KeynesianEconomics

Presented by : Ajinkya Badwe PH 0901 Alok Kalgi PH 0902 Amit Palande PH 0903 Aniket Kulkarni PH 0904 Anoop Kr. Singh PH 0905 Tushar Paul PH 0949

IntroductionKeynesian Economics is a macroeconomic theory

based on the ideas of the 20th century economist John Maynard Keynes

He provided the framework for synthesizing a host of economic ideas present between 1900 and 1940

The theories forming the basis of Keynesian Economics were first presented in “The General Theory of Employment, Interest and Money”, in 1936

AdvocaciesKeynesian Economics advocates a mixed economy

– predominantly private sector, but with a large role of the government and the public sector

It argues that private sector decisions, sometimes, lead to inefficient macroeconomic outcomes

Therefore, the Government and the Central Bank must exercise control with effective monetary and fiscal policies

MilestonesKeynesian Economics served as the economic model

during the latter part of the Great Depression, at the end of World War II, and during Capitalism (1945 – 1973)

This theory is somewhat of a middle way between laissez-faire, capitalism and socialism

During the recent economic crisis, this theory provided the underpinnings for the plans to rescue the world economy

OverviewIn Keynes’ theory, some micro-level actions of

individuals and firms can lead to aggregate macroeconomic outcomes, where the economy operates below its potential output and growth

Keynes contented that the aggregate demand for goods might be insufficient during economic downturns

This may lead to unnecessarily high unemployment and loss of potential output

SolutionAccording to Keynes, the solution to depression is

to stimulate the economy

Induce investments through a reduction in interest rates and government investment in infrastructure

These steps would, in general, result in more liquidity in the system, leading to increased demand and production ( the initial investment leads to a cascade effect )

Neo-Keynesian EconomicsNeo-classical theory supports that the two main costs that

determine the demand and supply are – labour and money

Through the distribution of monetary policy, demand and supply can be adjusted

If labour is more than the demand, then wages would fall until hiring began again

If there is too much saving, then the interest rates would fall until people cut their savings rate or started borrowing

Wages and SpendingThe high unemployment during the Great

Depression was due to high and rigid real wages

Keynes argued that – it is the nominal wages that are negotiated between the employers and employees

People will resist any nominal wage reductions, until they see other wages falling and a general reduction in prices

Wages and SpendingReal wages can be reduced in two ways :

- Nominal wages can be reduced - Price level can rise

However, reduced wages can lead to reduced aggregate demand, making the situation worse

Similarly, when prices are falling, people would expect them to fall further

Say’s LawIf the expansion of

aggregate demand leads to higher employment, then prior to the expansion involuntary unemployment must have prevailed.

This amounts to a refutation of Say’s Law based on asymmetry of wage and price responses.

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Some AccountingAssume a closed economy:• Output = Aggregate Expenditure = National Product Y = E = C + I + G = C + Ir + G

• But Y is also income, and from income we purchase consumer goods (C), save (S), or pay taxes (T), so Y = C + S + T• So that C + S + T = C + I + G Or S + T = I + G• Which means that saving and taxes paid by the public must finance investment and government spending.

Is Consumption related to Income?

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Excessive SavingExcessive savings (i.e.. savings beyond planned

investments), could encourage recession

Excessive savings are the result of falling investments, over investments in earlier years, or pessimistic business expectations

If savings did not fall immediately in step, then the economy would decline

ExplanationAssume that fixed investment falls :

i. Saving does not fall as much as the interest rates fall

ii. Planned fixed investments are made on long-term expectations, spending does not rise as much as the interest rates fall

iii. The supply of and demand for the money determines the interest rates, in the short run

iv. Excessive saving corresponds to unwanted accumulation of inventories, called “ general glut “

Fiscal PolicyKeynes’ theory suggested that active government

policy could be effective in managing the economy

He advocated countercyclical fiscal policy – deficit spending (fiscal stimulus) when the nation’s economy is in recession

The argument is that the government should solve problems in the short run

Plus PointsThis response should be adopted only when the

unemployment rate is persistently high

Here, “crowding out” is minimal, raising the business output, cash flow, profitability and business optimism

Government spending on infrastructure would be beneficial in the long term

Multiplier effectExogenous increase in spending, such as an increase

in government outlays, increases total spending by a multiple of that increase

Government could stimulate a great deal of new production if-

i. The people who receive this money spend most on consumption, and save the rest

ii. This extra spending allows businesses to hire more people, in turn increase consumer spending

ResultThis process is continuous

At each step the increase in spending is smaller than in the previous step, thus reaching equilibrium

The rise in imports and tax payments at each step reduces the amount of induced consumer spending and the size of the multiplier effect

Interest rates By this theory, the amount of investments was

determined by long-term profit expectations, and less by the interest rates

This facilitates the regulation of the economy through the monetary policy

This approach would be effective during normal times to stimulate the economy

Main Theories

The two key theories of mainstream Keynesian economics are :

I. The “ IS – LM Model “ of John Hicks

II. The “ Phillips Curve “

IS – LM ModelIt was with John Hicks, that Keynesian Economics

produced a clear model to determine policy and economic education

Aggregate demand and employment are related to three exogenous quantities :

i. The amount of money in circulationii. The government budgetiii. The state of business expectations

Phillips CurvePhillips curve indicated that decreased

unemployment implied increased inflationKeynes had predicted that falling unemployment

would cause a higher price, not a higher inflation rate

The economist could use the IS-LM model to predict that an increase in money supply would raise output and employment

Then use the Phillips curve to predict an increase in inflation

In the long term, we are all dead

- John Maynard Keynes

Thank You