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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 END 65