Keynesian Model

1. Keynesian Model also known as the... Multiplier Model Macro – Unit 3 – part 8

2. 2 primary models that represent our macro-economy: (1) The AS/AD model – which provides us with expected outcomes in general in terms of increases/decreases (2) The Keynesian model / Multiplier model which can make numeric predictions.

3. How much can $50 buy in this economy? $50 $50 $50 3 of 21

4. $50 $50 Let’s say you choose the pedicure. $50 The $50 you spend there is taken by the pedicurist to the Chinese restaurant.

5. $50 $50 $50 Then the chef at the Chinese restaurant takes that same $50 to buy an I-Pod Shuffle.

6. This is the idea behind the Multiplier Model …. $1.00 in expenditures can increase total income for your economy by $4.00 resources G&S Households G&S resources $ $ $ $ $ $ $ Supply Resources Supply G&S $ $ $ Demand Resources Demand G&S Land, Labor, Capital, Entrepreneurship $ $ $ $ $ resources $ $ $ $ $ Firms resources G&S G&S

7. A. Let’s examine...Aggregate expenditures -- total amount of spending on goods & services in the economy. Consists of... Autonomous expenditures (AEO) – expenditures that do not vary with income. We would have spent this money even if we had no income. 1) Induced expenditures – expenditures that change as Y changes. 2) 7 of 21

8. Aggregate Expenditures Function: Aggregate Expenditures autonomous expenditures induced expenditures = + ...represented mathematically.... = AEO mpeY AE +

9. B. We consumers have an mpe - marginal propensity to expend – or mpc - marginal propensity to consume. For each additional dollar we get we can … or

10. 1. Let’s say Anne gets $100 for her birthday and she tends to spend around ¾ of all she gets. .75 Her mpe = .____ Her new expenditures will be $_____ $75 2.mpe = .2 Y = $500 What will be the change in agg expend? $100 3. mpc = .5 Y = $1000 What will be the change in aggregate expenditures? 4. mpc = .8 Y = -$800 What will be the change in aggregate expenditures? $500 -$640

11. C. The marginal propensity to expend is an aggregation of the components of aggregate expenditures. What are the components ....what are our expenditures? C I G X M ____ + ____ + ____ + ( ____ - ____ ) There is a marginal propensity for each of these...mp to import...mp to invest...etc. 11 of 21

12. C I G X M ____ + ____ + ____ + ( ____ - ____ ) The mp of which component is the most important to determine the mpe? mpc = marginal propensity to consume (b/c consumption is the biggest part of expenditures) mps = marginal propensity to save mpc + mps = 1 because when people get additional income they either __________ it or ________ it. spend save

13. Practice 5. mpc = .7 Y = $100 How much of the additional income will the consumer spend? save? Spend $70 Save $30 6. mps = .25 Y = $4000 How much of the additional income will the consumer spend? Spend $3,000 7. mpc = .9 Y = -$1000 What will consumer do? Consumer will cut spending by $900

14. D. Knowing the mpc allows you to calculate what will be the GDP or equilibrium Y for an economy Multiplier Equation equilibrium Y = Multiplier x Autonomous Expenditures Expenditures Multiplier – tells us how much income will change in response to a change in autonomous expenditures If mpe = .5, what is the multiplier? __1___ (1 - mpe) Multiplier = 2

15. Multiplier Equation equilibrium Y = Multiplier x Autonomous Expenditures If the multiplier = 2, autonomous expenditures = $7,000, what is equilibrium Y? $14,000 Practice 8. mpc = .75, autonomous expenditures = $10,000, what is equilibrium Y? $40,000 9. mps = .2, autonomous expenditures = $5,000, what is equilibrium Y? $25,000 15 of 21

16. D. There are multiplier equations for all possible types of spending in an economy …. Investment Multiplier – for when there’s new spending on investment such as new factory, machinery, etc. __1___ (1 - mpc) = Government Spending Multiplier – for when there’s new gov’t spending such as new bridge, school, etc. __1___ (1 - mpc) =

17. Tax Multiplier – for when there’s a change in taxes __mpc___ mps = -- Note … (1) The tax multiplier is always negative. (2) The gov’t spending multiplier & investment multiplier are equal. (3) The tax multiplier has a weaker impact than the gov’t spending multiplier.

18. 10. So if you’re told the government would like to increase spending but not shift _____ thus causing ____________ …. AD inflation Then would the gov’t need to increase taxes or decrease taxes to counteract the increase in gov’t spending? PL LRAS SRAS Increase taxes so cosumers will have less disposable income PL0 AD1 AD YF Y1 Q=realGDP=Y

19. And should the gov’t increase taxes by …. … the same amount … more than the increase in gov’t spending … less than the increase? PL LRAS SRAS PL0 AD1 AD YF Y1 Q=realGDP=Y 19 of 21

20. E. Keynesian Model does not make any consideration of PL; prices are considered constant. There are often questions “what would Keynesian model say about..?” Your answer should not contain PL or inflation.

21. 1. An important assumption in Keynesian theory is that  (A) Prices are rigid downward and decreases in aggregate demand will lead to an increase in unemployment. (B) Prices rigidity will cause downturns in the economy to auto-correct. (C) When aggregate demand is inadequate, prices will fall. (D) When interest rates are high, many businesses borrow money. (E) Changes in the money supply are the major cause of changes in real output and price level Which choices can we rule out automatically? 21 of 21