The Simple Keynesian Model and Its Policy Implications - Essay Example

The simple Keynesian model and its policy implications Introduction: John Maynard Keynes was a great economist who developed his theory at the background of the Great Depression of 1930. It was felt during the Great Depression and afterwards that the self-adjusting economic theory is failing to pull the global economy out of the depression. Something else had to be done; some added help to the adjustment process is needed. Keynes identified that added help as strict government intervention and considering a closed economy formulated his model for economic equilibrium. Keynes considered a closed economy because at that point of time, government intervention was the prime needs to stabilize the economy and role of the government gets severely distorted under an open economy. The following is a very simple representation of his theory known as the Simple Keynesian Model. For the above-mentioned model we assume that the aggregate price level is fixed. The Simple Keynesian Model The central idea of Keynesian model is the output to be at the equilibrium level, it has to be equated with the aggregate demand. If ‘Y’ stands for total output, that is, the GDP and ‘E’ equals the aggregate demand, then equilibrium condition requires: Y = E (1) The aggregate demand or the desired expenditures on output is a summation of household consumption or ‘C’, desired business investment demand or ‘I’, and government expenditure or ‘G’ (government expenditure is nothing but the government sector’s demand for goods and services). Incorporating all these components into the equilibrium condition, the equilibrium condition can be written as: Y = E= C + I + G (2) Now, national income or ‘Y’ in general can be decomposed into three parts – one part of the national income gets consumed (C), one part gets paid in taxes (T) and the rest is saved (S). So we may write: Y ≡ C + S + T (3) Again, as Y is the national product, so it is equivalent to the summation of consumption, realized investment (Ir) and government spending in we may write: Y ≡ C + Ir + G (4) Equating equation (2) and (3), we may write: C + S+ T ≡ Y = C + I + G Or, S + T = I + G (canceling out C from both the sides) Similarly, equating (2) and (4), we may write: C + Ir + G ≡ Y = C + I + G Or, Ir = I (canceling out C and G from both the sides) So, the equilibrium condition for output in Simple Keynesian Model is desired business investment equal to realized investment. At any disequilibria situation, (Ir – I) will either be greater than or less than zero. Ir and I may differ in the following ways. Case 1: Level of output ‘Y’ (Y ≡ C + Ir + G) exceeds the level of aggregate demand ‘E’ (E= C + I + G) Therefore, we have: Y>E Or, C + Ir + G > C + I + G Or, Ir>I In the above case, (Ir-I) represents the unintended inventory accumulation. This is the amount by which the total output level surpasses the aggregate demand and will result in the unsold output that exceeds the level of desired inventory of the firms. Case 2: Aggregate demand exceeds the total output level Therefore, we have: E>Y Or, C + Ir + G < C + I + G Or, Ir0) and ‘b’ is the marginal propensity to consume. The marginal propensity to consume implies the rise in consumption due to per unit rise in disposable income. ‘b’ is always less than one and greater than zero (0 Read More