3. Keynesian Model

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Keynesian Model


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INTRODUCTION

John Maynard Keynes was a verypragmatic economist writing in thecontext of the Great Depression.

Many theories have been advancedin his name. Whether he wouldsupport any or all of them remainsan open issue.


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The distinguishing feature of aKeynesian model

The Keynesian Modelis undoubtedly toosimple to be realistic. Compared to theClassical Model, it makes one truly

revolutionary point: First, there can be an equilibrium at less

than full employment.

Second point is that aggregate demandshocks (in the form of changes ininvestment and government spending)can have large effects on output.
http://www.econmacro.com/keynesian/simple_keynesian_model.htmhttp://www.econmacro.com/keynesian/simple_keynesian_model.htm


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Keynesian model Keynesian model allows us to study

this model graphically andnumerically.

We can trace out the effects ofchanges in investment andgovernment spending.

Autonomous Investment

Government Spending

Interest Rates


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An Accounting Identity

The demand for output can bedecomposed as Y = C + I + G.

Income approach and output approach


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Consumption and Saving

Economic behavior. Consumption isa function of income. C = f(Y).


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Investment

I is autonomous for now.

Could go either way.


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Government Spending and Taxes

G is exogenous.


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A Simple Linear Consumption

Function Suppose C = a + b (Y - T ), where T is an

exogenous lump sum tax and a and b areparameters. (b is known as the marginalpropensity to consume.)

Equilibrium

We can solve for Y both graphically (see below)and algebraically.

The solution for equilibrium output is

Y = (1-b)-1 ( a + I + G - bT ).


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The Multiplier

The change in Y for a given changein G is known as the multiplier.

For lump-sum taxes, the multiplierfor G is (1-b)-1. That is, G ismultiplied by (1-b)-1 to determine Y.

Increasing the tax rate t decreasesY.


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The IS/LM Model

Physical Investment

An alternative, more common view is thatthe IS Curve shows those points that are

consistent with C + I + G = C + S + T.

These two views are operationallyequivalent if you take the supply of

loanable funds to be S and the demand tobe I + G - T.

That, is real capital investment is financedby borrowing.


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The IS/LM Model Cont

Savings be a function S(Y) of income, and Investment be a function I(R) of the

interest rate. An increase in income Y causes more

savings. This forces down the interestrate R so that investment increases andthe identity I(R) +G - T = S(Y) ismaintained.

The IS Curve is thus downwardsloping. The increase in income Y causesincreased savings, which drives down theinterest rate and increases investment.


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The AD/AS Diagram

The AggregateSupply/AggregateDemand DiagramRelaxing theassumption thatthe price level isfixed leads to a

more general modelwith an aggregatesupply and demanddiagram.


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Aggregate Demand

Holding M fixed and changing Pchanges the real money supply M/P.

This has the effect of shifting the LMcurve and changing Y.

The Aggregate Demand Curve tracesout the resulting combinations of Yand P.

The IS/MP Model


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The IS/MP Model

The MP Curve shows how

the central bank sets theinterest rate in reaction tothe level of income Y.

The effect of a monetary

policy that changes theinterest rate is fairlyobvious. As the MP curve,which is horizontal, goes

up and down, incomechanges according to theslope of the ISCurve. Fiscal policy, onthe other hand, shifts theIS Curve.


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Keynesian Theory

What is Keynesian Theory? Keynesian Theory or Keynesian Economics

is a Macroeconomic theory based on the ideasof 20th century British economist John Maynard

Keynes. What is the argument in the theory? The theory argues that, Private Sector decisions

sometimes lead to inefficient macroeconomicoutcomes and therefore advocates active policy

responses by the Public Sector, includingMonetary Policyactions by the Central Bankand Fiscal Policy actions by the government tostabilize output over the Business Cycle.
http://en.wikipedia.org/wiki/Macroeconomicshttp://en.wikipedia.org/wiki/Macroeconomicshttp://en.wikipedia.org/wiki/John_Maynard_Keyneshttp://en.wikipedia.org/wiki/John_Maynard_Keyneshttp://en.wikipedia.org/wiki/John_Maynard_Keyneshttp://en.wikipedia.org/wiki/John_Maynard_Keyneshttp://en.wikipedia.org/wiki/Private_sectorhttp://en.wikipedia.org/wiki/Public_sectorhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Public_sectorhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Fiscal_policyhttp://en.wikipedia.org/wiki/Fiscal_policyhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Fiscal_policyhttp://en.wikipedia.org/wiki/Business_cyclehttp://en.wikipedia.org/wiki/Business_cyclehttp://en.wikipedia.org/wiki/Business_cyclehttp://en.wikipedia.org/wiki/Fiscal_policyhttp://en.wikipedia.org/wiki/Central_bankhttp://en.wikipedia.org/wiki/Monetary_policyhttp://en.wikipedia.org/wiki/Public_sectorhttp://en.wikipedia.org/wiki/Private_sectorhttp://en.wikipedia.org/wiki/John_Maynard_Keyneshttp://en.wikipedia.org/wiki/John_Maynard_Keyneshttp://en.wikipedia.org/wiki/Macroeconomics


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Keynesian Theory cont

When and where this theory bepresented?

The theories forming the basis of

Keynesian Economics were firstpresented in The General Theory ofEmployment, Interest and Money,published in 1936 during the period ofGreat Depression.

The interpretations of Keynes arecontroversial and debateable, and severalschool of thoughts claim his legacy.
http://en.wikipedia.org/wiki/The_General_Theory_of_Employment,_Interest_and_Moneyhttp://en.wikipedia.org/wiki/The_General_Theory_of_Employment,_Interest_and_Moneyhttp://en.wikipedia.org/wiki/The_General_Theory_of_Employment,_Interest_and_Moneyhttp://en.wikipedia.org/wiki/The_General_Theory_of_Employment,_Interest_and_Money


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Keynesian Theory cont What Keynesian Economics advocates?

Keynesian Economics advocates a MixedEconomy predominantly related to privatesector, but with a large role of government

and public sector. What was Keynes Point of view in the

Theory?

Keynes basic point was that, economists had

been wrong to assume that they couldunderstand the functioning of the economy asa whole by explaining the workings of itscomponent parts.
http://en.wikipedia.org/wiki/Mixed_economyhttp://en.wikipedia.org/wiki/Mixed_economyhttp://en.wikipedia.org/wiki/Mixed_economyhttp://en.wikipedia.org/wiki/Mixed_economy


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Keynesian Theory cont According to him, If the economy was viewed as a system, it would

become apparent that the root cause of thedepression was an insufficiency in total demand.The level of aggregate income/output and thelevel of employment in a capitalist, freeenterprise economic system, was determinedmainly by the willingness of people to spend. Ascapitalism is an economic system in which themost important means of production is money.

Therefore, if the total amount people wanted tospend was less than the amount which wouldinduce producers to employ all availableresources, the level of income/output would fall.

Wants < Resources = Decrease level of

income/output.


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Keynesian Theory cont Keynes believed that,

There was no automatic mechanism built intothe free enterprise or Capitalist Economicsystem that would cause such a fall to be self-

correcting. However, in this situation,

The economy could become stuck at a less thanfull employment level of production until

something happened to cause people toincrease their spending. But, personal spendingon consumer goods and services could not beexpected to rise when peoples incomes werelow.


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Keynesian Theory cont Another possibility would be that, business

firms might increase their spending on capitalgoods. But, if the outlook for business wasgloomy, as it surely would be in the midst ofa depression, this too seemed unlikely. Evenif the cost of borrowing funds to finance realinvestment was to be reduced to very lowlevels, business expectations of futureearnings from investments might be evenlower.

The theory or model presented by Keynesserved as the economic model during thelatter part of the Great Depression.

The Great Depression.
http://en.wikipedia.org/wiki/Great_Depressionhttp://en.wikipedia.org/wiki/Great_Depressionhttp://en.wikipedia.org/wiki/Great_Depression


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The Great Depression cont

How did it happen? Crash of the stock market created this Great

Depression.

Who was the first country to hit withthis depression?

The first country to hit with this GreatDepression was U.S. where the stock-market prices collapsed on the New YorkStock Exchange in October 1929. This washappened six months earlier before theactual depression started.


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The Great Depression cont What are the results of this Great

Depression? Falling output, i.e., manufacturing output

had fallen to 54 percent by 1932 in US. Rising unemployment, i.e., unemployment

had risen to between 12 and 15 millionworkers, or 25-30 percent of the workforce in US.

Stock market prices during the next threeyears in the US had dropped to only about20 percent of their value in 1929.


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The Great Depression contUnemployed Industrial Workers in US and EU

(Source: www.english.illinois.edu)


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The Great Depression cont What are the main reasons/ causes for this

depression?1. Uneven distribution of income.2. Workers received a relatively small share of the

wealth produced.

3. Taxes were lowered for the upper class.4. World War I also weakened the economy.5. Extremely unstable international banking structure

by the late 1920s.6. Over-supplied international market after World

War I.7. Prices fell and farmers were unable to make a

profit.8. The stock market crash of 1929 specifically had an

impact on the Great Depression.

(ezinearticles.com)


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Application of Keynesian Model

after the Great Depression Keynesian Model served as the economic model

during the World War II (1939 1945), and thepost-war economic expansion (19451973),though it lost some influence following thestagflation of the 1970s, when the inflation rate

and unemployment were too high. Moreover,the arrival of the global financial crisis in 2007has caused resurgence in Keynesian thought.The former British Prime Minister GordonBrown, former President of the United States

George W. Bush, President Barack Obama, andother world leaders have used KeynesianEconomics through government stimulusprograms to attempt to assist the economicstate of their countries.


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3. Keynesian Model