The Keynesian Model in ActionTo complete the Keynesian model by adding the government and the foreign sector

Government spending an autonomous expenditure because government spending can be the result of political decisions regardless of national output

1.00

0.75

0.50

0.25

1 2 3 4

1.25

1.50

1.75

5 6 7 8 9 10Real GDP

Government Spending

Re

al G

ov

ern

me

nt

sp

en

din

g

G1

G2Government

Spending

1.00

0.75

0.50

0.25

1 2 3 4

1.25

1.50

1.75

5 6 7 8 9 10Real GDP

Positive Net Exports

Rea

l N

et E

xpo

rts

Negative Net Exports

(X-M)2

(X-M)1

(X-M)Zero Net Exports

Autonomous Net Exports

Equilibrium is the point toward which the economy tends

In the Keynesian model, equilibrium level of GDP is where the value of goods and services produced is equal to the spending for these goods and services

Aggregate Expenditures or AE = C + I + G + (X-M)

Aggregate Expenditures affect the economy by pulling aggregate output either higher or lower toward equilibrium

Excessive Inventories causes a decrease in real GDP and employment as firms cut back production and lay off workers in order to not add inventory

Inventory depletion causes an increase in GDP and employment

When inventories decline too much firms will increase production and hire more workers to meet the demand for their product

The aggregate expenditures-output model determines the equilibrium level of real GDP by the intersection of aggregate expenditures and aggregate output

6

4

3

2

1

1 2 3 4

5

6

7

5 6 7 8

Aggregate Expenditures-Output Model

AE = Y

AE

Real GDP

Inventory Depletion

C + I + G + (X-M)

Inventory Accumulation

Rea

l Ag

gre

gat

e E

xpen

dit

ure

s

GDP gap

Full employment

The aggregate expenditure curve must be shifted upward until the full-capacity output of $6 trillion is reached

Spending Multiplier: Any initial increase in spending will lead to a multiple increase in GDP

Initial increase in government

spending

Operates through a multiplier

Larger increase in real GDP

Multiplier Effect of a Change in Spending

4

3

2

1

1 2 3 4

5

6

7

5 6 7 8

AE1

Real GDP

AE2

Rea

l Ag

gre

gat

e E

xpen

dit

ure

s

Full employment

AE = Y

Multiplier Effect

Spending Change

Spending multiplier effect: Any initial change in spending causes a chain reaction of more spending

Round

1

2

Spending

$500

$250

$125

$63

$62

$1,000

3

4

All other rounds

Total spending

Marginal Propensity to Consume (MPC) is the change in consumption spending resulting from a given change in income

4

3

2

1

1 2 3 4

5

6

7

5 6 7 8

AE

Real GDP

Rea

l Agg

rega

te E

xpen

ditu

res

2

4

MPC = C

Y = 2

4 = .5

Marginal Propensity to Save (MPS) is the fraction of any change in real disposable income that households save

MPC + MPS = 1where

(1 – MPC)

Multiplier formula

when MPC = 0.8

1 M = =

MPS1

(1 – 0.8)

1 M = =

0.2

1= 5

MPC, MPS, and the Spending Multiplier

MPC

105

MPS

4

3

2

1.5

Spending Multiplier

.90

.80

.75

.67

.50

.33

.10

.20

.25

.33

.50

.67

4

3

2

1

1 2 3 4

5

6

7

5 6 7 8

Multiplier Effect of a Change in Spending

AE1

Real GDP

1 trillion dollars

AE2

.5 trillion dollars

Rea

l Agg

rega

te E

xpen

ditu

res AE = Y MPC = 1/2

GDP gap is the difference between full employment real GDP and actual real GDP

A recessionary gap is the amount by which aggregate expenditures fall short of the amount required to achieve full employment equilibrium

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3

2

1

1 2 3 4

5

6

7

5 6 7 8

Recessionary Gap

AE1

Real GDP

AE2

- GDP gapRea

l Agg

rega

te E

xpen

ditu

res

Full employment

AE = Y

Keynesian remedy for a recessionary gap is to increase autonomous spending by the amount of the recessionary gap

• Increase government spending• Lower taxes• Raise transfer payments

Government can close a recessionary gap

An inflationary gap is the amount by which aggregate expenditures exceed the amount required to achieve full employment equilibrium

4

3

2

1

1 2 3 4

5

6

7

5 6 7 8

Inflationary Gap

Real GDP

AE1

+ GDP gapRea

l Agg

rega

te E

xpen

ditu

res

AE2

Full employment

AE = Y

Reduce spending by the amount of the inflationary gap

Keynesian remedy for an inflationary gap

• Cut government spending• Increase taxes• Reduce transfer payments

Government can close an inflationary gap