keynes and the evolution of macroeconomic theory

7/28/2019 Keynes and the Evolution of Macroeconomic Theory

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To Accompany Economics: Private and Public Choice 11th ed.

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

Slides authored and animated by:

James Gwartney, David Macpherson, & Charles Skipton

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Copyright 2006 Thomson Business and

Economics. All rights reserved.

Keynes and the Evolutionof Macroeconomics

3 11

3 11


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I believe myself to be writing a bookon economic theory which will largely

revolutionizenot, 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)


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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 (now called classical economists)stressed the importance of production and

paid little heed to aggregate demand.

Says Law (named for a nineteenth-century

French economist J. B. Say) was central totheir analysis. Says Law:

The production (supply) of goods creates thepurchasing power (demand) required to

purchase the goods. Hence, deficient totaldemand could never be a problem as theproduction of goods always generates demandsufficient to purchase the goods produced; putanother way, supply creates its own demand.


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MacroeconomicsPrior to the Great Depression

Classical economists believed that markets

would adjust quickly and direct the economytoward full employment. The huge decline inoutput, prolonged unemployment, andlengthy duration of the Great Depression

undermined the classical view and providedthe foundation for Keynesian economics.


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Keynesian Explanationof the Great Depression

Keynesian economicswas developed during

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

for the severe and prolonged unemploymentof the 1930s.

Keynes argued that wages and pr ices werehighly inf lexible, 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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Keynesian Explanationof the Great Depression

Keynesian Viewof spending and output:

Keynes argued that spending inducedbusiness firms to supply goods & services.

Hence, if total spending fell, then firmswould respond by cutting back production.

Less spending would lead 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

>=

keynes and the evolution of macroeconomic theory

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