The Keynesian Model in Action

1. The Keynesian Model in Action • Key Concepts • Summary ©2005 South-Western College Publishing

2. What is the purpose of this chapter? To complete the Keynesian model by adding the government and the foreign sector to our analysis

3. Why is government spending considered an autonomous expenditure? Government spending is primarily the result of a political decision made independent of the level of national output

4. Autonomous Government Spending 2.00 1.75 Government Spending 1.50 G1 1.25 Real Government spendingTrillions of $ per year 1.00 0.75 G2 0.50 Government Spending 0.25 Real GDPTrillions of $ per year 1 2 3 4 5 6 7 8 9 10

5. Why is net exports assumed to be negative? For many years our spending for imports has exceeded the value of exports we have sold to foreigners.

6. Autonomous Net Exports 2.00 1.75 Positive Net Exports 1.50 (X-M)2 Real Net ExportsTrillions of $ per year 1.25 1.00 (X-M) Zero Net Exports 0.75 (X-M)1 0.50 Negative Net Exports 0.25 Real GDPTrillions of $ per year 1 2 3 4 5 6 7 8 9 10

7. What does the term equilibrium mean? In the Keynesian model, the equilibrium is the point toward which the economy tends

8. In the Keynesian model, where is the equilibrium level of GDP? It is where the total value of goods and services produced is precisely equal to the total spending for these goods and services

9. What can pull aggregate expenditures higher or lower in Keynesian economics? Aggregate expenditures C + I + G + (X-M)

10. What affect do aggregate expenditures have on the economy? Aggregate expenditures in Keynesian economics pull aggregate output either higher or lower toward equilibrium

11. What causes a decrease in real GDP and employment? Unplanned inventory investment accumulation

12. Why does unplanned inventory investment accumulation cause unemployment? Business firms will cut back production and lay off workers when they find themselves with surpluses

13. What causes an increase in real GDP and employment? Unplanned inventory investment depletion

14. Why does unplanned inventory depletion cause economic growth? Business firms will increase production and higher more workers to meet the level of demand for their product

15. What is the aggregate expenditures-output model? The model that determines the equilibrium level of real GDP by the intersection of aggregate expenditures and aggregate output

16. The Keynesian Aggregate Expenditures-Output Model 8 Inventory Accumulation AE = Y 7 6 E AE 5 Real Aggregate Expenditures C + I + G + )X-M) Full employment 4 3 GDP gap 2 Inventory Depletion 1 Real GDP 2 1 7 8 5 3 6 4

17. How can full employment be reached in the previous graph? The aggregate expenditure curve must be shifted upward until the full-capacity output of $6 trillion is reached

18. The Keynesian Aggregate Expenditures-Output Model 8 7 Less than Full employment AE2 6 AE1 5 Real Aggregate Expenditures 4 Full employment 3 2 1 Real GDP 2 1 7 8 5 3 6 4

19. What is theKeynesian multiplier? Any initial increase in spending will lead to a multiple increase in GDP

20. The Keynesian Aggregate Expenditures-Output Model 8 7  .5 trillion dollars AE2 6 AE1 5 Real Aggregate Expenditures 4  1 trillion dollars 3 2 1 1 2 3 4 5 6 7 8 Real GDP

21. Larger increase in aggregate expenditures Operates through a multiplier Initial increase in government spending

22. How does themultiplier work? Any initial change in spending by the government, households, or firms creates a chain reaction of further spending

23. The Keynesian Aggregate Expenditures-Output Model 8 7 MPC = .5 AE 6 5 Real Aggregate Expenditures  2 4 3 2  4 1 1 2 3 4 5 6 7 8 Real GDP

24. What is the Marginal Propensity to Consume? MPC is the change in consumption spending resulting form a given change in income

25. What is the Marginal Propensity to Save? MPS is the fraction of any change in real disposable income that households save

26. How does the multiplier work?

27. Spending Multiplier Effect Round  Spending $500 1 $250 2 $125 3 $63 4 ... All other rounds $1,000 Total spending

28. What is the relationship between MPC and MPS? MPC + MPS = 1

29. What is the formula for the multiplier? 1 / (1 – MPC) (or) 1 / MPS

30. If the MPS is 1/2, what is the multiplier? 1 / MPS = 1 / 1/2 = 2

31. Relationship between MPC, MPS, and the Spending Multiplier Spending Multiplier MPC MPS 10 .90 .10 5 .80 .20 4 .75 .25 3 .67 .33 2 .50 .50 1.5 .33 .67

32. What is the GDP gap? The difference between full employment real GDP and actual real GDP

33. What is therecessionary gap? The amount by which aggregate expenditures fall short of the amount required to achieve full employment equilibrium

34. The Keynesian Aggregate Expenditures - Output Model 8 7 AE2 E2 6 AE1 5 E1 Real Aggregate Expenditures Recessionary gap 4 3 Full employment 2 GDP gap 1 6 1 2 3 4 5 8 7 Real GDP

35. What is the Keynesian remedy for a recessionary gap? Increase autonomous spending by the amount of the recessionary gap

36. What can the government do to close a recessionary gap? • Increase government spending • Lower taxes • Raise transfer payments

37. What is an inflationary gap? The amount by which aggregate expenditures exceed the amount required to achieve full employment equilibrium

38. The Keynesian Aggregate Expenditures - Output Model 8 AE1 7 E1 6 AE2 5 E2 Real Aggregate Expenditures 4 Inflationary gap 3 Full employment 2  GDP gap 1 4 5 1 2 3 8 6 7 Real GDP

39. What is the Keynesian remedy for an inflationary gap? Reduce autonomous spending by the amount of the inflationary gap

40. How can the government close an inflationary gap? • Cut government spending • Increase taxes • Reduce transfer payments

41. Key Concepts

42. Why is government spending considered an autonomous expenditure? • What does the term equilibrium mean? • In the Keynesian model, where is the equilibrium level of GDP? • What can pull aggregate expenditures higher or lower in Keynesian economics? • What causes a decrease in real GDP and employment?

43. What causes an increase in real GDP and employment? • What is the aggregate expenditures-output model? • What is the Keynesian multiplier? • What is the Marginal Propensity to Consume? • What is the Marginal Propensity to Save?

44. What is the relationship between MPC and MPS? • What is the formula for the multiplier? • What is the GDP gap? • What is the recessionary gap? • What is the Keynesian remedy for a recessionary gap? • What is an inflationary gap? • What is the Keynesian remedy for an inflationary gap?

45. Summary

46. The Keynesian argues that the economy is inherently unstable and may require government intervention to control aggregate expenditures and restore full employment.

47. If we assume that real disposable income remains the same high proportion of real GDP, then we can substitute real GDP for real disposable income in the Keynesian model.

48. Government spending and net exports can be treated as autonomous expenditures in the Keynesian model.

49. Net exports are the only component of aggregate expenditures that changes from a positive to a negative value as real GDP rises. Both exports and imports are determined by foreign or domestic income, tastes, trade restrictions, and exchange rates.

50. Autonomous Government Spending 2.00 1.75 Government Spending 1.50 G1 1.25 Real Government spendingTrillions of $ per year 1.00 0.75 G2 0.50 Government Spending 0.25 Real GDPTrillions of $ per year 1 2 3 4 5 6 7 8 9 10