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The Macroeconomic Theory of Fiscal Policy I

The Simple Keynesian Model

The 45-degree Model

In this chapter, we investigate the macroeconomic effect of fiscal policy using the simple Keynesian model. It is useful to look at any standard macroeconomics textbooks including Mankiw (2014) to understand Keynesian economics more fully.

First, let us explain the simplest 45-degree model in order to analyze the effect of the size of the multiplier on GDP. This model assumes that aggregate demand determines GDP in the goods market. The fundamental mechanism of the Keynesian model assumes that the economic variable that responds to excess demand (demand minus supply) is not price but quantity. Since the Keynesian model presupposes underemployment, the demand side should determine macroeconomic activity. This formulation is plausible for investigating macroeconomic activities in a recession.

The equilibrium condition for the goods market is given as

where Y is national income (GDP), C is consumption, I is investment, G is government spending, and c (0 < c < 1) is the marginal (and average) propensity to consume. Equation (2.1) means that production Y is conducted to meet aggregate demand C + I + G. This is the equilibrium condition in a goods market.

Equation (2.2) is a simple formulation of the consumption function, which means that consumption is a constant share of income. Parameter c denotes the (average = marginal) propensity to consume. 1 — c means the (average = marginal)

© Springer Science+Business Media Singapore 2017 29

T. Ihori, Principles of Public Finance, Springer Texts in Business and Economics,

DOI 10.1007/978-981-10-2389-7_2

propensity to save. For simplicity, we assume here that the average propensity to consume, C/Y, is equal to the marginal propensity to consume, AC/AY. Substituting Eq. (2.2) into Eq. (2.1) and eliminating C, we have

Suppose I is exogenously given and fixed as the constant in this section. Then, Eq. (2.3) uniquely determines the equilibrium level of Y as a function of policy variable G.

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