Two school of Economics 1. Neo-classical – Free market, small gov 2.Keynesian – Use of Gov policy to reach full employment “Keynesian cross” Y-E model, Y = income, E=expenditure Keynesian SR model (aka) PAE model, SR= short run, Planned aggregate expenditure Output (GDP) determined by demand Equilibrium GDP can be > or cyclical Unemployment In Keynesian theory, Y D always tend to fall too low because of “uncertainty” etc

1. Y must equal to E (shown by 45degree) 2. Some spending on output even when income Y=0 similarly, Io, Go and Xo (X=export, I investment) 3. As Y ↑ → C ↑ → PAE ↑ → Output ↑ (C is Endogenous – within model) As Y ↑ → PAE ↑ by less (some of the extra Y is saved, spent on imports, etc) As low Y→ PAE > Y → Y↑ until Y ↑ → C ↑ → PAE ↑ → Y ↑... Ao = Co + Io + Go + Xo – Mo – C To All exogenous spending in economy Y YEYE Y D or PAE Slope of PAE = d – depends on c,t,m 45 Keynes’ General Theory based drown by Samuelson E

Equations : Cauculating YE and changes in YE YE = (1/(1-d) x Ao (d tells how much spending ↑ as Y ↑) d= c – ct – m + a (a=marginal propensity to invest, more output needs more machine) Ao = Co + Io + Go + Xo – Mo – c To (1/(1-d) = k, multiplier so effect of t and To on spending is smaller than equal change in Go, Xo etc Key Keynesian insight – Increase in exogenous spending increased household income and encourages higher I by Firms. For eg, ↑Go causes additional in C and I. Final ∆ Y must greater than initial ∆ Go. ∆ Y = ∆Go + ∆C + ∆I Small fiscal or monetary stimulus can return economy to Yfe, full employment NB. High saving from extra income reduces multiplier effect. High “marginal propensity to save”. Similarly, higher rate of income, tax and marginal propensity to import from extra income reduces multiplier. ∆ Y

GM – Model of Goods market can be used to predict effect of changes of government policy. Also effect of exogenous shocks. Eg, decrease in export ect. NB: Keynesian – assumption – price fixed, interest rate, r, assumed constant (despite ∆s in Y). Does not include financial sector (not a Keynesian Assumption) ↑X → larger ↑Y (multiplier effect) Y1 E E Y Y2 E Ao’ Ao Y1 D Y2 D ↑∆X ∆Y= ∆X+ ∆C= ∆X x multiplier ↔ ↑Y allows ↑C → final ∆Y> initial ∆X