Textbook Media Press. CH 27 Taylor: Principles of Economics 3e 1

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1 CH 27 Taylor: Principles of Economics 3e 1

2 The Building Blocks of Keynesian Analysis Keynesian economics is based on two main ideas: a) aggregate demand is more likely than aggregate supply to be the primary cause of a short-run economic event like a recession because aggregate supply usually moves slowly; b) wages and prices can be sticky, and so in an economic downturn unemployment can result. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 2

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4 Menu Costs Menu costs are the costs of changing prices. They include internal costs a business faces in changing prices in terms of labeling, record keeping, and accounting, and also the costs of communicating the price change to (possibly unhappy) customers. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 4

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6 The Components of Aggregate Demand The aggregate demand curve will shift based on movements in consumption, investment, government spending or taxes, exports, and imports. Consumption will change for a number of reasons, including movements in income, taxes, expectations about future incomes, and changes in wealth levels. Investment will change in response to its expected rate of return, which in turn is shaped by the real interest rate, the creation of new technologies, expectations about future economic growth, the price of key inputs, and tax incentives for investment. Government spending and taxes are determined by political considerations. Exports and imports change according to relative growth rates and prices between two economies. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 6

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8 The Phillips Curve A Phillips curve shows the trade-off between unemployment and inflation in an economy. From a Keynesian viewpoint, the Phillips curve should slope down so that higher unemployment means lower inflation, and vice versa. However, a downward-sloping Phillips curve is a short-term relationship that may shift after a few years. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 8

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12 Keynesian Macroeconomic Policy Keynesian macroeconomic policy suggests that aggregate demand should be increased (shifted to the right) when the economy is in recession, and decreased (shifted to the left) when the economy faces a situation of high inflation. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 12

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14 The Expenditure-Output Model The expenditure-output model or Keynesian cross diagram shows how the level of aggregate expenditure (on the vertical axis) varies with the level of economic output (shown on the horizontal axis). Since the value of all macroeconomic output also represents income to someone somewhere else in the economy, the horizontal axis can also be interpreted as national income (Y). The equilibrium in the diagram will occur where the aggregate expenditure line crosses the 45-degree line, which represents the set of Textbook Media Press CH 27 Taylor: Principles of Economics 3e 14

15 The Expenditure-Output Model The expenditure-output model or Keynesian cross diagram shows how the level of aggregate expenditure (on the vertical axis) varies with the level of economic output (shown on the horizontal axis). Since the value of all macroeconomic output also represents income to someone somewhere else in the economy, the horizontal axis can also be interpreted as national income (Y). The equilibrium in the diagram will occur where the aggregate expenditure line crosses the 45-degree line, which represents the set of points where aggregate expenditure in the economy is equal to output (or national income). Equilibrium in a Keynesian cross diagram can happen at potential GDP, or below or above that level. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 15

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17 Consumption as a Function of National Income The consumption function shows the upward-sloping relationship between national income and consumption. The marginal propensity to consume (MPC) is the amount consumed out of an additional dollar of income. A higher marginal propensity to consume means a steeper consumption function; a lower marginal propensity to consume means a flatter consumption function. The marginal propensity to save (MPS) is the amount saved out of an additional dollar of income. It is necessarily true that MPC + MPS = 1. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 17

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19 Investment as a Function of National Income The investment function is drawn as a flat line, showing that investment in the current year doesn t change with regard to the current level of national income. However, the investment function will move up and down based on the expected rate of return in the future. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 19

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21 Government Spending and Taxes as a Function of National Income Government spending is drawn as a horizontal line in the Keynesian cross diagram because its level is determined by political considerations, not by the current level of income in the economy. Taxes in the basic Keynesian cross model are taken into account by adjusting the consumption function. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 21

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24 Exports and Imports as a Function of National Income The export function is drawn as a horizontal line in the Keynesian cross diagram because exports don t change as a result of changes in domestic income, but they move as a result of changes in foreign income, as well as changes in exchange rates. The import function is drawn as a downward-sloping line because imports rise with national income, but imports are a subtraction from aggregate demand. Thus, a higher level of imports means a lower level of expenditure on domestic goods. The marginal propensity to import (MPI) can be changed by movements in exchange rates. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 24

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26 Equilibrium in the Keynesian Cross Model In a Keynesian cross diagram, the equilibrium may be at a level below potential GDP, which is called a recessionary gap, or at a level above potential GDP, which is called an inflationary gap. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 26

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30 The Multiplier Effect The multiplier effect describes how the impact of an original change in aggregate demand is multiplied as it cycles repeatedly through the economy. The size of the multiplier is determined by three leakages: spending on savings, taxes, and imports. The multiplier is defined as: Textbook Media Press CH 27 Taylor: Principles of Economics 3e 30

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33 Multiplier Trade-offs: Stability vs. the Power of Macroeconomic Policy An economy with a lower multiplier is more stable it is less affected either by economic events or by government policy than an economy with a higher multiplier. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 33

34 Is Keynesian Economics Pro-Market or Anti-Market? The Keynesian macroeconomic prescription for adjusting aggregate demand higher or lower, as needed, need not imply that the government should be passing laws or regulations that set prices and quantities in microeconomic markets. Textbook Media Press CH 27 Taylor: Principles of Economics 3e 34