11.1 Aggregate Demand in Keynesian Analysis

Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports. Consumption changes for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels. Investment changes in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment. Investment also changes when interest rates rise or fall. Government spending and taxes are determined by political considerations. Exports and imports change according to relative growth rates and prices between two economies.

11.2 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 such as a recession; and (b) wages and prices can be sticky, and so, in an economic downturn, unemployment can result. The latter is an example of a macroeconomic externality. Although surpluses cause prices to fall at the micro level, they do not drop necessarily at the macro level; instead, the adjustment to a decrease in demand occurs only through decreased quantities. One reason why prices may be sticky is menu costs, which is the costs of changing prices. These include the internal costs a business faces in changing prices in terms of labeling, recordkeeping, and accounting, and also the costs of communicating the price change to possibly unhappy customers. Keynesians also believe in the existence of the expenditure multiplier—the notion that a change in autonomous expenditure causes a more than proportionate change in GDP.

11.3 The Expenditure-Output or Keynesian Cross 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. Because 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. Equilibrium in the diagram occurs where the aggregate expenditure line crosses the 45° 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.

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. The investment function is drawn as a flat line, showing that investment in the current year does not change with regard to the current level of national income. However, the investment function moves up and down based on the expected rate of return in the future. 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 diagram are taken into account by adjusting the consumption function. The export function is drawn as a horizontal line in the Keynesian cross diagram because exports do not 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.

In a Keynesian cross diagram, 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.

The multiplier effect describes how an initial change in aggregate demand generates several times as much as cumulative GDP. The size of the spending multiplier is determined by three leakages: spending on savings, taxes, and imports. The formula for the multiplier is

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.

11.4 The Phillips Curve

A Phillips curve shows the tradeoff between unemployment and inflation in an economy. From a Keynesian viewpoint, the Phillips curve should slope downward 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.

Keynesian macroeconomics argues that the solution to a recession is expansionary fiscal policy, such as tax cuts to stimulate consumption and investment, or direct increases in government spending that shift the aggregate demand curve to the right. The other side of Keynesian policy occurs when the economy is operating above potential GDP. In this situation, unemployment is low, but inflationary rises in the price level are a concern. The Keynesian response is contractionary fiscal policy, which is to use tax increases or government spending cuts to shift AD to the left.

11.5 The Keynesian Perspective on Market Forces

The Keynesian prescription for stabilizing the economy implies government intervention at the macroeconomic level—increasing aggregate demand when private demand falls and decreasing aggregate demand when private demand rises. This does not imply that the government should be passing laws or regulations that set prices and quantities in microeconomic markets.