05 the keynesian model in action

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05 the keynesian model in action

  1. 1. Chapter 19The Keynesian Model in Action • Key Concepts • Summary • Practice Quiz • Internet Exercises ©2000 South-Western College Publishing 1
  2. 2. In this chapter, you will learn to solve these economic puzzles:Why does Keynes argue that Why did Keynes reject Can the Keynesian the government should the classical theory adopt active policies,ice Model explain an rather that “supply creates its cream war? thanown demand”? allowing the price system to prevail? 2
  3. 3. What is the purpose of this chapter?To complete the Keynesian model by adding the government and the foreign sector to our analysis 3
  4. 4. What percent of GDP is Government and the Foreign sector? About 17% of GDP 4
  5. 5. Why is Government spending considered anAutonomous Expenditure? Government spending is primarily the result of a political decision made independent of the level of national output 5
  6. 6. Autonomous Government Spending2.00 Real Government spending Trillions of $ per year1.75 Government Spending1.50 G11.251.000.750.50 G2 Government Spending0.25 Real GDP Trillions of $ per year 1 2 3 4 5 6 7 8 9 10 6
  7. 7. Why is Net Exportsassumed to be Negative? For many years our spending for imports has exceeded the value of exports we have sold to foreigners. 7
  8. 8. 2.00 Autonomous Net Exports Trillions of $ per year1.75 Real Net Exports Positive Net Exports1.50 (X-M)21.251.00 (X-M) Zero Net Exports0.750.50 (X-M)1 Negative Net Exports0.25 Real GDP Trillions of $ per year 1 2 3 4 5 6 7 8 9 10 8
  9. 9. What does the termEquilibrium mean?In the Keynesian model, the equilibrium is the point toward which the economy tends 9
  10. 10. 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 10
  11. 11. What can pull AggregateExpenditures higher or lower in Keynesian economics? Aggregate expenditures C + I + G + (X-M) 11
  12. 12. What affect do Aggregate Expenditures have on the economy?Aggregate expenditures in Keynesian economics pull aggregate output either higher or lower toward equilibrium 12
  13. 13. What causes adecrease in Real GDP and Employment?Unplanned inventory investment accumulation 13
  14. 14. Why does Unplanned Inventory Investment Accumulation cause Unemployment?Business firms will cut back production and lay off workers when they find themselves with surpluses 14
  15. 15. What causes anincrease in Real GDP and Employment? Unplanned inventory investment depletion 15
  16. 16. Why does Unplanned Inventory Depletioncause Economic Growth?Business firms will increase production and higher more workers to meet the level of demand for their product 16
  17. 17. 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 17
  18. 18. The Keynesian Aggregate8 Expenditures-Output Model Real Aggregate Expenditures7 Inventory Accumulation AE = Y6 E AE5 )X -M) I+ G+4 C+ Full employment3 +GDP gap2 Inventory Depletion1 Real GDP 1 2 3 4 5 6 7 8 18
  19. 19. How can FullEmployment be reached in the previous graph? The aggregate expenditure curve must be shifted upward until the full- capacity output of $6 trillion is reached 19
  20. 20. The Keynesian Aggregate8 Expenditures-Output Model Real Aggregate Expenditures7 Less than Full employment AE26 AE154 Full employment321 Real GDP 1 2 3 4 5 6 7 8 20
  21. 21. What is theKeynesian Multiplier?Any initial increase in spending will lead to a multiple increase in GDP 21
  22. 22. The Keynesian Aggregate 8 Expenditures-Output ModelReal Aggregate Expenditures 7 ∆ .5 trillion dollars AE2 6 AE1 5 4 ∆ 1 trillion dollars 3 2 1 1 2 3 4 5 6 7 8 Real GDP 22
  23. 23. Larger increase in aggregate expenditures Operates through a Initial multiplierincrease ingovernment spending 23
  24. 24. How does the Multiplier work?Any initial change in spending by the government, households, or firms creates a chain reaction of further spending 24
  25. 25. The Keynesian Aggregate 8 Expenditures-Output ModelReal Aggregate Expenditures 7 6 MPC = .5 AE 5 4 ∆2 3 2 1 ∆4 1 2 3 4 5 6 7 8 Real GDP 25
  26. 26. What is the MarginalPropensity to Consume? MPC is the change in consumption spending resulting form a given change in income 26
  27. 27. What is the Marginal Propensity to Save?MPS is the fraction of any change in real disposable income that households save 27
  28. 28. How does theMultiplier work? 28
  29. 29. Spending Multiplier Effect Round ∆ Spending 1 $500 2 $250 3 $125 4 $63All other rounds ...Total spending $1,000 29
  30. 30. What is the relationshipbetween MPC and MPS? MPC + MPS = 1 30
  31. 31. What is the formulafor the Multiplier? 1 / (1 – MPC) (or) 1 / MPS 31
  32. 32. If the MPS is , what is the Multiplier? 1 / MPS = 1 /  = 2 32
  33. 33. Relationship between MPC, MPS, and the Spending Multiplier Spending MPC MPS Multiplier .90 .10 10 .80 .20 5 .75 .25 4 .67 .33 3 .50 .50 2 .33 .67 1.5 33
  34. 34. What is the GDP Gap?The difference between full employment real GDP and actual real GDP 34
  35. 35. What is the Recessionary Gap?The amount by which aggregate expenditures fall short of the amount required to achieve full employment equilibrium 35
  36. 36. The Keynesian Aggregate 8 Expenditures - OutputReal Aggregate Expenditures 7 Model AE2 E2 6 AE1 5 E1 4 Recessionary 3 gap Full employment 2 1 + GDP gap 1 2 3 4 5 6 7 8 Real GDP 36
  37. 37. What is the Keynesian remedy for a Recessionary Gap?Increase autonomous spending by the amount of the recessionary gap 37
  38. 38. What can theGovernment do to close a Recessionary Gap? • Increase government spending • Lower taxes • Raise transfer payments 38
  39. 39. What is an Inflationary Gap?The amount by which aggregate expenditures exceed the amount required to achieve full employment equilibrium 39
  40. 40. The Keynesian Aggregate 8 Expenditures - OutputReal Aggregate Expenditures 7 Model AE1 E1 6 AE2 5 E2 4 Inflationary gap 3 Full employment 2 1 − GDP gap 1 2 3 4 5 6 7 8 Real GDP 40
  41. 41. What is the Keynesian remedy for an Inflationary Gap?Reduce autonomous spending by the amount of the inflationary gap 41
  42. 42. How can the Governmentclose an Inflationary Gap? • Cut government spending • Increase taxes • Reduce transfer payments 42
  43. 43. Key Concepts 43
  44. 44. Key Concepts• Why is Government spending considered an Au• What does the term Equilibrium mean?• In the Keynesian Model, where is the Equilibriu• What can pull Aggregate Expenditures higher o• What causes a decrease in Real GDP and Empl 44
  45. 45. Key Concepts cont.• What causes an increase in Real GDP and Em• What is the Aggregate Expenditures-output M• What is the Keynesian Multiplier?• What is the Marginal Propensity to Consume?• What is the Marginal Propensity to Save? 45
  46. 46. Key Concepts cont.• What is the relationship between MPC and M• 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? 46
  47. 47. Summary 47
  48. 48. The Keynesian argues that theeconomy is inherently unstable andmay require government interventionto control aggregate expenditures andrestore full employment. If we assumethat real disposable income remainsthe same high proportion of real GDP,then we can substitute real GDP forreal disposable income in theKeynesian model. 48
  49. 49. Government spending and netexports can be treated as autonomousexpenditures in the Keynesian model.Net exports are the only component ofaggregate expenditures that changesfrom a positive to a negative value asreal GDP rises. Both exports andimports are determined by foreign ordomestic income, tastes, traderestrictions, and exchange rates. 49
  50. 50. Autonomous Government Spending2.00 Real Government spending Trillions of $ per year1.75 Government Spending1.50 G11.251.000.750.50 G2 Government Spending0.25 Real GDP Trillions of $ per year 1 2 3 4 5 6 7 8 9 10 50
  51. 51. 2.00 Autonomous Net Exports Trillions of $ per year1.75 Real Net Exports Positive Net Exports1.50 (X-M)21.251.00 (X-M) Zero Net Exports0.750.50 (X-M)1 Negative Net Exports0.25 Real GDP Trillions of $ per year 1 2 3 4 5 6 7 8 9 10 51
  52. 52. The Keynesian aggregateexpenditures-output modeldetermines the equilibrium level ofreal GDP by the intersection of theaggregate expenditures and theaggregate output and incomeschedules. Each equilibrium level inthe economy is associated with alevel of employment andcorresponding unemployment rate. 52
  53. 53. Aggregate expenditures andreal GDP are equal, graphically,where the AE = C + I + G + (X-M)line intersects the 45-degree line. Atany output greater or less than theequilibrium real GDP, unintendedinventory investment pressuresbusinesses to alter aggregate outputand income until equilibrium at full-employment real GDP is restored. 53
  54. 54. The Keynesian Aggregate8 Expenditures-Output Model Real Aggregate Expenditures7 Inventory Accumulation AE = Y6 E AE5 (X -M) I+ G+4 C+ Full employment3 +GDP gap2 Inventory Depletion1 Real GDP 1 2 3 4 5 6 7 8 54
  55. 55. The spending multiplier is theratio of the change in equilibriumoutput to the initial change in any ofthe components of aggregateexpenditures. Algebraically, themultiplier is the reciprocal of themarginal propensity to save. Themultiplier effect causes theequilibrium level of real GDP tochange by several times the initialchange in spending. 55
  56. 56. A recessionary gap is the amountby which aggregate expenditures fallshort of the amount necessary for theeconomy to operate at full-employmentreal GDP. To eliminate a positive GDPgap, the Keynesian solution is toincrease autonomous spending by anamount equal to the recessionary gapand operate through the multiplier toincrease equilibrium output andincome. 56
  57. 57. The Keynesian Aggregate 8 Expenditures - OutputReal Aggregate Expenditures 7 Model AE2 E2 6 AE1 5 E1 4 Recessionary 3 gap Full employment 2 1 + GDP gap 1 2 3 4 5 6 7 8 Real GDP 57
  58. 58. An inflationary gap is the amountby which aggregate expendituresexceed the amount necessary toestablish full-employment equilibriumand indicates upward pressure on prices.To eliminate a negative GDP gap, theKeynesian solution is to decreaseautonomous spending by an amountequal to the inflationary gap and operatethrough the multiplier to decreaseequilibrium output and income . 58
  59. 59. The Keynesian Aggregate 8 Expenditures - OutputReal Aggregate Expenditures 7 Model AE1 E1 6 AE2 5 E2 4 Inflationary gap 3 Full employment 2 1 − GDP gap 1 2 3 4 5 6 7 8 Real GDP 59
  60. 60. Chapter 19 Quiz ©2000 South-Western College Publishing 60
  61. 61. 1. The net exports line can be a. positive. b. negative. c. zero. d. any of the above.D. Because net exports equals exports minus imports (X-M), the sign of net exports depends on the values of X and M. 61
  62. 62. 2. There will be unplanned inventory investment accumulation when a. aggregate output (real GDP) equals aggregate expenditures. b. aggregate output (real GDP) exceeds aggregate expenditures. c. aggregate expenditures exceed aggregate output (real GDP). d. firms increase output. B. 62
  63. 63. The Keynesian Aggregate8 Expenditures-Output Model Real Aggregate Expenditures7 Inventory Accumulation AE = Y6 E AE5 )X -M) I+ G+4 C+ Full employment3 +GDP gap2 Inventory Depletion1 Real GDP 1 2 3 4 5 6 7 8 63
  64. 64. 3. John Maynard Keynes proposed that the multiplier effect can correct an economic depression. Based on this theory, an increase in equilibrium output would be created by an initial a. increase in investment. b. increase in government spending. c. decrease in government spending. d. both (a) and (b). e. both (a) an (c) . D. A decrease in government spending is multiplied times the spending multiplier and decreases equilibrium output. 64
  65. 65. 4. The spending multiplier is defined as a. 1/(1 - marginal propensity to consume). b. 1/(marginal propensity to consume). c. 1/(1 - marginal propensity to save). d. 1/(marginal propensity to consume + marginal propensity to save).A. The spending multiplier is also defined as 1/MPS. 65
  66. 66. 5. If the value of the marginal propensity to consume (MPC) is 0.50, the value of the spending multiplier is a. .5. b. 1. c. 2. d. 5.C. Spending multiplier = 1/(1-MPC) =1/(1-0.5) = 1/0.50 = 1/50/100 = 2. 66
  67. 67. 6. If the marginal propensity to consume (MPC) is 0.80, the value of the spending multiplier is a. 2. b. 5. c. 8. d. 10.B. Spending multiplier = 1/(1-MPC =1/(1-0.80) = 1/20/100 = 5. 67
  68. 68. 7. If the marginal propensity to consume (MPC) is 0.75, a $50 billion decrease in government spending would cause equilibrium output to a. increase by $50 billion. b. decrease by $50 billion. c. increase by $200 billion. d. decrease by $200 billion.D. Change in equilibrium output (∆Y) = spending multiplier x change in government spending. Rewritten, ∆Y = 1/ (1-0.75) x -$50 billion = $200 billion = 4 x - $50 billion. 68
  69. 69. 8. If the marginal propensity to consume (MPC) is 0.90, a $100 billion increase in planned investment expenditure, other things being equal, will cause an increase in equilibrium output of a. $90 billion. b. $100 billion. c. $900 billion. d. $1,000 billion. D. Change in equilibrium output (∆Y) = spending multiplier x change in government. Rewritten, ∆Y = 1/(1-0.90) x $100 billion = 10 x $100 billion. 69
  70. 70. The Keynesian Aggregate8 Expenditures-Output Model Real Aggregate Expenditures7 Less than Full employment AE26 AE154 Full employment321 Real GDP 1 2 3 4 5 6 7 8 70
  71. 71. 9. Keynes’ criticism of the classical theory was that the Great Depression would not correct itself. The multiplier effect would restore an economy to full employment if a. government would follow a “least government is the best government” policy. b. government taxes were increased. c. government spending were increased. d. government spending were decreased. C. Keynes’ prescription to cure the Great Depression was for government to play an active role rather than depend on the classical theory that the price system will eventually restore full employment. 71
  72. 72. 10. The equilibrium level of real GDP is $1,000 billion, the full employment level of real GDP is $1,250 billion, and the marginal propensity to consume (MPC) is 0.60. The full-employment target can be reached if government spending is a. increased by $60 billion. b. increased by $100 billion. c. increased by $250 billion. d. held constant.B. Change in real GDP required = spending multiplier x change in government spending (∆G). Rewritten,∆G = 1/(1 - 0.60) x ($1,250 - $1,000)∆G x 2.5 = $250∆G = $100 billion. 72
  73. 73. The Keynesian Aggregate8 Expenditures-Output Model Real Aggregate Expenditures7 MPC = .66 AE654 ∆232 Full Employment1 Real GDP ∆3 1 2 3 4 5 6 7 8 73
  74. 74. 11. In Exhibit 9, the spending multiplier for this economy is equal to a. 1 . b. 2 . c. 3 . d. 5 . B. 1/(1-MPC) = 1/(1-3/5) = 1/2/5 = 5/2 = 2 1/2 74
  75. 75. 12. To close the recessionary gap and achieve full-employment real GDP as shown in Exhibit 9, the government should cut taxes by a. $3/5 trillion. b. $ 1 trillion. c. $2 trillion. d. $3 trillion.C. Change in taxes (T) x tax multiplier = change in real GDP (Y) spending multiplier (SM) = 1/(1-MPC) = 1/(1-3/5) = 1/2/5 = 5/2 tax multiplier = (1-SM) = (1-5/2) = -3/2 T x -3/2 = $3 trillion T = -2/3 x $3 trillion T = $2 trillion 75
  76. 76. Internet ExercisesClick on the picture of the book, choose updates by chapter for the latest internet exercises 76
  77. 77. END 77

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