Keynesian vs Classical Macroeconomic Model

8/22/2019 Keynesian vs Classical Macroeconomic Model

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To Accompany Economics: Private and Public Choice 10th ed.

James Gwartney, Richard Stroup, Russell Sobel, & David Macpherson

Slides authored and animated by:

James Gwartney, David Macpherson, & Charles Skipton

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Macro Only Text

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Keynesian Foundationsof Modern Macroeconomics

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3 11


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I believe myself to be writing a book oneconomic theory which wil l largely

revolutionizenot, I suppose, at once

but in the course of the next ten years

the way the world thinks about economicproblems.

-- John Maynard Keynes


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The Great Depressionand the Keynesian View


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MacroeconomicsPrior to the Great Depression

Prior to the Great Depression of the 1930s,

economists (they are now called classicaleconomists) stressed the importance of

production and paid little heed to aggregatedemand. Says Law (named for nineteenth-

century French economist J. B. Say) wascentral to their analysis.

Says Law:

The production (supply) of goods creates the

purchasing power (demand) required to purchasethe goods. Hence, general overproduction isimpossible because supply creates its own

demand.


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MacroeconomicsPrior to the Great Depression

Classical economists believed thatmarkets would adjust quickly anddirect the economy toward fullemployment. The huge decline in

output, prolonged unemployment,and lengthy duration of the GreatDepression undermined the classical

view and provided the foundationfor Keynesian economics.


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Keynesian Explanationof the Great Depression Keynesian economicsdeveloped during the

Great Depression (1930s). Keynesian theory provided an explanation for

the severe and prolonged unemployment of the1930s.

Keynes argued that wages and prices werehighlyinflexible, particularly in a downwarddirection. Thus, he did not think changes in

prices and interest rates would direct theeconomy back to full employment.


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Thomson Learning. All rights reserved.

Keynesian Explanationof the Great Depression

Keynesian Viewof spending andoutput:

Keynes argued that spendinginduced business firms to supply

goods & services. Hence, if total spending fell, then

firms would respond by cutting backproduction. Less spending wouldlead to less output.


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The Basic Keynesian Model


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Aggregateexpenditures =

PlannedNet

Exports

Plannedconsumption

+ Plannedinvestment

+Planned

governmentexpenditures

+

The Basic Keynesian Model In the Keynesian model:

as income expands, consumption increases,

but by a lesser amount than the increase inincome,

both planned investment and governmentexpenditures are independent of income, and,

planned net exports decline as incomeincreases.




Aggregate Consumption Function

3 6 9

Planned consumption(trillions of $)

Real disposableincome

(trillions of dollars)

6

9

12

3

12

45

45 line

C

Dis-saving

Saving

The Keynesian model assumes that there is a positiverelationship between consumption and income.

However, as income increases, consumption increases by asmaller amount. Thus, the slope of the consumption function

(line C) is less than 1 (less than the slope of the 45 line).




Total output(real GDP in trillions)

Planned exports(trillions)

Planned imports(trillions)

Planned net exports(trillions)

$1.2

1.21.21.21.2

$9.4 $1.00

9.7 1.0510.0 1.1010.3 1.1510.6 1.20

$0.20

0.150.100.05

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 amountof goods & services that they produce, and,

there are no unexpected changes ininventories, so,

producers have no reason to either expand orcontract their output during the next period.

Planned aggregateexpenditures =

Currentoutput

Keynesian Equilibrium According to the Keynesian viewpoint,

equilibrium occurs when:




Total aggregateexpenditures

Current

output

inventories fall and businesses respond withan expansion in output in an effort to restoreinventories to their normal levels.

When


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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 unemploymentwill persist into the future.

Aggregate demandis key to the Keynesianmacroeconomic model.

Keynes believed that weakaggregate demandwas the cause of the Great Depression.


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Total Output(real GDP)

Planned aggregateexpenditures

Plannedconsumption

PlannedNet Exports

Tendencyof output

Planned investment plusgovernment expenditures

Recall: Planned Aggregate Expenditures = Planned Consumption plusPlanned Investment

plusPlanned Government Expenditures plusPlanned Net Exports.

$ 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>

An Example of Keynesian Equilibrium

>=

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Keynesian vs Classical Macroeconomic Model