ECONOMIC INSTABILITY: A

CRITIQUE OF THE SELF-

REGULATING ECONOMY
(PART 2)
THE SIMPLE KEYNESIAN MODEL
IN THE AD-AS FRAMEWORK
The Keynesian Aggregate Supply Curve:

 In the Keynesian Model, price level is assumed to be

constant until it reaches its full-employment or Natural
Real GDP.

 Given SRAS is upward sloping, what happens if AD

shifts right?

 But for Keynesian Model, if we are less than Natural

Real GDP, and price level is constant, what should be
the slope of SRAS?
 What is the shape of supply in the long run?
THE SIMPLE KEYNESIAN MODEL
IN THE AD-AS FRAMEWORK
The Economy in a Recessionary Gap:
 According to Keynes, the economy can get stuck at a
recessionary gap.
 Keynes believed that the private sector – consisting of
households and business firms may not be able to move
the economy out from recession and back to long run
equilibrium.

Government’s Role in the Economy:

 Economic instability opens the door to government’s
playing a role in the economy.
 The private sector may not be able to regulate the
economy, so government must manage the economy
through policies which will shift AD to the right.
THE THEME OF THE SIMPLE
KEYNESIAN MODEL
1. The price level is constant until Natural Real GDP is
reached
2. The AD curve shifts if there are changes in C, I, or G.
3. According to Keynes, the economy could be in
equilibrium and in a recessionary gap too.
4. The private sector may not be able to get the economy
out of a recessionary gap. In other words, the private
sector may not be able to increase C or I enough to
shift the AD curve toward the right to reach Natural
Real GDP.
5. The government may have a management role to play
in the economy. According to Keynes, government may
have to raise aggregate demand enough to stimulate
the economy to move it out of the recessionary gap
and to its Natural Real GDP.
THE SIMPLE KEYNESIAN MODEL
IN THE TE-TP FRAMEWORK
 Using a different framework to analyse Keynesian
Economics instead of AD-AS analysis.

Deriving the Total Expenditures (TE) Curve

 Total Expenditure is the sum of consumption,
investment and government purchases.
 To derive TE, firstly, we must first find each of
these expenditures at the two Real GDP levels.
 Then, to find TE at these two Real GDP levels, we
have to add all the three expenditures.
 Finally, use the two points of Real GDP and TE to
plot the graph of TE.
DERIVING A TOTAL
EXPENDITURES
CURVE
 As disposable
income rises, so
does consumption
 Investment
remains constant
(assumed)
 Government
Purchases remains
constant
(assumed)
 What will shift TE?
COMPARING TOTAL
EXPENDITURES (TE) AND TOTAL
PRODUCTION (TP)
 Total Production: Businesses produce the
goods and service that are bought in the
three sectors of the economy (households,
business and government). Businesses may
produce too much or too little in comparison
to what the three sectors buy.

 There are three possible options:

1. Total Expenditures exceeds Total
Production
2. Total Production exceeds Total
Expenditures
MOVING FROM DISEQUILIBRIUM
TO EQUILIBRIUM
 TE<TP: Signals to firms they have
overproduced. Firms cut back on goods they
produce, lowering Real GDP closer to output
levels where economy is willing to buy.
Eventually, TE will equal TP.

 TE>TP: Signals to firms they have under

produced. They increase the quantity of
goods produced, causing Real GDP to rise.
Eventually, TP will equal TE.
GRAPHICAL FRAMEWORK OF THE THREE STATES
OF THE ECONOMY IN THE KEYNESIAN
FRAMEWORK
THE ECONOMY IN A
RECESSIONARY GAP AND THE
ROLE OF GOVERNMENT
 The economy is in
equilibrium,
producing QE, but the
Natural Real GDP is
level is QN. Because
the economy is
producing at a Real
GDP level less than
the Natural Real GDP,
it is in a recessionary
gap.
 How can we reach the
point where TP and
QN intersect?
SHIFTING OF TE : AN EXAMPLE
A CHANGE IN AUTONOMOUS INVESTMENT
SPENDING RELATIVE TO A CHANGE IN REAL
GDP
THE THEME OF THE SIMPLE
KEYNESIAN MODEL
1. The price level is constant until Natural Real GDP is
reached
2. The TE curve shifts if there are changes in C, I, or G.
3. According to Keynes, the economy could be in
equilibrium and in a recessionary gap too.
4. The private sector may not be able to get the economy
out of a recessionary gap. In other words, the private
sector may not be able to increase C or I enough to
shift the TE curve toward the right to reach Natural
Real GDP.
5. The government may have a management role to play
in the economy. According to Keynes, government may
have to raise TE enough to stimulate the economy to
move it out of the recessionary gap and to its Natural
Real GDP level.
FISCAL POLICY AND
THE FEDERAL
BUDGET
THE FEDERAL
BUDGET
THE FEDERAL BUDGET
 The Federal Budget is composed of two, not
necessarily equal, parts: Government
Expenditures and Tax Revenues.

 Note: Government Expenditure is NOT the

same Government Purchases. Government
Expenditures include Government Purchases
and Transfer Payments.

 Government Tax Revenues: Includes all taxes

that are collected by the government,
direct, indirect, social security taxes.
SOME NUMBERS FROM THE
BANGLADESH ECONOMY..
Tax Revenues (% Cash Surplus/Deficit GDP Growth
Year of GDP) (% of GDP) Rate (%)
2001 7.60 -0.66 5.27
2002 7.70 -0.17 4.42
2003 8.07 -0.12 5.26
2004 8.11 -0.73 6.27
2005 8.22 -1.12 5.96
2006 8.17 -1.44 6.63
2007 8.05 -1.33 6.43
2008 8.82 -0.96 6.19
2009 8.60 -1.66 5.74
2010 9.00 -0.93 6.07
2011 9.98 -0.93 6.71
INCOME TAX STRUCTURES
 Income Tax is usually a large portion of the
government tax revenue.

 Progressive Tax: An income tax system in which one’s

tax rate rises as one’s taxable income rises. A
progressive income tax is usually capped at some rate.
 Proportional Tax: An income tax system in which a
person’s tax rate is the same no matter what his or her
taxable income is. It is sometimes referred to as flat
tax.
 Regressive Income Tax: An income tax system in which
a person’s tax rate declines as his or her taxable
income rises.
BUDGET DEFICIT, SURPLUS OR
BALANCE
 If expenditures are greater than tax
revenues, a budget deficit exists.
 If tax revenues are greater than
expenditures, a budget surplus exists
 If expenditures equals tax revenues, a
balanced budget exists.

 In case of a budget deficit, how is the

government financing the additional
expenditure?
STRUCTURAL AND CYCLICAL
DEFICITS
 Cyclical Deficit: The part of the budget
deficit that is a result of a downturn in
economic activity.

 Structural Deficit: The part of the budget

deficit that would exist even if the economy
were operating at full employment.

 Total Budget Deficit = Structural Deficit +

Cyclical Deficit
THE PUBLIC DEBT
 A budget deficit occurs when government
expenditures are greater than tax revenues
for a single year.

 Public Debt (National debt) is the TOTAL

amount the federal government owes its
creditors.

 Some of this is held by one entity in the

government or owes it to another.
 The remainder is held by the public (net
public debt)
FISCAL POLICY
FISCAL POLICY
 Fiscal Policy: Changes in government expenditures
and/or taxes to achieve economic goals, such as low
unemployment, stable prices and economic growth.
 Expansionary Fiscal Policy: Increase in government
expenditure and/or decreases in taxes to achieve
particular economic goals.
 Contractionary Fiscal Policy: Decrease in
government expenditure and/or increases in taxes to
achieve particular economic goals.
 Discretionary Fiscal Policy: Deliberate changes of
government expenditures and/or taxes to achieve
economic goals.
 Automatic Fiscal Policy: Changes in government
expenditures and/or taxes that occur automatically
without additional government action.
DEMAND-SIDE FISCAL POLICY
 Fiscal Policy affect the demand side by shifting the
AD curve.

 Government Purchases: Increase shifts the AD to

the right, decreases shifts the AD to the left.

 Taxes can affect consumption and/or investment,

can will lead to shifts in AD
 Decrease in Income Tax  Rises Disposable Income
 Raises Consumption  Shifts AD to right
 Decrease in Business Tax  Rises After tax
profit Raises Investment  Shifts AD to right
FISCAL POLICY: KEYNESIAN PERSPECTIVE
(ECONOMY IS NOT SELF-REGULATING)
RECESSIONARY GAP
 Keynesians believe
that economy is not
self- regulating.
 The Keynesian
prescription is to
enact expansionary
fiscal policy (Increase
G and/or Reduce T) to
shift AD to the right.
 Move from Point 1 to
Point 2.
FISCAL POLICY: KEYNESIAN
PERSPECTIVE (ECONOMY IS NOT
SELF-REGULATING)
INFLATIONARY GAP
 Keynesians believe
that economy is not
self- regulating.
 The Keynesian
prescription is to
enact contractionary
fiscal policy (Decrease
G and/or Increase T)
to shift AD to the left.
 Move from Point 1 to
Point 2.