Using the Basic Keynesian Model

The basic Keynesian model illustrates the relationship between planned aggregate expenditures and output in the economy, assuming that the price level is not changing. Short-run equilibrium in the economy is determined where planned aggregate expenditure equals output, or where the planned aggregate expenditure (PAE) line intersects the 45-degree line in the Keynesian cross diagram. Changes in autonomous expenditures shift the PAE line, changing the short-run equilibrium level of output, leading to economic expansions and recessions.

Exploration: How do changes in autonomous spending affect the level of output in the economy?

The applet above illustrates the Keynesian cross diagram and lists the level of planned aggregate expenditure (PAE) at various levels of output (Y). Short-run equilibrium output is determined at the intersection of the PAE line and the 46-degree line in the Keynesian cross diagram or where PAE=Y in the table. If PAE > Y, firms will increase output to match demand and if PAE < Y, firms will reduce the level of output to match demand. Equilibrium occurs where PAE = Y. Changes in autonomous expenditure shift the PAE line, causing PAE to be greater or less than output, and leading to an increase or decrease in output. You can change the values of autonomous expenditure by dragging the sliders with your mouse. Clicking on the "Income Adjustment" button will then show the movement to the new short-run equilibrium level of output. Click the Reset button to restore the original values.

1. What is the initial short-run equilibrium level of output in the economy illustrated in the model above? How do you know? What are the initial levels of consumer expenditures (C), investment (I), government purchases (G), and net exports (NX) at this equilibrium?
   
   
2. The U.S.-led war against Iraq increased U.S. government spending in 2003. According to the basic Keynesian model, what effect would an increase of $100 billion in government spending have on output in the economy?
   
   
3. Restore the original values in the model by clicking on the Reset button. In 2000 and early 2001, investment spending on new capital goods, particularly in high-tech industries, fell dramatically. What effect would a $300 billion drop in autonomous investment have on equilibrium output in the economy, according to the basic Keynesian model?
   
   
4. In question #3, by how much has short-run equilibrium output decreased due to the decrease in autonomous investment spending? From this information, can you determine the value of the multiplier?
   
   
5. Restore the original values in the model by clicking on the Reset button. Reduce autonomous consumption expenditure by $500 billion and determine the new equilibrium level of output. How big is the resulting recessionary gap? By how much does government spending need to increase to eliminate the recessionary gap?
   
   
6. Restore the original values in the model by clicking on the Reset button. Repeat question #5, but this time change taxes to move the economy back to potential output. By how much do taxes need to be changed to reach this goal? Why is the change in taxes (in $) needed to bring the economy back to potential output different from the change in government spending you determined in question #5? Explain.
   
   
7. The U.S. Congress passed tax reduction legislation in the spring of 2003 that significantly reduced taxes for many consumers. Part of the rationale for the tax cut was that it would spur economic growth and help the U.S. economy move out of a recession that began in 2001. According to the basic Keynesian model, is this rationale economically plausible?
   

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