Lecture Notes: Keynesian Model and Aggregate Expenditure
Overview
Review of the Keynesian model focusing on nominal GDP (output) and aggregate expenditures.
Equilibrium in the Keynesian model occurs when aggregate expenditures equal output.
Disequilibrium:
Output < Equilibrium: Firms see inventory declines, signaling them to produce more.
Output > Equilibrium: Firms see inventory increases, signaling them to produce less.
Problems in the Keynesian Model
When equilibrium output (Y1) is below full employment output (YF), no automatic mechanism exists to reach YF.
Wages and prices are sticky and do not adjust quickly.
Increasing Aggregate Demand
To reach YF, increase aggregate demand (e.g., AE2)
Methods:
Change autonomous components of aggregate expenditures.
Adjust the marginal propensity to consume or import.
Government spending is an effective tool:
Increase or decrease spending/taxes to change aggregate expenditures.
The Multiplier Effect
Initial change in expenditures leads to larger changes in output.
Example: If the marginal propensity to consume is 0.9, a $100 increase in income leads to a $1000 total increase in income due to repeated spending cycles.
Multiplier Formula: 1 / (1 - MPC)
Adjusting the Economy
Government can "micromanage" the economy by adjusting spending/taxes.
Challenges include political difficulty in reducing government spending.
Demand-Driven Model
Output and expenditures equilibrium at different levels.
Over-expansion leads to inflation; under-expansion leads to unemployment.
Comparison with the AD-AS model, where Keynesian assumptions are applied.
Fiscal and Monetary Policy
Fiscal Policy: Changing government spending and taxes to influence aggregate demand.
Monetary Policy: Managing interest rates and the money supply to affect consumption and investment.
Taxation Principles
Benefit Principle: Taxes based on benefits received.
Ability to Pay Principle: Taxes based on income.
Fair taxation requires identical incomes and preferences, which is practically impossible.
Conclusion
Different models (Keynesian and AD-AS) explain different aspects of the economy.
Practical challenges in applying models due to political and economic complexities.