Keynesian Model

PGDM-HR (2019-20)
Term 2
Instructor: Dr. Ayona Bhattacharjee
Business Cycles

 The level of economic activity, the amount of buying and selling

changes over time
 Business cycle is the study of fluctuations in economic growth around
the trend growth path
 Recession is a period of declining real incomes and rising
unemployment for more than two consecutive quarters in a year
 Depression is a prolonged recession
 Changes can be caused by:
① Household spending decisions
② Firms’ decision making
③ External sources
④ Government policy
⑤ Confidence and expectations

Causes Of Changes In The Business Cycle

 ① Household Spending Decisions
Households decide how much labour to supply
The amount of labour supplied depends in part on the real wage rate

The rate of growth of wages in relation to prices affects consumers’

purchasing power

Households also make decisions based on changes in interest rates, house

prices and taxation
Increases in interest rates may encourage a rise in saving and a reduction in
consumption
People borrow on the strength of the value of their property
Tax rates changes affect different people in different ways
 ② Firms’ Decision Making
If firms face strong demand they are likely to:
increase output
take on more workers
buy more raw materials
Some firms may invest in new equipment and new premises or even
acquire other firms
If productivity levels rise then costs can be lowered and firms can be more
competitive
Firms will respond to changes in inventory levels by expanding or
contracting output as necessary
 ③ External Forces
Movements in exchange rates affect the competitiveness of domestic and
foreign firms through changes in import and export prices

Economic activity abroad can impact countries as consumption and

investment decisions by firms and consumers abroad change

Unpredictable events such as war and natural hazards can have effects
 ④ Government Policy
Governments collect taxes and spend the revenues

Changes in taxation and government spending (including infrastructure

spending) affect the economy

Although independent, central banks have targets to achieve

Changes in interest rates will affect both households and firms and measures
designed to help ease credit flows to business and households
 ⑤ Confidence and Expectations
Households and firms not only make decisions based on current needs but
also on the future

Expectations and confidence of the future shape decisions by firms and

households and can play a significant part in swings in economic activity
Keynesian Theory

 John Maynard Keynes (1883-1946) attributed the fluctuations in the

economy to low aggregate demand

 National income is a function of Aggregate Demand

 Sticky prices and wages
 Excess capacity exists
 Demand side Model
Keynesian Theory
 As per the General Theory of Money, Interest and Employment (1936),

 The more people want to spend -> more goods and services firms can sell -> The more
firms can sell, the more output they will choose to produce -> the more workers they
will choose to hire

 The problem during recessions and depressions, according to Keynes, was inadequate
spending

 Savings is a function of disposable income

Keynesian Theory
 According to Keynes, it was not necessary that a full employment eqm would
always be attained. The economy could remain for long periods in eqm where
there was large scale unemployment and insufficient aggregate demand

 Keynes said that even if full employment were attained, it was not necessarily
a stable situation due to inherent instability in the behaviour of various
components of aggregate expenditure, particularly investment spending

 Investment demand is highly volatile as it depends on a variety of factors such

as expectations of future profits, confidence in the economy, production costs
and animal spirits
 Key terms
 Disposable income

 Autonomous consumption

 Marginal propensity to consume

 Average propensity to consume

 Marginal propensity to save

Simple Closed Economy
 
 Consumption Function:

 Expenditure

 Equilibrium: AE
Multiplier Effect
The multiplier associated with increases in transfer payments is smaller than
that for government spending

Fiscal policy can act as a stabiliser: During recessions, the tax rate can be
lowered or government spending and transfer payments can be increased to
stimulate spending

Progressive tax structure is an automatic stabiliser: during a recession when

income declines, the amount of tax payments and the fall in disposable
income and consumption also fall thus dampening the effect of reduced
expenditure level
Multipliers

Lumpsum
Lumpsumtax taxmultiplier
multiplieris:
is:
DDY/
Y/DDTT==--MPC
MPC//(1
(1--MPC)
MPC)

The
Thegovernment-purchases
government-purchasesmultiplier
multiplieris:
is:
DDY/
Y/DDGG==11++MPC
MPC++MPC
MPC2++MPC
2
MPC3++…
3
…

DDY/
Y/DDGG==11//11--MPC
MPC
Multipliers
 Autonomous expenditure multiplier

 Investment multiplier

 Government expenditure multiplier

 Lumpsum tax multiplier

 Open economy multiplier

There are consequences on other areas of the economy from demand
management that can have long-term effects.
From the mid 1960’s the long term problems emerging in economies
cast doubt on demand management which lost favour.
After Keynes, John Hicks developed a theory that described the links
between the two.

Demand Management
The IS Curve

The IS curve is derived from the Keynesian cross diagram. In panel (a) initial equilibrium is
point a. A fall in the interest rate raises the expenditure line and a new equilibrium occurs at
point b.
 IS Curve
 The IS curve summarizes the relationship between the interest rate and the
level of income in the GM
 Planned investment : I = I (r)
 The IS curve is drawn for a given fiscal policy
 The more responsive are C and I, the flatter is the IS curve
 Changes in fiscal policy that raise the demand for goods and services -> shift
the IS curve to the right
 Changes in fiscal policy that reduce the demand for goods and services ->
shift the IS curve to the left