Keynesian analysis focuses on aggregate demand as a key driver of economic activity. This approach examines how consumption, investment, government spending, and net exports interact to determine real GDP and economic gaps.

The Keynesian AD-AS model provides a framework for understanding short-run and long-run economic equilibrium. It explores how changes in aggregate demand components can lead to shifts in the AD curve, affecting output and price levels.

Aggregate Demand in Keynesian Analysis

Real GDP and economic gaps

• Real GDP measures the total value of final goods and services produced in an economy, adjusted for inflation to account for changes in price levels over time
• Represents the actual output of an economy in a given period, typically a year or quarter
• Potential GDP represents the maximum sustainable output an economy can produce when fully employing its resources (labor, capital, and technology)
• Recessionary gap occurs when actual real GDP is below potential GDP
  • Indicates an economy is operating below its full capacity, leading to unemployment and underutilization of resources
  • Suggests a need for expansionary fiscal or monetary policies to stimulate aggregate demand and close the gap
• Inflationary gap occurs when actual real GDP exceeds potential GDP
  • Suggests an economy is producing beyond its sustainable capacity, leading to inflationary pressures and overheating
  • Calls for contractionary fiscal or monetary policies to reduce aggregate demand and close the gap

Structure of Keynesian AD-AS model

• Aggregate demand (AD) represents the total demand for goods and services in an economy at different price levels
  • AD curve slopes downward, showing an inverse relationship between price level and quantity demanded
  • Composed of consumption (C), investment (I), government spending (G), and net exports (NX)
• Aggregate supply (AS) represents the total supply of goods and services in an economy at different price levels
  • Short-run aggregate supply (SRAS) curve is upward sloping, reflecting the positive relationship between price level and quantity supplied in the short run
    • Assumes some input prices (wages) are fixed, allowing for increased output as prices rise
  • Long-run aggregate supply (LRAS) curve is vertical, indicating that output is determined by factors of production in the long run
    • All input prices adjust fully to changes in price level, resulting in no long-run tradeoff between inflation and output
• Equilibrium occurs at the intersection of the AD and AS curves, determining the price level and real GDP in the economy
  • Short-run equilibrium may differ from long-run equilibrium due to sticky prices
  • Changes in AD or AS lead to shifts in the curves and new equilibrium points

Determinants of consumption and investment

• Consumption expenditure (C) is determined by disposable income (Y-T) and the marginal propensity to consume (MPC)
  • Disposable income is total income (Y) minus taxes (T), representing the amount households have available to spend or save
  • MPC represents the proportion of an additional dollar of disposable income that is spent on consumption goods and services
    • $C = a + MPC(Y-T)$, where $a$ is autonomous consumption (spending independent of income)
    • Higher MPC implies a larger increase in consumption for a given increase in disposable income
• Investment expenditure (I) is influenced by the interest rate (i), expectations of future economic conditions, and the marginal efficiency of capital (MEC)
  • Higher interest rates increase the cost of borrowing, reducing the profitability of investment projects and thus decreasing investment spending
  • Positive expectations of future economic conditions (growth, demand) encourage businesses to invest in expansion and new projects
  • MEC represents the expected rate of return on investment projects, with higher MEC leading to increased investment
    • Businesses compare MEC to the interest rate when deciding whether to invest
  • Animal spirits can influence investment decisions, reflecting the role of intuition and emotion in business decision-making

Government and trade in aggregate demand

• Government spending (G) directly contributes to aggregate demand as a component of the AD equation
  • Increases in government spending, ceteris paribus (all else equal), shift the AD curve to the right, increasing real GDP and price level
    • Examples: infrastructure projects, defense spending, education, and healthcare
  • Decreases in government spending, ceteris paribus, shift the AD curve to the left, reducing real GDP and price level
    • May occur during fiscal consolidation or austerity measures
• Net exports (NX) represent the difference between exports (X) and imports (M), contributing to aggregate demand
  • $NX = X - M$
  • Exports are goods and services produced domestically but sold to foreign countries, generating income for the domestic economy
  • Imports are goods and services produced abroad but purchased by domestic consumers, representing a leakage from the circular flow of income
  • Increases in net exports (higher X or lower M), ceteris paribus, shift the AD curve to the right, increasing real GDP and price level
    • May result from increased foreign demand, improved competitiveness, or exchange rate depreciation
  • Decreases in net exports (lower X or higher M), ceteris paribus, shift the AD curve to the left, reducing real GDP and price level
    • May stem from reduced foreign demand, loss of competitiveness, or exchange rate appreciation
• Changes in government spending and net exports can be used as tools for fiscal policy to influence aggregate demand and stabilize the economy
  1. Expansionary fiscal policy (increased G or reduced taxes) can be employed during recessions to stimulate AD and promote growth
  2. Contractionary fiscal policy (decreased G or increased taxes) can be used during inflationary periods to reduce AD and control inflation
  3. Trade policies (tariffs, quotas, subsidies) can be adjusted to influence net exports and, consequently, AD

Keynesian Theory and Effective Demand

• John Maynard Keynes developed the concept of effective demand, which emphasizes the role of aggregate demand in determining economic output
• The multiplier effect describes how an initial change in spending leads to a larger change in GDP due to the circular flow of income
• Liquidity preference theory explains the demand for money and its impact on interest rates, influencing investment and aggregate demand