The Keynesian fiscal policy model asserts that the aggregate demand which is obtained from the sum of expenditure by businesses, households and the government is a vital driving force in the economy. The free markets lack self-balancing mechanisms that would lead to full employment while the government through public policies aims to achieve full employment and stability of prices.
The model relies on three key assumptions:
Rigid prices that prevent some markets from achieving equilibrium in the short run.
Effective demand causing consumption expenditures to base on actual income and not full employment.
Saving and investment determinants such as income and other influences beyond the interest rate.
The four components of the Keynesian model include consumption. Investment. Government expenditure and net exports.
The consumption expenditures are largely influenced by the consumers level of income. An increase in income would result in a slight increase in consumption. A relationship is established between consumption and income known as the consumption function.
This component includes expenditure on fixed assets such as machinery, changes in inventory, raw materials, and finished goods. It shows that in the short run, expenditure on investment is not a function of income.
Likewise to investment, planned government expenditures are not a function of income.
An increase in the aggregate income results in exports remaining constant and an increase in imports. Therefore, a rise in the aggregate income results in a reduction in the net exports.
The model views market economies as being inherently unstable and prone to booms and busts. Multiplier effects resulting in variations in demand tend to cause wild swings in the economy. However, private business investment fluctuations are seen to be the largest cause of swings to the economy at different levels of output.
The vital elements in the Keynesian fiscal policy that describe how the economy operates.
The aggregate demand.
This is influenced by many economic decisions made by both public and private sectors. Decisions made by the private sector can sometimes lead to adverse macroeconomic outcomes. Market failures also call for active policies by the government such as the fiscal stimulus package. Keynesian economics, therefore, supports a mixed economy mainly guided by the private sector but partly operated by the government.
Prices and wages.
These factors respond slowly to variations in demand and supply leading to periodic shortages and surpluses in labor.
Aggregate demand variation
A variation in the aggregate demand has a great impact in the short-run effect on the real output and employment and not on prices. The model assumes that as a result of the rigidity of prices, a variation in any of the component of spending would result in a change in the cause of output.
The multiplier effect
This is the expansion of a countrys money supply resulting from banks being able to lend. Its size depends on the percentage of deposits required by banks to be held as reserves. The output changes as a result of some multiple of the increase or decrease in spending that caused the variation. A fiscal multiplier greater than one means that one dollar increase in government spending would result in an increase in output of greater than one dollar.
Blinder, A. S. (2011, 01 30). The Concise Encyclopeida of Economics. Retrieved from keynesian ecinimics: http://www.econlib.org/library/Enc/KeynesianEconomics.html
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Lucas, R. (2016, 09 08). The Economist. Retrieved from Keynesian multiplier: https://www.google.com/url?q=https://www.economist.com/blogs/economist-explains/2016/09/economist-explains-economics-3&sa=U&ved=0ahUKEwjmq6ugl4LVAhVJPhQKHX2PAM4QFggFMAA&client=internal-uds-cse&usg=AFQjCNHnYazsCGd3y1kovkFKqZxTbN55CQ
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