Keynesian Economics

  • Originated by John M. Keynes during the Great Depression.

Economic Conditions of the Great Depression

  • Unemployment exceeded 20%.

  • Economic hardships led to bank collapses and a decline in employment.

  • Say's Law and classical economics were ineffective; intervention was necessary.

Classical vs Keynesian Economics

Classical Economics

  • Saving correlates directly with interest rates.

  • Wages and prices are flexible; markets self-regulate.

  • Recessionary gaps close naturally.

Keynesian Economics

  • Argues for inflexible wages and prices.

  • Recessionary gaps can persist and require government intervention.

  • Investment depends on business expectations, not only on interest rates.

Efficiency Wage Models

  • Firms may pay higher wages to enhance productivity.

  • Questions the self-regulating nature of the economy due to inflexible wages.

Simple Keynesian Model

  • Assumptions:

    • Price levels constant until full employment.

    • Closed economy; total spending is consumption, investment, and government purchases.

  • Consumption function: C=C<em>0+(MPC)(Y</em>d)C = C<em>0 + (MPC)(Y</em>d)

    • $C_0$ = autonomous consumption, $MPC$ = Marginal Propensity to Consume.

Marginal Propensity to Save (MPS)

  • Defined as: MPS=ΔS/Δ(Yd)MPS = \Delta S/ \Delta (Y_d).

  • Multiplier effect on GDP: Multiplier=11−MPCMultiplier = \frac{1}{1-MPC}.

Aggregate Demand (AD) and Supply (AS)

  • Shifts in AD due to changes in consumption, investment, or government spending.

  • Keynesian AS curve has a horizontal section suggesting price rigidity.

Government's Role in Economy

  • Essential during instability; can help eliminate recessionary gaps.

  • Key points of the Keynesian model include equilibrium in recessionary gaps and the constant price level until full GDP is achieved.