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A Beginner’s Guide to the Keynesian Model (Part 2)

How does the model explain the economy?

Keynesian economists believe that the economy does not move towards full employment automatically, as the Classical economists suggest. This will result in the following two scenarios:

  • If the equilibrium level in the economy (Y) is less than full employment (Y*), there will be a recessionary gap. The economy is producing less than the full employment level, resulting in high unemployment.
  • If the equilibrium level in the economy (Y1) is greater than full employment (Y*), there will be an inflationary gap. The production level exceeds the full employment level, causing the economy to overheat and create high inflation.

Fiscal Policy

In these situations, Keynesian economists believe that government intervention is necessary, as fiscal policy can be used to bring the economy back to the full employment level.

When there is a recessionary gap, they believe that expansionary fiscal policy can be used to close the gap. This is because measures such as increasing government expenditure and decreasing taxes can increase aggregate expenditure to the full employment level. (Economists like to describe this effect as ‘shifting the AE curve upwards.’)

On the contrary, when there is an inflationary gap, government can use contractionary fiscal policy to close the gap. This includes decreasing government expenditure or increasing taxes to lower aggregate expenditure back to the full employment level. (Economists like to describe this effect as ‘shifting the AE curve downwards.’)

Key terms

  • Classical economics – This is a branch of economics based on the concept that free markets regulate themselves, and that the economy always moves towards full employment without the need for government intervention.
  • Fiscal policy – This is the government’s use of taxation and spending to influence the economy – mainly to control the aggregate demand.
  • Full employment – This is a situation when everyone who is willing and able to work has a job.
  • Inflation – When the general level of prices of goods and services in an economy is increasing.
  • Inflationary gap – This is a situation when the economy is operating above the full employment level.
  • Keynesian economics – This is a branch of economics based around the concept that economic output is influenced by aggregate demand in the short run, and that full employment can be achieved by changing aggregate demand through intervention policies such as fiscal policy.
  • Recessionary gap – This is a situation when the economy is operating below the full employment level.
  • Unemployment – This is a situation in an economy where there are people who are willing and able to work but do not have a job.
  • Barriers to Entry Explained
    A Beginner's Guide to the Keynesian Model (Part 1)