keynes assignment help

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Keynesian theory
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Basic assumption of model

• It was the first model to explain why the output
  fluctuate around its potential output.
• There was interdependence between output and
  spending i.e. spending determines output and
  output and income determines spending.
• Price are constant in the short run
• Demand is the main component in deciding
  equilibrium output.
• Economy can supply whatever amount of goods are
  demanded at same price level.
• AS curve will be horizontal.

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Aggregate demand

• It is the sum total of the goods demanded in an
  economy.
• In the Keynesian model, AD C I G NX
• WHERE C is consumption by household
• I is investment in machines or capital
  formation.
• G is government expenditure
• NX is net exports i.e. exports - imports

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Equilibrium output

• It is that level of output at which the aggregate
  demand is equal to actual output.
• AD refers to the planned demand i.e. the amount
  of output they are planning to demand.
• In the figure, AD is plotted
• and to find the equilibrium
• we have drawn 45 line .
• Reason being AD should be
• equal to Y

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Consumption

• Consumption function is given by
• C c? cY
• where C minimum level of consumption /
  consumption at zero level of income
• c marginal propensity to consume
  i.e. by how much amount the consumption increase
  due to increase in the income.
• numerically it is C / Y
• if c is 0.9, it indicate that if income rise
  bi 1 , then the level of consumption will rise
  by 90 cents.

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Saving function
Income is either consumed or saved. S C Y S
- C ( 1-c ) Y Saving increases with an
increase in income
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Investment

• For convenience investment was assumed to be
  autonomous
• I I

Aggregate Demand

• AD C I
• considering G, NX0
• C C c Y
• I I
• AD C cY I
• A c Y

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Graphical presentation of aggregate demand
function
AD A c Y Where A decide the intercept
c decides the slope Higher A ,
higher Y higher c , higher Y E is the
equilibrium output.
I
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Equilibrium output
AD Y Y A c Y Y 1 A
1 c Another method to find the
equilibrium is equating saving and
investment Reason AD C I Y
C S for equilibrium AD Y, implying I S
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multiplier

• Multiplier tells the amount by which the
  equilibrium output will change due to the change
  in the autonomous aggregate demand.
• Suppose in an economy, there is an increase in
  autonomous aggregate demand by A . Output
  will increase by this amount. Thus, income also
  rise by this amount. Spending will increase by c
  times A. this process will continue so, the
  change in total output is much more than the
  initial increase in aggregate demand.

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• Y A c A c2 A
  .
• Y 1 A
• 1-c

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Government sector

• There are three components that add to aggregate
  demand when we include the government sector.
  These are
• Government taxes TA tY i.e. income tax and t
  is the tax rate.
• Government transfers TR it is the payment that
  government makes to individuals in form of
  unemployment benefit, old age benefits etc
• Government expenditure G is the expenditure by
  the government on the goods and services

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Aggregate demand in three sector model
AD C c( Y TR t Y) ? ? ?
c( 1-t) Y AD will become flatter5 And intercept
will be higher by the amount ? c TR
Equilibrium change to E and output to Ye.
aAD
E
Ye
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Effect on equilibrium output due to change in ?

• Effect is same as the change in the autonomous
  spending.

• Multiplier has reduced because the disposable
  income has reduced. Now, a proportion of income
  will be given to government as tax
• Higher the tax , lower the multiplier.
• It is just like a reduction in MPC.

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Effect on equilibrium output due to change in tax
rate

• Suppose the income tax rate reduced.
• this will increase the disposable income of the
  individual by the amount t Y. Thus the
  increase in aggregate demand is MPC times change
  in income. Due to induced spending, income will
  be generated and aggregate demand will further
  increase by MPC ( 1-t) times change in Y. thus
  total change in equilibrium output is given by

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Effect on equilibrium output due to change in
transfer payment
It is given by
Now, the multiplier is less than the government
expenditure because the part of the increase of
the income is saved. Thus, the effect is less .
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Budget surplus
BS tY -G - TR Where t Y is the tax revenue
G is government expenditure
TR is transfer payment.
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Change in budget surplus due to increase in
government expenditure

• It has two components
• the reduction in budget surplus by the amount
  G
• Increase in the tax revenue due to the increase
  in the income. This will increase the surplus by
  t Y. where
• Now, budget surplus
• - G 1 / t 1-c(1-t) G -
  (1-c) (1-t)/ 1-c(1-t)

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Change in budget surplus due to increase in tax
rate
This will increase the budget surplus by t Y.
but this will reduce the disposable income in the
economy and thus t Y. Increase in tax
rate will increase the budget surplus , despite
the fact that it will reduce the output.
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