Keynesian Perspective: AD/AS Model & Recessionary Gap - Essay Sample

Introduction

The Keynesian Perspective is an economic theory that focuses on aggregate demand. The availability of production factors determines the potential GDP; however, the real GDP largely depends on the need of the economy. The Keynesian View of the aggregate demand (AD)/ aggregate supply(AS) Model uses an SRAS curve (Greenlaw, Shapiro and Taylor).

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The recessionary gap, as a result, in instability of the aggregate supply (AS) and thus can change unexpectedly. If the economy starts where AD intersects SRAS at P0 and Yp, since Yp is potential output, then the economy is at full employment. However, the volatility of AD can easily fall. Therefore, even when the economy starts at Yp, and AD falls, a recessionary gap is experienced, and at equilibrium with less full employment, Y1. This perspective argues that the economy will tend to stay in a recessionary gap, with its attendant unemployment, for a significant period. The key policy implication for either situation is that the government needs to step in and close the gap by increasing the spending during recessions and decreasing spending during booms to return aggregate demand to match potential output. If AD increases, the economy could experience an inflationary gap, where demand is attempting to push the economy past potential output (Greenlaw, Shapiro and Taylor). Consequently, the economy experiences inflation. An example is an economic recession that took place in 2008-2009.

Keynes identifies several factors that affect consumption. They include 1) disposable income, 2) expected future income, and 3) wealth or credit. Keynesian economics, as a result, focuses on explaining why economic depression and recession occur and attempt to provide policy prescription for minimizing the effects (Greenlaw, Shapiro and Taylor).

Monetary Policy and Bank Regulation

The chapter explores how money flows in the economy, the roles the government, monetary institutions such as banks play in regulating the economic outcomes monetary policy. The Federal Reserve provides as many services to banks as the banks offer to its customers. The monetary policy is a collection of various policies on the supply of money. The basic quantity equation of money is money supply × velocity = nominal GDP (Greenlaw, Shapiro and Taylor).

When the country's economy is faced with a recession on depression, the Federal Reserve or central bank increases the money supply by buying the treasury bills from the banks, have more reserves that it can lend out, and ensure that banks lend out extra reserves. On vice versa, the central bank sells Treasury bonds to the banks, Banks buy the bonds and sends its reserves to the central bank. Finally, reduce its loans to meet the reserve requirement (Greenlaw, Shapiro and Taylor).

The Central bank executed its monetary policies in a variety of ways. For instance, to achieve higher interest rates, the feds reduce the money supply. Banks will reduce their amount of loans, raising the interest rate. Feds will continue to open market operations until the target rate is reached, and finally, when Feds cut interest rate target, it increases the money supply. Policies that reduce interest rates while increasing money supply is referred to as an expansionary (loose) monetary policy. Contractionary fiscal policy, on the other hand, is policies that increase interest rates while reducing the money supply.

The monetary policies affect the aggregate demand in various ways. For instance, the interest rates and quantity of loanable funds, which influence consumption and investment, thus raise aggregate demand. The expansionary policy consequently increases the GDP and price levels, while the contractionary policy reduces them. I also found out that monetary policy is countercyclical – that is, it moves the opposite direction of the business cycle. Therefore, fiscal policies will affect inflation and not output. A rise in money supply results in raised prices, thus reducing the AD to potential GDP. The goal of monetary policy is to stabilize output/employment and inflation. It is also important to note that Bank runs are when depositors race to the bank to withdraw their deposits for fear that otherwise they would be lost (Greenlaw, Shapiro and Taylor).

Government Budgets and Fiscal Policy

All levels of government—federal, state, and local—have budgets that show how much revenue the government expects to receive in taxes and other income and how it plans to spend it. Thus, when more funds are spent than received in taxes, it runs a budget deficit. When the spending is lower than collected taxes, it runs a budget surplus, while when expenditure and income are equal, the government is said to have a balanced budget. In the United States, about 73% of the spending goes to four primary areas: national defense, Social Security, healthcare, and interest payments on past borrowing, leaving 27% to other functions (Greenlaw, Shapiro and Taylor).

Taxes are the primary source of income for both the federal, state, and local income revenues. Nonetheless, there several other income revenues, but taxes are the single most considerable contributor. There are two major categories; the federal government collects and those that the state and local governments receive. There are different types of taxes, but the payroll tax is the second abundant source of federal revenue after federal tax (Greenlaw, Shapiro and Taylor). Taxes are progressive, and as a result, as a household's income increase, so are tax.

Federal Deficits and the National Debt a critical in the spending side of budgeting. The federal deficit is the amount the government has to lend, while the national debt is the amount borrowed by the government (Greenlaw, Shapiro and Taylor).

Fiscal policy focuses on how the federal government taxing and spending affects aggregate demand. For instance, Expansionary monetary policy increases the level of aggregate demand in a variety of ways. For example, increase consumption through disposable income on payroll taxes, investment from after-taxes, government purchases by raising grants. Contractionary fiscal policy does the reverse.

Works Cited

Greenlaw, Steven A., David Shapiro, and Timothy Taylor. Principles of Macroeconomics for AP® Courses 2e. Openstax: Houston, Texas, 2017. ebook.