the great depression and the keynesian view

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The Great Depression and the Keynesian View



MacroeconomicsPrior to the Great Depression

• Classical economists believed that markets would adjust quickly and direct the economy toward full employment.



Keynesian Explanation of the Great Depression

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

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

• 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

• 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 + Plannedinvestment + Planned

governmentexpenditures

+

The Basic Keynesian Model• In the Keynesian model:

• As Y, consumption , , but by a lesser amount than the increase in income,

• Planned I, G and X are independent of income



Aggregate Consumption Function

3 6 9

Planned consumption(trillions of £)

Real disposable income

(trillions of £s)

6

9

12

3

12

45º

45º line

CDis-saving

Saving

• The Keynesian model assumes as Y D• However, as Y D by a smaller amount. • Thus, the slope of the consumption function (line C) is <than

the slope of the 45° line).



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 in inventories, so,• producers have no reason to either output

during the next period.

Planned aggregateexpenditures = Current

output

Keynesian Equilibrium• According to the Keynesian viewpoint,

equilibrium occurs when:



Total aggregateexpenditures < Current

output


Firms stocks, output, employment

• When

Total aggregateexpenditures > Current

output

Firms output, employment in an effort to restore stocks to their normal levels.

• 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.



AS(real GDP)

AD C NetExports

Tendencyof output

I + G

Recall: Planned Aggregate Expenditures = Planned Consumption plus Planned Investment plus Planned Government Expenditures plus Planned Net Exports.

£9.4 9.7

10.0 10.310.6

£ 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

> =<<

• o/p < AD, expand their output to rebuild their inventories to regular levels.

• o/p > AD, and inventories accumulate. Firms reduce output in order to reduce this build-up of excessive inventories.

• AD = AS there is Keynesian macroeconomic equilibrium.



Aggregate Expenditures

Output(Real GDP -- trillions of £)

45º

Equilibrium(AD = 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 £)





45º


• At output levels below £10.0 trillion (for example 9.7) AD is above the 45° line – expenditures exceed output and thus businesses sell more than they currently produce, diminishing inventories. Businesses expand output.

9.7

AD = C + I + G + X

9.85

Unplanned reductionin inventories






45º


• At output levels above £10.0 trillion (for example 10.3) AD is below the 45° line – output exceeds expenditures and thus businesses sell less than they currently produce, increasing inventories. Businesses reduce output.

10.3

AD = C + I + G X

10.15

Unplanned increasein inventories

9.7

9.85

Unplanned reductionin inventories






45º


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

10.3

AD = C + I + G + X

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)






45º

AD = GDP

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

10.0

10.0

• If consumers, investors, governments, or foreigners spend more and thereby shift AD to AD2, output would reach its full employment potential.


AD1

10.3

AD2

10.3




Keynesian EquilibriumPlanned aggregate expenditures(trillions of £)


45º

AD = GDP

• Once full employment is reached, further increases in AD, such as to AD3, lead only to higher prices – nominal output expands along the black segment of AD (those points beyond the full employment output level at £10.3 trillion) while real output does not.

10.0

10.0


AD1

AD2

10.3

AD3

AS

10.6

10.3



Questions for Thought:1. What determines the

equilibrium rate of output in the Keynesian model? What did Keynes think was the cause of the prolonged, high unemployment during the Great Depression?



Questions for Thought:

2. According to the Keynesian view, which of the following is true?

a) Businesses will produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buy.

b) If planned aggregate expenditures are less than full employment output, output will fall short of its potential.

c) Equilibrium can only occur at the full employment rate of output.




3. Within the framework of the Keynesian model, if the planned expenditures on goods and services were less than current output, a. business firms would reduce their output and lay off workers in the near future.b. the wage rates of workers would decline and thereby help to direct the economy to full employment.



Questions for Thought:4. According to the Keynesian view, which of

the following is true? a) Businesses will produce only the quantity

of goods and services they believe consumers, investors, governments, and foreigners will plan to buy.

b) If planned aggregate expenditures are less than full employment output, output will fall short of its potential.

c) Equilibrium can only occur at the full employment rate of output.




5. Which of the following is the primary source of changes in output within the framework of the Keynesian model? a. changes in aggregate expenditures b. changes in interest rates c. changes in wage rates



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).



effectively, $4 million is spent in the economy.

• Here, a £1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until …

Expenditure stage

Additional income(Pounds)

Marginal propensity to consume

Additional consumption(Pounds)

For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.

1,000,000 750,000 562,500 421,875 316,406 949,219

750,000 562,500 421,875 316,406 237,305 711,914

Round 1 Round 2 Round 3 Round 4 Round 5

Total 4,000,000 3,000,000

All others

3/4 3/4 3/4 3/4 3/4 3/4

3/4

The Multiplier Principle

• The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% = 3/4).



MPCSize of

multiplier9/10

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

• As the MPC increases, more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.).

• The effect is that for higher MPCs, higher multipliers result. Specifically the relationship follows this equation:



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.



Keynesian Viewof the Business Cycle• Keynesians argue that a market economy,

if left to its own devices, is unstable and likely to experience prolonged periods of recession.



• 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 to propel the economy to an inflationary boom.

Keynesian Viewof the Business Cycle



• The Keynesian view argues that wide fluctuations in private investment are a major source of economic instability.

• The theory suggests that a market-directed economy, left to its own devices, will tend to fluctuate between economic recession and inflationary boom.

Keynesian Viewof the Business Cycle



Keynesian Viewof the Business Cycle• 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 would be attained.

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