Question

What is the Keynesian view on the cause of the cyclical swings in economic activity and the appropriate policy response to maintain full employment? Illustrate your answer with Keynesian PAE model.

Answer 1

The Keynesian view on the cause of cyclical swings in economic activities can be linked with one of the four sectors of the economy -

1. Private Consumption (C)
2. Private Investment (I)
3. Government Spending (G)
4. Net Exports (X-M)

Y = C + I + G + X-M, where C + I + G + X-M is the Planned Aggregate Expenditure in the economy. Suppose investment demand in economy declines. As can be seen, in the below diagram, after a decline in investment spending the planned aggregate expenditure curve declines from AE1 to AE2. This decline can be traced back to investment spending in the economy.

An appropriate policy response can be -

1. Increase government spending or give tax breaks so that a decline in investment spending can be countered by another form of spending.
2. Decrease interest rate so that there would be an increase in overall investment and consumer spending in the economy.