Keynesian Foundations of Modern Macroeconomics

1. Keynesian Foundations of Modern Macroeconomics 3 11 11 3

2. “ 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. The Great Depression and the Keynesian View

4. 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 production (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. 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. 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. 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. The Basic Keynesian Model

9. Plannedgovernmentexpenditures Aggregate expenditures Plannedconsumption Plannedinvestment = + + + 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. PlannedNetExports

10. Saving C Dis-saving Aggregate Consumption Function Planned consumption(trillions of $) 45º line 12 9 6 3 45º Real disposable income(trillions of dollars) 3 6 9 12 • 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. $1.2 1.2 1.2 1.2 1.2 Income and Net Exports Total output(real GDP in trillions) Planned exports(trillions) Planned imports(trillions) Planned net exports (trillions) $9.4 $1.00 $0.20 9.7 1.05 0.15 10.0 1.10 0.10 10.3 1.15 0.05 10.6 1.20 0.00 • 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. Keynesian Equilibrium

13. Planned aggregateexpenditures Currentoutput = Keynesian Equilibrium • According to the Keynesian viewpoint, equilibrium occurs when: • 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.

14. Total aggregateexpenditures Currentoutput < Total aggregateexpenditures Currentoutput > Keynesian Equilibrium • When firms accumulate unplanned additions to inventories that will cause them to cut back on future output and employment. • When inventories fall and businesses respond with an expansion in output in an effort to restore inventories to their normal levels.

15. 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. < < = > > An Example of Keynesian Equilibrium Planned aggregateexpenditures PlannedNet Exports Planned consumption Planned investment plusgovernment expenditures Tendencyof output Total Output(real GDP) $ 9.4 $ 9.70 $7.1 $2.4 $0.20 Expand 9.7 9.85 7.3 2.4 0.15 Expand 10.0 10.00 7.5 2.4 0.10 Equilibrium 10.3 10.15 7.7 2.4 Contract 0.05 10.6 10.30 7.9 2.4 Contract 0.00 Recall: Planned Aggregate Expenditures = Planned Consumption plus Planned Investmentplus 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 to slow the accumulation of further inventory. • When planned aggregate expenditures equal total output, there is Keynesian macroeconomic equilibrium.

17. Aggregate Expenditures Planned aggregate expenditures(trillions of $) Equilibrium(AE= GDP) 10.6 9.4 45º Output(Real GDP -- trillions of $) 9.4 10.6 • 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.

18. Unplanned reductionin inventories AE = C + I + G + NX Keynesian Equilibrium Planned aggregate expenditures(trillions of $) Equilibrium(AE= GDP) 9.7 45º Output(Real GDP -- trillions of $) 9.4 • 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.

19. Unplanned increasein inventories Unplanned reductionin inventories AE = C + I + G + NX Keynesian Equilibrium Planned aggregate expenditures(trillions of $) Equilibrium(AE= GDP) 10.3 9.7 45º Output(Real GDP -- trillions of $) 9.4 10.6 • 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.

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

21. AS AE2 Full Employment(potential GDP) Keynesian Equilibrium AE= GDP Planned aggregate expenditures(trillions of $) AE1 10.6 10.0 45º Output(Real GDP -- trillions of $) 10.0 10.6 • 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.

22. AE3 11.2 Full Employment(potential GDP) Keynesian Equilibrium AE= GDP AS Planned aggregate expenditures(trillions of $) AE2 AE1 10.6 10.0 45º Output(Real GDP -- trillions of $) 10.0 10.6 • 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 $10.6 trillion) while real output does not.

23. 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. 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?

24. 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. The Keynesian View Within the AD/AS Framework

26. 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. SRAS Keynesian range Full Employment(potential GDP) Goods & Services(real GDP) Keynesian Aggregate Supply Curve LRAS PriceLevel P1 YF • The Keynesian model implies a 90°, angle-shaped SRAS curve that is flat for outputs less than potential GDP YF – dueto 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.

28. Full Employment(potential GDP) Goods & Services(real GDP) Keynesian Aggregate Supply Curve SRAS LRAS PriceLevel Keynesian range P1 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.

29. e2 e1 AD2 AD1 Goods & Services(real GDP) AD/AS Presentation of the Keynesian Model: Polar Case SRAS LRAS PriceLevel P2 = P1 Y1 YF • 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).

30. e3 AD3 Goods & Services(real GDP) AD/AS Presentation of the Keynesian Model: Polar Case SRAS LRAS PriceLevel P3 e2 P2 = P1 e1 AD2 AD1 Y1 YF • Increases in demand beyond AD2 (like from AD2 to AD3) lead to higher price level P3, but real output remains constant.

31. Relaxed assumptions: SRAS now turns from horizontal to vertical more gradually. P2 e2 e1 AD2 AD1 Goods & Services(real GDP) Y1 AD/AS Presentation of the Keynesian Model: Relaxed Case LRAS PriceLevel SRAS P1 YF • 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).

32. e3 AD3 Goods & Services(real GDP) AD/AS Presentation of the Keynesian Model: Relaxed Case LRAS PriceLevel SRAS P3 P2 P1 e2 e1 AD2 AD1 Y1 Y3 YF • An unanticipated increase in AD with output at or beyond capacity leads mainly to increases in price level (e.g. from AD2 to AD3).

33. The Multiplier

34. 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. 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. 3/4 3/4 3/4 3/4 3/4 3/4 3/4 The Multiplier Principle Expenditure stage Additional income(dollars) Additional consumption(dollars) Marginal propensity to consume Round 1 1,000,000 750,000 562,500 Round 2 750,000 Round 3 562,500 421,875 421,875 316,406 Round 4 316,406 237,305 Round 5 949,219 711,914 All others Total 4,000,000 3,000,000 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.

37. 1 M= 1 - MPC A Higher MPC Means a Larger Multiplier Size of multiplier MPC 9/10 10.0 4/5 5.0 3/4 4.0 2/3 3.0 1/2 2.0 1/3 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:

38. The Keynesian view of the Business Cycle

39. 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. Keynesian View of the Business Cycle • 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.

41. 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. Evolution of Modern Macroeconomics

43. 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. 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. 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. 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. EndChapter 11