionary gap.
Keynes’ Prescription for Moving the Economy Back to Full Employment:
Increase government spending or cut taxes.
How does government intervention work?
Remember from above, that “changes in spending are amplified.” Here is the
formula for finding how a particular change in spending will affect output:
The change in output = the multiplier x the initial change in AE
Exercise 1:
Assume that k = 4 and that AE increases by $100. How will output change?
Answer: The change in output = 4 x $100 = $400. Output will rise by $400.
© 2010 Jane Himarios, Ph.D.
Exercise 2:
Assume that MPC = .80 and that government spending increases by $787 billion.
How will output change?
Answer: The change in output = (1/(1 – 0.80)) x $787 billion = 5 x $787 billion =
$3,935 billion. Output will rise by $3,935 billion.
Exercise 3:
Assume that MPC = .80 and that taxes increase by $787 billion. How will output
change?
Answer (this takes three steps):
Step 1: ΔYD = -ΔT = -($787 billion) = -$787 billion
Step 2: ΔC = MPC x -ΔYD = .80 x -$787 billion = -$629.6 billion. Consumption will
fall by $629.6 billion.
Step 3: The change in output = the multiplier x the initial change in AE = (1/(1 –
0.80)) x -$629.6 billion = 5 x -629.6 billion = -$3,148 billion. Output will fall by
$3,148 billion
Exercise 4:
Assume the multiplier = 5. What will happen if the government intervenes in the
economy to cure a recessionary gap by spending $787 billion and at the same
time raises taxes by $787 billion so that the federal budget remains balanced?
Answer: Output will rise by $787 billion. This outcome is known as the balanced
budget multiplier effect. “Equal changes in government spending and taxation
lead to an equal change in output. That is, the balanced budget multiplier is equal
to 1.”
Exercise 5:
Exercise 4 assumed the multiplier = 5, which implies that the MPC is .80. Will the
answer to exercise 4 change if the MPC is some number other than .80?
Answer: No. No matter what the values of MPC and MPS are, the balanced
budget multiplier is equal to 1.
Real World Intervention:
http://en.wikipedia.org/wiki/American_Recovery_and_Reinvestment_Act_of_200
9
Robert J. Barro, “The Stimulus Evidence One Year On,” Wall Street Journal,
2/23/2010.
“My research shows an extra $600 billion of public spending at the cost of
$900 billion in private expenditure.”