KEYNES’S MODEL Y4=C44 14+ G4+(X-M?*) (4.1) * Business cycles in Keynes's model are triggered by a change in expectations. Recessions begin with a decrease in business and speculator confidence that reduces stock and other asset prices and also investment demand. This creates a multiplier effect, where lower investment spending reduces aggregate income, which in turn forces households to reduce their spending, which further decreases aggregate income. How will this recession end? * First, it is possible that expectations will rise as people gradually reformulate their expectations as more and better information becomes available. * However, there is no guarantee that expectations and financial markets will quickly rebound during a recession because there is no clear market mechanism that will make this happen. * Second, Keynes believed that wages were not fixed, only sticky. If given enough time, workers will gradually reduce their nominal wage demands as they observe other similar workers taking nominal wage cuts. * This will reduce real wages and move the economy back toward full employment. The problem with this approach, however, is that there are no assurances about how long this process will ghake.* That leaves a third option, which is for the government to attempt to stabilize aggregate demand through the use of monetary or fiscal policy. * If falling aggregate demand causes recessions, then enacting a public policy that increases aggregate demand in a timely manner would minimize both the size and the length of contractions. three policy options available to the government * The first would be for the central bank to increase the money supply. Keynes believed that interest rates are the opportunity cost, or the price, of holding money. * The second option available to the government for increasing aggregate demand during a recession is to cut taxes. * However, when households face economic uncertainty, they tend to save the money from any tax cut and not spend it. * In this case, tax cuts will not significantly increase spending and will not generate large spending multipliers. 53-55/76 * The final option, and the one advocated by Keynes, is for the government to increase the level of its purchases of goods and services. What exactly these purchases are is of less importance than the fact that more government spending will increase aggregate expenditure. Only ———ightly-humorously;-Keynes-suggested-the following: * If the Treasury were to fill old bottles with bank notes, bury them at suitable depths in disused coal mines which are then filled up to the surface with the town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again ... There would be no more unemployment and with the help of the repercussions, the real income of the community would probably become a good deal larger than it is. It would, indged, be more sensible to build housesCONCLUSIONS + Aggregate demand is volatile and is the source of business cycle fluctuations. Output and employment are more volatile than prices and wages in the short run. Following a recession, the return movement of an economy towards its potential output takes place very slowly. Monetary and fiscal policy can be used to stabilize output. Keynesians are more worried about high unemployment than high