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Keynesian Models - The Role of Aggregate Demand

John Maynard Keynes was a very pragmatic economist writing in the context of the Great Depression.  Many theories have been advanced in his name.  Whether he would support any or all of them remains an open issue.

Here, the distinguishing feature of a Keynesian model is taken to be an emphasis on aggregate demand shocks as the cause of business cycles.

The Simple Keynesian Model

The Simple Keynesian Model is undoubtedly too simple to be realistic.   Compared to the Classical Model, it makes one truly revolutionary point:  There can be an equilibrium at less than full employment.  A secondary point is that aggregate demand shocks (in the form of changes in investment and government spending) can have large effects on output.

The present development of the Simple Keynesian Model adds a derivation of an IS Curve.  Making investment an explicit function of the interest rate within the framework of the Simple Keynesian Model shows that there is a relation between the interest rate and the level of output.  That relation is a version of the IS Curve that is the element common to all the Keynesian models.

The IS/LM Model

This version of the IS/LM Model is central to the discussion of Keynesian models.  The IS Curve is derived from equilibrium in the supply and demand for loanable funds.  The LM Curve is derived from equilibrium in the supply and demand for money.

Keynes' General Theory was published in 1936, in the middle of the Great Depression.  Given the extent of unemployed capital and labor, concern about a shortage of aggregate supply was not a major concern.  Subsequent refinements of the notion of a Keynesian model have incorporated aggregate supply.  Here, we add an aggregate supply and demand diagram to the IS/LM diagram.  The IS/LM Model with Flexible Prices

The IS/MP Model

The simple version of the IS/MP Model presented here illustrates an important point.  The simplified IS/MP Model adds a horizontal MP curve that depicts the interest rate set by the central bank regardless of the level of income Y.  The intersection with the IS Curve then determines equilibrium output.

The complete IS/MP Model is a modern reconstruction of the IS/LM Model.  The main changes are putting the real interest rate (instead of the nominal interest rate) on the vertical axis of the IS/MP diagram and putting the rate of inflation (instead of the price level) on the AD/IA diagram.  These changes allow for a focus on monetary policies where the central bank adjusts the interest rate in reaction to inflation.

References

Keynesian Economics, Alan S. Blinder, Concise Encyclopedia of Economics, gives a detailed account of the defining characteristics of Keynesian economics.
Keynesian Economics, Wikipedia.
John Maynard Keynes (1883-1946), Concise Encyclopedia of Economics.
John Maynard Keynes, Wikipedia.

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