Question

Explain the logic (give credit to Keynes for the sake of this exercise) of the money multiplier. What is Keynesian solution to recessions?

Answer 1

The money multiplier explains how an initial investment contributes to a greater final change in the total amount of money available. Often known as "monetary multiplier," it reflects the greatest degree to which money supply is affected by adjustments in deposit quantity. This defines the decrease and/or increase ratio of the money supply in relation to the decrease and/or increase in deposits. Under this scheme, these banks create the bulk of the money supply, as they only have to keep some of their deposits as reserves; as such banks make loans using the remainder of their deposits, this contributes to the production of new money.

Money multiplier = Change in total money supply ÷ Change in the monetary base

In the U.S., the Federal Reserve can use reserve ratio adjustments to control the money supply and thereby manage the economy of the nation. The goal is to strike a balance between inflation limitation and economic growth facilitation. When the reserve ratio is lowered by the Federal Reserve, commercial banks that lend more of their deposits. That results in more large-scale spending activity, which increases money supply, inflation rate, and overall economic growth. That's called expansionary monetary policy

Keynesian macroeconomics argues that expansionary fiscal policy is the solution to a recession, which moves the aggregate demand curve to the right. If the economy performs above real GDP, the other side of Keynesian economics happens. Unemployment is small in this situation but inflationary price-level increases are a problem. The keynesian response would be a contractionary fiscal policy moving aggregate demand towards the left.

Contractionary fiscal policy consists of tax rises or government spending cuts intended to reduce aggregate demand and inflationary pressures. Expansionary fiscal policy consists of tax cuts or government spending increases intended to raise aggregate demand and lift the economy out of recession.