S3M. Keynesian Theory
S3M. Keynesian Theory
S3M. Keynesian Theory
1929
1933
Macroeconomics in the Short Run
US Real GDP Percapita
Classical vs Keynesian Economics
Classical Economics Keynesian Economics:
• Role of Agg Supply in determination • Role of Aggregate Demand in
of Output and Employment determination of Output and Employment
• Assumes perfect competition in both • Assumption of perfect competition in both
output and labour markets labor and output markets is unrealistic.
• Says’ law i.e. supply creates it’s own • Says’ law failed during great depression.
demand, No fluctuations is output . AS≠AD always. In fact fall in AD lead to
AS=AD. Business cycle ( fluctuation in Output)
• Problem of AS • Problem of AD
• Labor is the only factor of production • Apart from Labor other factor of
productions are also important.
• Prices , Wages and Interest Rate are
flexible. • Prices, Wages & Interest Rates are Sticky.
• Long run Analysis. • Everything is in short run.
• LRAS is Vertical • SRAS is Upward sloping
• No Role of Govt. • Active Role of Govt.
• No Role of Money • Active Role of Money.
Keynesian Premises
J.M Keynes assumes that some Prices, Wages and Interest rates are fixed in the
short-run. It implies that some markets need not clear.
Equilibrium: AD=AS
• According to
Keynesian theory, in a
depressed economy
an increase in
aggregate spending
can increase output
without raising prices.
a. Aggregate Supply Functions/Curve
Aggregate Supply : The total supply of goods and services in an
economy which the economy produces by utilizing all its resources.
It depends on productivity.
Production Function: Y = f (K , N )
Where K is capital, fixed in short run
N is labor, variable in short run
Price Level
LRASC
SRASC
Output ( GDP)
b. Aggregate Demand of Income Curve
Aggregate Demand: Aggregate Demand Curve is the total demand curve (
aggregate expenditure) of all economic agent. It is negatively related with the price
level and hence slope down ward from left to right.
AD=C+I+G+(X-M)
P2
Y1 Y2
A. The Product Market Equilibrium: AD=AS
with Fixed vs.Flexible Prices
SRAS
According to Keynes, any change in AD will change Real GDP, thus output is demand determined.
Price level doesn’t change
B.
The Factor (Labour) Market Equilibrium
B. Labor Market Equilibrium
Labor Market in the Keynesian Sticky Wage Model
Nd= f( Money Wage rate ,W). They are
Involuntary negatively related. Nd is MRPL=W
Unemployment
Ns= f(Money Wage rate, W).They are
positively related. But due to rigid wage rate,
labour supply curve is perfectly elastic.
E F
Money wages are rigid or inflexible in the
downward direction, but they are flexible, in
G the upward direction due to (a) money illusion,
(b)trade union
Money Or Cash
Bond
C. Financial(Money) Market
Equilibrium: Md=Ms
i2 Liquidity trap
i1
Md (Y1, i)
M Ms, Md
Determination of Equilibrium
Level of Income and Output
AD(=AD) Y=E
E2
E1
450
Y1 Y2 AS(=AY)
3. Business Sector:
a. No corporate saving
b. No retain earning
4. All Prices are Fixed in Short-run: Sticky Price, Wage, and interest
rate.
I 0<MPC<1
2. Savings Functions: S = Y-C
=Y-C0-c*Y
=-C0+s*Y
Y S = - C0 + s * Y
where s= 1-c
-Co = Autonomous Saving
s = Marginal propensity to save out of income (MPS)
S= Saving
Equilibrium: Income and Output Determination
0<c<1 OR 0<MPC<1
Income and Output Determination :
Savings and Investment Approach
Agg Demand: Y= C + I
=> Y-C= I
Agg Supply: Y=C+S………………. Savings function
=> Y-C= S
=> S=I
Thus Agg Demand= Agg Supply implies Equilibrium
C+I=C+S
Since I= I0 i.e. Investment is fixed
Substituting S, we get
S=-C0+(1-c)*Y
=> I0 =-C0+(1-c)*Y
=> Y=(1/1-c)*C0+I0
S=I0 exposed or realized Only
S≠I0 exante or planned
Consumption and Saving Schedules: A
Hypothetical Case
Time Levels of GDP APC= APS= MPC= MPS=
( Year) or Y C=200+cY S=Y-C C/Y S/Y dC/dY 1-MPC
1990 100 275 -175 2.75 -1.75 0.75 0.25
1991 200 350 -150 1.75 -0.75 0.75 0.25
1992 300 425 -125 1.42 -0.42 0.75 0.25
1993 400 500 -100 1.25 -0.25 0.75 0.25
1994 500 575 -75 1.15 -0.15 0.75 0.25
1995 600 650 -50 1.08 -0.08 0.75 0.25
1996 700 725 -25 1.04 -0.04 0.75 0.25
1997 800 800 0 1.00 0.00 0.75 0.25
1998 900 875 25 0.97 0.03 0.75 0.25
1999 1000 950 50 0.95 0.05 0.75 0.25
2000 1100 1025 75 0.93 0.07 0.75 0.25
2001 1200 1100 100 0.92 0.08 0.75 0.25
2002 1300 1175 125 0.90 0.10 0.75 0.25
2003 1400 1250 150 0.89 0.11 0.75 0.25
1st 100.00
=> ΔY=ΔC+ ΔI
Given C= C0+c*Y
=> C+ΔC= C0+c(Y+Δ Y)
=> ΔC= c ΔY
Substituting ΔC in above model
=> ΔY= cΔ Y + Δ I 1
Y 1 is called as
=>ΔY(1-c)= Δ I = =
I 1− c 1− c investment multiplier
Uses and Limits of the Multiplier
Limitations
a. Multiplier process works only when there is adequate availability of consumer goods.
b. Full value of multiplier is achieved only when various increments in investments are
repeated at regular intervals.
c. The full value of the multiplier can be achieved only when there is no change in the MPC
during the process of income propagation.
Applications
“Savings is a virtue”
Given:
AD = C + I + G+X-M
C = C0 + c * Yd
Yd=Y-T
T=T0+t*Y
I = I0, G=G0 , GTr=GT0>0 , X=X0,
M =M0+ m*Y
Now C= C0 + c * (Y-T0-t*Y+GT0)