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Full Length Text Part: 3 Macro Only Text Part: 3 Chapter: 11 Chapter: 11
To Accompany Economics: Private and Public Choice 11th ed. James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson Slides authored and animated by: James Gwartney, David Macpherson, & Charles Skipton
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Copyright 2006 Thomson Business and Economics. 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 (1935)
Planned Planned Planned + Planned + government + Net consumption investment Exports expenditures
45 line
12 9 Dis-saving 6
Saving
3 45 3 6 9 12
(trillions of dollars)
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).
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Planned exports
(trillions)
Planned imports
(trillions)
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.
Keynesian Equilibrium
Keynesian Equilibrium
According to the Keynesian viewpoint, equilibrium occurs when:
Planned aggregate expenditures Current output
Keynesian Equilibrium
When
Total aggregate expenditures
<
Current output
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.
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.
10.3 10.6
10.15 10.30
7.7 7.9
2.4 2.4
Contract Contract
Recall: Planned Aggregate Expenditures = Planned Consumption plus Planned Investment plus Planned Government Expenditures plus Planned Net Exports.
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 in order to reduce this build-up of excessive inventories. When planned aggregate expenditures equal total output, there is Keynesian macroeconomic equilibrium.
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Aggregate Expenditures
Planned aggregate expenditures
(trillions of $)
Equilibrium
(AE = GDP)
10.0
5.0
45 5.0 10.0
Output
(Real GDP -trillions of $)
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.
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Keynesian Equilibrium
Planned aggregate expenditures
(trillions of $)
Equilibrium
(AE = GDP)
AE = C + I + G + NX
9.85
45 9.7
Output
(Real GDP -trillions of $)
At output levels below $10.0 trillion (for example 9.7) AE is above the 45 line expenditures exceed output and thus businesses sell more than they currently produce, diminishing inventories. Businesses expand output.
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Keynesian Equilibrium
Planned aggregate expenditures
(trillions of $)
Equilibrium
(AE = GDP)
AE = C + I + G + NX
At output levels above $10.0 trillion (for example 10.3) AE is below the 45 line output exceeds expenditures and thus businesses sell less than they currently produce, increasing inventories. Businesses reduce output.
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Keynesian Equilibrium
Planned aggregate expenditures
(trillions of $)
AE = C + I + G + NX
10.15 10.00 9.85
Full Employment
(potential GDP)
Output
(Real GDP -trillions of $)
Keynesian equilibrium exists where planned expenditures just equal actual output. Here that point is at $10.0 trillion. Full-employment for this example exists at $10.3 trillion. In the Keynesian model, macroeconomic equilibrium does not necessarily coincide with full-employment. Copyright 2006 Thomson Business and
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Economics. All rights reserved.
Keynesian Equilibrium
Planned aggregate expenditures
(trillions of $)
AE = GDP
10.3 10.0
AE2 AE1
Full Employment
(potential GDP)
45 10.0 10.3
Output
(Real GDP -trillions of $)
If equilibrium is less than its capacity, only an increase in expenditures (shift AE) can lead to full employment output. If consumers, investors, governments, or foreigners spend more and thereby shift AE to AE2, output would reach its full employment potential. Copyright 2006 Thomson Business and
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Economics. All rights reserved.
Keynesian Equilibrium
Planned aggregate expenditures
(trillions of $)
AS
AE = GDP
Full Employment
(potential GDP)
45 10.0 10.3
Output
(Real GDP -trillions of $)
Once full employment is reached, further increases in AE, such as to AE3, lead only to higher prices nominal output expands along the black segment of AE (those points beyond the full employment output level at $10.3 trillion) while real Copyright 2006 Thomson Business and output does not. Jump to first page Economics. All rights reserved.
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
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SRAS LRAS
Keynesian range P1
Full Employment
(potential GDP)
YF
The Keynesian model implies a 90, angle-shaped SRAS curve that is flat for outputs less than potential GDP YF due to downward wage and price inflexibility. This flat range is referred to as the Keynesian range. Output here is entirely dependent on the level of aggregate demand.
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SRAS LRAS
Keynesian range P1
Full Employment
(potential GDP)
YF
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.
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SRAS LRAS
P2 = P1
e1
e2
AD2 AD1
Y1 YF
Goods & Services
(real GDP)
Above are the polar implications of the Keynesian model. When output is less than capacity (e.g. Y1) an increase in AD (like from AD1 to AD2) expands output without an increase in the price level (P2 = P1). Copyright 2006 Thomson Business and
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Economics. All rights reserved.
SRAS LRAS
P3 P2 = P1
e3 e1 e2
Increases in demand beyond AD2 (like from AD2 to AD3) lead to the higher price level P3, but real output remains constant.
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LRAS SRAS
Relaxed assumptions: SRAS now turns from horizontal to vertical more gradually.
P2
P1
e1
e2
AD1
Y1 YF
AD2
Goods & Services
(real GDP)
This Keynesian model relaxes the assumptions regarding complete short-run price and output inflexibility beyond YF. An unanticipated increase in AD with output below capacity leads mainly to increases in output (e.g. from AD1 to AD2).
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LRAS SRAS
P3
e3 e1 e2
P2
P1
Y1
YF Y3
An unanticipated increase in AD with output at or beyond capacity leads mainly to increases in price level (e.g. from AD2 to AD3).
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The Multiplier
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).
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Additional consumption
(dollars)
750,000 562,500
For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.
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). Here, a $1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent etc. until effectively, $4 million is spent in the economy.
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Size of multiplier
10.0 5.0 4.0 3.0 2.0 1.5
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:
1 M = 1 - MPC
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Modern macroeconomics is a hybrid reflecting elements of both classical and Keynesian analysis as well as some insights drawn from other areas of economics.
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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?
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End Chapter 11