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The Great Depression and the Keynesian View

The Great Depression and the Keynesian View. Macroeconomics Prior 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.

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The Great Depression and the Keynesian View

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  1. The Great Depression and the Keynesian View

  2. Macroeconomics Prior to the Great Depression • Classical economists believed that markets would adjust quickly and direct the economy toward full employment.

  3. 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.

  4. 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.

  5. The Basic Keynesian Model

  6. Plannedgovernmentexpenditures Aggregate expenditures Plannedconsumption Plannedinvestment = + + + 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 PlannedNetExports

  7. Saving C Dis-saving Aggregate Consumption Function Planned consumption(trillions of £) 45º line 12 9 6 3 45º Real disposable income(trillions of £s) 3 6 9 12 • 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).

  8. Keynesian Equilibrium

  9. Planned aggregateexpenditures Currentoutput = Keynesian Equilibrium • According to the Keynesian viewpoint, equilibrium occurs when: • 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.

  10. Total aggregateexpenditures Currentoutput < Total aggregateexpenditures Currentoutput > Keynesian Equilibrium • When Firms  stocks,  output,  employment • When Firms  output,  employment in an effort to restore stocks to their normal levels.

  11. 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.

  12. < < = > > An Example of Keynesian Equilibrium AD Net Exports C I + G Tendencyof output AS(real GDP) £9.4 £ 9.70 £7.1 £2.4 £0.20 Expand 9.7 9.85 7.3 2.4 0.15 Expand 10.0 10.00 7.5 2.4 0.10 Equilibrium 10.3 10.15 7.7 2.4 Contract 0.05 10.6 10.30 7.9 2.4 Contract 0.00 Recall: Planned Aggregate Expenditures = Planned Consumption plus Planned Investmentplus Planned Government Expenditures plus Planned Net Exports. • 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.

  13. Aggregate Expenditures Planned aggregate expenditures(trillions of £) Equilibrium(AD= GDP) 10.0 5.0 45º Output(Real GDP -- trillions of £) 5.0 10.0 • 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.

  14. Unplanned reductionin inventories AD = C + I + G + X Keynesian Equilibrium Planned aggregate expenditures(trillions of £) Equilibrium(AD= GDP) 9.85 45º Output(Real GDP -- trillions of £) 9.7 • 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.

  15. Unplanned increasein inventories Unplanned reductionin inventories AD = C + I + G X Keynesian Equilibrium Planned aggregate expenditures(trillions of £) Equilibrium(AD= GDP) 10.15 9.85 45º Output(Real GDP -- trillions of £) 9.7 10.3 • 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.

  16. Keynesianequilibrium AD = C + I + G + X Full Employment(potential GDP) Keynesian Equilibrium Planned aggregate expenditures(trillions of £) Equilibrium(AD= GDP) 10.15 10.00 9.85 45º Output(Real GDP -- trillions of £) 10.0 10.3 • Keynesian equilibrium exists where planned expenditures just equal actual output. Here that point is at £10.0 trillion. 9.7 • Full-employment for this example exists at £10.3 trillion. In the Keynesian model, macroeconomic equilibrium does not necessarily coincide with full-employment.

  17. AD2 Full Employment(potential GDP) Keynesian Equilibrium AD= GDP Planned aggregate expenditures(trillions of £) AD1 10.3 10.0 45º Output(Real GDP -- trillions of £) 10.0 10.3 • If equilibrium is less than its capacity, only an increase in expenditures (shift AD) can lead to full employment output. • If consumers, investors, governments, or foreigners spend more and thereby shift AD to AD2, output would reach its full employment potential.

  18. AS AD3 10.6 Full Employment(potential GDP) Keynesian Equilibrium AD= GDP Planned aggregate expenditures(trillions of £) AD2 AD1 10.3 10.0 45º Output(Real GDP -- trillions of £) 10.0 10.3 • 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.

  19. Questions for Thought: • 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?

  20. Questions for Thought: • According to the Keynesian view, which of the following is true? • Businesses will produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buy. • If planned aggregate expenditures are less than full employment output, output will fall short of its potential. • Equilibrium can only occur at the full employment rate of output.

  21. Questions for Thought: • 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.

  22. Questions for Thought: • According to the Keynesian view, which of the following is true? • Businesses will produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buy. • If planned aggregate expenditures are less than full employment output, output will fall short of its potential. • Equilibrium can only occur at the full employment rate of output.

  23. Questions for Thought: • 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

  24. The Multiplier

  25. 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).

  26. 3/4 3/4 3/4 3/4 3/4 3/4 3/4 The Multiplier Principle Expenditure stage Additional income(Pounds) Additional consumption(Pounds) Marginal propensity to consume Round 1 1,000,000 750,000 562,500 Round 2 750,000 Round 3 562,500 421,875 421,875 316,406 Round 4 316,406 237,305 Round 5 949,219 711,914 All others Total 4,000,000 3,000,000 For simplicity (here) it is assumed that all additions to income are either spent domestically or saved. • 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). • Here, a £1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent … etc. … until … effectively, $4 million is spent in the economy.

  27. 1 M= 1 - MPC A Higher MPC Means a Larger Multiplier Size of multiplier MPC 9/10 10.0 4/5 5.0 3/4 4.0 2/3 3.0 1/2 2.0 1/3 1.5 • 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:

  28. 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.

  29. Keynesian View of 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.

  30. Keynesian View of the Business Cycle • 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.

  31. Keynesian View of 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.

  32. Keynesian View of 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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