Question

Explain how the Keynesian transmission mechanism works.

Short answer

The Keynesian transmission mechanism works by the multiplier effect, where an initial amount of spending leads to a larger change in output due to a spending cycle. People spend a part of their income (marginal propensity to consume), which becomes someone else's income, stimulating further spending. Keynes suggested that government spending can kickstart this cycle and increase effective demand, leading to a boost in output.

Step-by-step solution

Understanding the Multiplier Effect

The multiplier effect is the idea that an initial amount of spending can lead to a much larger change in output or income. This happens because when one person spends money, it becomes someone else's income. This person may then spend part of this income, which becomes someone else's income, and so forth.

Understanding the Marginal Propensity to Consume

The marginal propensity to consume (MPC) is the proportion of an additional income that a person consumes or spends, rather than saves. If a person gains an extra dollar and spends 60 cents of it, the MPC is 0.6. The Keynesian model predicts that people will spend a significant portion of their income, which can lead to further increases in income due to the multiplier effect.

Relating to the Principle of Effective Demand

The principle of effective demand states that the level of demand for goods and services is determined by the amount of money people are willing and able to spend. If people are willing to spend more, due to an increase in income or a change in behavior, income and output will both increase. According to Keynes, government spending can stimulate people to spend more, thereby increasing effective demand.