Macroeconomics: Assignment

Lee Ka Nga (Alex)

Keynesian, who was against the classical assumption that economy can run automatically, believed disequilibrium will lead to recession or inflation. It is mainly about the change of aggregate demand in the economy which means total demand of all goods and services at any given price level. In formula, aggregate demand is the sum of consumption, investment, government spending and net export. Keynesian’s idea mostly focuses in short run as he thought that all people will be dead in long run. He revealed that the any changes in aggregate demand will affect the economic demand for output, inflation rate and unemployment rate. In a recession, it means decreasing or insufficient aggregate demand. When there is a disequilibrium economy which withdraws is higher than injections, national income will decrease.

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A decrease in aggregate demand will lead to a decrease in total income as a decrease in GDP. In the graph shown above, recession means aggregate demand shifting from AD1 to AD0 and income will change from Y1 to Y0.

In Keynesian theory, he believes that aggregate demand cannot automatically adjust itself but only be influenced by fiscal and monetary policies. Government should use different appropriate policies to against economic recession period. Fiscal policy means government changing the spending or tax rate to shift the aggregate demand upwards. To against recession, government should make budget deficit to pull the economy out of the recession period. Increasing government spending and reducing taxation push aggregate demand upwards and AD0 will shift back to AD1. For further explanation, increase in government spending will lead the injection increase. If There is an imbalance between withdraw and injection, firms will employ more people for extra aggregate demand. That’s why total income will increase until it retains balance. It is also reported that those policies will also have multiplier effect. That means increasing one dollar in government spending will not only have one dollar increase in GDP but more than that. As when people earn more money, they will spend more. The effectiveness of policy depends on many factors, such as marginal propensity to consume, tax rate and income elasticity on money demand and so on. However, there is also a crowding out effect which reduces the effectiveness of fiscal policy. Since fiscal policy will cause an increase in interest rate which reduces the investment and aggregate demand. Beside, fiscal policies also need to consider the time lag, which means after government has taken actions; it takes time to recognise the national income but not immediately. Finally, Keynesian economics state one more point of income distribution as if the poor have more money, they will more likely to spend it.

On monetary policy, central bank can increase interest rate to decrease saving and increase investment or consumption. Beside, government can reduce the money supply with the same function of interest rate. The impact of them will raise aggregate demand and therefore the level of output increases. However, Keynesian also pointed out a theory of liquidity trap which means when money demand is perfectly inelastic and interest rate is near to zero, monetary policy will be useless.

As further information of Keynesian’s view on recession, he said that in recession period, investment in the economy will become nearly zero. However, when it starts to recover, investment will increase rapidly which even faster than the growth rate of total income. This phenomenon will call “accelerator”. Also, to reduce the magnitude of the economy fluctuation, there are automatic stabilisers. Whenever national income increases or decreases, stabilisers will stable it by using tax rate or etc. On the other hand, from the observation of different recession period, there are three terms always appear which are related to