Welcome to the power of macroeconomics. The purpose of this lesson is to illustrate the basic Keynesian model arguably one of the most important models in macroeconomic history. In this lecture we will also introduce you to one of the most important tools in macroeconomics, that of fiscal policy. >> In macroeconomics the basic Keynesian model goes by many names. Some economists refer to it as the multiplier model. While others call it the aggregate production aggregate expenditures model. Throughout this lecture, we will use these names interchangeably, as we show you how the development and application of the basic Keynesian model gave birth to fiscal policy. Fiscal policy involves the use of Government expenditures or tax changes to stimulate or contract an economy. The basic Keynesian Model provides a very straight-forward approach to using fiscal policy to close a recessionary gap. At least in theory, this model may be used to calculate very precisely how much government expenditures must be increased. Or alternatively, how much taxes must be cut to stimulate an economy back to full employment. Note however, that while we shall present this model in the very mechanical way that it was taught at universities in the 1960s, macroeconomics is hardly as simple as the Keynesian model would suggest. Harsh reality, that economists learned in the 1970s with the emergence of a virulent stagflation. We'll talk much more about stagflation and the complexities of macroeconomics later. For now, let's try to master the simple Keynesian model and the use of fiscal policy. If you were to sit down tonight and read John Maynard Keynes's famous little book, the General Theory of Employment, Interest and Money. You would find little in that book resembling today's basic textbook Keynesian model. How Keynes's arcane prose was transformed into an easily-understood algebraic and graphical model is a story in and of itself. Involving two key figures, professors Alvin Hansen and Paul Samuelson. Alvin Hansen was a textbook writer and classical economist who, in the mid nineteen thirties left the University of Wisconsin to take a post at Harvard. As the story goes, somewhere on the train between Madison and Cambridge, Hansen converted to the Keynesian faith. At Harvard, Hansen led a seminar that became an important cauldron of ideas for the Keynesian doctrine. And Hansen also took regular trips to Washington D.C. to spread the Keynesian gospel to the nations policymakers. Perhaps most importantly, Hansen wrote A Guide to Keynes, which became the bible for economic students in the 1950s. While Hansen's star pupil, Paul Samuelson began writing what would become the definitive macroeconomic textbook for more than three decades. Out of these writings has emerged the basic Keynesian model. The most important assumption underlying this model is that prices are fixed. Keynes himself didn't believe this believe this, of course. But Keynes did believe that when an economy is in the recessionary range, prices and wages were sufficiently inflexible. So that income would adjust much faster than prices. Therefore, for simplicity, price changes could be assumed away. The beauty of this fixed price assumption is that it allowed Hansen and Samuelson to develop a Keynesian aggregate production-aggregate expenditures model. Readily distinguishable from the aggregate supply-aggregate demand model that we developed in the last lecture. This figure illustrates the Keynesian model. The vertical axis measures total spending or aggregate expenditures. The horizontal axis measures real GDP or output. And there is a 45 degree line that measures aggregate production. In addition there is an aggregate expenditures curb that is calculated by totaling consumption plus investment plus government spending plus net exports. Note that equilibrium in this model will occur where the aggregate expenditure and aggregate production curves cross. Note also, that this equilibrium doesn't necessarily have to occur at the economy's full potential output, Q sub P. For example, if equilibrium occurs at, say, Q sub R, actual output is below potential output Q sub P. And the economy is experiencing a recessionary gap. If however the economy is at Q sub I actual out put exceeds potential out put and there is an inflationary gap. One useful way of thinking about these recessionary and inflationary gaps is through the concept of leakages versus injections. Let's do this now within the context of our now familiar circular flow diagram. Recall that in this diagram the flow of income moves from right to left at the top of the figure and represents aggregate supply. Now a leakage, is income not directly spent on domestic output but rather is diverted from the circular flow. And one important leakage we discussed within the context of Say's law occurs when consumers save a portion of their income. But remember, that this savings leakage might be offset by an investment injection. Where an injection is an addition of income to the circular flow. This figure lists the various leakages and injections in the macro economy. The broader point here is that any particular macroeconomic equilibrium will depend on the balance between these injections and leakages. Of those listed in the figure, consumer savings and business investment are the primary sources of imbalances in a totally private and closed economy. But in an economy with a government sector, taxes represent an important leakage while government spending is a crucial injection. Same time, in an open economy where trading occurs, import leakages and export injections are likewise very important in determining actual output. Here then is an updated version of our circular flow diagram that allows for both trade and a government sector. Take a few minutes to study it. As you do so remember that our next task is to understand how each of the components of the Keynsian model are constructed. And then learn how fiscal policy can be used to close a recessionary or inflationary gap.
