Keynes and the Evolution of Macroeconomics Chapter 11.
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Transcript of Keynes and the Evolution of Macroeconomics Chapter 11.
Keynes and the Evolution of Macroeconomics
Chapter 11
“ 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)
The Great Depression and the Keynesian View
Macroeconomics Prior to the Great Depression
• Say’s Law (named for a nineteenth-century French economist J. B. Say) – Say’s Law:
“supply creates its own demand.”
MacroeconomicsPrior 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.
Keynesian Explanation of the Great Depression
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.
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.
The Basic Keynesian Model
Aggregate expenditures =
PlannedNet
ExportsPlanned
consumption+ Planned
investment+
Plannedgovernmentexpenditures
+
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.
3 6 9
Planned consumption(trillions of $)
Real disposable income
(trillions of dollars)
6
9
12
3
12
45º
45º line
C
Dis-saving
Saving
Aggregate Consumption Function
Total output(real GDP in trillions)
Planned exports(trillions)
Planned imports(trillions)
Planned net exports (trillions)
$1.2 1.2 1.2 1.2 1.2
$9.4 $1.00 9.7 1.05 10.0 1.10 10.3 1.15 10.6 1.20
$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.
Keynesian Equilibrium
• 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 aggregateexpenditures = Current
output
Keynesian Equilibrium• According to the Keynesian viewpoint,
equilibrium occurs when:
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.
Total Output(real GDP)
Planned aggregateexpenditures
Planned consumption
PlannedNet Exports
Tendencyof output
Planned investment plusgovernment expenditures
$ 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
2.4
2.4
2.4
Expand Expand
Equilibrium
Contract
Contract > > =<<
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.
5.0
5.0
10.0
10.0
Planned aggregate expenditures(trillions of $)
Keynesian Equilibrium
Output(Real GDP -- trillions of $)
45º
Equilibrium(AE = GDP)
• 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. expand output.
9.7
AE = C + I + G + NX
9.85
Unplanned reductionin inventories
Planned aggregate expenditures(trillions of $)
Keynesian Equilibrium
Output(Real GDP -- trillions of $)
45º
Equilibrium(AE = GDP)
• 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.
10.3
AE = C + I + G + NX
10.15
Unplanned increasein inventories
9.7
9.85
Unplanned reductionin inventories
Planned aggregate expenditures(trillions of $)
Keynesian Equilibrium
Output(Real GDP -- trillions of $)
45º
Equilibrium(AE = GDP)
• Keynesian equilibrium exists where planned expenditures just equal actual output. Here that point is at $10.0 trillion.
10.3
AE = C + I + G + NX
10.15
9.7
9.8510.00
10.0
• Full-employment for this example exists at $10.3 trillion. In the Keynesian model, macroeconomic equilibrium does not necessarily coincide with full-employment.
Keynesianequilibrium
Full Employment(potential GDP)
Planned aggregate expenditures(trillions of $)
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
10.0
• If consumers, investors, governments, or foreigners spend more and thereby shift AE to AE2, output would reach its full employment potential.
Full Employment(potential GDP)
AE1
10.3
AE2
10.3
Planned aggregate expenditures(trillions of $)
Keynesian EquilibriumPlanned aggregate expenditures(trillions of $)
Output(Real GDP -- trillions of $)
45º
AE = GDP
• 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 output does not.
10.0
10.0
Full Employment(potential GDP)
AE1
AE2
10.3
AE3
AS
10.6
10.3
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).
MPCSize 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 = 1
1 - MPC
A Higher MPCMeans a Larger Multiplier
Real-World Significance of 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.
The Keynesian View withinthe AD/AS Framework
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.
• 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.
Keynesian Aggregate Supply CurvePriceLevel LRAS
YF
P1
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.
Keynesian Aggregate Supply Curve
PriceLevel LRAS
YF
P1
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.
AD/AS Presentation of theKeynesian Model: Polar Case
PriceLevel LRAS
YF
P1
SRAS
Goods & Services(real GDP)
• Above are the polar implications of the Keynesian model.
AD1
P2 = e1
Y1
AD2
e2
AD/AS Presentation of theKeynesian Model: Polar Case
PriceLevel LRAS
YF
P1
SRAS
Goods & Services(real GDP)
• Increases in demand beyond AD2 (like from AD2 to AD3) lead to the higher price level P3, but real output remains constant.
AD2AD1
e2e1P2 =
P3
Y1
AD3
e3
LRAS
AD/AS Presentation of theKeynesian Model: Relaxed Case
PriceLevel
P1
SRAS
Goods & Services(real GDP)
• This Keynesian model relaxes the assumptions regarding complete short-run price and output inflexibility beyond YF.
AD1
e1
Y1
AD2
P2
Relaxed assumptions:SRAS now turns from horizontal to vertical more gradually.
YF
• An unanticipated increase in AD with output below capacity leads mainly to increases in output (e.g. from AD1 to AD2).
e2
LRAS
AD/AS Presentation of theKeynesian Model: Relaxed Case
PriceLevel
YF
P1
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 AD2 to AD3).
AD2AD1
e2e1
P2
Y1
AD3
P3
Y3
SRAS
e3
Evolution of Modern Macroeconomics
The Evolution ofModern Macroeconomics
• Major insights of Keynesian Economics: – Market forces may fail to restore full employment
quickly. During a serious recession, excess capacity and pessimism about the future are likely to slow the adjustment process.
– 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.
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.
Questions for Thought:3. According to the Keynesian view, market
economies are relatively unstable because ofa. 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?
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?