Keynes and the Evolution of Macroeconomics

1
Keynes and the Evolution of Macroeconomics

• Chapter 11

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 (1935)
3

• The Great Depression
• and the Keynesian View

4
Macroeconomics Prior to the Great Depression

• Says Law (named for a nineteenth-century French
  economist J. B. Say)
• Says Law 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

• 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.

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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

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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
Planned consumption(trillions of )
45º line
12
9
6
3
45º
Real disposable income(trillions of dollars)
3
6
9
12
Aggregate Consumption Function
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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

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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.

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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.

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Planned aggregateexpenditures
Planned consumption
PlannedNet Exports
Tendencyof output
Planned investment plusgovernment expenditures
Total Output(real GDP)
9.4
9.70
7.1
0.20
2.4
Expand
9.7
9.85
7.3
0.15
2.4
Expand
10.0
10.00
7.5
0.10
2.4
Equilibrium
10.3
10.15
7.7
2.4
Contract
0.05
10.6
10.30
7.9
2.4
Contract
0.00
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Aggregate Expenditures
Planned aggregate expenditures(trillions of )
Equilibrium(AE GDP)
10.0
5.0
45º
Output(Real GDP -- trillions of )
5.0
10.0

• 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.

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Keynesian Equilibrium
Planned aggregate expenditures(trillions of )
Equilibrium(AE GDP)
9.85
45º
Output(Real GDP -- trillions of )
9.7

• 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.

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Keynesian Equilibrium
Planned aggregate expenditures(trillions of )
Equilibrium(AE GDP)
10.15
9.85
45º
Output(Real GDP -- trillions of )
10.3
9.7

• 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.

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Keynesian Equilibrium
Planned aggregate expenditures(trillions of )
Equilibrium(AE GDP)
10.15
10.00
9.85
45º
Output(Real GDP -- trillions of )
10.3
9.7
10.0

• Keynesian equilibrium exists where planned
  expenditures just equal actual output. Here that
  point is at 10.0 trillion.

• Full-employment for this example exists at 10.3
  trillion. In the Keynesian model, macroeconomic
  equilibrium does not necessarily coincide with
  full-employment.

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Keynesian Equilibrium
AE GDP
Planned aggregate expenditures(trillions of )
AE1
10.3
10.0
45º
Output(Real GDP -- trillions of )
10.0
10.3

• 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.

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Keynesian Equilibrium
AE GDP
Planned aggregate expenditures(trillions of )
AE2
AE1
10.3
10.0
45º
Output(Real GDP -- trillions of )
10.0
10.3

• 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.

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• The Multiplier

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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).

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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
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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.

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• The Keynesian View within
• the AD/AS Framework

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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.

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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 due to 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.

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Keynesian Aggregate Supply Curve
LRAS
SRAS
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.

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AD/AS Presentation of the Keynesian Model Polar
Case
LRAS
SRAS
PriceLevel
P2
P1
YF
Y1

• Above are the polar implications of the Keynesian
  model.

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AD/AS Presentation of the Keynesian Model Polar
Case
LRAS
SRAS
PriceLevel
P3
e2
P2
P1
e1
AD2
AD1
YF
Y1

• Increases in demand beyond AD2 (like from AD2 to
  AD3) lead to the higher price level P3, but real
  output remains constant.

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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).

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AD/AS Presentation of the Keynesian Model
Relaxed Case
LRAS
PriceLevel
SRAS
P3
P2
P1
e2
e1
AD2
AD1
YF
Y1
Y3

• An unanticipated increase in AD with output at or
  beyond capacity leads mainly to increases in
  price level (e.g. from AD2 to AD3).

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• Evolution of
• Modern Macroeconomics

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The Evolution of Modern 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.

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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.
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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?
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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?