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 ( )

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: Macroeconomics National Council on Economic Education Visual 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 ynesianthought/keynesianformulas.swf

Equilibrium & Disequilibrium in the Keynesian Model Unit 3: Macroeconomics National 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: onomics2/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. 3 rd ed. New York: National Council on Economic Education, Print. Reffonomics.