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Multiplier/ Aggregat
LRAS Accelerator e
Demand
5 most
important
Money points
Supply 45˚ line
Keynesian Theory
Keynesian Theory - Total Expenditure (or AMD) and
the way in which the level an equilibrium level of
income is achieved.
Income
MPC = LM/LN
2. Consumption, Savings and Equilibrium Income
0 Investment
A B
3. Investment - cont’d
I+G+X = S+T+M
Injections Withdrawals
1 or ___1___ The higher the value of the MPC the greater the
value
(1 - MPC) MPS + MPT + MPM of the multiplier.
Example - Government increases its spending by $50m, Investment increases by $80m and
exports increases by $70m. Out of any increase in income 3/4 is consumed, and the
remainder saved, taxed or spent on imports.
∆Y
C+I+G2 ∆J
S
YY1
C+I+G1
ST
T
45˚
Y Y1 Y
Deflationary Gap Inflationary Gap
EXP EXP
AMD2 a AMD1
a
AMD1 AMD2
b b
45˚ 45˚
Y FE FE Y
Y Y
Actual Actual
The deflationary gap is ab = the amount by The inflationary gap is ab = the amount by
which AMD must rise to increase Y to its Full which AMD must be reduced to remove
Employment (FE) level. demand-pull inflation i.e. to make nominal
Y at FE = real Y at FE
Questions often ask by how much must J (injections) be increased to eliminate a
deflationary gap.
“The full employment level of Y is $250m; the present level of Y is $200m. Four-fifths of
any increase in Y is spent. By how much must investment (I) be increased to eliminate
the gap?
Liquidity Trap
Money
Monetarist Theory
Monetarism is an economic school of thought that stresses the primary importance of the
money supply in determining nominal GDP and the price level.
MxV=PxT
M= stock of money V = velocity of circulation P = Average Price Level T = Volume of
transactions
Calculation: if M=$60, V=4 and T=12, then P can be found.
P = MV = 60 x 4 = $20
T 12
1. Money is a unique asset, and it can be distinguished from all other financial and real
assets.
2. Increases in the money supply (after a time lag) produce a proportionate increase in
nominal income, at first in output, and later in the general level of prices.
3. Monetary policy is an effective technique for controlling the economy; fiscal policy is
ineffective and incomes policy is counter-productive.
4. Effective monetary policy requires the adoption of a system of monetary base control, as
well as a ‘monetary rule’ (where the annual rate of allowable monetary growth is equal to the
expected rise in real output) with a view of influencing expectations in a downward direction.
5. Reduction of Government borrowing reduces monetary growth and thus also inflation.
6. Increases in Government spending simply increase inflation and not employment.
7. Unemployment can only be maintained at a level below its natural rate at the cost of
accelerating inflation.
8. Excessive wage increases in tight monetary conditions increase unemployment.
Keynesian Monetarist
The economy is basically unstable. The economy is basically stable. Price
Markets do not function efficiently. changes efficiently allocate resources.
Private expenditure is very volatile. Private expenditure is relatively stable.
Depressions and mass unemployment Full employment (or 'the natural rate of
can persist - no automatic tendency to unemployment') is the normal condition
self-correction in the economy. - deviations are temporary.
Inflation is caused by independent
cost-push factors (wages and output Inflation is caused by excessive growth
prices) and causes increases in the of the money supply
money supply.
Governments use of fiscal policy is
Governments use fiscal policy to
doomed to failure. Reflation simply
manipulate the economy. Budget
means inflation. No long-run trade off
deficits act as stimulus to the economy
between inflation and unemployment.
via the multiplier. Monetary policy can
Budget deficits cause increase in
only be used to influence interest rates.
money supply and/or increases in
'Money' is impossible to define and
interest rates, crowding out private
attempts to control the money stock at
expenditure. Reduction in inflation is a
best irrelevant and at worst cause
precondition of success in other
permanent loss of output.
objectives.
Demand for money is interest-elastic Demand for money is interest-inelastic
Extreme Monetarist Extreme Keynesian
Price Price
AS AS
Level Level
P1
P1
P AMD2
P
AMD1
AMD AMD1
AMD
Output
Output
(real income)
(real income)
(b) Explain what is meant by liquidity preference and discuss how it
might be affected by an increase in unemployment. [13] June 2010