Keynesian Theory – Study Notes (B.A. (General), Economics)
Goal: Master the core ideas, mathematical tools, and subtle points of Keynesian economics to tackle exam questions (e.g., IIT‑JEE, NTA‑BSc, state‑board, etc.).
1. Overview
| Feature | Keynesian View | Classical View |
|---|---|---|
| Equilibrium | Determined by aggregate demand (AD) | By supply (SRAS) |
| Role of prices | Sticky nominal wages & prices → output adjusts | Prices adjust instantly |
| Government | Can and should intervene | Limited role |
| Business cycle | Caused by fluctuations in AD | Caused by supply shocks |
| Policy tool | Fiscal & monetary counter‑cyclical | Monetary only (price mechanism) |
Keynesian economics (1920‑1960s) emphasises that in the short run, the economy may lie below full employment because of insufficient AD. Counter‑cyclical fiscal/monetary policies can help restore equilibrium.
2. Fundamental Components
2.1 Aggregate Demand (AD)
[ AD = C + I + G + NX ]
- C – Consumption
- I – Investment
- G – Government spending
- NX – Net exports (X – M)
2.2 Consumption Function
[ C = a + bY_d = a + b(Y - T) ]
- (a) : autonomous consumption (independent of income)
- (b) : marginal propensity to consume (MPC), (0 < b < 1)
- (Y) : national income (output)
- (T) : taxes
Important: (b = \frac{\Delta C}{\Delta Y_d}).
2.3 Investment Function
Often taken as exogenous or investment‑income:
[ I = I_0 - c, r ]
- (I_0) : autonomous investment
- (c) : sensitivity to the real interest rate (r)
2.4 Government Budget
[ G = T + \Delta B ]
- (T) : tax revenue
- (\Delta B) : change in the public debt (usually zero in the short run)
3. The Keynesian Cross (Diagrammatic Analysis)
- Horizontal Axis – National income (Y).
- Vertical Axis – Aggregate expenditure (AE).
- AE Curve – (AE = C + I + G + NX).
- Equilibrium – Intersection of AE and 45° line ((AE=Y)).
Key Insight: If (AE) falls below (Y), firms cut production → unemployment rises. Government can shift the AE curve rightwards by increasing (G) or cutting (T).
4. The Multiplier – Core Derivation
4.1 Simple (No Tax) Multiplier
Let a change (\Delta G) in government spending increase AD.
[ \Delta Y = \Delta G \times \frac{1}{1 - b} ]
Derivation:
- (\Delta AE = \Delta G).
- Firms produce (\Delta Y = \Delta AE) in first round.
- New income (\Delta Y) generates extra consumption: (b,\Delta Y).
- Those additional purchases generate further income: (b^2 \Delta Y), etc.
- Sum of geometric series: [ \Delta Y = \Delta G \left(1 + b + b^2 + \dots \right) = \Delta G \frac{1}{1 - b} ]
4.2 Multiplier with Taxes
Assume taxes are a constant proportion of income: (T = tY), (0 < t < 1).
Consumption becomes (C = a + b(Y - tY) = a + b(1-t)Y).
The effective MPC is (b(1-t)). Thus:
[ \boxed{\Delta Y = \Delta G \times \frac{1}{1 - b(1-t)}} ]
Interpretation: The higher the tax rate (t), the smaller the multiplier.
4.3 Investment Multiplier
Similarly, if investment changes by (\Delta I):
[ \Delta Y = \Delta I \times \frac{1}{1 - b(1-t)} ]
The fiscal multiplier is usually larger than the monetary multiplier, as monetary policy typically operates through the interest‑rate channel.