AP AE Model

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AP / AE Model

• The Keynesian Model
• Keynes observed that one of the most important
  determinants of spending is income. As income
  rises, so does spending.

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AP / AE Model
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AP / AE Model

• The Keynesian Model
• In the model, this correlation between income and
  spending is assumed to be relatively stable.

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AP / AE Model

• The Keynesian Model
• Keynes attempted to explain the the causes and
  adjustment process when production (income) and
  expenditures are no longer in equilibrium.

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AP / AE Model

• The AP/AE model attempts to determine the impact
  on the economy that occurs in response to an
  autonomous change in economic conditions.

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AP / AE Model

• An Autonomous change is a change that occurs
  outside the model (not considered by the
  model).
• It is a change in spending that occurs because of
  a change in something other than a change in
  income.

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AP / AE Model

• Autonomous Change in Spending might occur when
• Change in consumption (C) due to change in
  consumer expectations.
• Change in investment spending (I) due to change
  in technological advances or a change in business
  expectations.

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AP / AE Model

• Autonomous Change in Spending might occur when
• Change in governmental spending or taxing
  decisions (Gn).
• Change in exchange rates, or change in economic
  growth in foreign countries (X -M).

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AP / AE Model

• Autonomous Change in Spending
• Induced Change in Spending

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AP / AE Model

• Induced Change in Spending
• A change in total spending that occurs as a
  result of an autonomous change.
• An induced change in spending occurs when income
  changes.

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AP / AE Model
Induced Spending Change
Income
Income
Spending
Spending
0 1000 1000 1000 1900 900 2000 1000 2800
900 3000 1000 3700 900
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AP / AE Model

• Induced Spending
• The impact on total spending will depend upon the
  how much of the change in income is spent and how
  much is saved.

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AP / AE Model

• Marginal Propensity to Expend (mpe)
• The fraction spent from an additional dollar of
  income.
• If income changes by 1,000 and I spend an
  additional 900, then my mpe is

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AP / AE Model

• Marginal Propensity to Save (mps)
• The fraction saved from an additional dollar of
  income.
• If income changes by 1,000 and I save an
  additional 100, then my mps is

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AP / AE Model
mpe mps 1.0 0.9 0.1 1.0
100 of the income must be accounted for
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AP / AE Model

• The Multiplier Effect
• Autonomous change in expenditures
• Changes income levels
• Induced change in expenditures
• Changes income levels again

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AP / AE Model

• Determining the Multiplier
• Multiplier 1 / (1 - mpe)
• Suppose mpe 0.9
• The multiplier 1 / (1 - 0.9)
• The multiplier 1 / 0.1 10

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AP / AE Model

• The Keynesian multiplier
• Gave policy makers something specific to guide
  governmental action.

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AP / AE Model

• Implications of the Multiplier
• The stock market collapsed in October, 1929
• Frightened consumers and businesses cut back on
  consumption and investment (both components of
  expenditures)
• Aggregate expenditures decreased, sending the
  multiplier into action
• Businesses further decreased production which
  lowered income and induced a further decrease in
  aggregate expenditures

Irwin McGraw-Hill
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AP / AE Model

• Keynes solution to the Depression
• If the depression is caused by a decline in
  aggregate expenditures, then the solution is to
  stimulate spending.

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AP / AE Model

• Keynes Solution to the Depression
• Fiscal stimulation would include a massive
  federal government boost in spending, tax cuts,
  or both
• Monetary stimulation would mean an injection of
  money into the economy and lowering of interest
  rates

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AP / AE Model
Application of the Multiplier As economic
advisor to the President you have been asked how
much additional government spending is needed to
raise the GDP by 70billion Suppose mps 0.10
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If mps 0.10, what is the multiplier?
AP / AE Model
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AP / AE Model
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AP / AE Model
C
I
G
X-M
GDP
billions
1929
1933
1945
Source U.S. Dept. of Commerce. Reprinted in The
Economy Today 6th Edition, Shiller, McGraw-Hill
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AP / AE Model
Total G
Federal G
State/Local G
1929
1933
1945
Source U.S. Dept. of Commerce. Reprinted in The
Economy Today 6th Edition, Shiller, McGraw-Hill
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AP / AE Model
Federal Government Spending
1929 1.5 1933 2.1 1945 1.1
74.3 National Defense
Source U.S. Dept. of Commerce. Reprinted in The
Economy Today 6th Edition, Shiller, McGraw-Hill
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AP / AE Model

• The impact of autonomous spending in the economy
  depends upon how close the economy is to its
  full-employment potential level of output.

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AP / AE Model
Keynesian Range A
Intermediate Range B
Classical Range C

Price Level
Real output
Irwin, McGraw-Hill
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AP / AE Model
Range B
Real Expenditure ()
Real Output ()
Q1
Q2
Q1
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AP / AE Model
Keynesian Range A
Intermediate Range B
Classical Range C

Price Level
Real output
Irwin, McGraw-Hill
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AP / AE Model
Range C
AE1
Real Expenditure ()
Potential Output Level
Real Output ()
Q2
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AP / AE Model

• Limitations of Multiplier Model
• Gives us an estimate, not a precise measure, of
  the size of the adjustment in GDP to expect.
• Price level changes affect expenditures and real
  GDP. Changes in price difficult to predict.
• Expectations by consumers and producers of a
  change in policy can alter the impact of the
  policy. (rational expectations model).
• Expenditures depend upon much more than current
  income.