Keynesian Foundations
of Modern Macroeconomics
Full Length Text — Part: 3
Macro Only Text — Part: 3
Chapter: 11
Chapter: 11
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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“ 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 1930s,
economists (they are now called classical
economists) stressed the importance of
production and paid little heed to aggregate
demand. Say’s Law (named for nineteenthcentury French economist J. B. Say) was
central to their analysis.
• Say’s Law:
•
The production (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 (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 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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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.
Aggregate
expenditures
=
Planned
Planned
Planned + Planned + government + Net
consumption
investment
Exports
expenditures
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Aggregate Consumption Function
Planned consumption
(trillions of $)
45º line
12
Saving
C
9
Dis-saving
6
3
45º
3
6
9
12
Real disposable
income
(trillions of dollars)
• 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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Income and Net Exports
Total output
Planned exports
Planned imports
Planned net exports
(real GDP in trillions)
(trillions)
(trillions)
(trillions)
$9.4
9.7
10.0
10.3
10.6
$1.2
1.2
1.2
1.2
1.2
$1.00
1.05
1.10
1.15
1.20
$0.20
0.15
0.10
0.05
0.00
• 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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Keynesian Equilibrium
• According to the Keynesian viewpoint,
equilibrium occurs when:
Planned aggregate
expenditures
=
Current
output
• 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.
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Keynesian Equilibrium
• When
Total aggregate
expenditures
<
Current
output
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.
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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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An Example of Keynesian Equilibrium
Planned
Total Output Planned aggregate
expenditures
(real GDP)
consumption
$ 9.4
9.7
10.0
10.3
10.6
<
<
=
>
>
Planned investment plus
government expenditures
Planned
Net Exports
Tendency
of output
$ 9.70
9.85
$7.1
7.3
$2.4
2.4
$0.20
0.15
Expand
Expand
10.00
7.5
2.4
0.10
Equilibrium
10.15
10.30
7.7
7.9
2.4
2.4
0.05
Contract
Contract
0.00
Recall: Planned Aggregate Expenditures = Planned Consumption plus Planned Investment
plus Planned Government Expenditures plus Planned Net Exports.
• 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
Planned aggregate
expenditures
Equilibrium
(trillions of $)
(AE = GDP)
10.6
9.4
45º
Output
9.4
10.6
(Real GDP -trillions of $)
• 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.
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Keynesian Equilibrium
Planned aggregate
expenditures
Equilibrium
(trillions of $)
(AE = GDP)
Unplanned
reduction
in inventories
AE = C + I + G + NX
9.7
45º
Output
9.4
(Real GDP -trillions of $)
• 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.
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Keynesian Equilibrium
Planned aggregate
expenditures
Equilibrium
(trillions of $)
(AE = GDP)
Unplanned
reduction
in inventories
AE = C + I + G + NX
10.3
9.7
Unplanned
increase
in inventories
45º
Output
9.4
10.6
(Real GDP -trillions of $)
• 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.
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Keynesian Equilibrium
Planned aggregate
expenditures
Equilibrium
(trillions of $)
Keynesian
equilibrium
(AE = GDP)
AE = C + I + G + NX
10.3
10.0
9.7
Full Employment
(potential GDP)
45º
Output
9.4 10.0 10.6
(Real GDP -trillions of $)
• Keynesian equilibrium exists where planned expenditures
just equals actual output. Here that point is at $10.0 trillion.
• Full-employment for this example exists at $10.6 trillion. In
the Keynesian model, macroeconomic equilibrium does not
necessarily coincide with full-employment.
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Keynesian Equilibrium
Planned aggregate
expenditures
AE = GDP
AS
(trillions of $)
AE2
AE1
10.6
10.0
Full Employment
(potential GDP)
45º
Output
10.0 10.6
(Real GDP -trillions of $)
• If equilibrium is less than its capacity, only an increase in
expenditures (shift AE) can lead to full employment output.
• If consumers, investors, governments, or foreigners spend
more and thereby shift AE to AE2, output would reach its
full employment potential.
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Keynesian Equilibrium
Planned aggregate
expenditures
AE = GDP
AS
AE3
AE2
AE1
(trillions of $)
11.2
10.6
10.0
Full Employment
(potential GDP)
45º
Output
10.0 10.6
(Real GDP -trillions of $)
• Once full employment is reached, further increases in AE,
such as to AE3, 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.
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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 fullemployment,
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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Keynesian Aggregate Supply Curve
Price
Level
SRAS LRAS
Keynesian range
P1
Full Employment
(potential GDP)
YF
Goods & Services
(real GDP)
• The Keynesian model implies a 90°, angle-shaped SRAS
curve that is flat for outputs less than potential GDP YF
– due to downward wage and price inflexibility.
• 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
SRAS LRAS
Keynesian range
P1
Full Employment
(potential GDP)
YF
Goods & Services
(real GDP)
• 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
P2 = P1
SRAS LRAS
e2
e1
AD2
AD1
Y1
YF
Goods & Services
(real GDP)
• Above are the polar implications of the Keynesian model.
• When output is less than capacity (e.g. Y1) … an increase in
AD (like from AD1 to AD2) expands output without an
increase in the price level (P2 = P1).
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AD/AS Presentation of the
Keynesian Model: Polar Case
Price
Level
SRAS LRAS
P3
e3
P2 = P1
e2
e1
AD3
AD2
AD1
Y1
YF
Goods & Services
(real GDP)
• Increases in demand beyond AD2 (like from AD2 to AD3)
lead to higher price level P3, but real output remains
constant.
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AD/AS Presentation of the
Keynesian Model: Relaxed Case
LRAS SRAS
Price
Level
P2
Relaxed assumptions:
SRAS now turns from
horizontal to vertical
more gradually.
P1
e2
e1
AD2
AD1
Y1
YF
Goods & Services
(real GDP)
• This Keynesian model relaxes the assumptions regarding
complete short-run price and output inflexibility beyond YF.
• An unanticipated increase in AD with output below capacity
leads mainly to increases in output (e.g. from AD1 to AD2).
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AD/AS Presentation of the
Keynesian Model: Relaxed Case
LRAS SRAS
Price
Level
e3
P3
P2
P1
e2
e1
AD3
AD2
AD1
Y1
YF Y3
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
AD2 to AD3).
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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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The Multiplier Principle
Expenditure
stage
Additional income
Additional consumption
Marginal propensity
to consume
(dollars)
(dollars)
Round 1
Round 2
Round 3
Round 4
Round 5
All others
1,000,000
750,000
562,500
421,875
316,406
949,219
750,000
562,500
3/4
3/4
421,875
316,406
237,305
711,914
3/4
3/4
3/4
3/4
Total
4,000,000
3,000,000
3/4
For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.
• 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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A Higher MPC
Means a Larger Multiplier
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
• 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:
1
M = 1 - MPC
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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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Keynesian View
of the Business Cycle
• 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.
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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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Have a nice day
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