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Assumptions and Simplifications Use the Keynesian aggregate expenditures model Prices are fixed GDP = DI Begin with private, closed economy Consumption spending Investment spending LO1 11-2

Consumption and Investment Investment Demand Curve Investment Schedule r and i (percent) 8 20 Investment demand curve 20 Investment (billions of dollars) (a) Investment demand curve ID Investment (billions of dollars) 20 Investment schedule 20 I g Real domestic product, GDP (billions of dollars) (b) Investment schedule LO1 11-3

Equilibrium GDP Determination of the Equilibrium Levels of Employment, Output, and Income: A Private Closed Economy (1) Possible Levels of Employment, Millions (2) Real Domestic Output (and Income) (GDP = DI),*Billio ns (3) Consumption (C), (4) Saving (S), (5) Investment (I g ), (6) Aggregate Expenditure (C+I g ), (7) Unplanned Changes in Inventories, (+ or -) (8) Tendency of Employment, Output, and Income (1) 40 $370 $375 $-5 $20 $395 $-25 Increase (2) 45 390 390 0 20 410-20 Increase (3) 50 410 405 5 20 425-15 Increase (4) 55 430 420 10 20 440-10 Increase (5) 60 450 435 15 20 455-5 Increase (6) 65 470 450 20 20 470 0 Equilibrium (7) 70 490 465 25 20 485 +5 Decrease (8) 75 510 480 30 20 500 +10 Decrease (9) 80 530 495 35 20 515 +15 Decrease (10) 85 550 510 40 20 530 +20 Decrease * If depreciation and net foreign factor income are zero, government is ignored and it is assumed that all saving occurs in the household sector of the economy, then GDP as a measure of domestic output is equal to NI,PI, and DI. Household income = GDP LO1 11-4

Equilibrium GDP Aggregate expenditures, C + I g (billions of dollars) 530 510 490 470 450 430 410 390 370 Equilibrium point Aggregate expenditures 45 (C + I g = GDP) C + I g 370 390 410 430 450 470 490 510 530 550 Real domestic product, GDP (billions of dollars) C I g = $20 billion C = $450 billion LO1 11-5

Other Features of Equilibrium GDP Saving equals planned investment Saving is a leakage of spending Investment is an injection of spending No unplanned changes in inventories Firms do not change production LO2 11-6

Changes in Equilibrium GDP Aggregate expenditures (billions of dollars) 510 490 470 450 430 45 Increase in investment 430 450 470 490 510 Real domestic product, GDP (billions of dollars) (C + I g ) 1 (C + I g ) 0 (C + I g ) 2 Decrease in investment LO3 11-7

Adding International Trade Include net exports spending in aggregate expenditures Private, open economy Exports create production, employment, and income Subtract spending on imports X n can be positive or negative LO4 11-8

The Net Export Schedule Two Net Export Schedules (in ) (1) Level of GDP (2) Net Exports, X n1 (X > M) (3) Net Exports, X n2 (X < M) $370 $+5 $-5 390 +5-5 410 +5-5 430 +5-5 450 +5-5 470 +5-5 490 +5-5 510 +5-5 530 +5-5 550 +5-5 LO4 11-9

Net Exports and Equilibrium GDP Aggregate expenditures (billions of dollars) 510 490 470 450 Aggregate expenditures with positive net exports C + I g +X n1 C + I g C + I g +X n2 Aggregate expenditures with negative net exports 430 Net exports, X n (billions of dollars) +5 0-5 45 430 450 470 490 510 Real domestic product GDP (billions of dollars) Positive net exports 450 470 490 Negative net exports X n1 X n2 Real GDP LO4 11-10

International Economic Linkages Prosperity abroad Can increase U.S. exports Exchange rates Depreciate the dollar to increase exports A caution on tariffs and devaluations Other countries may retaliate Lower GDP for all LO4 11-11

Global Perspective Source: World Trade Organization, http://www.wto.org. LO4 11-12

Adding the Public Sector Government purchases and equilibrium GDP Government spending is subject to the multiplier Taxation and equilibrium GDP Lump sum tax Taxes are subject to the multiplier DI = GDP LO4 11-13

Government Purchases and Eq. GDP The Impact of Government Purchases on Equilibrium GDP (1) Real Domestic Output and Income (GDP=DI), (2) Consumption (C), (3) Saving (S), (4) Investment (I g ), (5) Net Exports (X n ), Exports (X) Imports (M) (6) Government Purchases (G), (7) Aggregate Expenditures (C+I g +X n +G), (2)+(4)+(5)+(6) (1) $370 $375 $-5 $20 $10 $10 $20 $415 (2) 390 390 0 20 10 10 20 430 (3) 410 405 5 20 10 10 20 445 (4) 430 420 10 20 10 10 20 460 (5) 450 435 15 20 10 10 20 475 (6) 470 450 20 20 10 10 20 490 (7) 490 465 25 20 10 10 20 505 (8) 510 480 30 20 10 10 20 520 (9) 530 495 35 20 10 10 20 535 (10) 550 510 40 20 10 10 20 550 LO4 11-14

Government Purchases and Eq. GDP Aggregate expenditures (billions of dollars) Government spending of $20 billion 45 470 550 C + I g + X n + G C + I g + X n C Real domestic product, GDP (billions of dollars) LO4 11-15

Taxation and Equilibrium GDP Determination of the Equilibrium Levels of Employment, Output, and Income: Private and Public Sectors (1) Real Domestic Output and Income (GDP=DI), (2) Taxes (T), (3) Disposable Income (DI),, (1)-(2) (4) Consumption (C), (5) Saving (S), (6) Investment (I g ), Export s (X) Import s (M) (7) Net Exports (X n ), (8) Government Purchases (G), (9) Aggregate Expenditures (C+I g +X n +G), (4)+(6)+(7) +(8) (1) $370 $20 $350 $360 $-10 $20 $10 $10 $20 $400 (2) 390 20 370 375-5 20 10 10 20 415 (3) 410 20 390 390 0 20 10 10 20 430 (4) 430 20 410 405 5 20 10 10 20 445 (5) 450 20 430 420 10 20 10 10 20 460 (6) 470 20 450 435 15 20 10 10 20 475 (7) 490 20 470 450 20 20 10 10 20 490 (8) 510 20 490 465 25 20 10 10 20 505 (9) 530 20 510 480 30 20 10 10 20 520 (10) 550 20 530 495 35 20 10 10 20 535 LO4 11-16

Taxation and Equilibrium GDP Aggregate expenditures (billions of dollars) 45 490 550 C + I g + X n + G C a + I g + X n + G $15 billion decrease in consumption from a $20 billion increase in taxes Real domestic product, GDP (billions of dollars) LO4 11-17

Equilibrium versus Full-Employment Recessionary expenditure gap Insufficient aggregate spending Spending below full-employment GDP Increase G and/or decrease T Inflationary expenditure gap Too much aggregate spending Spending exceeds full-employment GDP Decrease G and/or increase T LO5 11-18

Equilibrium versus Full-Employment Aggregate expenditures (billions of dollars) 530 510 490 45 490 510 530 Full employment Real GDP (a) Recessionary expenditure gap AE 0 AE 1 Recessionary expenditure gap = $5 billion LO5 11-19

Equilibrium versus Full-Employment Aggregate expenditures (billions of dollars) 530 510 490 Inflationary expenditure gap = $5 billion AE 2 AE 0 Full employment 45 490 510 530 Real GDP (b) (billions of dollars) LO5 11-20

Application: The Recession of 2007-09 December 2007 recession began Aggregate expenditures declined Consumption spending declined Investment spending declined Recessionary expenditure gap LO5 11-21

Application: The Recession of 2007-09 Federal government undertook Keynesian policies Tax rebate checks $787 billion stimulus package LO5 11-22

Say s Law, Great Depression, Keynes Classical economics Say s Law Economy will automatically adjust Laissez-faire Keynesian economics Cyclical unemployment can occur Economy will not correct itself Government should actively manage macroeconomic instability 11-23

Say s Law Supply creates its own demand. By producing goods and services, firms create a total demand for goods and services equal to what they have produced. Say s law apparently rules out the possibility of a widespread glut of goods.

The Classical view Market industrialized economies are inherently stable and tend automatically to full employment. Government policies that aim to improve the performance of the economy do more harm than good. Laissez-faire.

The Keynesian View Market, industrialized economies are inherently unstable and do not automatically tend to full employment. Private spending (and most importantly, investment spending) is volatile causing business cycle fluctuations. The economy needs to be stabilized, the economy can be stabilized, the economy should be stabilized. Keynesian economics is an attack on the Classical theory. J.M. Keynes