The Keynesian Model

Gap analysis is a simple way of describing the main policy implications of the Keynesian theory. The deflationary gap is the amount by which aggregate demand must be increased to push the equilibrium national income, through the multiplier, to the full employment national income. The government has a number of possible policy instruments which it can use for this purpose. Increase government spending will raise aggregate demand directly and, by increasing total injections, will have a multiplier effect on income. To achieve full employment, it is necessary to shift the AD line upwards by the full amount of the deflationary gap. If taxes are raised to finance the spending, the policy will still be expansionary and so reduce unemployment so long

Generally, these policies were successful in preventing heavy unemployment like that experienced in the 1930s, but unfortunately they tended to give rise to the phenomenon known as `stop-go'. That is, in periods of high unemployment, the government would expand aggregate demand: this would reduce the unemployment but at the same time tend to create inflationary pressure so that eventually the government would have to reduce aggregate demand again. Thus, all 'go' periods tended to be followed by 'stop' periods and it became difficult to achieve long-term economic growth. Possibly the main problem is that the Keynesian model is only short term and, in the short run, it is not always easy to predict the effects of policy changes, and the management of the economy, therefore, may become very erratic. A second limitation of the Keynesian model is that it fails to take adequately into account the problem of inflation. Indeed, the basic model assumes that wages and prices are fixed and the only time we allowed them to rise was after the attainment of full employment. Experience in the 1970s in particular has shown us that high rates of inflation can coexist with high rates of unemployment and no adequate explanation of this is provided by the Keynesian theory Furthermore, the coincidence of inflation and unemployment

This is part of the classical theory of full employment, according to which competitive forces and flexible wages and prices ensure that full employment equilibrium is achieved with no overproduction. The main limitations of the simple Keynesian model are that it fails to pay adequate attention to the effects of changes in wages and prices, and ignores the monetary sector of the