CHAPTER 11  
 The Keynesian AS/AD MacroEconomic Model

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I.        Keynesian Explanation Of The Great Depression

                A.        Keynesian economics developed during the Great Depression (1930s)

                B.        Keynesian theory provided an explanation for the severe and prolonged unemployment of the 1930s.

                C.        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. 

                D.  Keynesian View of Spending and Output

                        1.                Keynes argued that spending induced business firms to supply goods and services. Thus, if total spending fell, then business firms would respond by cutting back production. Less spending would thus lead to less output.

        II.    Basic Keynesian Model

                A.        Aggregate expenditures = Planned Consumption + Investment + Government Expenditures + Net Exports

                B.    In the Keynesian model, as income expands, consumption increases, but by a lesser amount than the income increase. Both planned investment and government expenditures are independent of income in the Keynesian model. Planned net exports decline as income increases.

        III.   Keynesian Equilibrium 

                A.    In the Keynesian view, equilibrium takes place when planned aggregate expenditures equal the value of current output.  When this is the case, businesses are able to sell the total amount of goods and services that they produce. There are no unexpected changes in inventories. Thus, producers have no reason to either expand or contract their output during the next period.

                B.        When total expenditures are less than current output, business firms will accumulate unplanned additions to inventories that will cause them to cut back on future output and employment. 

                C.        When total expenditures are greater than output, inventories will fall and businesses will respond with an expansion in output in an effort to restore inventories to their normal levels.

                D.        Keynesian Equilibrium can occur at less than full employment. When it does, the high rate of unemployment will persist into the future.

                E.        Aggregate Demand is key to Keynesian model. Keynes believed that weak aggregate demand was the cause of the Great Depression.

        IV.   The Keynesian View Can Be Illustrated Within the AD/AS Framework

                A.        When output is less the full employment, primary impact of an increase in aggregate demand will be an increase in output.

                B.        When output is at or beyond the full employment level, the primary impact of an increase in demand will be higher prices.

        V.    The Multiplier

                A.    The Multiplier: View that a change in autonomous expenditures investment, for example generally leads to an even larger change in aggregate income.

                B.        Spending of one party increases the income of others. Thus, an increase in spending can expand output by a much larger amount.

                C.    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.

                D.    In evaluating the importance of the multiplier, one should remember that (a) taxes and spending on imports will dampen the size of the multiplier; (b) it takes time for the multiplier to work; and (c) the amplified effect on real output will be valid only when the additional spending brings idle resources into production without price changes.

        VI.   The Keynesian View of the Business Cycle

                A.        Keynesian economists argue that a market economy, if left to its own devices, is unstable and likely to experience prolonged periods of recession.

                B.        According to the Keynesian view of the business cycle, upswings and downswings tend to feed on themselves. During a downturn, business pessimism, declining investment, and the multiplier principle combine to plunge the economy further toward recession. During an economic upswing, business and consumer optimism and expanding investment interact with the multiplier principle to propel the economy to an inflationary boom.  The theory suggests that a market‑directed economy, left to its own devices, will tend to fluctuate between economic recession and inflationary boom.

                C.        Regulation of aggregate expenditures is the crux of sound macroeconomic policy according to the Keynesian view. If we could assure aggregate expenditures large enough to achieve capacity output, but not so large as to result in inflation, the Keynesian view implies that maximum output, full employment, and price stability could be attained.

        VII. Evolution of Modern Macroeconomics              

                A.  Major Insights of Keynesian Economics

                        1.                Changes in output, as well as changes in prices, play a role in the macroeconomic adjustment process, particularly in the short run.

                        2.                The responsiveness of aggregate supply to changes in demand will be directly related to the availability of unemployed resources.

                        3.                Fluctuations in aggregate demand are an important potential source of business instability.