Keynesian economics Study Guide

📖 Core Concepts Aggregate Demand (AD) – Total spending on goods & services at a given price level; drives output & inflation. Effective Demand – The AD level that actually determines equilibrium output & employment (Keynesian cross). Multiplier Effect – The chain reaction where an initial autonomous spending change induces a larger total income change. Liquidity Preference – The demand for money as a function of the interest rate (and income in later formulation). IS‑LM Model – Two‑equation framework: IS (investment = saving) and LM (liquidity preference = money supply) that captures fiscal‑monetary interaction. Fiscal Policy – Government spending & taxation used to raise or lower AD, especially via deficit spending in recessions. Monetary Policy – Central‑bank actions (money supply, interest rates) that affect investment & consumption through liquidity preference. Wage Rigidity – Wages do not fall enough to clear labor markets, allowing involuntary unemployment. 📌 Must Remember Simple multiplier: \(k = \frac{1}{1-c}\) where \(c\) = marginal propensity to consume (MPC). In money market equilibrium: \(L(r)=\hat{M}\) (or \(L(Y,r)=\hat{M}\) with income dependence). IS curve: points where \(I(Y,r)=S(Y)\). LM curve: points where \(L(Y,r)=\hat{M}\). Liquidity trap: interest rate at lower bound → money‑supply changes do not shift LM. Deficit spending = government spending > tax revenue; financed by bond issuance. Crowding‑in can occur when high unemployment makes fiscal stimulus raise private investment profitability. 🔄 Key Processes Multiplier Calculation Determine MPC \(c\). Compute \(k = \frac{1}{1-c}\). Multiply the initial autonomous change in spending by \(k\) to get total income change. IS‑LM Equilibrium Plot IS: set \(I(Y,r)=S(Y)\). Plot LM: set \(L(Y,r)=\hat{M}\). Intersection gives equilibrium output \(\hat{Y}\) and interest rate \(\hat{r}\). Fiscal Stimulus via Deficit Spending Identify shortfall in private AD. Choose size of government spending increase (or tax cut) large enough to fill the gap. Apply multiplier to estimate total impact on output. 🔍 Key Comparisons Keynesian AD vs Classical Say’s Law Keynesian: AD can be insufficient → recession. Classical: Supply creates its own demand → markets self‑adjust. Fiscal Policy vs Monetary Policy in a Liquidity Trap Fiscal: Directly raises AD; still effective. Monetary: Interest rates at zero lower bound; additional money supply ineffective. Crowding‑out vs Crowding‑in Crowding‑out: High employment → stimulus raises rates, reduces private investment. Crowding‑in: High unemployment → stimulus raises profitability, encourages private investment. ⚠️ Common Misunderstandings “Multiplier = MPC” – The multiplier is the reciprocal of the marginal propensity to save (or \(1/(1-c)\)), not equal to MPC itself. Liquidity Preference = Money Supply – Liquidity preference is demand for money; equilibrium requires it to equal the exogenous money supply. Deficit Spending = Permanent Debt Growth – In recession, temporary deficits can raise output; the long‑run debt impact depends on growth of GDP. 🧠 Mental Models / Intuition “Spill‑over ripple” – Think of an initial government outlay as a stone dropped in a pond; the ripple (multiplier) expands outward, magnifying the effect. “Two‑Road Intersection” – IS‑LM is like two roads crossing: moving along IS (more spending, higher output) shifts the economy horizontally; moving along LM (more money, lower rates) shifts it vertically. 🚩 Exceptions & Edge Cases Liquidity Trap – When LM is vertical (interest rate cannot fall), monetary expansion fails to shift equilibrium. High Public Debt – Large existing deficits may dampen the size of the fiscal multiplier (debated in literature). Open Economy Leakages – Imports, taxes, and savings reduce the multiplier; simple \(k = 1/(1-c)\) overstates effect in a non‑closed economy. 📍 When to Use Which Use the Multiplier when evaluating the total impact of a discrete change in autonomous spending (e.g., a stimulus bill). Use IS‑LM for policy interaction analysis: how simultaneous fiscal and monetary moves move output & interest rates. Apply Liquidity Preference when assessing the effectiveness of monetary policy, especially to check for a liquidity trap. Invoke Wage Rigidity when explaining involuntary unemployment despite flexible prices elsewhere. 👀 Patterns to Recognize AD Shortfall → Unemployment, AD Excess → Inflation – Look for phrasing about “below potential output” vs “above potential output.” “Vertical LM” → Liquidity trap scenario. “Crowding‑in” language appears alongside high‑unemployment contexts. “Effective demand” is always paired with equilibrium output in Keynesian cross diagrams. 🗂️ Exam Traps Distractor: “The multiplier equals the marginal propensity to consume.” – Wrong; the multiplier is larger than MPC. Distractor: “In a liquidity trap, increasing the money supply lowers interest rates.” – Wrong; rates are stuck at the lower bound. Distractor: “Say’s law holds in modern economies.” – Wrong; Keynes showed AD can be insufficient. Distractor: “Deficit spending always crowds out private investment.” – Wrong; crowding‑out is minimal under high unemployment, and crowding‑in can occur. --- All bullets are drawn directly from the provided outline; no external information was introduced.