Keynes and the Evolution of Macroeconomics

Chapter 11

“ 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)

The Great Depression and the Keynesian View

Macroeconomics Prior to the Great Depression

• Say’s Law (named for a nineteenth-century French economist J. B. Say) – Say’s Law:

“supply creates its own demand.”

MacroeconomicsPrior 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.

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.

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.

The Basic Keynesian Model

Aggregate expenditures =

PlannedNet

ExportsPlanned

consumption+ Planned

investment+

Plannedgovernmentexpenditures

+

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.

3 6 9

Planned consumption(trillions of $)

Real disposable income

(trillions of dollars)

6

9

12

3

12

45º

45º line

C

Dis-saving

Saving

Aggregate Consumption Function

Total output(real GDP in trillions)

Planned exports(trillions)

Planned imports(trillions)

Planned net exports (trillions)

$1.2 1.2 1.2 1.2 1.2

$9.4 $1.00 9.7 1.05 10.0 1.10 10.3 1.15 10.6 1.20

$0.20 0.15 0.10 0.05 0.00

Income and Net Exports

• 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.

Keynesian Equilibrium

• 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.

Planned aggregateexpenditures = Current

output

Keynesian Equilibrium• According to the Keynesian viewpoint,

equilibrium occurs when:

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.

Total Output(real GDP)

Planned aggregateexpenditures

Planned consumption

PlannedNet Exports

Tendencyof output

Planned investment plusgovernment expenditures

$ 9.4 9.7

10.0

10.3

10.6

$ 9.70 9.85

10.00

10.15

10.30

$7.1 7.3

7.5

7.7

7.9

$0.20 0.15

0.10

0.05

0.00

$2.4 2.4

2.4

2.4

2.4

Expand Expand

Equilibrium

Contract

Contract > > =<<

Aggregate Expenditures

Output(Real GDP -- trillions of $)

45º

Equilibrium(AE = GDP)

• 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.

5.0

5.0

10.0

10.0

Planned aggregate expenditures(trillions of $)

Keynesian Equilibrium

Output(Real GDP -- trillions of $)

45º

Equilibrium(AE = GDP)

• 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.

9.7

AE = C + I + G + NX

9.85

Unplanned reductionin inventories

Planned aggregate expenditures(trillions of $)

Keynesian Equilibrium

Output(Real GDP -- trillions of $)

45º

Equilibrium(AE = GDP)

• 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.

10.3

AE = C + I + G + NX

10.15

Unplanned increasein inventories

9.7

9.85

Unplanned reductionin inventories

Planned aggregate expenditures(trillions of $)

Keynesian Equilibrium

Output(Real GDP -- trillions of $)

45º

Equilibrium(AE = GDP)

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

10.3

AE = C + I + G + NX

10.15

9.7

9.8510.00

10.0

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

Keynesianequilibrium

Full Employment(potential GDP)

Planned aggregate expenditures(trillions of $)

Keynesian Equilibrium

Output(Real GDP -- trillions of $)

45º

AE = GDP

• If equilibrium is less than its capacity, only an increase in expenditures (shift AE) can lead to full employment output.

10.0

10.0

• If consumers, investors, governments, or foreigners spend more and thereby shift AE to AE2, output would reach its full employment potential.

Full Employment(potential GDP)

AE1

10.3

AE2

10.3

Planned aggregate expenditures(trillions of $)

Keynesian EquilibriumPlanned aggregate expenditures(trillions of $)

Output(Real GDP -- trillions of $)

45º

AE = GDP

• 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.

10.0

10.0

Full Employment(potential GDP)

AE1

AE2

10.3

AE3

AS

10.6

10.3

The Multiplier

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).

MPCSize of

multiplier

9/10 4/5 3/4 2/3 1/2 1/3

10.0 5.0 4.0 3.0 2.0 1.5

M = 1

1 - MPC

A Higher MPCMeans a Larger Multiplier

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.

The Keynesian View withinthe AD/AS Framework

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.

• 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.

Keynesian Aggregate Supply CurvePriceLevel LRAS

YF

P1

SRAS

Goods & Services(real GDP)

Full Employment(potential GDP)

Keynesian range

• This flat range is referred to as the Keynesian range. Output here is entirely dependent on the level of aggregate demand.

Keynesian Aggregate Supply Curve

PriceLevel LRAS

YF

P1

SRAS

Goods & Services(real GDP)

Full Employment(potential GDP)

Keynesian range

• 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.

AD/AS Presentation of theKeynesian Model: Polar Case

PriceLevel LRAS

YF

P1

SRAS

Goods & Services(real GDP)

• Above are the polar implications of the Keynesian model.

AD1

P2 = e1

Y1

AD2

e2

AD/AS Presentation of theKeynesian Model: Polar Case

PriceLevel LRAS

YF

P1

SRAS

Goods & Services(real GDP)

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

AD2AD1

e2e1P2 =

P3

Y1

AD3

e3

LRAS

AD/AS Presentation of theKeynesian Model: Relaxed Case

PriceLevel

P1

SRAS

Goods & Services(real GDP)

• This Keynesian model relaxes the assumptions regarding complete short-run price and output inflexibility beyond YF.

AD1

e1

Y1

AD2

P2

Relaxed assumptions:SRAS now turns from horizontal to vertical more gradually.

YF

• An unanticipated increase in AD with output below capacity leads mainly to increases in output (e.g. from AD1 to AD2).

e2

LRAS

AD/AS Presentation of theKeynesian Model: Relaxed Case

PriceLevel

YF

P1

Goods & Services(real GDP)

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

AD2AD1

e2e1

P2

Y1

AD3

P3

Y3

SRAS

e3

Evolution of Modern Macroeconomics

The Evolution ofModern 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.

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.

Questions for Thought:3. According to the Keynesian view, market

economies are relatively unstable because ofa. 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?

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?