Answer to Question #258332 in Macroeconomics for Sadiq

Question

Lucas’ point of view, what are the limitations of the Keynesian model? What improvements does he suggest?

Answer 1

The most significant limitation is the " Lucas Critique" of the public investment by fiscal policy. Keynesian economic advocates for government spending to ensure the production level is returned to trends level when aggregate demand of exogenous decreases. The interest rate can be increased as a result of the increased demand for real balances. With increased income or output levels, demand for goods and money increases. The lower interest rate will increase business investment due to decreased cost for borrowing and high-cost opportunities in using the capital. Therefore, the government expenditure can get back the output to trend levels but at an extra cost of private investment.