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The Basic Principles of Keynesian Economics
Keynesian economics is based off of how changes in aggregate demand affect inflation and output.
1. When there is a change in taxes (fiscal policy) or a change in the money supply (monetary policy), the demand curve is influenced in response.
2. Demand consists of Consumption, Investment, Government Spending, and Net Exports. Any change in any of those variables, changes output because it causes a shift in the demand curve (see graph top right).
3. Things like a minimum wage and labor unions make it difficult for wages to decrease tremendously over a short period of time, thus giving them the name "sticky." (For example, it is hard for a corporation to lower the salaries of their employees because their employees could strike until their wages are more acceptable to them. The minimum wage also prevents wages from decreasing below a certain point.) Because of these sticky wages and prices, when the government injects money into the economy, as Keynes suggested, there is a multiplier effect. If wages and prices were flexible and adjusted to changes in the economy, government spending would just result in an overall percentage increase of prices and wages throughout the economy. (See the next section, Review: The Multiplier Effect for further detail about calculations for the AP Exam.)
4. Keynesians feel the unemployment rate is too high and changes too often, but would not if the government intervened more often. They also feel that recessions and depressions are just economic issues that can be avoided also trough government intervention.
5. The most important focus of Keynesian economics is to decrease the peaks and troughs of the business cycle, or to keep fluctuations in the economy as small as possible. However, the government does not know enough to make smaller adjustments to the economy because of lags that include a need for a change in policy, recognition of this, and noticing when the changes occur. Therefore, Keynesians go for the basic and larger intervention in the economy such as simply expanding when unemployment is high.
6. Keynesians believe the government can be involved in the economy because dramatic changes in the economy decrease "well-being" for citizens, and the government has resources and knowledge to deal with the economy.
1. When there is a change in taxes (fiscal policy) or a change in the money supply (monetary policy), the demand curve is influenced in response.
- If taxes are lowered, people will spend more because they will have more money, which increases demand, and shifts the demand curve to the right.
- If taxes are increased, people will spend less because they will have less money, which decreases demand, and shifts the demand curve to the left.
- If the money supply increases, interest rates decrease because the increased supply of money makes the interest rate go down to match the demand of money. This decrease of the interest rate, means more people will borrow money to spend, which increases demand and expands the economy.
- If the money supply decreases, interest rates increase because the decreased supply of money makes the interest rate go up to match the demand of money. This increase in the interest rate, means fewer people wil borrow money to spend, which decreases demand and contracts the economy.
2. Demand consists of Consumption, Investment, Government Spending, and Net Exports. Any change in any of those variables, changes output because it causes a shift in the demand curve (see graph top right).
3. Things like a minimum wage and labor unions make it difficult for wages to decrease tremendously over a short period of time, thus giving them the name "sticky." (For example, it is hard for a corporation to lower the salaries of their employees because their employees could strike until their wages are more acceptable to them. The minimum wage also prevents wages from decreasing below a certain point.) Because of these sticky wages and prices, when the government injects money into the economy, as Keynes suggested, there is a multiplier effect. If wages and prices were flexible and adjusted to changes in the economy, government spending would just result in an overall percentage increase of prices and wages throughout the economy. (See the next section, Review: The Multiplier Effect for further detail about calculations for the AP Exam.)
4. Keynesians feel the unemployment rate is too high and changes too often, but would not if the government intervened more often. They also feel that recessions and depressions are just economic issues that can be avoided also trough government intervention.
5. The most important focus of Keynesian economics is to decrease the peaks and troughs of the business cycle, or to keep fluctuations in the economy as small as possible. However, the government does not know enough to make smaller adjustments to the economy because of lags that include a need for a change in policy, recognition of this, and noticing when the changes occur. Therefore, Keynesians go for the basic and larger intervention in the economy such as simply expanding when unemployment is high.
6. Keynesians believe the government can be involved in the economy because dramatic changes in the economy decrease "well-being" for citizens, and the government has resources and knowledge to deal with the economy.
Review: The Multiplier Effect
Because of sticky wages and prices, when the government injects money into the economy, as Keynes suggested, there is a multiplier effect. This means that if the government spends money on a war, they will spend money on something like tanks, which will give money to the companies producing the tanks and then maybe metal companies. These companies will all have more money from the government's purchase, and increase the salaries or bonuses of their employees, who will spend their extra money and get the economy moving again. Because the money injected into the economy "multiplies," the government only has to spend a portion of the money they wish to see moving through the economy. Here is how it works:
MPS = Marginal Propensity to Save
MPC = Marginal Propensity to Consume
If you are given the change in saving or consumption and change in disposable income, and you need MPC or MPS, you can do the following...
MPC + MPS = 1
Multiplier: 1/MPS
The following video discussed the Keynesian Multiplier and how to complete calculations. The first part of the video involves a hypothetical scenario to help you understand the basic ideas of what happens with the formulas. The calculations start at around 7:50 minutes.
MPS = Marginal Propensity to Save
MPC = Marginal Propensity to Consume
If you are given the change in saving or consumption and change in disposable income, and you need MPC or MPS, you can do the following...
- MPS = Change in Saving/Change in Disposable Income
- MPC = Change in Consumption/Change in Disposable Income
MPC + MPS = 1
Multiplier: 1/MPS
- The example in the paragraph above, depicts a situation in which this formula would be used to calculate how much money the government has to spend for the economy to grow.
- The tax multiplier will be negative. This formula deals the effects of increasing or decreasing taxes, so if taxes increase, the economy will contract, resulting in negative growth or a negative multiplier.
The following video discussed the Keynesian Multiplier and how to complete calculations. The first part of the video involves a hypothetical scenario to help you understand the basic ideas of what happens with the formulas. The calculations start at around 7:50 minutes.