1. To Accompany “Economics: Private and Public Choice 10th ed.” James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson Slides authored and animated by: James Gwartney, David Macpherson, & Charles Skipton Full Length Text — Macro Only Text — Part: Chapter: Next page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Foundations of Modern Macroeconomics 311 3

2. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. “ I believe myself to be writing a book on economic theory which will largely revolutionize—not, I suppose, at once but in the course of the next ten years— the way the world thinks about economic problems. ” -- John Maynard Keynes

3. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Great Depression and the Keynesian View

4. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Macroeconomics Prior to the Great Depression Prior to the Great Depression of the 1930s, economists (they are now called classical economists) stressed the importance of production and paid little heed to aggregate demand. Say’s Law (named for nineteenth- century French economist J. B. Say) was central to their analysis. Say’s Law: The p roduction (supply) of goods creates the purchasing power (demand) required to purchase the goods. Hence, general overproduction is impossible because “supply creates its own demand.”

5. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Macroeconomics Prior to the Great Depression Classical economists believed that markets would adjust quickly and direct the economy toward full employment. The huge decline in output, prolonged unemployment, and lengthy duration of the Great Depression undermined the classical view and provided the foundation for Keynesian economics.

6. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Explanation of the Great Depression Keynesian economics developed during the Great Depression (1930s). Keynesian theory provided an explanation for the severe and prolonged unemployment of the 1930s. Keynes argued that wages and prices were highly inflexible, particularly in a downward direction. Thus, he did not think changes in prices and interest rates would direct the economy back to full employment.

7. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Explanation of the Great Depression Keynesian View of spending and output: Keynes argued that spending induced business firms to supply goods & services. Hence, if total spending fell, then firms would respond by cutting back production. Less spending would lead to less output.

8. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Basic Keynesian Model

9. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Aggregate expenditures = Planned Net Exports Planned consumption + Planned investment + Planned government expenditures + The Basic Keynesian Model In the Keynesian model: as income expands, consumption increases, but by a lesser amount than the increase in income, both planned investment and government expenditures are independent of income, and, planned net exports decline as income increases.

10. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Aggregate Consumption Function 369 Planned consumption (trillions of $) Real disposable income (trillions of dollars) 6 9 12 3 45º 45º line C Dis-saving Saving The Keynesian model assumes that there is a positive relationship between consumption and income. However, as income increases, consumption increases by a smaller amount. Thus, the slope of the consumption function (line C) is less than 1 (less than the slope of the 45° line).

11. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Total output (real GDP in trillions) Planned exports (trillions) Planned imports (trillions) Planned net exports (trillions) $1.2 1.2 $9.4$1.00 9.71.05 10.01.10 10.31.15 10.61.20 $0.20 0.15 0.10 0.05 0.00 Income and Net Exports Because exports are determined by income abroad, they are constant at $1.2 trillion. Imports increase as domestic income expands. Thus, planned net exports fall as domestic income increases.

12. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Equilibrium

13. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. When this is the case: businesses are able to sell the total amount of goods & services that they produce, and, there are no unexpected changes in inventories, so, producers have no reason to either expand or contract their output during the next period. Planned aggregate expenditures = Current output Keynesian Equilibrium According to the Keynesian viewpoint, equilibrium occurs when:

14. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Total aggregate expenditures < Current output Keynesian Equilibrium firms accumulate unplanned additions to inventories that will cause them to cut back on future output and employment. When Total aggregate expenditures > Current output inventories fall and businesses respond with an expansion in output in an effort to restore inventories to their normal levels. When

15. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Equilibrium Keynesian equilibrium can occur at less than the full employment output level. When it does, the high rate of unemployment will persist into the future. Aggregate demand is key to the Keynesian macroeconomic model. Keynes believed that weak aggregate demand was the cause of the Great Depression.

16. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Total Output (real GDP) Planned aggregate expenditures Planned consumption Planned Net Exports Tendency of output Planned investment plus government expenditures Recall: Planned Aggregate Expenditures = Planned Consumption plus Planned Investment plus Planned Government Expenditures plus Planned Net Exports. $ 9.4 9.7 10.0 10.3 10.6 $ 9.70 9.85 10.00 10.15 10.30 $7.1 7.3 7.5 7.7 7.9 $0.20 0.15 0.10 0.05 0.00 $2.4 2.4 Expand Equilibrium Contract > An Example of Keynesian Equilibrium > = < < In the Keynesian system, when total output is less than planned aggregate expenditures, purchases exceed output and inventories are depleted. Firms expand their output to rebuild their inventories to regular levels. When output is more than planned aggregate expenditures, output exceeds purchases, and inventories accumulate. Firms reduce output to slow the accumulation of further inventory. When planned aggregate expenditures equal total output, there is Keynesian macroeconomic equilibrium.

17. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Aggregate Expenditures Output (Real GDP -- trillions of $) 45º Equilibrium (AE = GDP) Aggregate expenditures will be equal to total output for all points along the 45° line from the origin. The 45° line maps out potential equilibrium levels of output for the Keynesian model. 9.4 10.6 Planned aggregate expenditures (trillions of $)

18. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Equilibrium Output (Real GDP -- trillions of $) 45º Equilibrium (AE = GDP) At output levels below $10.0 trillion (for example 9.4) AE is above the 45° line – expenditures exceed output and thus businesses sell more than they currently produce, diminishing inventories. Businesses expand output. 9.4 AE = C + I + G + NX 9.7 Unplanned reduction in inventories Planned aggregate expenditures (trillions of $)

19. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Equilibrium Output (Real GDP -- trillions of $) 45º Equilibrium (AE = GDP) At output levels above $10.0 trillion (for example 10.6) AE is below the 45° line – output exceeds expenditures and thus businesses sell less than they currently produce, increasing inventories. Businesses reduce output. 10.6 AE = C + I + G + NX 10.3 Unplanned increase in inventories 9.4 9.7 Unplanned reduction in inventories Planned aggregate expenditures (trillions of $)

20. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Equilibrium Output (Real GDP -- trillions of $) 45º Equilibrium (AE = GDP) Keynesian equilibrium exists where planned expenditures just equals actual output. Here that point is at $10.0 trillion. 10.6 AE = C + I + G + NX 10.3 9.4 9.7 10.0 Full-employment for this example exists at $10.6 trillion. In the Keynesian model, macroeconomic equilibrium does not necessarily coincide with full-employment. Keynesian equilibrium Full Employment (potential GDP) Planned aggregate expenditures (trillions of $)

21. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Equilibrium Output (Real GDP -- trillions of $) 45º AE = GDP If equilibrium is less than its capacity, only an increase in expenditures (shift AE) can lead to full employment output. 10.0 If consumers, investors, governments, or foreigners spend more and thereby shift AE to AE 2, output would reach its full employment potential. Full Employment (potential GDP) AE 1 10.6 AS AE 2 10.6 Planned aggregate expenditures (trillions of $)

22. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Equilibrium Planned aggregate expenditures (trillions of $) Output (Real GDP -- trillions of $) 45º AE = GDP Once full employment is reached, further increases in AE, such as to AE 3, lead only to higher prices – nominal output expands along the black segment of AE (those points beyond the full employment output level at $10.6 trillion) while real output does not. 10.0 Full Employment (potential GDP) AE 1 AE 2 10.6 AS AE 3 11.2 10.6

23. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 1. What determines the equilibrium rate of output in the Keynesian model? What did Keynes think was the cause of the prolonged, high unemployment during the Great Depression? 2. According to the Keynesian view, which of the following is true? a. Businesses will produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buy. b. If planned aggregate expenditures are less than full employment output, output will fall short of its potential. c. Equilibrium can only occur at the full employment rate of output.

24. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 3.Within the framework of the Keynesian model, if the planned expenditures on goods and services were less than current output, a. business firms would reduce their output and lay off workers in the near future. b. the wage rates of workers would decline and thereby help to direct the economy to full employment. 4.Which of the following is the primary source of changes in output within the framework of the Keynesian model? a. changes in aggregate expenditures b. changes in interest rates c. changes in wage rates

25. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Keynesian View Within the AD/AS Framework

26. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Equilibrium Within the AD/AS Framework When output is less than full- employment, the primary impact of an increase in aggregate demand will be an increase in output. When output is at or beyond the full- employment level, the primary impact of an increase in demand will be higher prices.

27. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Keynesian model implies a 90°, angle-shaped SRAS curve that is flat for outputs less than potential GDP Y F – due to downward wage and price inflexibility. Keynesian Aggregate Supply Curve Price Level LRAS YFYF P1P1 SRAS Goods & Services (real GDP) Full Employment (potential GDP) Keynesian range This flat range is referred to as the Keynesian range. Output here is entirely dependent on the level of aggregate demand.

28. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian Aggregate Supply Curve Price Level LRAS YFYF P1P1 SRAS Goods & Services (real GDP) Full Employment (potential GDP) Keynesian range The Keynesian model implies that real output rates beyond full employment are unattainable, both the SRAS and LRAS curves are vertical at full employment - potential output.

29. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD/AS Presentation of the Keynesian Model: Polar Case Price Level LRAS YFYF P1P1 SRAS Goods & Services (real GDP) Above are the polar implications of the Keynesian model. When output is less than capacity (e.g. Y 1 ) … AD 1 P 2 = e1e1 Y1Y1 AD 2 e2e2 an increase in AD (like from AD 1 to AD 2 ) expands output without an increase in the price level (P 2 = P 1 ).

30. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. AD/AS Presentation of the Keynesian Model: Polar Case Price Level LRAS YFYF P1P1 SRAS Goods & Services (real GDP) Increases in demand beyond AD 2 (like from AD 2 to AD 3 ) lead to higher price level P 3, but real output remains constant. AD 2 AD 1 e2e2 e1e1 P 2 = P3P3 Y1Y1 AD 3 e3e3

31. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. LRAS AD/AS Presentation of the Keynesian Model: Relaxed Case Price Level P1P1 SRAS Goods & Services (real GDP) This Keynesian model relaxes the assumptions regarding complete short-run price and output inflexibility beyond Y F. AD 1 e1e1 Y1Y1 AD 2 P2P2 Relaxed assumptions: SRAS now turns from horizontal to vertical more gradually. YFYF An unanticipated increase in AD with output below capacity leads mainly to increases in output (e.g. from AD 1 to AD 2 ). e2e2

32. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. LRAS AD/AS Presentation of the Keynesian Model: Relaxed Case Price Level YFYF P1P1 Goods & Services (real GDP) An unanticipated increase in AD with output at or beyond capacity leads mainly to increases in price level (e.g. from AD 2 to AD 3 ). AD 2 AD 1 e2e2 e1e1 P2P2 Y1Y1 AD 3 P3P3 Y3Y3 SRAS e3e3

33. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Multiplier

34. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Multiplier The Multiplier: The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate income. An increase in spending by one party increases the income of others. Thus, growth in spending can expand output by a multiple of the original increase. The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income. The size of the multiplier increases with the marginal propensity to consume (MPC).

35. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Multiplier In evaluating the importance of the multiplier, one should remember: taxes and spending on imports will dampen the size of the multiplier; it takes time for the multiplier to work; and, the amplified effect on real output will be valid only when the additional spending brings idle resources into production without price changes.

36. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. effectively, $4 million is spent in the economy. Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until … Expenditure stage Additional income (dollars) Marginal propensity to consume Additional consumption (dollars) For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. 1,000,000 750,000 562,500 421,875 316,406 949,219 750,000 562,500 421,875 316,406 237,305 711,914 Round 1 Round 2 Round 3 Round 4 Round 5 Total 4,000,0003,000,000 All others 3/4 The Multiplier Principle The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% = 3/4).

37. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. MPC Size of multiplier 9/10 4/5 3/4 2/3 1/2 1/3 10.0 5.0 4.0 3.0 2.0 1.5 M =M = 1 1 - MPC A Higher MPC Means a Larger Multiplier As the MPC increases more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.). The effect is that for higher MPCs, higher multipliers result, specifically the relationship follows this equation:

38. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Keynesian view of the Business Cycle

39. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian View of the Business Cycle Keynesians argue that a market economy, if left to its own devices, is unstable and likely to experience prolonged periods of recession.

40. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. According to the Keynesian view of the business cycle, upswings and downswings tend to feed on themselves: During a downturn, business pessimism, declining investment, and the multiplier principle combine to plunge the economy further toward recession. During an economic upswing, business and consumer optimism and expanding investment interact with the multiplier to propel the economy to an inflationary boom. The theory suggests that a market-directed economy, left to its own devices, will tend to fluctuate between economic recession and inflationary boom. Keynesian View of the Business Cycle

41. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Keynesian View of the Business Cycle Regulation of aggregate expenditures is the crux of sound macroeconomic policy according to the Keynesian view. If we could assure aggregate expenditures large enough to achieve capacity output, but not so large as to result in inflation, the Keynesian view implies that maximum output, full employment, and price stability would be attained.

42. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Evolution of Modern Macroeconomics

43. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. The Evolution of Modern Macroeconomics Major insights of Keynesian Economics: Changes in output, as well as in prices, play a role in the macroeconomic adjustment process, particularly in the short run. The responsiveness of aggregate supply to changes in demand will be directly related to the availability of unemployed resources. Fluctuations in aggregate demand are an important source of business instability. Modern macroeconomics is a hybrid – reflecting elements of both classical and Keynesian analysis as well as some insights drawn from other areas of economics.

44. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 1. What is the multiplier principle? What determines the size of the multiplier? Does the multiplier principle make it more or less difficult to stabilize the economy? Explain. 2.The multiplier principle indicates that if businesses increase their investment expenditures by $5 billion, real GDP will increase by a. more than $5 billion if the economy was initially operating well below capacity. b. more than $5 billion if the economy was initially operating at full employment capacity.

45. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 3. According to the Keynesian view, market economies are relatively unstable because of a. errors on the part of policymakers. b. instability in the rate of private investment. c. fluctuations in the real rate of interest. 4. (a) Widespread acceptance of the Keynesian aggregate expenditure (AE) model took place during and immediately following the Great Depression. Explain why. (b) The AE model declined in popularity when many economies experienced both high rates of unemployment and inflation during the 1970s. Was this surprising?

46. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Questions for Thought: 5. The proponents of government subsidies for sports stadiums often argue that they generate multiplier effects that expand local employment and output. Is this view correct? Who is helped and who is hurt by these subsidies?

47. Jump to first page Copyright 2003 South-Western Thomson Learning. All rights reserved. Have a nice day