1 The Keynesian Model in Action

2 What is the purpose of this chapter? To complete the Keynesian model by adding the government (G) and the foreign sector (net exports – X-M)

3 Why is government spending an autonomous expenditure? Government spending can be the result of political decisions regardless of national output

Real GDP Trillions of $ per year Government Spending Real Government spending Trillions of $ per year Government Spending G1G1 G2G2 Autonomous Government Spending

5 Why is net exports assumed to be negative? Spending for imports usually exceeds the value of exports

Autonomous Net Exports 10 Real GDP Trillions of $ per year Positive Net Exports Real Net Exports Trillions of $ per year Negative Net Exports (X-M) 2 (X-M) 1 (X-M) Zero Net Exports

7 Autonomous Consumption

8 In the Keynesian model, where is the equilibrium level of GDP? It is where the value of goods and services produced (Real GDP) is equal to the spending for these goods and services (Aggregate Expenditures)

9 Aggregate output and income (Y) What does Real GDP mean?

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Aggregate Expenditures-Output Model AE = Y Real GDP Real Aggregate Expenditures (Spending) (Income)

12 Aggregate expenditures = C + I + G + (X-M) What does aggregate expenditures mean?

13 Autonomous Consumption AE = C+I+G+(X-M)

Aggregate Expenditures-Output Model AE = Y AE Real GDP C + I + G + (X-M) E Real Aggregate Expenditures (Spending) (Income)

15 How do aggregate expenditures affect the economy? They pull aggregate output (Y) either higher or lower toward equilibrium

16 Autonomous Consumption AE = C+I+G+(X-M) Unplanned Inventory Investment = AO - AE If aggregate output is less than aggregate expenditures (negative #), real GDP and employment will increase (expansion) If aggregate output is equal to aggregate expenditures then an equilibrium exists If aggregate output is more than aggregate expenditures (positive #), real GDP and employment will decrease (contraction)

17 What causes a decrease in real GDP and employment? Excessive inventories (+) Aggregate Expenditures is greater than Aggregate Output therefore business cut output by spending less (ex. cut jobs)

18 Why do excessive inventories cause unemployment? Firms will cut back production and lay off workers in order not to add to inventories excessively

Aggregate Expenditures-Output Model AE = Y AE Real GDP C + I + G + (X-M) Inventory Accumulation (Excessive) E Real Aggregate Expenditures

20 Autonomous Consumption AE = C+I+G+(X-M) Unplanned Inventory Investment = AO - AE If aggregate output is less than aggregate expenditures (negative #), real GDP and employment will increase (expansion) If aggregate output is equal to aggregate expenditures then an equilibrium exists If aggregate output is more than aggregate expenditures (positive #), real GDP and employment will decrease (contraction)

21 What causes an increase GDP and employment? Inventory depletion (-) Aggregate expenditures excees Aggregate Output therefore businesses will hire more workers to increase output (ex. Income)

22 What happens when inventories decline too much? Firms will increase production and higher more workers to meet the demand for their product

Aggregate Expenditures-Output Model AE = Y AE Real GDP Inventory Depletion C + I + G + )X-M) E Real Aggregate Expenditures

24 Autonomous Consumption AE = C+I+G+(X-M) Unplanned Inventory Investment = AO - AE If aggregate output is less than aggregate expenditures real GDP and employment will increase (expansion) If aggregate output is equal to aggregate expenditures then an equilibrium exists If aggregate output is more than aggregate expenditures, real GDP and employment will decrease (contraction)

25 What is the aggregate expenditures-output model? It determines the equilibrium level of real GDP by the intersection of aggregate expenditures (AE) and aggregate output (Y)

Aggregate Expenditures-Output Model AE = Y AE Real GDP C + I + G + )X-M) E Real Aggregate Expenditures Full employment GDP gap

27 How can the macroeconomic goal of 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

Multiplier Effect of a Change in Spending AE 1 Real GDP AE 2 Real Aggregate Expenditures Full employment Less than Full employment AE = Y Small Change Bigger Change

29 What is the Keynesian multiplier? Any initial increase in spending will lead to a multiple increase in GDP

30 Initial increase in government spending Operates through a multiplier Larger increase in real GDP

Δ in equilibrium real GDP Initial Δ in spending 31 How does the multiplier work? Any initial change in spending causes a chain reaction of more spending Spending multiplier =

32 Spending Multiplier Effect Round 1- Gov’t Spending 2 - Consumption  Spending $500 $250 $125 $63... $1, Consumption 4 - Consumption All other rounds Total spending Initial change in AE Change in equilibrium real GDP 1, = 2

33 What is the Marginal Propensity to Consume? MPC is the change in consumption spending resulting form a given change in income

Aggregate Expenditures-Output Model AE Real GDP Real Aggregate Expenditures  2  4 MPC =.5

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

36 What is the relationship between MPC and MPS? MPC + MPS = 1

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

38 If the MPS is.5, what is the multiplier? 1 / MPS = 1 /.5 = 2

39 Relationship between MPC, MPS, and the Spending Multiplier MPC 10 5 MPS Spending Multiplier

The Multiple Effect of a Change in Spending AE 1 Real GDP  1 trillion dollars AE 2 .5 trillion dollars Real Aggregate Expenditures AE = Y MPC =.5 MPS =.5

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

42 What is the recessionary gap? The amount by which aggregate expenditures fall short of the amount required to achieve full employment equilibrium

Recessionary Gap AE 1 Real GDP AE 2 GDP gap Real Aggregate Expenditures E1E1 E2E2 Recessionary gap Full employment AE = Y

44 What is the Keynesian remedy for a recessionary gap? Increase autonomous spending by the amount of the recessionary gap

45 What can the government do to close a recessionary gap? Increase government spending Lower taxes Raise transfer payments

46 What is an inflationary gap? The amount by which aggregate expenditures exceed the amount required to achieve full employment equilibrium

An Inflationary Gap AE 2 Real GDP AE 1 GDP gap Real Aggregate Expenditures E2E2 E1E1 Inflationary gap Full employment AE = Y

48 What is the Keynesian remedy for an inflationary gap? Reduce spending by the amount of the inflationary gap

49 How can the government close an inflationary gap? Cut government spending Increase taxes Reduce transfer payments

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SQ&P #8 51 Autonomous investment $50 b Autonomous investment $150 b Full employment is at $525 billion A. B.

Aggregate Expenditures-Output Model AE = Y AE Real GDP E Real Aggregate Expenditures (Spending) (Income) Full employment AE 2 A.

Aggregate Expenditures-Output Model AE = Y AE Real GDP E Real Aggregate Expenditures (Spending) (Income) Full employment AE 2 B.

SQ&P #9 Tax Multiplier = 1 – spending multiplierTax Multiplier = 1 – spending multiplier Δ AE = Δ in taxes (T) x tax multiplierΔ AE = Δ in taxes (T) x tax multiplier *cutting taxes does not have the same effect as raising gov’t spending 54 If the MPC =.75, then the spending multiplier is ______ (1/MPS) If the GDP gap is $100 b, then the amount in spending is ________ (SMxΔC)=$100b) The ΔC x MPC = an increase in consumption by _______ The ΔC x SM = Δ in GDP _________ 4 $25 B $18.75 B $75 B $75 B is not enough to fill the $100 B GDP gap

SQ&P #10 Tax Multiplier = 1 – spending multiplierTax Multiplier = 1 – spending multiplier Δ AE = Δ in taxes (T) x tax multiplierΔ AE = Δ in taxes (T) x tax multiplier *cutting taxes does not have the same effect as raising gov’t spending 55 If the MPC =.5, then the spending multiplier is ______ (1/MPS) If the GDP gap is $100 b, then the amount in spending is ________ (SMxΔC)=$100b) The ΔC x MPC = an increase in consumption by _______ The ΔC x SM = Δ in GDP _________ 2 $50 B $25 B $50 B