Keynesian Short-Run Model Study Notes
Chapter 8: Keynesian Short-Run Model
Demand-Side Policies
1. Short Run vs Long Run Equilibrium
Short Run equilibrium occurs at the intersection of Aggregate Demand (AD) and Short-Run Aggregate Supply (SAS) where the economy operates at the current moment.
Long Run equilibrium occurs at the intersection of Aggregate Demand (AD) and Long-Run Aggregate Supply (LRAS) which reflects the economy's performance over the long term.
2. Short-Run Equilibrium
Definition: Short-run equilibrium is established where the SAS and AD curves intersect.
Graphical Representation:
Point E marks the short-run equilibrium where:
Price Level = $PL_0$
Output Level = $Y_0$
3. Long-Run Equilibrium
Definition: Long-run equilibrium occurs where the LRAS intersects with the AD curve.
Graphical Representation:
Point E is the long-run equilibrium where:
Price Level = $P_Y$
4. Key Insight of Keynes
Short-run equilibrium output may diverge from long-run potential output, defined as:
Short Run equilibrium output: The output level in the short term.
Long Run equilibrium occurs at potential output, which is the maximum sustainable output an economy can produce using available resources and production methods.
5. Short-Run Equilibrium in the AD/AS Model - Shift of AD
Shifting the AD curve to the right causes the equilibrium to shift from point E to point F, resulting in:
Increase in output from $Y0$ to $Y1$
Increase in price level from $P0$ to $P1$
6. Long-Run Equilibrium in the AD/AS Model - Shift of AD
A shift in the AD curve in long-run equilibrium changes the equilibrium from E to H, resulting in:
Increase in price level from $P0$ to $P1$
No change in output level.
7. Short-Run Equilibrium in the AD/AS Model - Shift of SAS
A leftward shift in the short-run aggregate supply results in a change in equilibrium from point E to G, causing:
Decrease in output from $Y0$ to $Y1$
Increase in price level from $P0$ to $P1$
8. Recession vs. Inflation
Classical and Keynesian perspectives differ in their analysis of situations where short-run and long-run equilibriums do not align.
9. Recessionary Gap in the AD/AS Model
Definition: A recessionary gap describes the extent to which equilibrium output is below potential output.
Graphically represented as the gap $YP - Y1$.
Characteristics of a recessionary gap:
Current GDP < Potential GDP.
Employment < Full employment.
Unemployment rate > Natural rate of unemployment.
10. Recessionary Gap - Self-Correcting Classical View
In the classical view, a recessionary gap may self-correct without government intervention.
Eventually, short-run equilibrium and long-run equilibrium align as prices and wages decrease, causing:
SAS to shift downward, restoring equilibrium at point E.
11. Inflationary Gap in the AD/AS Model
Definition: An inflationary gap shows the extent to which equilibrium output exceeds potential output.
Graphically represented as the gap $Y1 - YP$.
Characteristics of an inflationary gap:
Current GDP > Potential GDP.
Employment > Full employment.
Unemployment rate < Natural rate of unemployment.
Inflationary gaps occur at the peak of business cycles.
12. Inflationary Gap - Self-Correcting Classical View
In the classical perspective, an inflationary gap may also self-correct without government intervention.
Eventually, equilibrium levels align as wages and prices adjust upwards, leading SAS to shift back to its original position.
13. Keynesian Key Insight
Economies may struggle to return to potential output levels, possibly worsening during recessions.
14. Keynes Critique of Classical
Keynesian View: Y can represent GDP or income.
Economic downturns typically lead individuals to save more due to fear of job insecurity, which:
Increases savings (beneficial for individual).
Decreases consumption, leading to:
Decreased AD and subsequently, decreased GDP.
Lower GDP results in diminished income, perpetuating a downward spiral labeled the “Paradox of Thrift.”
15. Paradox of Thrift
During a recessionary gap of $YP - Y0$:
Behavioral changes cause people to reduce spending, which further decreases:
Aggregate Demand.
Output, resulting in a negative spiral downward.
16. Keynes Approach
The self-correcting process may take considerable time and might not restore the economy fully to long-run potential output.
This necessitates activist demand management policies by governments to mitigate economic fluctuations.
17. Fiscal Policy – Need for AD in Keynesian View
Classical premise: The economy will self-correct.
Keynesian stance: Government intervention becomes necessary when output is not at potential.
Fiscal Policy: Intentional changes in government spending or taxes aimed to stimulate or slow down the economy, subjected to congressional approval.
18. Fiscal Policy: Tools and Impact
Two main tools in fiscal policy (affecting AD):
Change in Government Spending
Example: Infrastructure spending increases AD allowing for output (Y) and employment to rise.
Tax Policy
Increase in individual income taxes results in decreased disposable income and consumption, hence decreasing AD.
Conversely, cutting taxes increases disposable income and consumption, boosting AD.
19. Expansionary Fiscal Policy
Tools: Increase government spending or decrease tax rates to stimulate the economy.
Goals:
Increase GDP.
Decrease unemployment.
Possible resulting inflation, elevating the price level.
20. Expansionary Fiscal Policy Implementation
For a recessionary gap where output is $YP - Y0$, the fiscal policy entails:
Increasing government spending or reducing taxes shifts AD rightward, aligning output back with potential output at $YP$ while increasing prices to $P1$.
21. Contractionary Fiscal Policy
Tools: Decrease government spending or increase taxes to cool the economy.
Goals:
Decrease GDP and inflation.
Likely results in increased unemployment.
22. Contractionary Fiscal Policy Implementation
For an inflationary gap where output is $Y2 - YP$, the appropriate fiscal action involves:
Reducing government spending or raising taxes, prompting a leftward shift in AD that returns output to potential output ($Y_P$) while curbing inflation.
23. Limitations of Fiscal Policy
Implementing changes to taxes and government spending via legislation can be time-consuming.
Estimating potential output, which denotes the output level achievable without inflation, is inherently challenging.
24. Multiplier Effect
The multiplier effect refers to the greater-than-proportional impact of a change in government spending or tax policy on the economy.
This indicates that government doesn't need to proportionally increase spending to achieve a desired increase in GDP.
25. Understanding the Multiplier Effect
An increase in aggregate demand can lead to:
Higher production (Y) and thereby, higher income (Y = output = income).
Increased income further enhances consumption, thereby augmenting demand.
26. Mechanism of the Multiplier Effect
The initial increase in government spending cascades through the economy:
Higher demand forces firms to ramp up production, which in turn necessitates purchasing inputs from other firms (secondary increase in demand).
This leads to increased hiring and enhanced income levels, prompting further consumption increases.
Example: Government-driven infrastructure plans like bridge and road construction.
27. Visibility of the Multiplier Effect
Shifts in AD by small amounts often yield disproportionately larger effects on GDP (Y) due to the downward slope of the AD curve.
28. Classical vs Keynesian Views
Classical Economics: Believes in self-correction in the economy, positing that wages and prices adjust accordingly to restore long-run potential.
Keynesian Economics: Argues that government intervention is necessary since wages and prices are often "sticky," requiring fiscal measures to restore the economy to optimal output.