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Chapter 19 The Keynesian Model in Action

• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2002 South-Western College Publishing

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What is the purpose of this chapter?

To complete the Keynesian model by adding the government and the foreign sector to our analysis

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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

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1.000.750.500.25

1 2 3 4

1.251.501.752.00

5 6 7 8 9 10Real GDP

Trillions of $ per year

Government SpendingR

eal G

over

nmen

t spe

ndin

gTr

illio

ns o

f $ p

er y

ear

Government Spending

G1

G2

Autonomous Government Spending

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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.

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1.000.750.500.25

1 2 3 4

1.251.501.752.00

5 6 7 8 9

Autonomous Net Exports

10Real GDP

Trillions of $ per year

Positive Net ExportsR

eal N

et E

xpor

tsTr

illio

ns o

f $ p

er y

ear

Negative Net Exports

(X-M)2

(X-M)1

(X-M)Zero Net Exports

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What does the term equilibrium mean?

In the Keynesian model, the equilibrium is the point toward which the economy tends

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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

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What can pull aggregate expenditures higher or

lower in Keynesian economics?

Aggregate expendituresC + I + G + (X-M)

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What affect do aggregate

expenditures have on the economy?

Aggregate expenditures in Keynesian economics pull aggregate output either higher or lower toward equilibrium

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What causes a decrease in real GDP

and employment?Unplanned inventory investment accumulation

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Why does unplanned inventory investment accumulation cause

unemployment? Business firms will cut back production and lay off workers when they find themselves with surpluses

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What causes an increase in real

GDP and employment?

Unplanned inventory investment depletion

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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

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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

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4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures-Output

Model AE = Y

AE

Real GDPRea

l Agg

rega

te E

xpen

ditu

res

Inventory Depletion

C + I + G + )X-M)

Inventory Accumulation

E

Full employment

GDP gap

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How can full employment be reached in the previous graph?The aggregate expenditure curve must be shifted upward until the full-capacity output of $6 trillion is reached

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4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures-Output Model

AE1

Real GDP

Full employment

AE2 R

eal A

ggre

gate

Exp

endi

ture

sLess than Full employment

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What is theKeynesian multiplier?Any initial increase in spending will lead to a multiple increase in GDP

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4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures-Output

Model

AE1

Real GDP

1 trillion dollars

AE2 .5 trillion dollars

Rea

l Agg

rega

te E

xpen

ditu

res

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Initial increase in government

spending

Operates through a multiplier

Larger increase in aggregate

expenditures

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How does themultiplier work?

Any initial change in spending by the government, households, or firms creates a chain reaction of further spending

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4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures-Output Model

AE

Real GDP

Rea

l Agg

rega

te E

xpen

ditu

res

2

4

MPC = .5

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What is the Marginal Propensity to

Consume?MPC is the change in consumption spending resulting form a given change in income

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What is the Marginal Propensity to Save?MPS is the fraction of any change in real disposable income that households save

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How does the multiplier work?

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Spending Multiplier EffectRound

12

Spending

$500$250$125

$63...

$1,000

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All other rounds

Total spending

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What is the relationship between

MPC and MPS?MPC + MPS = 1

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What is the formula for the multiplier?1 / (1 – MPC)

(or)1 / MPS

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If the MPS is 1/2, what is the multiplier?

1 / MPS = 1 / 1/2 = 2

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Relationship between MPC, MPS, and the Spending MultiplierMPC

105

MPS

432

1.5

Spending Multiplier

.90

.80

.75

.67

.50.33

.10

.20

.25

.33

.50.67

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What is the GDP gap?The difference between full employment real GDP and actual real GDP

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What is therecessionary gap?

The amount by which aggregate expenditures fall short of the amount required to achieve full employment equilibrium

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4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures - Output Model

AE1

Real GDP

AE2

GDP gapRea

l Agg

rega

te E

xpen

ditu

res

E1

E2

Recessionary gap

Full employment

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What is the Keynesian remedy for a

recessionary gap?Increase autonomous spending by the amount of the recessionary gap

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What can the government do to close

a recessionary gap?• Increase government spending

• Lower taxes• Raise transfer payments

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What is an inflationary gap?

The amount by which aggregate expenditures exceed the amount required to achieve full employment equilibrium

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4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures - Output Model

AE2

Real GDP

AE1

GDP gapRea

l Agg

rega

te E

xpen

ditu

res

E2

E1

Inflationary gap

Full employment

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What is the Keynesian remedy for an

inflationary gap?Reduce autonomous spending by the amount of the inflationary gap

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How can the government close an

inflationary gap?• Cut government spending• Increase taxes• Reduce transfer payments

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Key Concepts

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Key Concepts• Why is government spending considered an a

utonomous expenditure?• What does the term equilibrium mean?• In the Keynesian model, where is the equilibri

um level of GDP?• What can pull aggregate expenditures higher

or lower in Keynesian economics?• What causes a decrease in real GDP and em

ployment?

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Key Concepts cont.• What causes an increase in real GDP and e

mployment?• What is the aggregate expenditures-output m

odel?• What is the Keynesian multiplier?• What is the Marginal Propensity to Consume?• What is the Marginal Propensity to Save?

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Key Concepts cont.• What is the relationship between MPC and M

PS?• 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?

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Summary

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The Keynesian argues that the economy is inherently unstable and may require government intervention to control aggregate expenditures and restore full employment.

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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.

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Government spending and net exports can be treated as autonomous expenditures in the Keynesian model.

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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.

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1.000.750.500.25

1 2 3 4

1.251.501.752.00

5 6 7 8 9 10Real GDP

Trillions of $ per year

Government SpendingR

eal G

over

nmen

t spe

ndin

gTr

illio

ns o

f $ p

er y

ear

Government Spending

G1

G2

Autonomous Government Spending

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1.000.750.500.25

1 2 3 4

1.251.501.752.00

5 6 7 8 9

Autonomous Net Exports

10Real GDP

Trillions of $ per year

Positive Net ExportsR

eal N

et E

xpor

tsTr

illio

ns o

f $ p

er y

ear

Negative Net Exports

(X-M)2

(X-M)1

(X-M)Zero Net Exports

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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.

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Each equilibrium level in the economy is associated with a level of employment and corresponding unemployment rate.

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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.

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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.

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4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures-Output

Model AE = Y

AE

Real GDPRea

l Agg

rega

te E

xpen

ditu

res

Inventory Depletion

C + I + G + )X-M)

Inventory Accumulation

E

Full employment

GDP gap

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The spending multiplier is the ratio of the change in equilibrium output to the initial change in any of the components of aggregate expenditures.

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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.

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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.

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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.

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4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures - Output Model

AE1

Real GDP

AE2

GDP gapRea

l Agg

rega

te E

xpen

ditu

res

E1

E2

Recessionary gap

full employment

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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.

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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 .

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4321

1 2 3 4

5678

5 6 7 8

The Keynesian Aggregate Expenditures - Output Model

AE2

Real GDP

AE1

GDP gapRea

l Agg

rega

te E

xpen

ditu

res

E2

E1

Inflationary gap

full employment

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END