Answer to Question #50553 in Macroeconomics for nidhi

Question

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

Answer 1

One of the most important limitations of the Keynesian model is that public investments can be ”crowdedout” by fiscal policy. In the case of an exogenous decrease in aggregate demand Keynesian economic model advocates using government spending to return production to trend levels. It can increase the interest rate through an increased demand for real balances. With increased output/income levels, demand for money and goods increases. The higher interest rate decreases business investment due to increased costs for borrowing, and a higher opportunity cost in using money. The end result is that government expenditure can return output to trend levels, but at the cost of private investment.