Keynesian Economics: Aggregate Demand and Income Balance
The Keynesian Model: Role of Aggregate Demand
According to Keynes, high unemployment results from deficient aggregate demand, particularly low investment demand. Marshall argued that knowledge and training could increase workforce skills and prevent poor economic decisions leading to unemployment. Keynes proposed that economic policy actions could raise output and employment by stimulating production and increasing consumer income.
Simple Keynesian Model: Equilibrium Conditions
Equilibrium occurs when production (Y) equals aggregate demand (E): Y = E. Aggregate demand comprises:
- Household consumption (C)
- Desired business investment (I)
- Government demand for goods and services (G)
Equilibrium: Y = E = C + I + G. If Y > E, inventories accumulate, leading to reduced production. If E > Y, inventories decrease, prompting increased production. Equilibrium is achieved when Y = E.
Components of Aggregate Demand
Consumption: The largest component (60-69% of GNP). Keynesian consumption function: C = a + bYd (where Yd is disposable income, a > 0, 0 < b < 1). MPC (marginal propensity to consume) is the slope of this function.
Investment: Keynes considered investment the most variable component of aggregate demand, influenced by interest rates and business expectations. Entrepreneurs face uncertainty and often extrapolate past trends or follow the majority.
Public Expenditure and Taxation: These are policy tools to control the economy and do not depend directly on income levels.
Income Balance Findings
Equilibrium income (Ybar) = (1 / (1 – b)) * (a – bT + I + G). The autonomous spending multiplier (1 / (1 – b)) shows how changes in autonomous spending affect equilibrium income. Income changes mainly result from changes in autonomous components, especially investment.
Changes in Income Balance
The multiplier effect explains how changes in investment affect overall income. An initial investment increase raises demand, leading to increased production and income. This generates new savings equal to the investment increase. The multiplier shows how shocks in one sector transmit throughout the economy. Tax changes also affect equilibrium income, with the tax multiplier being one less in absolute value than the spending multiplier.
Fiscal Policy Stabilization
The government can use fiscal policy (public spending and taxation) to stabilize aggregate demand and income. Increasing public spending or reducing taxes can offset unstable investment. Since the tax multiplier is smaller, a larger tax reduction is needed compared to a spending increase to achieve the same effect.