Keynesian Model

INTRODUCTION

John Maynard Keynes was a very

pragmatic economist writing in the
context of the Great Depression.
Many theories have been advanced
in his name. Whether he would
support any or all of them remains
an open issue.

The distinguishing feature of a

Keynesian model

The Keynesian Model is undoubtedly too

simple to be realistic. Compared to the
Classical Model, it makes one truly
revolutionary point:
First, there can be an equilibrium at less
than full employment.
Second point is that aggregate demand
shocks (in the form of changes in
investment and government spending) can
have large effects on output.

Keynesian model

Keynesian model allows us to study this

model graphically and numerically.
We can trace out the effects of changes
in investment and government
spending.
Autonomous Investment
Government Spending
Interest Rates

An Accounting Identity

The demand for output can be

decomposed as Y = C + I + G.
Income approach and output approach

Consumption and Saving

Economic behavior. Consumption is

a function of income. C = f(Y).

Investment

I is autonomous for now.

Could go either way.

Government Spending and Taxes

G is exogenous.

A Simple Linear Consumption

Suppose C = a + b (Y - T ), where T is an
exogenous lump Function
sum tax and a and b are
parameters. (b is known as the marginal
propensity 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 ).

The Multiplier

The change in Y for a given change

in G is known as the multiplier.
For lump-sum taxes, the multiplier
for G is (1-b)-1. That is, G is
multiplied by (1-b)-1 to determine Y.
Increasing the tax rate t decreases
Y.

The IS/LM Model

Physical Investment

An alternative, more common view is that

the IS Curve shows those points that are
consistent with C + I + G = C + S + T.
These
two
views
are
operationally
equivalent if you take the supply of loanable
funds to be S and the demand to be I + G T.
That, is real capital investment is financed
by borrowing.

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 interest rate
R so that investment increases and the
identity I(R) +G - T = S(Y) is
maintained.
The IS Curve is thus downward sloping.
The increase in income Y causes increased
savings, which drives down the interest
rate and increases investment.

The AD/AS Diagram

The Aggregate
Supply/Aggregate
Demand Diagram
Relaxing the
assumption that the
price level is fixed
leads to a more
general model with
an aggregate
supply and demand
diagram.

Aggregate Demand

Holding M fixed and changing P

changes the real money supply M/P.
This has the effect of shifting the LM
The IS/MP Model
curve and changing
Y.
The Aggregate Demand Curve traces
out the resulting combinations of Y
and P.

The IS/MP Model

The MP Curve shows how the
central bank sets the interest
rate in reaction to the level of
income Y.
The effect of a monetary
policy that changes the
interest rate is fairly obvious.
As the MP curve, which is
horizontal, goes up and down,
income changes according to
the slope of the IS Curve.
Fiscal policy, on the other
hand, shifts the IS Curve.

Keynesian Theory

What is Keynesian Theory?

Keynesian Theory or Keynesian Economics
is a Macroeconomic theory based on the ideas
of 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 macroeconomic
outcomes and therefore advocates active policy
responses by the Public Sector, including
Monetary Policy actions by the Central Bank
and Fiscal Policy actions by the government to
stabilize output over the Business Cycle.

Keynesian Theory cont

When and where this theory be

presented?
The theories forming the basis of
Keynesian Economics were first
presented in The General Theory of
Employment, Interest and Money,
published in 1936 during the period of
Great Depression.
The interpretations of Keynes are
controversial and debateable, and several
school of thoughts claim his legacy.

Keynesian Theory cont

What Keynesian Economics advocates?

Keynesian Economics advocates a Mixed
Economy predominantly related to private
sector, 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 could
understand the functioning of the economy as a
whole by explaining the workings of its
component parts.

Keynesian Theory cont

According to him,
If the economy was viewed as a system, it would
become apparent that the root cause of the depression
was an insufficiency in total demand. The level of
aggregate income/output and the level of employment
in a capitalist, free enterprise economic system, was
determined mainly by the willingness of people to
spend. As capitalism is an economic system in which
the most important means of production is money.
Therefore, if the total amount people wanted to spend
was less than the amount which would induce
producers to employ all available resources, the level of
income/output would fall.
Wants < Resources = Decrease level of income/output.

Keynesian Theory cont

Keynes believed that,

There was no automatic mechanism built into the
free enterprise or Capitalist Economic system
that would cause such a fall to be self-correcting.
However, in this situation,
The economy could become stuck at a less than
full employment level of production until
something happened to cause people to increase
their spending. But, personal spending on
consumer goods and services could not be
expected to rise when peoples incomes were low.

Keynesian Theory cont

Another possibility would be that, business

firms might increase their spending on capital
goods. But, if the outlook for business was
gloomy, as it surely would be in the midst of a
depression, this too seemed unlikely. Even if
the cost of borrowing funds to finance real
investment was to be reduced to very low
levels, business expectations of future earnings
from investments might be even lower.
The theory or model presented by Keynes
served as the economic model during the latter
part of the Great Depression.
The Great Depression.

The Great Depression

What is Great Depression?

The Great Depression was an economic
slump in North America, Europe, and other
industrialized areas of the world that began
in 1929 and lasted until about 1939. It was
the longest and most severe depression
ever experienced by the industrialized
Western world.
When did it happen?
Start Date: October 29, 1929
End Date: until about 1939

The Great Depression cont

How did it happen?

Crash of the stock market created this Great
Depression.

Who was the first country to hit with

this depression?
The first country to hit with this Great
Depression was U.S. where the stockmarket prices collapsed on the New York
Stock Exchange in October 1929. This was
happened six months earlier before the
actual depression started.

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 million
workers, or 25-30 percent of the work
force in US.
Stock market prices during the next three
years in the US had dropped to only about
20 percent of their value in 1929.

The Great Depression cont

Unemployed Industrial Workers in US and EU

(Source: www.english.illinois.edu)

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)

Application of Keynesian Model

after the Great Depression

Keynesian Model served as the economic model

during the World War II (1939 1945), and the
post-war economic expansion (19451973),
though it lost some influence following the
stagflation of the 1970s, when the inflation rate
and unemployment were too high. Moreover, the
arrival of the global financial crisis in 2007 has
caused resurgence in Keynesian thought. The
former British Prime Minister Gordon Brown,
former President of the United States George W.
Bush, President Barack Obama, and other world
leaders have used Keynesian Economics through
government stimulus programs to attempt to
assist the economic state of their countries.