Introduction

FIGURE 12.1Signs of a RecessionHome foreclosures were just one of the many signs and symptoms of the recent Great Recession. During that time, many businesses closed and many people lost their jobs. (Credit: modification of "Foreclosure" by Taber Andrew Bain/Flickr Creative Commons, CC BY 2.0)

In this chapter, you will learn about:

• Aggregate Demand in Keynesian Analysis
• The Building Blocks of Keynesian Analysis
• The Phillips Curve
• The Keynesian Perspective on Market Forces

BRING IT HOME The Great Recession The 2008–2009 Great Recession hit the U.S. economy hard. According to the Bureau of Labor Statistics (BLS), the number of unemployed Americans rose from 6.8 million in May 2007 to 15.4 million in October 2009. During that time, the U.S. Census Bureau estimated that approximately 170,000 small businesses closed. Mass layoffs peaked in February 2009 when employers gave 326,392 workers notice. U.S. productivity and output fell as well. Job losses, declining home values, declining incomes, and uncertainty about the future caused consumption expenditures to decrease. According to the BLS, household spending dropped by 7.8%. Home foreclosures and the meltdown in U.S. financial markets called for immediate action by Congress, the President, and the Federal Reserve Bank. For example, the government implemented programs such as the American Restoration and Recovery Act to help millions of people by providing tax credits for homebuyers, paying “cash for clunkers,” and extending unemployment benefits. From cutting back on spending, filing for unemployment, and losing homes, millions of people were affected by the recession. While the United States is now on the path to recovery, people will feel the impact for many years to come. What caused this recession and what prevented the economy from spiraling further into another depression? Policymakers looked to the lessons learned from the 1930s Great Depression and to John Maynard Keynes' models to analyze the causes and find solutions to the country’s economic woes. The Keynesian perspective is the subject of this chapter. We have learned that the level of economic activity, for example output, employment, and spending, tends to grow over time. In Economic Growth we learned the reasons for this trend. The Macroeconomic Perspective pointed out that the economy tends to cycle around the long-run trend. In other words, the economy does not always grow at its average growth rate. Sometimes economic activity grows at the trend rate, sometimes it grows more than the trend, sometimes it grows less than the trend, and sometimes it actually declines. You can see this cyclical behavior in Figure 12.2.

FIGURE 12.2U.S. Real Domestic Product, Percent Changes 1930–2020The chart tracks the percent change in Real GDP since 1930. The magnitude of both recessions and peaks was quite large between 1930 and 1945. (Source: Bureau of Economic Analysis, “National Economic Accounts,” https://apps.bea.gov/itable/index.cfm) This empirical reality raises two important questions: How can we explain the cycles, and to what extent can we moderate them? This chapter (on the Keynesian perspective) and The Neoclassical Perspective explore those questions from two different points of view, building on what we learned in The Aggregate Demand/ Aggregate Supply Model. Access multimedia content (http://openstax.org/books/principles-macroeconomics-3e/pages/12-introduction- to-the-keynesian-perspective) Percent Change of U.S. Real Gross Domestic Product.

12.1 Aggregate Demand in Keynesian Analysis

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain real GDP, recessionary gaps, and inflationary gaps
• Recognize the Keynesian AD/AS model
• Identify the determining factors of both consumption expenditure and investment expenditure
• Analyze the factors that determine government spending and net exports

The Keynesian perspective focuses on aggregate demand. The idea is simple: firms produce output only if they expect it to sell. Thus, while the availability of the factors of production determines a nation’s potential GDP, the amount of goods and services that actually sell, known as real GDP, depends on how much demand exists across the economy. Figure 12.3 illustrates this point.

FIGURE 12.3The Keynesian AD/AS ModelThe Keynesian View of the AD/AS Model uses an SRAS curve, which is horizontal at levels of output below potential and vertical at potential output. Thus, when beginning from potential output, any decrease in AD affects only output, but not prices. Any increase in AD affects only prices, not output. Keynes argued that, for reasons we explain shortly, aggregate demand is not stable—that it can change unexpectedly. Suppose the economy starts where AD intersects SRAS at P0 and Yp. Because Yp is potential output, the economy is at full employment. Because AD is volatile, it can easily fall. Thus, even if we start at Yp, if AD falls, then we find ourselves in what Keynes termed a recessionary gap. The economy is in equilibrium but with less than full employment, as Y1 in Figure 12.3 shows. Keynes believed that the economy would tend to stay in a recessionary gap, with its attendant unemployment, for a significant period of time. In the same way (although we do not show it in the figure), if AD increases, the economy could experience an inflationary gap, where demand is attempting to push the economy past potential output. Consequently, the economy experiences inflation. The key policy implication for either situation is that government needs to step in and close the gap, increasing spending during recessions and decreasing spending during booms to return aggregate demand to match potential output. Recall from The Aggregate Supply-Aggregate Demand Model that aggregate demand is total spending, economy-wide, on domestic goods and services. (Aggregate demand (AD) is actually what economists call total planned expenditure. Read the appendix on The Expenditure-Output Model for more on this.) You may also remember that aggregate demand is the sum of four components: consumption expenditure, investment expenditure, government spending, and spending on net exports (exports minus imports). In the following sections, we will examine each component through the Keynesian perspective.

What Determines Consumption Expenditure?

Consumption expenditure is spending by households and individuals on durable goods, nondurable goods, and services. Durable goods are items that last and provide value over time, such as automobiles. Nondurable goods are things like groceries—once you consume them, they are gone. Recall from The Macroeconomic