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Chapter 19
The Keynesian
Model in Action
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2002 South-Western College Publishing
1
What is the purpose
of this chapter?
To complete the
Keynesian model by
adding the government
and the foreign sector to
our analysis
2
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
3
Real Government spending
Trillions of $ per year
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Autonomous Government Spending
Government Spending
G1
G2
Government Spending
Real GDP
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
4
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.
5
Real Net Exports
Trillions of $ per year
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Autonomous Net Exports
Positive Net Exports
(X-M)2
(X-M)
Zero Net Exports
(X-M)1
Negative Net Exports
Real GDP
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
6
What does the term
equilibrium mean?
In the Keynesian model,
the equilibrium is the
point toward which the
economy tends
7
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
8
What can pull aggregate
expenditures higher or
lower in Keynesian
economics?
Aggregate expenditures
C + I + G + (X-M)
9
What affect do
aggregate
expenditures have on
the economy?
Aggregate expenditures
in Keynesian economics
pull aggregate output
either higher or lower
toward equilibrium
10
What causes a
decrease in real GDP
and employment?
Unplanned inventory
investment accumulation
11
Why does unplanned
inventory investment
accumulation cause
unemployment?
Business firms will cut
back production and lay
off workers when they
find themselves with
surpluses
12
What causes an
increase in real
GDP and
employment?
Unplanned inventory
investment depletion
13
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
14
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
15
The Keynesian Aggregate
Expenditures-Output
Model
Inventory
AE = Y
Accumulation
8
7
6
5
4
3
2
1
E
AE
Full
employment
Inventory Depletion
GDP gap
Real GDP
1
2
3
4
5
6
7
8
16
How can full
employment be reached
in the previous graph?
The aggregate expenditure
curve must be shifted
upward until the fullcapacity output of $6
trillion is reached
17
8
7
6
5
4
3
2
1
The Keynesian Aggregate
Expenditures-Output Model
Less than Full
employment
AE2
AE1
Full
employment
Real GDP
1
2
3
4
5
6
7
8
18
What is the
Keynesian multiplier?
Any initial increase in
spending will lead to a
multiple increase in GDP
19
The Keynesian Aggregate
Expenditures-Output
 .5 trillionModel
dollars
8
7
6
5
4
3
2
1
AE2
AE1
 1 trillion dollars
1
2 3
4
5
6
Real GDP
7
8
20
Larger
increase in
aggregate
expenditures
Initial
increase in
government
spending
Operates
through a
multiplier
21
How does the
multiplier work?
Any initial change in
spending by the
government, households,
or firms creates a chain
reaction of further
spending
22
8
7
6
5
4
3
2
1
The Keynesian Aggregate
Expenditures-Output Model
MPC = .5
AE
2
4
1
2 3
4
5 6
Real GDP
7
8
23
What is the Marginal
Propensity to
Consume?
MPC is the change in
consumption
spending resulting
form a given change
in income
24
What is the Marginal
Propensity to Save?
MPS is the fraction of
any change in real
disposable income that
households save
25
How does the
multiplier work?
26
Spending Multiplier Effect
Round
 Spending
All other rounds
$500
$250
$125
$63
...
Total spending
$1,000
1
2
3
4
27
What is the
relationship between
MPC and MPS?
MPC + MPS = 1
28
What is the formula
for the multiplier?
1 / (1 – MPC)
(or)
1 / MPS
29
If the MPS is 1/2, what
is the multiplier?
1 / MPS = 1 / 1/2 = 2
30
Relationship between MPC, MPS,
and the Spending Multiplier
Spending
Multiplier
MPC
MPS
.90
.80
.75
.67
.10
.20
.25
.33
10
5
4
3
.50
.33
.50
.67
2
1.5
31
What is the GDP gap?
The difference between full
employment real GDP
and actual real GDP
32
What is the
recessionary gap?
The amount by which
aggregate expenditures
fall short of the amount
required to achieve full
employment equilibrium
33
8
7
6
5
4
3
2
1
The Keynesian Aggregate
Expenditures - Output Model
AE2
E2
AE1
E1
Recessionary
gap
Full employment
GDP gap
1
2 3
4
5
Real GDP
6
7
8
34
What is the Keynesian
remedy for a
recessionary gap?
Increase autonomous
spending by the
amount of the
recessionary gap
35
What can the
government do to close
a recessionary gap?
• Increase government
spending
• Lower taxes
• Raise transfer payments
36
What is an
inflationary gap?
The amount by which
aggregate expenditures
exceed the amount
required to achieve full
employment equilibrium
37
The Keynesian Aggregate
Expenditures - Output Model
8
AE
7
1
E1
6
AE2
5
E2
Inflationary
4
gap
3 Full employment
2
 GDP gap
1
1
2
3
4
5
Real GDP
6
7
8
38
What is the Keynesian
remedy for an
inflationary gap?
Reduce autonomous
spending by the amount
of the inflationary gap
39
How can the
government close an
inflationary gap?
• Cut government spending
• Increase taxes
• Reduce transfer
payments
40
Key Concepts
41
Key Concepts
• Why is government spending considered
an autonomous expenditure?
• What does the term equilibrium mean?
• In the Keynesian model, where is the
equilibrium level of GDP?
• What can pull aggregate expenditures
higher or lower in Keynesian economics?
• What causes a decrease in real GDP and
employment?
42
Key Concepts cont.
• 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?
43
Key Concepts cont.
• 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?
44
Summary
45
The Keynesian argues that the
economy is inherently unstable
and may require government
intervention to control aggregate
expenditures and restore full
employment.
46
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.
47
Government spending and net
exports can be treated as
autonomous expenditures in
the Keynesian model.
48
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.
49
Real Government spending
Trillions of $ per year
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Autonomous Government Spending
Government Spending
Government Spending
G1
G2
Real GDP
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
50
Real Net Exports
Trillions of $ per year
2.00
1.75
1.50
1.25
1.00
0.75
0.50
0.25
Autonomous Net Exports
Positive Net Exports
(X-M)2
(X-M)
Zero Net Exports
(X-M)1
Negative Net Exports
Real GDP
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
51
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.
52
Each equilibrium level in the
economy is associated with a level
of employment and corresponding
unemployment rate.
53
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.
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
The Keynesian Aggregate
Expenditures-Output
Model
Inventory
AE = Y
Accumulation
8
7
6
5
4
3
2
1
E
AE
Full
employment
Inventory Depletion
GDP gap
Real GDP
1
2
3
4
5
6
7
8
56
The spending multiplier is the
ratio of the change in
equilibrium output to the initial
change in any of the
components of aggregate
expenditures.
57
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.
58
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.
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
8
7
6
5
4
3
2
1
The Keynesian Aggregate
Expenditures - Output Model
AE2
E2
AE1
E1
Recessionary
gap
full employment
GDP gap
1
2 3
4
5
Real GDP
6
7
8
61
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.
62
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 .
63
The Keynesian Aggregate
Expenditures - Output Model
8
AE
7
1
E1
6
AE2
5
E2
Inflationary
4
gap
3 full employment
2
 GDP gap
1
1
2
3
4
5
Real GDP
6
7
8
64
Chapter 19 Quiz
©2002 South-Western College Publishing
65
1. The net exports line can be
a. positive.
b. negative.
c. zero.
d. any of the above.
D. Because net exports equals exports
minus imports (X-M), the sign of net
exports depends on the values of X
and M.
66
2. There will be unplanned inventory
investment accumulation when
a. aggregate output (real GDP) equals
aggregate expenditures.
b. aggregate output (real GDP) exceeds
aggregate expenditures.
c. aggregate expenditures exceed
aggregate output (real GDP).
d. firms increase output.
B.
67
The Keynesian Aggregate
Expenditures-Output
Model
Inventory
AE = Y
Accumulation
8
7
6
5
4
3
2
1
E
AE
full
employment
Inventory Depletion
GDP gap
Real GDP
1
2
3
4
5
6
7
8
68
3. John Maynard Keynes proposed that the
multiplier effect can correct an economic
depression. Based on this theory, an
increase in equilibrium output would be
created by an initial
a. increase in investment.
b. increase in government spending.
c. decrease in government spending.
d. both (a) and (b).
e. both (a) an (c) .
D. A decrease in government spending
is multiplied times the spending
multiplier and decreases equilibrium
output.
69
4. The spending multiplier is defined as
a. 1/(1 - marginal propensity to
consume).
b. 1/(marginal propensity to
consume).
c. 1/(1 - marginal propensity to save).
d. 1/(marginal propensity to consume
+ marginal propensity to save).
A. The spending multiplier is also
defined as 1/MPS.
70
5. If the value of the marginal
propensity to consume (MPC) is
0.50, the value of the spending
multiplier is
a. .5.
b. 1.
c. 2.
d. 5.
C. Spending multiplier = 1/(1-MPC) =
1/(1-0.5) = 1/0.50 = 1/50/100 = 2.
71
6. If the marginal propensity to
consume (MPC) is 0.80, the value of
the spending multiplier is
a. 2.
b. 5.
c. 8.
d. 10.
B. Spending multiplier = 1/(1-MPC =
1/(1-0.80) = 1/20/100 = 5.
72
7. If the marginal propensity to consume
(MPC) is 0.75, a $50 billion decrease in
government spending would cause
equilibrium output to
a. increase by $50 billion.
b. decrease by $50 billion.
c. increase by $200 billion.
d. decrease by $200 billion.
D. Change in equilibrium output (Y) =
spending multiplier x change in
government spending Y = 1/(1-0.75) x
-$50 billion = $200 billion = 4 x - $50
billion.
73
8. If the marginal propensity to consume
(MPC) is 0.90, a $100 billion increase in
planned investment expenditure, other
things being equal, will cause an increase
in equilibrium output of
a. $90 billion.
b. $100 billion.
c. $900 billion.
d. $1,000 billion.
D. Change in equilibrium output (Y) spending multiplier x change in
government Y = 1/(1-0.90) x $100
billion = 10 x $100 billion.
74
8
7
6
5
4
3
2
1
The Keynesian Aggregate
Expenditures-Output Model
less than Full
employment
AE2
AE1
full
employment
Real GDP
1
2
3
4
5
6
7
8
75
9. Keynes’ criticism of the classical theory
was that the Great Depression would not
correct itself. The multiplier effect would
restore an economy to full employment if
a. government would follow a “least
government is the best government”
policy.
b. government taxes were increased.
c. government spending were
increased.
d. government spending were
decreased.
C. Keynes’ prescription to cure the Great
Depression was for government to play
an active role rather than depend on the
classical theory that the price system
76
will eventually restore full employment.
10. The equilibrium level of real GDP is
$1,000 billion, the full employment level
of real GDP is $1,250 billion, and the
marginal propensity to consume (MPC)
is 0.60. The full-employment target can
be reached if government spending is
a. increased by $60 billion.
b. increased by $100 billion.
c. increased by $250 billion.
d. held constant.
B. Change in real GDP required =
spending multiplier x change in
government spending (G). Rewritten,
G = 1/(1 - 0.60) x ($1,250 - $1,000)
G x 2.5 = $250
G = $100 billion.
77
8
7
6
5
4
3
2
1
The Keynesian Aggregate
Expenditures-Output Model
AE
MPC = .66
2
3
full employment
Real GDP
1
2 3
4
5 6
7
8
78
11. In Exhibit 9, the spending multiplier for
this economy is equal to
a. 1
b. 2
c. 3
d. 5
C. 1 / MPS = 1 divided by 1/3 = 3
79
12. To close the recessionary gap shown
in Exhibit 9, the government should cut
taxes by
a. $.75 trillion
b. $ 1 trillion
c. $1.5 trillion
d. $3 trillion
C. The tax multiplier is -2(1 - MPC). If the
government cuts taxes by $ 1.5 trillion,
the tax multiplier effect will generate the
desired $3 trillion increase in total
spending, enough to push the economy
to full employment.
80
END
81