In the simples and most naïve
Keynesian model, increasing the budget deficit by incremental tax ratio causes
output to explain by the inverse of the marginal propensity to save. In the
standard IS-LM analysis of monetary economies, this expansion of output raises
the demand for money. If the money supply is fixed (that is the deficits is
bond financed), interest rates must raise and private investment falls. This in
turn reduces output and partially offsets the Keynesian multiplier effect.
Many
traditional Keynesians such as Eisner and Keynes argue that deficits need not
crowd out private investment. Eisner suggests that increased aggregate demand changes
the profitability of private investment and leads to a higher level of
investment at nay given rate of interest. Thus, deficits may actually stimulate
aggregate saving and investment despite the fact that they raise interest
rates. Thus, increased consumption is supplied from otherwise utilized
resources. Keynes view allows for the possibility that some economic resources
are unemployed and presupposes the existence of large number of myopic,
liquidity constrained individuals.
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