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Management Managerial Economics

Simple Keynesian Model

Principal Investigator

Co-Principal Investigator

Paper Coordinator

Content Writer

Prof. S P Bansal Vice Chancellor Maharaja Agrasen University, Baddi

Prof. Yoginder Verma

Pro–Vice Chancellor

Central University of Himachal Pradesh.Kangra.H.P.

Prof. S K Garg Former Dean & Director,

H.P. University, Shimla(H.P.)

Indervir Singh

Assistant Professor,Dept. of Economics and Public Policy

Central University of Himachal Pradesh.Kangra.H.P.

Paper: 11, Managerial Economics

Module: 30, Simple Keynesian Model

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Management Managerial Economics

Simple Keynesian Model

Items Description of Module

Subject Name Management

Paper Name Managerial Economics

Module Title Simple Keynesian Model

Module Id Module no.-30

Pre- Requisites Basic understanding of macroeconomic aggregates.

Objectives To enable students to understand Keynesian argument about importance of

aggregate demand in economic stabilization.

Keywords Aggregate supply, Aggregate demand, Effective demand, Multiplier

effect.

QUADRANT-I

Module 30:Simple Keynesian Model

1. Learning Outcome

2. Background

3. Simple Keynesian Model

4. Criticism of Keynesian Model

5. Summary

1. Learning Outcome:

After completing this module the students will be able to:

understand the Keynesian argument about importance of aggregate demand.

understand the meaning of effective demand and its importance from policy perspective.

2. Background

John Maynard Keynes published his book,“The General Theory of Employment, Interest and Money” in

1936.The book became one of the most influential works in the history of economics, and led to the rise of

Keynesian economics.The General Theory was an attempt to explain the Great Depression of 1920-30s. The

Classical economists believed that full employment is the natural state of an economy and any departure

from it is temporary as the market forces will lead the economy back to the full employment equilibrium. In

contrast, Keynes argued that an unregulated competitive economy does not automatically lead to full

employment,instead the economy may have a stable equilibrium with under-employment (or under-

production)as its natural state.He argued that without an active intervention of government, this equilibrium

maystay for a long time.

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Management Managerial Economics

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Before discussing Keynes’s argument, let us briefly discuss the argument of the classical economists. The

argument of classical economists can be best described with Say’s law. Say’s law rejects the possibility of

general over-production. Over-production may happen in some markets due to misallocation of resources,

that is, low demand of a product means excess demand of another good. If there is over-production of one

commodity, then the market forces will lead to shift in production, so that, in the long run,supply is equal to

demand.Here, it should be mentioned that production at optimum point also means full employment, as

resources will be fully employed and all that is produced is sold. In case of unemployment, the wage rate

will decline until all those who wish to work get employed.

Say’s law is based on the argument that people produce commodities because they want other commodities

in exchange (here, self-consumption of commodities is ignored as it does not cause over-production).

Therefore, each person while producing a commodity also creates a demand of equal worth. In a barter

economy, the validity of the argument is clear, as the people will produce goods only if they are interested in

exchanging them for others commodities. In other words, the nature of exchange ensures that the demand of

commodities is equal to supply of commodities. If a product is not sold, that is, there is over-production of a

commodity, then the nature of exchange requires that there is under-production of some other commodity. In

this situation, some of the people who were engaged in over-produced commodity will shift to the

production of under-produced commodity.

To make the argument clearer, let us suppose that there are just three commodities, x, y and z, produced in an

economy. In a barter economy, people produce with a purpose to exchange their produce with other

commodities. For example, a person, in our three commodity case, produces commodity x only if she wishes

to have commodity y or z or certain quantity of both. Similarly, the producer of y and z commodities will

like to get at least one of the other two commodities in exchange. Now, suppose a producer of x fails to

exchange some of her produce for the desired commodity (say, y), then there will be over-production of x in

the economy. In a barter economy, x will only be produced in excess if at least one of the other commodities

(that is, y or z or both) is under produced. Remember that in abarter economy, the producer of a commodity

has no other use of her produce than exchanging it with another commodity. As in our case,the producers of

y have just two commodities (x and z) to exchange their produce. If the producer of y does not exchange y

for x, then the situation means either under production of y or higher demand for z (in terms of quantity of y

required to get a unit of z). If z is under produced, more y will be required to get a unit of z. This situation is

similar to having high profits in the production of y or z or both if money is used for exchange.

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Management Managerial Economics

Simple Keynesian Model

In this situation, the producer of x will start shifting to the production of zor y or both until over-production

ceases to exist. This three commodity case can be extended to n commodity case without any change in the

basic argument.The crux of the argument is that over-production of some commodities means under-

production of some other commodities. Therefore, it is possible to have over-production in some of the

markets but not all markets. Also, over production is a short-run phenomenon, as shift in production will

remove this over-production. In other words, in the long run, all that is supplied will be consumed, and the

resources will be fully employed.

Before proceeding further, let us discuss the meaning and implications of general over production. General

over-production is a situation, when over-production exists in a number of markets without other

commodities being under-produced. This has a direct implication on economic activity as well as on

employment. If over-production is associated with under-production in other markets, the resources will shift

from one type of production to other. However, non-existence of excess demand for other commodities

means, the resources, which gets unemployed due to lower demand, will not be absorbed elsewhere. This

situation means the existence of unemployment in the long run. For example, the over-production of x, in the

previous three commodities case, will be general over-production if there is no under-production of z or y.

So the labour force, which will get unemployed due to reduction of production of x(as there is no point

producing the quantity that remains unsold or unexchanged), will not be absorbed anywhere else.

Classical economists applied the same argument toan economy which uses money for exchange. Bringing

money into the picture creates a problem, as money can be saved. In barter economy, a commodity is not

produced to be exchanged at some future date. So, supply and demand is produced at the same time.

However, when commodities are exchanged for money, the producer may not spend the money received

after selling the commodity.As a result, the value of commodities produced may not be equal to total

expenditure of the people. However, the total expenditure may still be equal to value of commodities

produced if total saving of the people is equal to total investment. The classical economists believed that a

rational person will invest his savings. Therefore,total income will be equal to total expenditure.If all savings

are invested, over-production of some commodities means under-production of some other goods, that is,

people are spending more on some commodities relative to others. In this situation, under-produced

commodities will be earning higher profit as their prices will increase due to high demand, and over-

produced commodities, due to fall in their prices, will be bearing loss.As a result, there will be shift from the

production of the over-produced commodities to under-produced commodities. Again, the classical

argument denies the possibility of general over-production.

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Management Managerial Economics

Simple Keynesian Model

Keynes, however, pointed out that general over production may happen due to lower aggregate demand in

the economy. Though many economists, like Thomas Robert Malthus, have already made the argument that

under-consumption may lead to general over-production, they failed to provide a complete explanation for it.

3. Simple Keynesian Model

Keynes provided a theory of employment and output by arguing that depressions are the result of inadequate

aggregate demand in the economy. He argued that production decisions of the firms are based on spending

decisions of the people. Increasing expenditure of the people leads to increase in production, whereas

decrease in spending results into decline in production.Thus, it is the aggregate demand that decides the level

of output in the economy.Keynes by pointing out the possibility of lower spending rejected the classical

economists’ argumentwhich denied the possibility of general over-production. As per Keynes, the aggregate

spending may not always match the income generated in an economy at full employment level. In Keynesian

theory, equilibrium exists in the economy where spending decisions of the people match production

decisions of the firm, that is, aggregate demand is equal to aggregate supply (see, Module 28 for discussion

on macroeconomic aggregates). Keynes termed this point effective demand.

To understand Keynesian argument, we shall differentiate between actual expenditure and planned

expenditure.Actual expenditure is the amount spentby consumers, firms and government to purchase

commodities. Actual expenditure in the economy is equal to total income of the country, as one person’s

spending is other person’s income (see, Module 29 of the present paper for discussion on national income).

In a closed economy, it is equivalent to gross domestic product (GDP). Planned expenditure, on the other

hand, is the amount that consumers, firms and government plan to spend on commodities. Planned

expenditure may differ from actual expenditure, as a firm may sell more or less than its plannedsale leading

to increase or decrease in firm’s inventories.Thus, the planned expenditure may be less or more than the

actual expenditure.

In a closed economy, the planned expenditure (P) consists of consumption (C), planned investment (I) and

government expenditure (G).Therefore, it can be written as:

𝑃 = 𝐶 + 𝐼 + 𝐺 …(1)

Let 𝐶 = 𝑓(𝑌 − 𝑇) be a consumption function, where Y is the income of the people and T is tax paid to the

government. The function shows that consumption depends on the disposable income, 𝑌 − 𝑇, of the

people.After replacing C in (1) with the consumption function, one will get:

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Management Managerial Economics

Simple Keynesian Model

𝑃 = 𝑓(𝑌 − 𝑇) + 𝐼 + 𝐺 …(2)

Let us assume that investment, government expenditure and tax are exogenously determined and fixed. To

distinguish fixed investment, tax and government expenditure, we will write them as 𝐼 , 𝐺 and 𝑇 . Now, the

equation (3) can be written as:

𝑃 = 𝑓(𝑌 − 𝑇 ) + 𝐼 + 𝐺 (3)

Equation (3) shows that planned expenditure is the function of income (Y),tax (𝑇 ), government expenditure

(𝐺 ) and planned investment (𝐼 ).Figure 1 shows the relation between planned expenditure (P) and income (Y).

For convenience, a linear relation between Y and P is assumed. However, one may drop this assumption

without any change in the basic argument or relations. A linear relationship means a constant slop of the

line. The slope of the line is the ratio of change in consumption (ΔC) and change in income (ΔY), which

represents change in consumption expenditure with a unit change in income. This ratio is called marginal

propensity to consume (MPC).

𝑀𝑃𝐶 =𝛥𝐶

𝛥𝑌

For example, MPC is 0.8 if for 100 rupees increase in income, the consumption increases by 80 rupees. For a

differentiable consumption function, MPC can also be the derivative of C with respect to Y, that is,𝑑𝐶

𝑑𝑌.For

example, if 𝐶 = 𝑎 + 𝑏(𝑌 − 𝑇 ), then 𝑀𝑃𝐶 =𝑑𝐶

𝑑𝑌= 𝑏.Since tax, investment and government expenditure are

assumed as fixed (in equation 3 and figure 1), MPC is equal to slope of planned expenditure line. Therefore,

MPC in figure 1 is also equal to 𝛥𝑃

𝛥𝑌.The slope of line in Figure 1 shows that with eachRs. 1 increase in

income, the increase in planned expenditure will be less than Rs.1, that is, MPC<1. It is expected as people

often do not consume their entire increased income.

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Management Managerial Economics

Simple Keynesian Model

The economy is in equilibrium when the planned expenditure, P, is equal to income, Y (that is, actual

expenditure). However, as discussed earlier, the planned expendituremay be higher or lower than income.

Figure 2 shows these three possibilities. The economy is in equilibrium at point E as planned expenditure is

equal to income. Since the plans of the people realize in equilibrium (or aggregatedemand is equal to

aggregate supply), the firms need not change their production.Now assume the second possibility that

planned expenditure is higher than income (at income, Y1in Figure 2). At this point, the firms are selling

more than their production, therefore, their inventories will decline. In response, the firms will increase the

production and hire more workers. In other words, if planned expenditure is higher than income in any

period, income and employment will increase in the next period. An increase in income will also lead to

increase in planned expenditure. Nonetheless, increase in planned expenditure will be less compared to

income increase, as MPC<1.Due to increase in income and planned expenditure, the economy will move

towards the equilibrium point E.

ΔP

Figure: 1

Pla

nn

ed E

xpen

dit

ure

(P

)

Income (Y)

−

Y1 Y2

ΔY = Y2 – Y1

ΔY

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Management Managerial Economics

Simple Keynesian Model

Now suppose that the economy is at income, Y2, andthe planned expenditure (P2) is lower than the income.

Here, the firms will be selling less than their plan, and the firms will accumulate inventories. The firms will

respond to the situation by lowering their production, and the total income will decline. Lowering of the

production will be accompanied withlower employment, as extra workforce will be laid off. The planned

expenditure will also declinewith the income decline, however, its decline will be less as MPC<1. Again the

economy will move towards equilibrium point E. Thus, the economy has a tendency to come back to

equilibrium, where planned expenditure is equal to income. The employment in the economy will also be

corresponding to the income, Y. However, Eneed not be a full employment equilibrium. The equilibrium, E,

is a point where aggregate demand in the economy is equal to aggregate supply. It is possible that the full

employment income level is towards the right side of Y. Let us suppose, Y2 is the full employment income

level. Itis not sustainable income level due to lower aggregate demand (or lower planned expenditure), and

economy will return to income, Y.There will be general over-production at full employment income (that is,

Y2). The situation can be imagined as an equilibrium point where no over-production exists, however, a share

of worker force is not included (or partially included) in production and exchange process.

P2< Y2

P1>Y1 P=Y

Y2

Y1

Y1 Y

P2

P, Y

P1

Figure: 2

45o

Pla

nn

ed E

xp

end

itu

re (

P)

Income (Y)

P = C + I + G

P = Y

Y2

E

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Management Managerial Economics

Simple Keynesian Model

Keynes argued that the government can use fiscal policy to stimulate the economy and put it at a higher

income level. The argument can be explained using Figure 3. Let us suppose, the economy is at equilibrium

E1. Let us suppose that income, Y2, is full employment equilibrium. It means that economy is producing at

below full employment level of income. As previously discussed, any change in income will not sustain

unless the equilibrium is shifted to E2, which is corresponding to the full employment income. Now suppose

that the government increases its expenditure by a fixed amount ΔG. This increase will shift the planned

expenditure upwards, as thisadditional expenditure will add to the planned expenditure at each income level.

Due to this shift, the new equilibrium will be at E2, and Y2 will be the new equilibrium level of income. Also,

the economy will be at full employment level in the new equilibrium. Thus, the fiscal policy may increase

the income to full employment level. In addition to advocating increase in government expenditure, Keynes

also criticized classical argument that wage decline will lead to full employment. In Keynesian model, the

planned expenditure is an important determinant of the income level. Keynes argued that any decline in the

wage rate also lowers the purchasing power of the people, which shifts the planned expenditure line

downwards towards worse income equilibrium. Therefore, the decline in wage rate cannot solve the problem

of general over-production.

E1

E2

Figure: 3

ΔG

45o

Pla

nn

ed E

xp

end

itu

re (

P)

Income (Y)

P = C + I + G

P = Y

P = C + I + G + ΔG

Y1 Y2

ΔY = Y2 – Y1

ΔY

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Management Managerial Economics

Simple Keynesian Model

The above model shows increase in income due to increase in government expenditure. However, this

increase in income in Keynesian model is higher than the increase in government expenditure. It is called

Multiplier effect. The additional government expenditure increases the income of the people. This increased

income also increases consumption of the people. Since the consumption of one person is the income of

another, the consumption out of income received from additional government expenditure further increases

the income. Since the income receiver at each stage will consume a portion of their income, this process will

go on. Thus, the actual income will be higher than the additional government expenditure.The total increase

in income due to government interference depends on MPC. For example, if the government increases the

expenditure by Rs. 100, then the immediate increase in income will be Rs. 100. Now suppose that people

spend 80 percent of their additional income, that is, MPC is 0.8. The next increase in income due to first

receivers’ consumption will be Rs. 80 (multiply income with 0.8 to get the next increase in income).

Assuming that the receivers’ of Rs. 80 also has MPC=0.8, the next income increase will be Rs. 64. The

income increase in the subsequent rounds can be calculated in a similar way. The total increase in income in

this example can be written as (using infinite geometric series):

Total Income Increase = 100 + 100 × 0.8 + 100 × 0.82 + 100 × 0.83 + ⋯

= 100 + 80 + 64 + 51.2 + ⋯ = 100 ×1

1 − 0.8= 𝑅𝑠. 500

In general, the formula for total increase in income (ΔY)due to increase in government expenditure (ΔG) can

be written as:

𝛥𝑌 = 𝛥𝐺 + 𝛥𝐺 × 𝑀𝑃𝐶 + 𝛥𝐺 × 𝑀𝑃𝐶2 + 𝛥𝐺 × 𝑀𝑃𝐶3 + ⋯ = 𝛥𝐺1

1 − 𝑀𝑃𝐶

The multiplier effect is the change in income due to change in government spending, therefore, multiplier

(𝛥𝑌

𝛥𝐺) is

1

1−𝑀𝑃𝐶. In other words, the multiplier effect depends on the marginal propensity to consume. A larger

MPC means higher increase in income, and lower MPC means low increase in income. It should also be

mentioned that the multiplier effect is discussed as a static concept here. We have calculated income increase

as if the government spending will immediately increase the income. In reality, the income increase is not

immediate, and happens in multiple periods. In each period, the income responds to the change in planned

expenditure and the economy moves to the new equilibrium income level. This multiple period effect on

income is called dynamic multiplier.

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Management Managerial Economics

Simple Keynesian Model

4. Criticism of Keynesian Model

Keynesian theory is also criticized for failing to provide good prediction of economic activities. Keynesian

theoryemphasized the problem of low aggregate demand. However, most of the unemployment after 1950s

was due to supply side constraints. The problem happens because Keynes considered aggregate supply curve

to be elastic even in long run. However, it is true only in the short run, asthe shape of aggregate supply curve

depends on flexibility of prices and wage rate in economy. If prices and wage rate are flexible, the excess

production will disappear as argued by classical economists (lower prices and wages increase the demand for

commodities and labour services). Therefore, the total production in an economy depends on amount of

capital and labour, and on existing technology, and aggregate supply curve isinelastic. On the other hand, the

rigid prices and wage rate makes the adjustment difficult, and, as a result, aggregate supply curve is elastic.

The prices and wages tend to be rigid in short run and flexible in the long run. Therefore, the long run

aggregate supply curve is vertical as shown in Figure 4(a). The vertical aggregate supply curve represents no

effect of prices on supply of goods. However, prices and wage rates tend to be rigidin the short run.

Therefore, aggregate supply curve is horizontalas shown in Figure 4(b), which means producers respond to

the price change by changing the production, where lower prices will means lower production. If the total

output in the economy is determined by interaction of aggregate demand and aggregate supply.Increasing

aggregate demand increase the production only in short run, andincreasing aggregate demand will have no

effect on incomein long run. One of the implications of aggregate demand–aggregate supply model is that

demand management will not work if supply constraint is the problem.

Long run Aggregate Supply

Pri

ce L

evel

(P

)

Output (Y) Y*

Pri

ce L

evel

(P

)

Output (Y)

Short run Aggregate Supply

Figure: 4(a) Figure: 4(b)

AS

AS

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Management Managerial Economics

Simple Keynesian Model

There are also problems related to using Keynesian policy suggestion during recession. To understand this,

let us consider the possible ways of funding additional government expenditure.The additional expenditure

can be funded by raising taxes orbudget deficit.High tax rate discourages economic activity, and lowers the

consumption of the people. Thus, any positive effect of additional expenditure is negated by negative effect

of taxes (in fact, Keynesian economists suggest cutting taxes during recession). Therefore, deficit financing

is the best way to finance the additional expenditure.Budget deficit may be financed by borrowing from the

market or printing money. If supply constraint is the problem,borrowing money from the market leads to

increase in rate of interest (especially in a full employment situation), which lowers the private investment in

the economy (called crowding out effect).Thus, the positive effect of the additional expenditure may be

much lower or even negative (if government expenditure is less productive than private investment). Further,

the financing of deficit by printing money may lead to inflation, especially if the economy is already

recovering.In addition, it is difficult to know the exact amount of increase in government expenditure (or

fiscal stimulus) required to bring the economy out of recession. A larger stimulus may lead to much higher

negative effect of inflation and crowding out. Therefore, increasing government expenditure is not free from

problems.

5. Summary

Keynesian theory originates from the failure of classical economists’ to explain the 1920-30s depression, and

changed the way economists think about macroeconomic issues. The theory is based on the argument that in

an economy, the income depends on the aggregate demand. The aggregate demand by influencing the

expectations of the producers determines the level of production in the economy. The economy is at

equilibrium where the expectations of the people are met. However, this equilibrium point need not be full

employment equilibrium. Therefore, the government interference through increase in expenditure may bring

about full employment equilibrium in the economy. Despite many criticisms, the theory along with the

debates surrounding it provided important insights into the macroeconomic aspects and role of government

expenditure.