Paper: 11, Managerial Economics

Module: 30, Simple Keynesian Model

Prof. S P Bansal
Principal Investigator Vice Chancellor
Maharaja Agrasen University, Baddi

Prof. Yoginder Verma

Co-Principal Investigator Pro–Vice Chancellor
Central University of Himachal Pradesh.Kangra.H.P.

Prof. S K Garg
Paper Coordinator Former Dean & Director,
H.P. University, Shimla(H.P.)

Indervir Singh
Content Writer Assistant Professor,Dept. of Economics and Public Policy
Central University of Himachal Pradesh.Kangra.H.P.

Managerial Economics
Management
Simple Keynesian Model
 Items Description of Module
Subject Name Management
Paper Name Managerial Economics
Module Title Simple Keynesian Model
Module Id Module no.-30
Pre- Requisites Basic understanding of macroeconomic aggregates.
Objectives To enable students to understand Keynesian argument about importance of
aggregate demand in economic stabilization.
Keywords Aggregate supply, Aggregate demand, Effective demand, Multiplier
effect.

QUADRANT-I

Module 30:Simple Keynesian Model

1. Learning Outcome
2. Background
3. Simple Keynesian Model
4. Criticism of Keynesian Model
5. Summary

1. Learning Outcome:

After completing this module the students will be able to:

 understand the Keynesian argument about importance of aggregate demand.
 understand the meaning of effective demand and its importance from policy perspective.

2. Background

John Maynard Keynes published his book,“The General Theory of Employment, Interest and Money” in
1936.The book became one of the most influential works in the history of economics, and led to the rise of
Keynesian economics.The General Theory was an attempt to explain the Great Depression of 1920-30s. The
Classical economists believed that full employment is the natural state of an economy and any departure
from it is temporary as the market forces will lead the economy back to the full employment equilibrium. In
contrast, Keynes argued that an unregulated competitive economy does not automatically lead to full
employment,instead the economy may have a stable equilibrium with under-employment (or under-
production)as its natural state.He argued that without an active intervention of government, this equilibrium
maystay for a long time.

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 Before discussing Keynes’s argument, let us briefly discuss the argument of the classical economists. The
argument of classical economists can be best described with Say’s law. Say’s law rejects the possibility of
general over-production. Over-production may happen in some markets due to misallocation of resources,
that is, low demand of a product means excess demand of another good. If there is over-production of one
commodity, then the market forces will lead to shift in production, so that, in the long run,supply is equal to
demand.Here, it should be mentioned that production at optimum point also means full employment, as
resources will be fully employed and all that is produced is sold. In case of unemployment, the wage rate
will decline until all those who wish to work get employed.

Say’s law is based on the argument that people produce commodities because they want other commodities
in exchange (here, self-consumption of commodities is ignored as it does not cause over-production).
Therefore, each person while producing a commodity also creates a demand of equal worth. In a barter
economy, the validity of the argument is clear, as the people will produce goods only if they are interested in
exchanging them for others commodities. In other words, the nature of exchange ensures that the demand of
commodities is equal to supply of commodities. If a product is not sold, that is, there is over-production of a
commodity, then the nature of exchange requires that there is under-production of some other commodity. In
this situation, some of the people who were engaged in over-produced commodity will shift to the
production of under-produced commodity.

To make the argument clearer, let us suppose that there are just three commodities, x, y and z, produced in an
economy. In a barter economy, people produce with a purpose to exchange their produce with other
commodities. For example, a person, in our three commodity case, produces commodity x only if she wishes
to have commodity y or z or certain quantity of both. Similarly, the producer of y and z commodities will
like to get at least one of the other two commodities in exchange. Now, suppose a producer of x fails to
exchange some of her produce for the desired commodity (say, y), then there will be over-production of x in
the economy. In a barter economy, x will only be produced in excess if at least one of the other commodities
(that is, y or z or both) is under produced. Remember that in abarter economy, the producer of a commodity
has no other use of her produce than exchanging it with another commodity. As in our case,the producers of
y have just two commodities (x and z) to exchange their produce. If the producer of y does not exchange y
for x, then the situation means either under production of y or higher demand for z (in terms of quantity of y
required to get a unit of z). If z is under produced, more y will be required to get a unit of z. This situation is
similar to having high profits in the production of y or z or both if money is used for exchange.

Managerial Economics
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 In this situation, the producer of x will start shifting to the production of zor y or both until over-production
ceases to exist. This three commodity case can be extended to n commodity case without any change in the
basic argument.The crux of the argument is that over-production of some commodities means under-
production of some other commodities. Therefore, it is possible to have over-production in some of the
markets but not all markets. Also, over production is a short-run phenomenon, as shift in production will
remove this over-production. In other words, in the long run, all that is supplied will be consumed, and the
resources will be fully employed.

Before proceeding further, let us discuss the meaning and implications of general over production. General
over-production is a situation, when over-production exists in a number of markets without other
commodities being under-produced. This has a direct implication on economic activity as well as on
employment. If over-production is associated with under-production in other markets, the resources will shift
from one type of production to other. However, non-existence of excess demand for other commodities
means, the resources, which gets unemployed due to lower demand, will not be absorbed elsewhere. This
situation means the existence of unemployment in the long run. For example, the over-production of x, in the
previous three commodities case, will be general over-production if there is no under-production of z or y.
So the labour force, which will get unemployed due to reduction of production of x(as there is no point
producing the quantity that remains unsold or unexchanged), will not be absorbed anywhere else.

Classical economists applied the same argument toan economy which uses money for exchange. Bringing
money into the picture creates a problem, as money can be saved. In barter economy, a commodity is not
produced to be exchanged at some future date. So, supply and demand is produced at the same time.
However, when commodities are exchanged for money, the producer may not spend the money received
after selling the commodity.As a result, the value of commodities produced may not be equal to total
expenditure of the people. However, the total expenditure may still be equal to value of commodities
produced if total saving of the people is equal to total investment. The classical economists believed that a
rational person will invest his savings. Therefore,total income will be equal to total expenditure.If all savings
are invested, over-production of some commodities means under-production of some other goods, that is,
people are spending more on some commodities relative to others. In this situation, under-produced
commodities will be earning higher profit as their prices will increase due to high demand, and over-
produced commodities, due to fall in their prices, will be bearing loss.As a result, there will be shift from the
production of the over-produced commodities to under-produced commodities. Again, the classical
argument denies the possibility of general over-production.

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 Keynes, however, pointed out that general over production may happen due to lower aggregate demand in
the economy. Though many economists, like Thomas Robert Malthus, have already made the argument that
under-consumption may lead to general over-production, they failed to provide a complete explanation for it.

3. Simple Keynesian Model

Keynes provided a theory of employment and output by arguing that depressions are the result of inadequate
aggregate demand in the economy. He argued that production decisions of the firms are based on spending
decisions of the people. Increasing expenditure of the people leads to increase in production, whereas
decrease in spending results into decline in production.Thus, it is the aggregate demand that decides the level
of output in the economy.Keynes by pointing out the possibility of lower spending rejected the classical
economists’ argumentwhich denied the possibility of general over-production. As per Keynes, the aggregate
spending may not always match the income generated in an economy at full employment level. In Keynesian
theory, equilibrium exists in the economy where spending decisions of the people match production
decisions of the firm, that is, aggregate demand is equal to aggregate supply (see, Module 28 for discussion
on macroeconomic aggregates). Keynes termed this point effective demand.

To understand Keynesian argument, we shall differentiate between actual expenditure and planned
expenditure.Actual expenditure is the amount spentby consumers, firms and government to purchase
commodities. Actual expenditure in the economy is equal to total income of the country, as one person’s
spending is other person’s income (see, Module 29 of the present paper for discussion on national income).
In a closed economy, it is equivalent to gross domestic product (GDP). Planned expenditure, on the other
hand, is the amount that consumers, firms and government plan to spend on commodities. Planned
expenditure may differ from actual expenditure, as a firm may sell more or less than its plannedsale leading
to increase or decrease in firm’s inventories.Thus, the planned expenditure may be less or more than the
actual expenditure.

In a closed economy, the planned expenditure (P) consists of consumption (C), planned investment (I) and
government expenditure (G).Therefore, it can be written as:

𝑃 =𝐶 +𝐼+𝐺 …(1)

Let 𝐶 = 𝑓(𝑌 − 𝑇) be a consumption function, where Y is the income of the people and T is tax paid to the
government. The function shows that consumption depends on the disposable income, 𝑌 − 𝑇, of the
people.After replacing C in (1) with the consumption function, one will get:

Managerial Economics
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Simple Keynesian Model
 𝑃 = 𝑓(𝑌 − 𝑇) + 𝐼 + 𝐺 …(2)

Let us assume that investment, government expenditure and tax are exogenously determined and fixed. To
distinguish fixed investment, tax and government expenditure, we will write them as 𝐼 , 𝐺 and 𝑇. Now, the
equation (3) can be written as:

𝑃 = 𝑓(𝑌 − 𝑇) + 𝐼 + 𝐺 (3)

Equation (3) shows that planned expenditure is the function of income (Y),tax (𝑇), government expenditure
(𝐺 ) and planned investment (𝐼 ).Figure 1 shows the relation between planned expenditure (P) and income (Y).
For convenience, a linear relation between Y and P is assumed. However, one may drop this assumption
without any change in the basic argument or relations. A linear relationship means a constant slop of the
line. The slope of the line is the ratio of change in consumption (ΔC) and change in income (ΔY), which
represents change in consumption expenditure with a unit change in income. This ratio is called marginal
propensity to consume (MPC).

𝛥𝐶
𝑀𝑃𝐶 =
𝛥𝑌
For example, MPC is 0.8 if for 100 rupees increase in income, the consumption increases by 80 rupees. For a
𝑑𝐶
differentiable consumption function, MPC can also be the derivative of C with respect to Y, that is,𝑑𝑌 .For
𝑑𝐶
example, if 𝐶 = 𝑎 + 𝑏(𝑌 − 𝑇), then 𝑀𝑃𝐶 = 𝑑𝑌 = 𝑏.Since tax, investment and government expenditure are

assumed as fixed (in equation 3 and figure 1), MPC is equal to slope of planned expenditure line. Therefore,
𝛥𝑃
MPC in figure 1 is also equal to .The slope of line in Figure 1 shows that with eachRs. 1 increase in
𝛥𝑌

income, the increase in planned expenditure will be less than Rs.1, that is, MPC<1. It is expected as people
often do not consume their entire increased income.

Managerial Economics
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Simple Keynesian Model
 Planned Expenditure (P)
−

ΔP
ΔY

Income (Y)
Y1 Y2
ΔY = Y2 – Y1

Figure: 1

The economy is in equilibrium when the planned expenditure, P, is equal to income, Y (that is, actual
expenditure). However, as discussed earlier, the planned expendituremay be higher or lower than income.
Figure 2 shows these three possibilities. The economy is in equilibrium at point E as planned expenditure is
equal to income. Since the plans of the people realize in equilibrium (or aggregatedemand is equal to
aggregate supply), the firms need not change their production.Now assume the second possibility that
planned expenditure is higher than income (at income, Y1in Figure 2). At this point, the firms are selling
more than their production, therefore, their inventories will decline. In response, the firms will increase the
production and hire more workers. In other words, if planned expenditure is higher than income in any
period, income and employment will increase in the next period. An increase in income will also lead to
increase in planned expenditure. Nonetheless, increase in planned expenditure will be less compared to
income increase, as MPC<1.Due to increase in income and planned expenditure, the economy will move
towards the equilibrium point E.

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Simple Keynesian Model
 P=Y

Planned Expenditure (P)

Y2
P=C+I+G
P2
P2< Y2
P, Y E
P=Y
P1 P1>Y1

Y1

45o
Y1 Y Y2 Income (Y)
Figure: 2

Now suppose that the economy is at income, Y2, andthe planned expenditure (P2) is lower than the income.
Here, the firms will be selling less than their plan, and the firms will accumulate inventories. The firms will
respond to the situation by lowering their production, and the total income will decline. Lowering of the
production will be accompanied withlower employment, as extra workforce will be laid off. The planned
expenditure will also declinewith the income decline, however, its decline will be less as MPC<1. Again the
economy will move towards equilibrium point E. Thus, the economy has a tendency to come back to
equilibrium, where planned expenditure is equal to income. The employment in the economy will also be
corresponding to the income, Y. However, Eneed not be a full employment equilibrium. The equilibrium, E,
is a point where aggregate demand in the economy is equal to aggregate supply. It is possible that the full
employment income level is towards the right side of Y. Let us suppose, Y2 is the full employment income
level. Itis not sustainable income level due to lower aggregate demand (or lower planned expenditure), and
economy will return to income, Y.There will be general over-production at full employment income (that is,
Y2). The situation can be imagined as an equilibrium point where no over-production exists, however, a share
of worker force is not included (or partially included) in production and exchange process.

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Simple Keynesian Model
 P=Y

Planned Expenditure (P)

P = C + I + G + ΔG
E2
ΔG P=C+I+G

E1
ΔY

45o
Y1 Y2 Income (Y)

ΔY = Y2 – Y1

Figure: 3

Keynes argued that the government can use fiscal policy to stimulate the economy and put it at a higher
income level. The argument can be explained using Figure 3. Let us suppose, the economy is at equilibrium
E1. Let us suppose that income, Y2, is full employment equilibrium. It means that economy is producing at
below full employment level of income. As previously discussed, any change in income will not sustain
unless the equilibrium is shifted to E2, which is corresponding to the full employment income. Now suppose
that the government increases its expenditure by a fixed amount ΔG. This increase will shift the planned
expenditure upwards, as thisadditional expenditure will add to the planned expenditure at each income level.
Due to this shift, the new equilibrium will be at E2, and Y2 will be the new equilibrium level of income. Also,
the economy will be at full employment level in the new equilibrium. Thus, the fiscal policy may increase
the income to full employment level. In addition to advocating increase in government expenditure, Keynes
also criticized classical argument that wage decline will lead to full employment. In Keynesian model, the
planned expenditure is an important determinant of the income level. Keynes argued that any decline in the
wage rate also lowers the purchasing power of the people, which shifts the planned expenditure line
downwards towards worse income equilibrium. Therefore, the decline in wage rate cannot solve the problem
of general over-production.

Managerial Economics
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Simple Keynesian Model
 The above model shows increase in income due to increase in government expenditure. However, this
increase in income in Keynesian model is higher than the increase in government expenditure. It is called
Multiplier effect. The additional government expenditure increases the income of the people. This increased
income also increases consumption of the people. Since the consumption of one person is the income of
another, the consumption out of income received from additional government expenditure further increases
the income. Since the income receiver at each stage will consume a portion of their income, this process will
go on. Thus, the actual income will be higher than the additional government expenditure.The total increase
in income due to government interference depends on MPC. For example, if the government increases the
expenditure by Rs. 100, then the immediate increase in income will be Rs. 100. Now suppose that people
spend 80 percent of their additional income, that is, MPC is 0.8. The next increase in income due to first
receivers’ consumption will be Rs. 80 (multiply income with 0.8 to get the next increase in income).
Assuming that the receivers’ of Rs. 80 also has MPC=0.8, the next income increase will be Rs. 64. The
income increase in the subsequent rounds can be calculated in a similar way. The total increase in income in
this example can be written as (using infinite geometric series):

Total Income Increase = 100 + 100 × 0.8 + 100 × 0.82 + 100 × 0.83 + ⋯

1
= 100 + 80 + 64 + 51.2 + ⋯ = 100 × = 𝑅𝑠. 500
1 − 0.8

In general, the formula for total increase in income (ΔY)due to increase in government expenditure (ΔG) can
be written as:

1
𝛥𝑌 = 𝛥𝐺 + 𝛥𝐺 × 𝑀𝑃𝐶 + 𝛥𝐺 × 𝑀𝑃𝐶 2 + 𝛥𝐺 × 𝑀𝑃𝐶 3 + ⋯ = 𝛥𝐺
1 − 𝑀𝑃𝐶

The multiplier effect is the change in income due to change in government spending, therefore, multiplier
𝛥𝑌 1
(𝛥𝐺 ) is 1−𝑀𝑃𝐶 . In other words, the multiplier effect depends on the marginal propensity to consume. A larger

MPC means higher increase in income, and lower MPC means low increase in income. It should also be
mentioned that the multiplier effect is discussed as a static concept here. We have calculated income increase
as if the government spending will immediately increase the income. In reality, the income increase is not
immediate, and happens in multiple periods. In each period, the income responds to the change in planned
expenditure and the economy moves to the new equilibrium income level. This multiple period effect on
income is called dynamic multiplier.

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 4. Criticism of Keynesian Model

Keynesian theory is also criticized for failing to provide good prediction of economic activities. Keynesian
theoryemphasized the problem of low aggregate demand. However, most of the unemployment after 1950s
was due to supply side constraints. The problem happens because Keynes considered aggregate supply curve
to be elastic even in long run. However, it is true only in the short run, asthe shape of aggregate supply curve
depends on flexibility of prices and wage rate in economy. If prices and wage rate are flexible, the excess
production will disappear as argued by classical economists (lower prices and wages increase the demand for
commodities and labour services). Therefore, the total production in an economy depends on amount of
capital and labour, and on existing technology, and aggregate supply curve isinelastic. On the other hand, the
rigid prices and wage rate makes the adjustment difficult, and, as a result, aggregate supply curve is elastic.
The prices and wages tend to be rigid in short run and flexible in the long run. Therefore, the long run
aggregate supply curve is vertical as shown in Figure 4(a). The vertical aggregate supply curve represents no
effect of prices on supply of goods. However, prices and wage rates tend to be rigidin the short run.
Therefore, aggregate supply curve is horizontalas shown in Figure 4(b), which means producers respond to
the price change by changing the production, where lower prices will means lower production. If the total
output in the economy is determined by interaction of aggregate demand and aggregate supply.Increasing
aggregate demand increase the production only in short run, andincreasing aggregate demand will have no
effect on incomein long run. One of the implications of aggregate demand–aggregate supply model is that
demand management will not work if supply constraint is the problem.

Long run Aggregate Supply Short run Aggregate Supply

AS
Price Level (P)

Price Level (P)

AS

Output (Y) Output (Y)

Y*
Figure: 4(a) Figure: 4(b)

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 There are also problems related to using Keynesian policy suggestion during recession. To understand this,
let us consider the possible ways of funding additional government expenditure.The additional expenditure
can be funded by raising taxes orbudget deficit.High tax rate discourages economic activity, and lowers the
consumption of the people. Thus, any positive effect of additional expenditure is negated by negative effect
of taxes (in fact, Keynesian economists suggest cutting taxes during recession). Therefore, deficit financing
is the best way to finance the additional expenditure.Budget deficit may be financed by borrowing from the
market or printing money. If supply constraint is the problem,borrowing money from the market leads to
increase in rate of interest (especially in a full employment situation), which lowers the private investment in
the economy (called crowding out effect).Thus, the positive effect of the additional expenditure may be
much lower or even negative (if government expenditure is less productive than private investment). Further,
the financing of deficit by printing money may lead to inflation, especially if the economy is already
recovering.In addition, it is difficult to know the exact amount of increase in government expenditure (or
fiscal stimulus) required to bring the economy out of recession. A larger stimulus may lead to much higher
negative effect of inflation and crowding out. Therefore, increasing government expenditure is not free from
problems.

5. Summary

Keynesian theory originates from the failure of classical economists’ to explain the 1920-30s depression, and
changed the way economists think about macroeconomic issues. The theory is based on the argument that in
an economy, the income depends on the aggregate demand. The aggregate demand by influencing the
expectations of the producers determines the level of production in the economy. The economy is at
equilibrium where the expectations of the people are met. However, this equilibrium point need not be full
employment equilibrium. Therefore, the government interference through increase in expenditure may bring
about full employment equilibrium in the economy. Despite many criticisms, the theory along with the
debates surrounding it provided important insights into the macroeconomic aspects and role of government
expenditure.

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Simple Keynesian Model