Slides Created By Kevin Brady and Eric Chiang Keynesian Macroeconomics Interactive Examples To navigate, please click the appropriate green buttons. (Do

Slides Created By

Kevin Brady and Eric Chiang

Keynesian Macroeconomics

Interactive Examples

To navigate, please click the appropriate green buttons.(Do not use the arrows on your keyboard)

Material from this presentation can be found in:

Chapter 18

CoreEconomics, 2e

Begin


AggregateExpenditures

(AE)

Income (Y)

The Keynesian Model focuses on the relationship between Aggregate Expenditures (AE) in the economy and Income (Y) in the economy.

Recall that AE = C + I + G + (X-M), where:

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C = ConsumptionI = InvestmentG = Government Spending(X-M) = Net Exports

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(AE)

Income (Y)

By tracing out all of the points where Income is equal to Aggregate Expenditures, we can show the Y = AE line.

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Y = AE

For example, notice that when AE = $4,000, Y also equals $4,000.

Question: In this graph, when AE = $10,000, what does Y equal?

Answer



(AE)

Income (Y)

By tracing out all of the points where Income is equal to Aggregate Expenditures, we can show the Y = AE line.

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Y = AE

For example, notice that when AE = $4,000, Y also equals $4,000.

Question: In this graph, when AE = $10,000, what does Y equal?

Answer = $10,000

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(AE)

Income (Y)

Let’s assume for a moment that the aggregate expenditures in our economy are made up of only consumption (C). In other words, there is no investment, no government spending, and no trade.

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We can add a line that traces out the amount of consumption for various income levels.

Y = AE

C

Question: When income is $2,000 how much are consumers spending in this economy?

Answer



(AE)

Income (Y)

Question: When income is $2,000, what do consumers spend in this economy?

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Y = AE

C

Answer: $3,000

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(AE)

Income (Y)


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Y = AE

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Answer: $3,000

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Question: How is it possible that income in the economy is only $2,000, while consumer spending is $3,000?

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(AE)

Income (Y)


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Y = AE

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Answer: $3,000

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Question: How is it possible that income in the economy is only $2,000, while consumer spending is $3,000?

Answer: Just like many college students, consumers in the entire economy can borrow to spend more than they are currently earning!

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(AE)

Income (Y)

On the other hand, it is possible for spending in the economy as a whole to be less than income.

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Y = AE

CQuestion: How much saving is there in the economy when income is $8,000?

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(AE)

Income (Y)

On the other hand, it is possible for spending in the economy as a whole to be less than income.

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Y = AE

CQuestion: How much saving is there in the economy when income is $8,000?

Answer: When income is $8,000, spending in the economy is only $6,000. This implies there is $2,000 in savings.

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(AE)

Income (Y)

Question: On this graph, when is the economy in equilibrium? In other words, at what level of income are aggregate expenditures equal to income?

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Y = AE

C

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(AE)

Income (Y)

Question: On this graph, when is the economy in equilibrium? In other words, at what level of income are aggregate expenditures equal to income?

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Y = AE

CAnswer: Recall that we are ignoring investment, government spending, and trade for now. Thus, consumption represents all aggregate expenditures.

This means that when the consumption line crosses the Y = AE line, we have the answer to our question!

This occurs at an income level of $4,000.

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(AE)

Income (Y)

Let us now add investment to our economy. Suppose businesses spend $1,000 on investment no matter what the income level is in the economy.

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Y = AE

C

Question: How can we show this in our model?

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(AE)

Income (Y)

Let us now add investment to our economy. Suppose businesses spend $1,000 on investment no matter what the income level is in the economy.

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Y = AE

C

Question: How can we show this in our model?

Answer: By adding $1,000 to consumption for every possible income level, we arrive at a new AE curve labeled “AE = C + Io”

AE = C+Io

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(AE)

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Question: What is the new equilibrium in this economy?

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Y = AE

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AE = C+Io

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Question: What is the new equilibrium in this economy?

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Y = AE

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AE = C+IoAnswer: The new equilibrium is where the AE = C+Io line crosses the Y = AE line.

The new equilibrium is $6,000 in income and $6,000 in aggregate expenditures.

Did you notice something remarkable here?

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(AE)

Income (Y)

Did you notice something remarkable here?

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Y = AE

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AE = C+IoTo see what is remarkable, let’s take a step backwards. With only consumption in the model, the equilibrium income level in the economy was $4,000.

When we added investment spending of $1,000, the new equilibrium income level in the economy was $6,000.

An increase in investment spending of $1,000 led to a $2,000 increase in income in the economy!!!

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Income (Y)

This remarkable phenomena is known as the multiplier effect, which in essence shows that added spending can change equilibrium income in the economy by more than the additional spending.

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Y = AE

C

AE = C+Io

Question: Why does this happen?

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Answer:

Because one person’s spending becomes another person’s income, part of which that person then spends, which then becomes another person’s income, part of which they spend, and so on and so forth.

In our example, the spending multiplier was 2, because a $1,000 increase in investment spending resulted in a $2,000 increase in income in the economy.

This process allows us to calculate the spending multiplier, which tells us how many more times income will change in the economy for each extra dollar in spending.

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Question: What is the general formula for the spending multiplier?

Answer


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Question: What is the general formula for the spending multiplier?

The spending multiplier depends on how much each person spends of their additional income.

The spending multiplier (k) is found by computing 1 / (1 – MPC), where MPC is the marginal propensity to consume. The MPC is the change in consumption associated with a given change in income.

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Question: If spending in the economy rises $90 for the next $100 earned in income, what is the MPC? What is k?

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Answer:

The MPC would be $90 / $100, or .90.

Since k = 1 / (1 – MPC), we find that

k = 1 / (1 - .90) = 10

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Question: If businesses decide to invest an additional $50, and the marginal propensity to consume is .80, by how much will income in the economy grow?

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Answer:

Since the MPC is .8, we know the spending multiplier is 1 / (1 - .8), which is 5.

To find the change in income, take change in spending and multiply it by the spending multiplier.

In this case, $50 * 5 = $250. Income will rise by $250 in the economy.

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(AE)

Income (Y)

Recall that aggregate expenditures in a modern economy also depend on government spending (G) and net exports (X-M). We can add these components in the same way we added investment. As we did for investment, let’s assume the level of G is the same at each income level.

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Y = AE

C

AE = C+Io

Question: If government spending is $2,000, what is the new equilibrium income level in the economy?

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(AE)

Income (Y)

Answer:

We can add $2,000 to our C+Io line for each income level to get a new AE line, namely C + Io + Go.

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Y = AE

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AE = C+Io

AE = C+Io+Go

The new equilibrium income in the economy is $10,000.

Remember that we can also use this framework to analyze changes in net exports.

Also remember that the multiplier effect also occurs in reverse: a cut in spending will lead to a larger drop in equilibrium income!

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Slides Created By Kevin Brady and Eric Chiang Keynesian Macroeconomics Interactive Examples To navigate, please click the appropriate green buttons. (Do