Chapter 12: Keynesian Perspective Flashcards
After what event did Keynesian Economic theory become more mainstream? Why?
Great Depression
Instead of letting the economy self-balance, active fiscal policy was used to alleviate weak aggregate demand
How does Neoclassical economics prescribe dealing with a recession?
It will self-correct. No action needed. “Hands off” policy approach.
How does Keynesian economics prescribe dealing with a recession?
Implement active fiscal and monetary policies
What happens tot he aggregate demand curve in a recession?
Shifts left
Person Keynesian economics is named after
John Maynard Keynes
Economics theory that markets don’t self-correct quickly, because prices & wages take time to adjust. During recessions it is necessary for the government to get involved by using monetary and fiscal policy to increase output, decrease unemployment.
Keynesian Economics
Stagflation
When inflation is high, economic growth rate slows, and unemployment remains steadily high
Monetarism
Focused on price stability. Money supply should be increased slowly and predictably to allow for steady growth.
Name that economics theory: Focuses on aggregate demand. Firms produce output only if they expect it to sell.
Keynesian Economics
Potential Output
What can be produced if the economy is operating at maximum (natural) employment
In Keynesian Economics, when AD (aggregate demand) falls, what occurs?
Less than full unemployment / recessionary gap. Government should increase spending to boost aggregate demand.
In Keynesian Economics, when AD (aggregate demand) increases, what occurs?
Inflation, where demand attempts to push the economy past potential output. Government should decrease spending to ease aggregate demand.
Aggregate Demand
Total spending, economy-wide, on domestic goods and services
Consumption + Investment + Government Spending + Net Exports
Durable Goods
Things that last and provide value over time
Example: Automobiles
Nondurable Goods
Once you consume them, they are gone
Example: Groceries
3 Factors that affect consumption (Keynes)
- Disposable Income
- Expected Future Income
- Wealth or Credit
Disposable income
Take home pay / income after taxes
How do consumer expectations for the future affect aggregate demand?
Optimistic - consume more
News of recession - pull back and spend less
How do people spend beyond their income?
Borrowing/credit
What will occur to Aggregate Demand (on a graph) if there is a shift towards consumption rather than saving?
AD will shift to the right
4 Categories of Investment Expenditure
- Durable equipment/software
- Nonresidential structures
- Change in inventory
- Residential structures
How does confident expectation of future profits affect business investment expenditure?
Businesses will increase investment
How do low interest rates affect investment spending?
Increases investment/spending
2 Factors that Affect Business Investment Spending
- Expectation of future profits
2. Interest rates
How can the government influence Aggregate Demand?
- Increasing or decreasing government spending
2. Lowering or raising tax rates
Why do sticky wages and prices increase the impact of an economic downturn?
The macroeconomy adjusts slowly to shifts in aggregate demand because of wages and prices that do not respond to decreases/increases in demand
2 Building Blocks of Keynesian Economics
- Aggregate demand is not always high enough to incentivize firms to hire enough workers to reach full employment
- Sticky wages/prices do not respond to demand shifts
What kind of situation and timeframe does Keynesian Economics focus on?
Depressions/Recessions
Relative Short Term
Offers policy prescription for minimizing effects of economic downturn
What “law” did the Great Depression contradict?
Say’s Law that “supply creates its own demand”. There were just as many factories and workers/same supply as before the crash, but not enough demand.
Coordination Argument
No centralized way to implement coordinated wage reductions in bad economic times, so workers will fight against wage reductions. Keeps wages sticky.
Menu Costs
Costs of changing prices. Price changes may leave consumers confused or angry.
Expenditure Multiplier
Measure of how many times Real GDP will be increases/decreased as a result of an autonomous change in aggregate spending in the economy.
(change in Y) / (change in spending) > 1
* Y = RGDP = aggregate demand spending
How does an inflationary gap occur?
Aggregate demand increases when the economy is already at potential output. AS is already vertical, so any increase in AD leads to a higher price (inflation) but not higher GDP.
Marginal Propensity to Consume (MPC)
Ratio of Change in Consumption Expenditure (C) to the Change in Disposable Income (DI)
MPC = (change C) / (change DI)
How to calculate the expenditure multiplier
Expenditure Multiplier = 1 / (1 - MPC)
* MPC = Marginal Propensity to Consume
Phillips Curve
Inflation and unemployment have a stable and inverse relationship. With economic growth comes inflation, which it turn leads to more jobs and less unemployment.
Keynesian Zone
Levels of output far below potential in the Aggregate Supply Curve. AS curve is flat. High unemployment, low inflation.
Neoclassical Zone
Levels of output above potential in the Aggregate Supply Curve. As curve is essentially vertical. Low unemployment, high inflation.
Intermediate Zone
Between the Keynesian and Neoclassical Zones in the Aggregate Supply Curve
Stagflation
Unhealthy combination of high inflation and high unemployment. Could not be explained by traditional Keynesian economics.
What do Keynesian macroeconomists view as the solution to a recession?
Expansionary fiscal policy such as tax cuts to increase consumption, or increased government spending. Shifts the demand curve to the right.
Does Keynesian economics require government to set controls on prices, wages, or interest rates?
No. It focuses more on aggregate economic demand through government spending and tax cuts.
3 Practical Problems with Keynesian solutions
- government’s ability to estimate GDP
- government decision between tax cuts or spending
- time lag for government legislation
Multiplier Effect
An initial increase in spending cycles repeatedly throughout the economy, resulting in a larger impact than the initial dollar spent
What occurs in an economy with a high multiplier?
Change in aggregate demand is magnified
Economy is unstable
Government policies on expenditure will have large effect
What occurs in an economy with a low multiplier?
Change in aggregate demand is low
Economy is relatively stable
Government policy has weak effect on expenditures
