Keynesian Model and Macroeconomic policy - Essay Example

Macroeconomic policy Running head: MACROECONOMIC POLICY Keynesian model and Macroeconomic policy Student Ref: University: Course: Date: John Maynand Keynes argued that the volatility (instability) of expectations meant that aggregate demand was subject to large fluctuations in the level of output and employment. He went ahead and argued that product prices and images are downwardly inflexible, resulting in what is graphically illustrated below as a horizontal aggregate supply curve. Therefore aggregate demand is subject to periodic changes caused by changes in the determinants of aggregate demand. [Lipsey, Richard, G. (1989)]. Price (p) P1 AD0 AD1 0 Q1 Q2 Real GDP (q) Aggregate demand is unstable because prices and wages are downwardly inflexible. This decline (from AD0 to AD1) has no effect on price level but real output falls from Q0 to Q1 and can remain at its equilibrium indefinitely. Keynesians therefore believe that it is necessary for governments to intervene and manage the level of demand in the economy inorder to obtain and retain full employment. In other words, unless careful measures are taken to offset increase in aggregate demand, real output may remain below full employment. The Keynesian-monetary transmission mechanism is the transmission mechanism through which a change in money supply affects real output according to the IS-LM model. Keynesians emphasize the role of interest rates and investment spending in accounting for changes of money supply that affect real output. A change in monetary policy changes the country's money supply. The change in money supply affects the interest rates, which changes investment levels. The change in investment levels when the economy is operating at less than capacity changes the real output level by the income multiplier effect. In another scenario where the economy is achieving full employment a change in investment will affect the real output through change in price levels. Change in Change in Change in Change in the Change in monetary policy commercial money supply interest rates investment policy bank reserves levels Change in real output (GPD) of the Economy Recession can be defined as that period/phase when there is a decline in economic activity in an economy. At this time, high unemployment levels, and low investments in new equipments and machinery together with low levels of technology characterize the economy. When in a recession, Aggregate demand is low in that the sales are low, high unemployment that the jobs suffer meaning that the population has no money ad therefore low spending. To recover from a recession, private business investments and governments hold the key because the consumers have limited amounts of money in their hands and therefore they are not the cause of ups and downs of the business cycle. To remedy a recession, the Keynesians can enlarge the levels of investments in the economy or the governments can create public substitutes for the shortages in private investments because the government provides some utility goods for free. Also if the economy contractions are mild, the interest rates can be reduced to induce more borrowing and provide easy credit/loan. This will help to stimulate private investment and restore aggregate demand to a level rhyming with full employment. For severe contractions, the Sterner remedy of deliberate budget deficits can be employed either in the form of spending on public works e.g. free education, health, transport or subsidizing the consumer. A fiscal policy is a government activity that concerns taxation and public spending. These are the government's tools in their hands in economic policies like maintaining economic growth. A fiscal policy can be expansionary or contractionary. Expansionary fiscal policy In this case GDP expands. Usually the government reduces/cut the taxation level. It so happens if the economy is potential output level. The government may cut the tax to expand the output in the economy. At this time full employment is also equal to potential employment. If there is a tax reduction/cut, the equilibrium output increases and the rate of inflation is constant. In the short run, a tax cut results to increased spending and aggregate demand increases and the equilibrium output is greater than the potential output. In the long run prices will increase to high demand. This leads to a gradual rise in inflation. This analysis is only sustainable on the basis of the assumption that the economy is stating at the potential level of output and if the assumption is relaxed, then the whole analysis doesn't hold. Expansionary fiscal policy Long run Inflation () IA - Inflation Adjustment curve y* - Full employment 0 IA y** - Potential employment AD0 AD1 0 y* y** Output () Short run Inflation () IA1 IA0 AD0 AD1 0 y* y** Output () In the short run the aggregate demand curve shifts outwards from AD0 to AD1 and the output level increases from y** (the potential output) to y* (full employment level) the inflation level remains constant. In the long run the inflation rises gradually (indicated by broken line) from 0 to 1. The level output which is also the full employment level reduces from y* to y**. Contractionary fiscal policy In this case the GDP is reduced. It arises if the government chooses to cut down on its own expenditure like education, retrenchment, and health care. This leads to a reduced aggregate demand. If the economy is at its potential level of output, aggregate demand declines causes the short run equilibrium level of output to be below the potential output. When this happens we expect inflation to fall overtime thereby returning the economy to potential output with low inflation. Short run Input () IA AD1 AD0 0 y* y** Output () In the short run due to reduced level of spending, the aggregate demand shifts inwards from AD0 to AD1 (decline). Long run Input ( ) 0 IA0 1 IA1 AD1 AD0 0 y* y** Output () In the long run, we expect that there will be a gradual decline in inflation from 0 to 1 and the inflation adjustment curve shifts from IA. to IA. and the economy is brought back to full employment at y**. References Lipsey, Richard, G. (1989). An Introduction to Positive Economics. English Language Book Society, 7th ed. Pp573-577, 670. Campbell R. McConnell, Stanley L. Brue. Economics. Principles, Problems and Policies. 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