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. 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. What percent of GDP is
Government and the
Foreign sector?
About 17% of GDP
4
5. 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
5
6. Autonomous Government Spending
2.00
Real Government spending
Trillions of $ per year
1.75 Government Spending
1.50 G1
1.25
1.00
0.75
0.50 G2
Government Spending
0.25 Real GDP
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
6
7. 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.
7
8. 2.00 Autonomous Net Exports
Trillions of $ per year
1.75 Real Net Exports Positive Net Exports
1.50 (X-M)2
1.25
1.00 (X-M)
Zero Net Exports
0.75
0.50 (X-M)1
Negative Net Exports
0.25 Real GDP
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
8
9. What does the term
Equilibrium mean?
In the Keynesian model,
the equilibrium is the
point toward which the
economy tends
9
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. What can pull Aggregate
Expenditures higher or lower
in Keynesian economics?
Aggregate expenditures
C + I + G + (X-M)
11
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. What causes a
decrease in Real GDP
and Employment?
Unplanned inventory
investment accumulation
13
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. What causes an
increase in Real GDP
and Employment?
Unplanned inventory
investment depletion
15
16. 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
16
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. The Keynesian Aggregate
8 Expenditures-Output Model
Real Aggregate Expenditures
7 Inventory Accumulation AE = Y
6
E AE
5 )X -M)
I+ G+
4 C+ Full employment
3
+GDP gap
2 Inventory Depletion
1 Real GDP
1 2 3 4 5 6 7 8
18
19. 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
19
20. The Keynesian Aggregate
8 Expenditures-Output Model
Real Aggregate Expenditures
7 Less than Full employment AE2
6 AE1
5
4 Full employment
3
2
1 Real GDP
1 2 3 4 5 6 7 8
20
21. What is the
Keynesian Multiplier?
Any initial increase in
spending will lead to a
multiple increase in GDP
21
22. The Keynesian Aggregate
8 Expenditures-Output Model
Real 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. Larger
increase in
aggregate
expenditures
Operates
through a
Initial multiplier
increase in
governmen
t spending
23
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. The Keynesian Aggregate
8 Expenditures-Output Model
Real 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. What is the Marginal
Propensity to Consume?
MPC is the change in
consumption spending
resulting form a given
change in income
26
27. What is the Marginal
Propensity to Save?
MPS is the fraction of any
change in real disposable
income that households save
27
34. What is the GDP Gap?
The difference between
full employment real
GDP and actual real GDP
34
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. The Keynesian Aggregate
8 Expenditures - Output
Real 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. What is the Keynesian
remedy for a
Recessionary Gap?
Increase autonomous
spending by the amount
of the recessionary gap
37
38. What can the
Government do to close
a Recessionary Gap?
• Increase government
spending
• Lower taxes
• Raise transfer payments
38
39. What is an
Inflationary Gap?
The amount by which
aggregate expenditures
exceed the amount
required to achieve full
employment equilibrium
39
40. The Keynesian Aggregate
8 Expenditures - Output
Real 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. What is the Keynesian
remedy for an
Inflationary Gap?
Reduce autonomous
spending by the amount
of the inflationary gap
41
42. How can the Government
close an Inflationary Gap?
• Cut government spending
• Increase taxes
• Reduce transfer payments
42
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. 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. 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
48. The Keynesian argues that the
economy is inherently unstable and
may require government intervention
to control aggregate expenditures and
restore full employment. 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
49. Government spending and net
exports can be treated as autonomous
expenditures in the Keynesian model.
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.
49
50. Autonomous Government Spending
2.00
Real Government spending
Trillions of $ per year
1.75 Government Spending
1.50 G1
1.25
1.00
0.75
0.50 G2
Government Spending
0.25 Real GDP
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
50
51. 2.00 Autonomous Net Exports
Trillions of $ per year
1.75 Real Net Exports Positive Net Exports
1.50 (X-M)2
1.25
1.00 (X-M)
Zero Net Exports
0.75
0.50 (X-M)1
Negative Net Exports
0.25 Real GDP
Trillions of $ per year
1 2 3 4 5 6 7 8 9 10
51
52. The Keynesian aggregate
expenditures-output model
determines the equilibrium level of
real GDP by the intersection of the
aggregate expenditures and the
aggregate output and income
schedules. Each equilibrium level in
the economy is associated with a
level of employment and
corresponding unemployment rate.
52
53. Aggregate expenditures and
real GDP are equal, graphically,
where the AE = C + I + G + (X-M)
line intersects the 45-degree line. At
any output greater or less than the
equilibrium real GDP, unintended
inventory investment pressures
businesses to alter aggregate output
and income until equilibrium at full-
employment real GDP is restored.
53
54. The Keynesian Aggregate
8 Expenditures-Output Model
Real Aggregate Expenditures
7 Inventory Accumulation AE = Y
6
E AE
5 (X -M)
I+ G+
4 C+ Full employment
3
+GDP gap
2 Inventory Depletion
1 Real GDP
1 2 3 4 5 6 7 8
54
55. The spending multiplier is the
ratio of the change in equilibrium
output to the initial change in any of
the components of aggregate
expenditures. Algebraically, the
multiplier is the reciprocal of the
marginal propensity to save. The
multiplier effect causes the
equilibrium level of real GDP to
change by several times the initial
change in spending.
55
56. A recessionary gap is the amount
by which aggregate expenditures fall
short of the amount necessary for the
economy to operate at full-employment
real GDP. To eliminate a positive GDP
gap, the Keynesian solution is to
increase autonomous spending by an
amount equal to the recessionary gap
and operate through the multiplier to
increase equilibrium output and
income.
56
57. The Keynesian Aggregate
8 Expenditures - Output
Real 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. An inflationary gap is the amount
by which aggregate expenditures
exceed the amount necessary to
establish full-employment equilibrium
and indicates upward pressure on prices.
To eliminate a negative GDP gap, the
Keynesian solution is to decrease
autonomous spending by an amount
equal to the inflationary gap and operate
through the multiplier to decrease
equilibrium output and income .
58
59. The Keynesian Aggregate
8 Expenditures - Output
Real 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
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. 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. The Keynesian Aggregate
8 Expenditures-Output Model
Real Aggregate Expenditures
7 Inventory Accumulation AE = Y
6
E AE
5 )X -M)
I+ G+
4 C+ Full employment
3
+GDP gap
2 Inventory Depletion
1 Real GDP
1 2 3 4 5 6 7 8
63
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. 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. 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. 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. 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. 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. The Keynesian Aggregate
8 Expenditures-Output Model
Real Aggregate Expenditures
7 Less than Full employment AE2
6 AE1
5
4 Full employment
3
2
1 Real GDP
1 2 3 4 5 6 7 8
70
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. 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. The Keynesian Aggregate
8 Expenditures-Output Model
Real Aggregate Expenditures
7
MPC = .66 AE
6
5
4 ∆2
3
2 Full Employment
1 Real GDP
∆3
1 2 3 4 5 6 7 8
73
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. 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
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