Question

Suppose a government has been running large government deficits. In order to address these deficits, the government has decided to decrease its spending (G) and raise taxes (T). Using the complete Keynesian model, explain in as much detail as possible what will likely happen to the economy (including GDP, the interest rate, investment spending, any multiplier effects). Finally, under what conditions would GDP be less effected (e.g., high or low mpc, steep or flat money demand, steep or flat investment schedule)?

Answer 1

Keynesian model is a theory of total spending in the economy.(known as aggregate demand) and its effects on output and inflation.

Keyenesian Theory believes that  the government should increase demand to boost growth. It believes that consumer demand is the primary driving force in an economy.

GDP means is the amount of goods and services actually being sold being called as real GDP. Depends on how much demand exists in the economy.

The three principles of how the economy works is keynesian theory.

• Aggregate demand : Aggregate demand is influenced by economic decisions. both public and private.
• Aggregate demand consists of consumption expenditure, government spending, investment expenditure,and spending on net exports - net imports.

2. Prices

3. Changes in Aggregate Demand : Aggregate demand is not constant it fluctuates.

Stabilizing Economy : Keynesian theory belives that during economic downturn government should spend more on labor and intensive infrastructure projects to steady employment and stabilise wages during downturn.

As per keynesian theory states that government should fix the problems in the short run rather than waiting for market forces to fix in the long run.

Keynesian Multiplier : is an economic theory that an increase in private consumption expenditure,investment expenditure or net government spending(gross government spending - tax revenue) raises the total Gross Domestic Product(GDP) by more.

Therefore if private consumption expediture increase by 5 units the total GDP will increase by more than 5 units.

The expenditure- output model detemines the actual level of real GDP. That is the total or aggregate expenditure in the economy are equal to the amount of output produced.

Conclusion : Hence Keynesian Theory allows for increased government spending during recessionary times.

it also calls for a government restraint for a rapidly growing eonomy. Increase in demand is prevented that leads to rise in inflation.