The Keynesian Model in Action To complete the Keynesian model by adding the government and the foreign sector

Government spending an autonomous expenditure because government spending can be the result of political decisions regardless of national output Real GDP Government Spending Real Government spending G1G1 G2G2 Government Spending

Real GDP Positive Net Exports Real Net Exports Negative Net Exports (X-M) 2 (X-M) 1 (X-M) Zero Net Exports Autonomous Net Exports

Equilibrium is the point toward which the economy tends In the Keynesian model, equilibrium level of GDP is where the value of goods and services produced is equal to the spending for these goods and services Aggregate Expenditures or AE = C + I + G + (X-M) Aggregate Expenditures affect the economy by pulling aggregate output either higher or lower toward equilibrium Excessive Inventories causes a decrease in real GDP and employment as firms cut back production and lay off workers in order to not add inventory

Inventory depletion causes an increase in GDP and employment When inventories decline too much firms will increase production and hire more workers to meet the demand for their product The aggregate expenditures-output model determines the equilibrium level of real GDP by the intersection of aggregate expenditures and aggregate output

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

The aggregate expenditure curve must be shifted upward until the full-capacity output of $6 trillion is reached Spending Multiplier: Any initial increase in spending will lead to a multiple increase in GDP Initial increase in government spending Operates through a multiplier Larger increase in real GDP

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

Spending multiplier effect: Any initial change in spending causes a chain reaction of more spending Round 1 2  Spending $500 $250 $125 $63 $62 $1, All other rounds Total spending

Marginal Propensity to Consume (MPC) is the change in consumption spending resulting from a given change in income AE Real GDP Real Aggregate Expenditures  2  4 MPC =  C  Y =  2  4 =.5

Marginal Propensity to Save (MPS) is the fraction of any change in real disposable income that households save MPC + MPS = 1 where (1 – MPC) Multiplier formula when MPC = M == MPS 1 (1 – 0.8) 1 M == = 5

MPC, MPS, and the Spending Multiplier MPC 10 5 MPS Spending Multiplier

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

GDP gap is the difference between full employment real GDP and actual real GDP A recessionary gap is 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 Full employment AE = Y

Keynesian remedy for a recessionary gap is to increase autonomous spending by the amount of the recessionary gap Increase government spending Lower taxes Raise transfer payments Government can close a recessionary gap An inflationary gap is the amount by which aggregate expenditures exceed the amount required to achieve full employment equilibrium

Inflationary Gap Real GDP AE 1 + GDP gap Real Aggregate Expenditures AE 2 Full employment AE = Y

Reduce spending by the amount of the inflationary gap Keynesian remedy for an inflationary gap Cut government spending Increase taxes Reduce transfer payments Government can close an inflationary gap