The Great Depression
and the Keynesian View
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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.
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Keynesian Explanation
of the Great Depression
• Keynesian economics was 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
• 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 Y, consumption , , but by a lesser
amount than the increase in income,
• Planned I, G and X are independent of
income
Aggregate
expenditures
=
Planned
Planned + Planned +
government +
investment
consumption
expenditures
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Planned
Net
Exports
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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 £s)
• The Keynesian model assumes as Y D
• However, as Y D by a smaller amount.
• Thus, the slope of the consumption function (line C) is <than
the slope of the 45° line).
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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 in inventories,
so,
• producers have no reason to either output
during the next period.
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Keynesian Equilibrium
• When
Total aggregate
expenditures
<
Current
output
Firms  stocks,  output,  employment
• When
Total aggregate
expenditures
>
Current
output
Firms  output,  employment in an effort to
restore stocks 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
AD
AS
C
I+G
Net
Exports
Tendency
of output
(real GDP)
£9.4
9.7
10.0
10.3
10.6
<
<
=
>
>
£ 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.
• o/p < AD, expand their output to rebuild their inventories to
regular levels.
• o/p > AD, and inventories accumulate. Firms reduce output
in order to reduce this build-up of excessive inventories.
• AD = AS there is Keynesian macroeconomic equilibrium.
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Aggregate Expenditures
Planned aggregate
expenditures
Equilibrium
(trillions of £)
(AD = GDP)
10.0
5.0
45º
Output
5.0
10.0
(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 £)
(AD = GDP)
Unplanned
reduction
in inventories
AD = C + I + G + X
9.85
45º
Output
9.7
(Real GDP -trillions of £)
• At output levels below £10.0 trillion (for example 9.7) AD 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 £)
(AD = GDP)
Unplanned
reduction
in inventories
AD = C + I + G X
10.15
9.85
Unplanned
increase
in inventories
45º
Output
9.7
10.3
(Real GDP -trillions of £)
• At output levels above £10.0 trillion (for example 10.3) AD
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
(AD = GDP)
AD = C + I + G + X
10.15
10.00
9.85
Full Employment
(potential GDP)
45º
Output
10.0 10.3
(Real GDP -trillions of £)
• Keynesian equilibrium exists where planned expenditures
just equal actual output. Here that point is at £10.0 trillion.
9.7
• Full-employment for this example exists at £10.3 trillion. In
the Keynesian model, macroeconomic equilibrium does not
necessarily coincide with full-employment.
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Keynesian Equilibrium
AD = GDP
Planned aggregate
expenditures
(trillions of £)
AD2
AD1
10.3
10.0
Full Employment
(potential GDP)
45º
Output
10.0 10.3
(Real GDP -trillions of £)
• If equilibrium is less than its capacity, only an increase in
expenditures (shift AD) can lead to full employment output.
• If consumers, investors, governments, or foreigners spend
more and thereby shift AD to AD2, output would reach its
full employment potential.
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Keynesian Equilibrium
Planned aggregate
expenditures
AD = GDP
AS
AD3
AD2
AD1
(trillions of £)
10.6
10.3
10.0
Full Employment
(potential GDP)
45º
Output
10.0 10.3
(Real GDP -trillions of £)
• Once full employment is reached, further increases in AD,
such as to AD3, lead only to higher prices – nominal output
expands along the black segment of AD (those points beyond
the full employment output level at £10.3 trillion) while real
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output does not.
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Economics. All rights reserved.
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?
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Questions for Thought:
2.
a)
b)
c)
According to the Keynesian view, which of the
following is true?
Businesses will produce only the quantity of goods
and services they believe consumers, investors,
governments, and foreigners will plan to buy.
If planned aggregate expenditures are less than full
employment output, output will fall short of its
potential.
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.
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Questions for Thought:
4.
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:
5. 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 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 Principle
Expenditure
stage
Additional income
Additional consumption
Marginal propensity
to consume
(Pounds)
(Pounds)
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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Real-World Significance
of 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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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.
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Keynesian View
of the Business Cycle
• The Keynesian view argues that wide
fluctuations in private investment are a
major source of economic instability.
• 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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