Macroeconomic Views: The Keynesian Model

AP Macroeconomics

This unit, National Income & Price Determination…

Will explore the Keynesian Model, income and expenditure, aspects of Aggregate Demand and Aggregate Supply, and Fiscal Policy and the Multiplier

We will spend a substantial amount of time exploring concepts and models in this unit.

Fort Myers, FL Boom town in 2003, 2004 Unemployment rate 3% Something went wrong. Jobs became scarce.

Unemployment rate reaches 14%. Foreclosures galore.

What happened? People were buying and selling houses as

investments, pushing the cost of housing up higher than what people were willing to pay

They key here is investment spending – the business cycle is driven by ups and downs in the investment spending

It all began in 1933…

The term “macroeconomics” was coined in 1933 by Ragnar Frisch

However, the study was well underway long before that

Mostly concerned with aggregate price level and aggregate output

The Classical Model of the Price Level As the money supply increases, so too does

the aggregate price level (ultimately leading to inflation)

Prior to 1930s, this model dominated economic thought, and it guided monetary policy

They left out the effect of price on aggregate output…

John Maynard Keynes (1883-1946)

John Maynard Keynes (a background) Classical economists felt that consumption

was a function of interest rates Keynes felt that consumption was a function

of income Technically, as income rises, then so too

should expenditures (or output) However, consumption expenditures do not

equal income Why not? Even if people’s income is zero, they

can beg and borrow, and even steal. Another reason is savings.

John Maynard Keynes

The Keynesian Model is the simplest macro model, and is the starting point from the national income accounting identity: GDP = C + I + G + X-M (or GDP = C + I + G + NX)

This model helps us to find the equilibrium income and to understand the relationship among the concepts of income, consumption, and spending

GDP = C + I + G + X-M is always true…kinda…

Planned aggregate expenditures (GDP) are equal to the sum of planned consumption, planned investment, government spending, and net exports

Planned consumption (C) always occur Government spending (G) always occurs Net exports (X-IM or NX) always occur However, investment spending (I) does not

necessarily occur

Why doesn’t (I) always necessarily occur?

Sometimes, inventories accumulate more than businesses planned, and sometimes businesses draw down inventories more than planned

Simple Keynesian Model

Planned aggregate expenditure = C + I + G + NX

45 degree line: all points where production (real GDP) = aggregate expenditure

Equilibrium occurs where planned aggregate expenditure equals production (the equilibrium is where the 45 degree line intersects the C + I + G + NX line)

Unit 3: MacroeconomicsNational Council on Economic EducationVisual 3.1

This line represents production

This line represents income (Y)

Consumption

Consumption can be represented by the equation C = a + bY, where Y is income or output

b is the marginal propensity to consume (MPC), which shows the amount by which consumption will increase if income increases by $1

MPC = change in consumption/change in income

http://www.reffonomics.com/textbook2/macroeconomics2/keynesianthought/keynesianformulas.swf

Equilibrium & Disequilibrium in the Keynesian Model

Unit 3: MacroeconomicsNational Council on Economic Education Visual 3.2

•The equilibrium output level is Y

•Aggregate expenditures equal output at this point

•At Y1, the total output produced is 0B and the total expenditures are 0A

•0B is greater than 0A

•Therefore, more is produced than is demanded - disequilibrium

Why more produced than is demanded? Firms experience a build-up of inventories:

More product is unsold and sitting in the warehouse

Firms respond by producing less and laying off workers

Output decreases and moves the economy toward the equilibrium level of output Y

•If we draw a vertical line at a level of output below Y, what’s going on in the economy?

•More demanded than supplied

•Firms experience unplanned inventory production and employment, and the economy moves toward Y

Important Note

The Keynesian Model is at the heart of the study of Macroeconomics, helping us to understand the consumption function and something called the “multiplier process” (discussion to come)

This model holds the price level constant, which is not a realistic representation of the economy

The aggregate demand and aggregate supply model (which the price level and output are determined) is the central model for macroeconomic analysis.

And now…

Some resources:

http://www.reffonomics.com/textbook2/macroeconomics2/keynesianthought/keynesiancross.swf

Works Cited

Krugman, Paul, and Robin Wells. Krugman’s Economics for AP. New York: Worth Publishers.

Morton, John S. and Rae Jean B. Goodman. Advanced Placement Economics: Teacher Resource Manual. 3rd ed. New York: National Council on Economic Education, 2003. Print.

Reffonomics. www.reffonomics.com.