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Keynesian Model


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).


I is autonomous for now. Could go either way.

Government Spending and Taxes

G is exogenous.

A Simple Linear Consumption Function

Suppose C = a + b (Y - T ), where T is an exogenous lump 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 Y. curve and changingModel 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 selfcorrecting. 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


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. (

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.