Fixed price keynesian model:

The classical economists  suggested that  there  should be  free  tmde  in  the emnomy  based on market  mechanism and little  intervention  by  the government,  as  it would  be  ineffective. Keynes, however,  advocated  intervention  by the government  in macroeconomic  variables in order to correct the disequilibrium  in  the economy.

For equilibrium  to be realised there should  be equality between aggregate demand  and aggregate  supply. As we have seen earlier, aggregate supply  is  the  total output  produced in the economy while aggregate demand  is the sum of  consumption, investment and government expenditure. Keynesian model assumes that there  is  price  rigidity so  that adjustment takes place through changes m  output level.

in  Fig. we depict  the adjustment  process  in the emnomy when price  fixed. On  the x -axis  we measure aggregate  supply (level  of  output) while aggregate demand  (C+I+G) is measured  an  the  y-axis. In Fig. we have drawn a 45^O  line  on which  AS =AD. We assume  that  investment  (I)  and government  expenditure  (G)  are  exogenous variables  in the sense that their  levels  do  not depend upon  the level of output or  income. &  the aggregate  demand  htion  will  be apdel  shift  in  the  consumption  function, the  diffance between  the  two  indicating the sum  of  investment  and government expenditure  (I*).

In Fig. we observe  that  equilibrium  level of  output is Y  as  the  line indicating  (C+I+G) crosses the 45⁰  line  at  this  level of output. We know  tha the slope  of the  consumption function  is  equal  to MPC. Suppose  there is  a decrease  in  the MPC  from c  to c  '(implies an  increase  in  the prbpensity  to save).  It implies that for one Rupee increase  in income, a  lower amount will be spent  on  consumption-and  more will be devoted  to  saving.  In  Fig. such  a decline  in MPC will result  in a  downward  rotation  of  the consumption  function from C  to C' (see the dotted  line). Accordingly, (C'+I+G) will also  rotate downward and  the new equilibrium output  level will be YLNotice  that  an  increase  in  the propensity to save  is  resulting  in a decline  in output.

We observe that aggregate demand changes  if there  is  change in C, I or G  Therefore, increase  in business investment or government expenditure  will increase aggregate demand,  and  thus  equilibrium output will incxme. Similarly,  a decline  in investment or government expenditure will dampen aggregate demand and result in a decline in  equilibrium output.