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Keynesian Economics

Keynesian Economics Macroeconomics, branch of economics concerned with the aggregate, or overall, economy. Macroeconomics deals with economic factors such as total national output and income, unemployment, balance of payments, and the rate of inflation. It is distinct from microeconomics, which is the study of the composition of output such as the supply and demand for individual goods and services, the way they are traded in markets, and the pattern of their relative prices. At the basis of macroeconomics is an understanding of what constitutes national output, or national income, and the related concept of gross national product (GNP). The GNP is the total value of goods and services produced in an economy during a given period of time, usually a year.

The measure of what a country’s economic activity produces in the end is called final demand. The main determinants of final demand are consumption (personal expenditure on items such as food, clothing, appliances, and cars), investment (spending by businesses on items such as new facilities and equipment), government spending, and net exports (exports minus imports). Macroeconomic theory is largely concerned with what determines the size of GNP, its stability, and its relationship to variables such as unemployment and inflation. The size of a country’s potential GNP at any moment in time depends on its factors of production-labor and capital-and its technology. Over time the country’s labor force, capital stock, and technology will change, and the determination of long-run changes in a country’s productive potential is the subject matter of one branch of macroeconomic theory known as growth theory.

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The study of macroeconomics is relatively new, generally beginning with the ideas of British economist John Maynard Keynes in the 1930s. Keynes’s ideas revolutionized thinking in several areas of macroeconomics, including unemployment, money supply, and inflation. Keynesian Theory and Unemployment Unemployment causes a great deal of social distress and concern; as a result, the causes and consequences of unemployment have received the most attention in macroeconomic theory. Until the publication in 1936 of The General Theory of Employment, Interest and Money by Keynes, large-scale unemployment was generally explained in terms of rigidity in the labor market that prevented wages from falling to a level at which the labor market would be in equilibrium. Equilibrium would be reached when pressure from members of the labor force seeking work had bid down the wage to the point where either some dropped out of the labor market (the supply of labor fell) or firms became willing to take on more labor given that the lower wage increased the profitability of hiring more workers (demand increased). If, however, some rigidity prevented wages from falling to the point where supply and demand for labor were at equilibrium, then unemployment could persist. Such an obstacle could be, for example, trade union action to maintain minimum wages or minimum-wage legislation. Keynes’s major innovation was to argue that persistent unemployment might be caused by a deficiency in demand for production or services, rather than by a disequilibrium in the labor market.

Such a deficiency of demand could be explained by a failure of planned (intended) investment to match planned (intended) savings. Savings constitute a leakage in the circular flow by which the incomes earned in the course of producing goods or services are transferred back into demand for other goods and services. A leakage in the circular flow of incomes would tend to reduce the level of total demand. Real investment, known as capital formation (the production of machines, factories, housing, and so on), has the opposite effect-it is an injection into the circular flow relating income to output-and tends to raise the level of demand. In the earlier classical models of unemployment, such as the one described above, deficiency of demand in the aggregate market for goods and services (known by the short-hand term as the goods market) was ruled out. It was believed that any discrepancy between planned savings and planned investment would be eliminated by changes in the rate of interest.

Thus, for example, if planned savings exceeded planned investment, the rate of interest would fall, which would reduce the supply of savings and, at the same time, increase the desire of companies to borrow money to invest in machines, buildings, and so on. In other words, changes in the rate of interest would provide the equilibrating force bringing the overall (aggregate) goods market into equilibrium in the same way that changes in, say, the price of apples would be the equilibrating force bringing the supply and demand for apples into equilibrium. In the Keynesian model, changes in the level of output and income bring planned savings and investment into equilibrium, and thereby lead to equilibrium in total national income and output. However, this equilibrium level of income and output is not necessarily the level of output at which the demand for labor equals the supply of labor. Furthermore, Keynes maintained, a cut in wages in such a situation would not help eliminate unemployment. Keynes was not the first economist to explain unemployment in terms of an aggregate deficiency of demand in the goods market.

The 19th-century British economist Thomas Robert Malthus and others had advanced similar explanations. The Keynesian revolution implied that, in the terminology of macroeconomics, the goods market could be at an underemployment equilibrium, in that it did not ensure equilibrium in the labor market. In such a labor market, employers would not employ workers up to the point where it would have been profitable for them to do so had there been adequate demand for their output. Concepts of underemployment equilibrium, and related concepts of constrained demand for labor were extensively developed in subsequent years. Keynes’s emphasis on demand as the key determinant of output in the short run stimulated developments in many other fields of macroeconomics.

It was partly instrumental in the development of national income accounting, which measures the components of GNP-consumption, investment, government spending and net exports. The Keynesian approach also stimulated analysis of the factors influencing these components of GNP. For example, economists have analyzed how aggregate consumer demand is related to income levels and how likely it is to change when rates of interest change. Money Supply Theories regarding the money supply are central to macroeconomics. They are also the subject of debate between Keynesians and monetarists (economists who believe that growth in the money supply is the most important factor that determines economic growth). The classical or pre-Keynes view was that the interest rate led to a balance between savings and investment, which in turn would cause equilibrium in the goods market. Keynes disagreed and believed that the interest rate was largely a monetary phenomenon; its chief function was to balance the unpredictable supply and demand for money, not savings and investment. This view explained why the amount of savings was not always correlated with the amount of investment or the interest rate. Keynesians and monetarists also disagree about how changes in the money supply affect employment and output.

Some economists argue that an increase in the supply of money will tend to reduce interest rates, which in turn will stimulate investment and total demand. Therefore, an alternative way of reducing unemployment would be to expand the money supply. Keynesians and monetarists disagree on how successful this method of raising output would be. Keynesians believe that under conditions of underemployment, the increased spending will lead to greater output and employment. Monetarists, however, generally believe that an increase in the money supply will lead to inflation in the long run. Inflation For several decades after World War II (1939-1945) the main inflation theories were demand-pull and cost-push. The cost-push theory basically emphasized the role of excessive increases in wages relative to productivity increases as a cause of inflation, whereas the demand-pull theory tended to attribute inflation more to excess demand in the goods market caused by expansion of the money supply. A central concept in inflationary theory since the mid-1950s has been the Phillips curve, which relates the level of unemployment to the rate of inflation. The Phillips curve suggests that society can make a choice between various combinations of inflation rate and unemployment level.

Many economists, however, dispute whether such a choice really exists, saying that in order to keep unemployment under control it will be necessary to accept continuously increasing inflation. At the same time many other economists dispute whether a stable relationship between unemployment and the level of real wage demands exists. Modern Theories During the last few decades there have been numerous refinements of the Keynesian theory of unemployment. For example, although there is still much disagreement as to the importance of wage rigidity, significant progress has been made in explaining it without recourse to trade union behavior or government regulation. At first it seemed difficult to reconcile the notion of wage rigidity with the usual economist’s assumption that people seek to maximize utility or satisfaction and would be willing to accept a lower wage in order to get a job.

However, by widening the range of variables over which individuals optimize to include variables such as loyalty and self-respect, it has become easier to reconcile labor market disequilibrium with the usual assumptions of optimizing behavior. Macroeconomic theories regarding the way that the determinants of total final demand operate form the basis of large macroeconomic models of the economy that are used in economic forecasting to make predictions of output and employment and related variables. During the last few years, the record of most such predictions has been poor, and an analysis of the errors has led to continual revisions of the basic models and refinements of the theory. Phillips curve The Phillips curve illustrates the trade-off found by economist A. W. Phillips between lower unemployment and increased inflation. If unemployment is low at 4 percent, inflation is slightly high at 6 percent (point a). If inflation is eliminated, unemployment increases to 8 percent (point b).

The trade-off poses a dilemma for policy-makers, although economists disagree on whether this relationship exists. Microsoft Chart Economics.


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