Unit 5 - Models of Output
Determination

Two Primary Schools
of Economic Thought are:
Classical Economics (Smith,
Ricardo, Von Mises, Say, Hayek, Hazlitt,
Friedman, economic conservatives).
2. Keynesian Economics (Keynes, Galbraith,
economic liberals).
1.
Macroeconomics
Unit 5 - Models of Output
Determination
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The Classical Model:
is based on Adam Smith’s
Wealth of Nations (1776).
is the foundation for neo-classical and
Austrian school economics, rational
expectationism, and monetarism.
was dominant before the 1920s. Gained in
popularity again since the 1980s.
Macroeconomics
Unit 5 - Models of Output
Determination
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Classical Economists Believe that:
Market forces (flexible prices, wages, and
interest rates) correct economic problems.
Limited government involvement in the
economy leads to maximum wealth and
the highest standard of living.
Artificial government stimulation of the
economy leads to problems in the long
run.
Macroeconomics
Unit 5 - Models of Output
Determination
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The Keynesian Model:
is based on the works of
John Maynard Keynes
(1883 – 1946).
gained acceptance during the 1930s and was
supported by almost all western economists
and politicians during the 1950s, 1960s, and
1970s.
Macroeconomics
1.
2.
3.
4.
0 of 5
Keynes said: “In the long run we
are all dead.” Do you agree?
Yes
No
Not sure
I don’t care (we’re
all dead soon)
:10
Unit 5 - Models of Output
Determination
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Keynes’s Analogy
The economy is like an
elevator. If it goes up, it will
continue to go up for a while.
If it goes down, it will go
down and may hit the bottom,
unless someone stops it.
Macroeconomics

Unit 5 - Models of Output
Determination
The Keynesian Theory
During a recession,
 Production decreases.
 Thus, layoffs increase.
 Thus, incomes and demand for products fall.
 Thus, production decreases even more.
 Thus, layoffs increase further.
 And so forth.
During an expansion the opposite happens.
Macroeconomics
Unit 5 - Models of Output
Determination

1.
2.
The Keynesian Solution
The government must intervene (stop the
elevator) through:
Active fiscal policy
Active monetary policy
Macroeconomics
Unit 5 - Models of Output
Determination

Active Fiscal Policy
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During recessions, Keynes supports:
Increases in government spending.
Decreases in taxes.

Of the two, Keynes prefers increases in
government spending, because
households and businesses may not
spend their tax rebates.
Unit 5 - Models of Output
Determination
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Active Fiscal Policy
Increases in government spending and
decreases in taxes lead to (Keynes):
Higher incomes
Increases in spending
Increases in production
More jobs
Higher incomes
And so forth
Unit 5 - Models of Output
Determination

Active Fiscal Policy

During expansions, Keynes supports
Decreases in government spending
Increases in taxes

Unit 5 - Models of Output
Determination
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Active monetary policy
During recessions, Keynes supports
increases in the nation’s money supply.
In the United States, the Federal Reserve
Board controls the nation’s money supply.
Macroeconomics
Unit 5 - Models of Output
Determination

Active monetary policy
According to Keynes:
Money supply
interest rates
borrowing
Spending
GDP
Macroeconomics
Unit 5 - Models of Output
Determination

The Keynesian Multiplier
When government increases spending,
total spending in the economy increases by
a multiple of the increase in government
spending.
Macroeconomics
Unit 5 - Models of Output
Determination

Multiplier Example
Let’s say a government spends $1 billion
($1,000 million) on the construction of a
stadium.
This increases construction workers’ incomes
by $1 billion, compared to if the government
hadn’t spent the money.
What happens to this $1 billion?
Macroeconomics
Unit 5 - Models of Output
Determination

Example (cont’d)
Let’s assume that the construction workers
spend 80% ($800 million) of their additional
income. We say that their Marginal
Propensity to Consume (MPC) is 80%.
Let’s say they spend it on clothes.
Macroeconomics
Unit 5 - Models of Output
Determination

Example (cont’d)
This generates $800 million in additional
income for the clothes suppliers.
What happens to the $800 million?
Macroeconomics
Unit 5 - Models of Output
Determination
$512

Example (cont’d)
$640
$800
$1,000
Let’s assume the clothes producers spend
80% of their additional income on food.
This generates $640 million in additional
income for food suppliers.
What will the food suppliers do with the
additional income? You get the picture.
Macroeconomics
Unit 5 - Models of Output
Determination

Example (cont’d)
Thus, total spending in the economy
increases by (in millions):
$1,000 + $800 + $640 + $512 + … = $5,000
Macroeconomics
Unit 5 - Models of Output
Determination

Example
$5,000 million is 5 times $1,000 million.
$1,000 is the initial government spending
change.
Keynes called this factor 5 “the multiplier”.
Macroeconomics
Unit 5 - Models of Output
Determination

The Change in Total Spending in the
Economy
According to Keynes:
The additional total spending in the economy =
multiplier x the change in initial spending.
Or:
total spending = m x
initial spending.
Macroeconomics
Unit 5 - Models of Output
Determination

The Formula for the Multiplier
Multiplier = 1 / (1 – MPC)
Or,
Multiplier = 1 / MPS
Where MPS = Marginal Propensity to Save
Macroeconomics
Unit 5 - Models of Output
Determination

Multiplier Example 1
If the MPC = .8, then
m = 1 / (1 – .8)
= 1/(.2)
= 5.
Macroeconomics
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7.5
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If the MPC is .9, then the
multiplier is:
10
Unit 5 - Models of Output
Determination
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Multiplier Example 2
If the MPC = .9, then
m = 1 / (1 – .9)
= 1/(.1)
= 10.
Macroeconomics
1.
2.
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5.
6.
7.
0 of 5
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2
3
4
5
7.5
10
If the MPC is .75, then the
multiplier is:
10
Unit 5 - Models of Output
Determination
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Multiplier Example 3
When the MPC = .75, then
m = 1 / (1 – .75)
= 1/(.25)
= 4.
Macroeconomics
If the MPS is .2, the multiplier is:
1.
2.
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5.
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3
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5
7.5
10
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Unit 5 - Models of Output
Determination
Multiplier Example 4
If the MPC = .75, and the government increases
spending by $2,000, by how much will total spending
change?
Remember,
total spending = m x
Thus,
Thus,
initial spending.
total spending = 4 x $2,000.
total spending = $8,000.
Macroeconomics
If the MPC is .9, and government increases
spending by $20, what is the change in total
spending in the economy?
1. $10
2. $18
3. $100
4. $200
5. $1,000
0 of 5
10
Unit 5 - Models of Output
Determination

Recessionary and Inflationary Gaps:
are the differences (negative and positive,
respectively) between what GDP is now and
what GDP is at full employment.
Macroeconomics
Unit 5 - Models of Output
Determination

Recessionary and Inflationary Gaps
Example
By how much should the government increase
government spending if current GDP is $5,000, and
full employment GDP is $6,000, and the MPC = .80?
Answer: $X times 5 = $1,000. $X = $200.
Macroeconomics
If current GDP is $10,000 and full employment GDP
is $12,000, and the MPC is .8, by how much should
government increase spending to eliminate the
recessionary gap?
1.
2.
3.
4.
5.
6.
0 of 5
$200
$300
$400
$500
$1,000
$2,000
10
Unit 5 - Models of Output
Determination

Recessionary Gaps and Inflationary
Gaps Example
Answer to the previous question:
The equation to use is:
Change in GDP = multiplier x change in
government spending.
So:
$2,000 = 5 x $400.
Macroeconomics
Will a change in government spending
cause a change in real GDP?
1.
2.
3.
4.
Yes, both in the
short and long run
Yes, but only in
the short run
Yes, but only in
the long run
Not sure
:10
Unit 5 - Models of Output
Determination

Evaluation of the Keynesian Theory
Let’s evaluate the effects of government
spending.
If the government increases spending, how
does it pay for this?
Macroeconomics
Unit 5 - Models of Output
Determination
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Evaluation of the Keynesian Theory
The funds can come from 3 sources:
newly printed money, or
borrowed money, or
increase in taxes
Macroeconomics
Unit 5 - Models of Output
Determination

Evaluation of the Keynesian Theory
If the prints more money, it:
 lowers interest rates in the short run. This
increases borrowing and spending, and stimulates
the economy in the short run.
 but it causes inflation and increases interest rates,
and slows down the economy in the long run.
Macroeconomics
Unit 5 - Models of Output
Determination

Evaluation of the Keynesian Theory
If the government borrows the money, it:
 increases funds for the government. This
increases spending in the government sector.
 but it decreases funds in the private sector. This
decreases private sector spending.
 increases the national debt and increases future
taxes. This slows down the economy in the long
run.
Macroeconomics
Unit 5 - Models of Output
Determination

Evaluation of the Keynesian Theory
If the government increases taxes, it:
 increases funds for the government. This
increases spending in the government sector.
 but it decreases people’s incomes in the private
sector. This decreases private sector spending.
 discourages people from working. This slows
down the economy.
Macroeconomics
Unit 5 - Models of Output
Determination

Evaluation of the Keynesian Theory
Conclusion:
Keynesian policy may help the
economy in the short run, but is
harmful to the economy in the long run.
Macroeconomics
Unit 5 - Models of Output
Determination

The Role of Savings
Keynesian theory:


Savings are a leakage from our economy.
Only increases in consumption lead to
increases in production.
Unit 5 - Models of Output
Determination

The Role of Savings
Classical Theory:
 Savings are important to
our economy.
 Increases in savings lead to increases in
funds for businesses.
 Businesses use these funds for research
and technology and business expansions.
Macroeconomics
Unit 5 - Models of Output
Determination

The Role of Savings
Investments in research
and technology lead
to increases in productivity.
This enables businesses to pay higher real
wages. This leads to real (not artificial)
increases in demand.
Macroeconomics
Unit 5 - Models of Output
Determination

The Role of Savings
Real demand increases
are made possible by
greater capacities to produce, and not by
artificial increases in government
spending or newly printed money.
Macroeconomics
Unit 5 - Models of Output
Determination
Aggregate Demand and Supply

Aggregate = “the sum of”
Aggregate demand = the demand for
all products in the economy.
Macroeconomics
Unit 5 - Models of Output
Determination

Aggregate Demand
The Aggregate
demand curve
is downward
sloping
Macroeconomics
Unit 5 - Models of Output
Determination

Aggregate Supply
The aggregate
supply curve is
upward sloping.
Macroeconomics
Unit 5 - Models of Output
Determination

A Shift in Aggregate Demand
According to
Keynesian theory,
an increase in AD
in the horizontal
part of the AS curve
increases GDP.
Macroeconomics
Unit 5 - Models of Output
Determination

A Shift in Aggregate Demand
According to
Keynesian theory,
an increase in AD
in the vertical
part of the AS curve
increases the
price level.
Macroeconomics
Unit 5 - Models of Output
Determination

A Shift in Aggregate Demand
According to
Keynesian theory,
an increase in AD
in the upward
part of the AS curve
increases GDP and
the price level.
Macroeconomics
Unit 5 - Models of Output
Determination

The Phillips Curve
According to
Keynesian theory,
there exists an
inverse relationship
between inflation
and unemployment.
Macroeconomics
Unit 5 - Models of Output
Determination

A Shift in Aggregate Supply
According to
Classical theory,
an increase in AS
increases GDP, and
lowers the price
level.
Macroeconomics