John M. Keynes emphasized the importance of aggregate demand in determining the overall level of output in the economy. If spending decreases due to pessimism on the part of consumers and investors, business will respond by cutting output. At this point, the argument is precisely the same as that used in the classical AD/AS model. But the classical AD/AS model depends on a subsequent reduction in resource prices to restore long-run equilibrium, namely a reduction in wages. Keynes, however, felt that resource prices, especially wages, were highly inflexible in a downward direction. Hence, in Keynes' view, the economy would languish for an extended period of time with high unemployment.

The Keynesian equilibrium occurs when spending is equal to output. Since extreme downward price rigidity is present, prices do not play a role in the Keynesian Aggregate Expenditure Model. Hence, if demand is slack, “there are no automatic forces capable of assuring full employment.” Instability in the Keynesian model is driven from the demand side of the economy. The main sources of economic instability are consumer spending, private investment, and government expenditures.

b: Explain the major components of the Keynesian model.

Planned consumption is determined primarily by disposable income. As income rises, consumption will also rise. However, the rise in consumption will not be on a one-to-one basis with income since a portion of each additional dollar is saved.

Planned investment (I) and government spending (G) are assumed to be autonomous or given in this model. They are not directly related to income. Therefore, a change in one of these variables will shift the aggregate expenditure (AE = C + I + G + NX) schedule up or down by the amount of the change. Planned net exports decrease as income increases.

Planned expenditures must be distinguished from actual expenditures. If actual consumer expenditures turn out to be less than planned (below the equilibrium level), actual inventory investment will be greater than planned (unplanned inventory investment is positive), employees will be laid-off and output will fall. Since inventories are considered investment, the above argument shows that investment is the primary source of economic instability.

c: Explain Keynesian macroequilibrium.

A key point to remember is that this equilibrium can occur away from the full employment rate of output and that it is spending which drives this equilibrium. Hence, if the economy is operating at less than full employment, only additional spending can drive the economy back to full employment.

If equilibrium output is less than the economy's full employment capacity, how can the economy reach its full employment capacity? It can be reached only by an increase in aggregate expenditures. AE shifts from AE1 to AE2 as expenditures increase.

d: Define and calculate the marginal propensity to consume and the expenditure multiplier.

The proportion of each additional dollar of income spent on personal consumption is called the marginal propensity to consume (MPC). Mathematically: MPC = additional consumption divided by additional income.

Assume you receive an additional $1,000 payment. You consume some of it ($1,000 x MPC) and save the rest. What happens to the amount you spent? It represents someone else's additional income ($1,000 x MPC). They will spend some [($1,000 x MPC) x MPC] and save the rest. This process continues indefinitely. You can see that the original $1,000 of income expands or is multiplied into more than $1,000 of total income for the economy.

The amount of the expansion is called the expenditures multiplier and is equal to: M = 1/(1 - MPC)

Therefore, if investment spending increases by $1,000, total spending will increase by M x $1,000.

The multiplier shows why small changes in C, I, or G can cause large changes in output. This is the key to the multiplier concept.

e: Explain the importance of the expenditure multiplier within the framework of the Keynesian model.

The proportion of each additional dollar of income spent on personal consumption is called the marginal propensity to consume (MPC). Mathematically: MPC = additional consumption divided by additional income.

Assume you receive an additional $1,000 payment. You consume some of it ($1,000 x MPC) and save the rest. What happens to the amount you spent? It represents someone else's additional income ($1,000 x MPC). They will spend some [($1,000 x MPC) x MPC] and save the rest. This process continues indefinitely. You can see that the original $1,000 of income expands or is multiplied into more than $1,000 of total income for the economy.

The amount of the expansion is called the expenditures multiplier and is equal to: M = 1/(1 - MPC)

Therefore, if investment spending increases by $1,000, total spending will increase by M x $1,000.

The multiplier shows why small changes in C, I, or G can cause large changes in output. This is the key to the multiplier concept.

f: Discuss the Keynesian view of the business cycle.

Assume there is an increase in aggregate demand (perhaps from higher incomes abroad or an increase in consumer or business optimism). The multiplier magnifies the increased demand. The higher demand leads to income growth. The income growth leads to additional consumption and growing business sales. This leads to declining inventories, so businesses expand their output. Unemployment declines and the economy experiences a boom. Eventually, the economy reaches full employment, which constrains additional growth. As growth slows, consumers and businesses become less optimistic and cut back on their expenditures. The multiplier magnifies the reduced expenditures. Business inventories begin to build, and so businesses cut back on production and people are laid off. Some businesses begin to experience bankruptcy.

Keynes thought that the primary problem was wide fluctuations in private investment. He also thought that recessions would be long because lower interest rates and falling resource prices are sufficient to offset the decline in incomes and spending.

2.A: Fiscal Policy

a: Explain the process by which fiscal policy affects aggregate demand and aggregate supply.

The Keynesian argument recommends increased spending to push the economy back to full employment. Expansionary fiscal policy is precisely this kind of increased spending. Either reducing taxes or increasing spending will expand the budget deficit. Weak demand (AD1) causes an output level of GDP1 and a price level of P1. Expansionary fiscal policy bypasses the traditional adjustment path and increases demand from AD1 to AD2. The result would be increased output (GDPf) and higher prices (P2).

Restrictive fiscal policy works in the opposite way. The result of restrictive fiscal policy is lower prices and reduced output. Countercyclical policy is a combination of expansionary and restrictive fiscal policy designed to smooth output fluctuations brought on by the business cycle. For example, in the Keynesian world, if the economy is in a recession, a planned budget deficit is enacted. Conversely, if the economy is operating above full employment (boom), a planned budget surplus is enacted.