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Keynesian Economics and Model

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At the time of The Great Depression, which took aback economists and politicians in a similar way, John Maynard Keynes who was an exponent of neoclassical economics until the 1930s developed a theory of economy. The economists of that era continued to hold, against growing evidence to the contrary, that time and nature would restore prosperity if government refrained from manipulating the economy. The agreed remedies did not work. In the U.S., Franklin D. Roosevelt's 1932 landslide presidential victory over Herbert Hoover attested to the political bankruptcy of laissez-faire policies. At this stage some new explanations and fresh policies were urgently needed. This was precisely what Keynes provided. In his lasting effort in the shape of his book”(The General Theory of Employment, Interest, and Money)”1, his vital message falls into two powerful propositions. Firstly: existing explanations of unemployment he stated to be not correct. Neither high prices nor high wages could elucidate continual dejection in economy and mass unemployment. Secondly: he proposed an alternative explanation of this what he termed “aggregate demand “that is,” the total spending of consumers, business investors, and governmental bodies”. When aggregate demand is low, he theorized, sales and jobs suffer; when it is high, all is well and prosperous.

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     From these generalities emerged a powerful and comprehensive view of economic behavior, the basis of contemporary macroeconomics. Because consumers were limited in the amounts that they could spend by the size of their incomes, they could not be the source of the ups and downs of the business cycle. It indicated that the active forces were business investors and governments. In a recession or depression, the appropriate thing to do was either to enlarge private investment or create public substitutes for the shortfalls in private investment. In mild economic contractions, easy credit and low interest rates (monetary policy) might stimulate business investments and restore aggregate demand to a figure consistent with full employment. More severe contractions required the remedy of deliberate budget deficits either in the form of spending on public works or subsidies to afflicted groups.

Keynesian Theory and Various Aspects


     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 inflexibility in the labor market that prevented wages from falling to a level at which the labor market would be in equilibrium. Balance would be attained 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 or firms became willing to take on more labor given that the lower wage increased the profitability of hiring more workers (demand increased). If some rigidity prevented wages from falling to the point where supply and demand for labor were at balance, then unemployment could continue. Such an obstacle could be, for example, trade union action to maintain minimum wages or minimum-wage legislation.

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        Keynes's chief novelty was to disagree that persistent unemployment might be caused by a deficiency in demand for production or services, rather than by non-equilibrium in the labor market. Such a deficiency of demand could be explained by a failure of planned investment to match planned 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. An outflow in the 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 a booster into the 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 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.

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      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 Keynesian revolution implied that, in the terminology of macroeconomics, the goods market could be at 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.

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Supply Of Money

     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 fact; its principal purpose 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.

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The economists who combine the assumption of rational expectations with the stickiness of prices and wages are much discussed in Keynesian economy. New Keynesians stress the existence of institutions which may quite rationally lead to sticky prices, such as menu costs, or long-term contracts in which prices are fixed well in advance, and cannot thus be changed in response to economic events. The foundations of New Keynesian economics rest on the presence of menu costs. This can be combined with an unwillingness to change real or relative prices. In New Keynesian economics, firms are assumed to be able to set their prices. Consequently, New Keynesian models require the assumption of imperfect competition, usually taking the form of monopolistic competition. In combination, if prices are set above their equilibrium level, this means that an expansion in the nominal money supply would increase economic welfare.

       The menu costs associated with changing prices should primarily be thought of as relating to the resources required estimating cost and demand curves, rather than to the physical costs associated with changing prices. Technological change, combined with a long-standing history of inflation, means that the physical cost of changing prices has become insignificant. At a theoretical level, the greatest challenge facing New Keynesian economists is to convince others that when demand changes, it takes a greater effort by management to change the price of their output rather than change the quantity produced.

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Some empirical support is given to New Keynesian economics by (Blinder 1991)2 who in a survey of U.S. firms has found that 55 per cent of firms in the United States change their prices at most once a year or less. On the other hand, 10 per cent of companies in the U.S. change the price of their output more than once per month. Blinder lists the reasons that managers most commonly offer interviewers as to why they only change their prices infrequently. The most commonly quoted reason is that they tend to adjust auxiliary services rather than price. To the extent that this is true, price stickiness for a constant quality product does not exist. The second most important reason is that firms are unwilling to change their prices unless other firms do likewise. This supports the notion of (Ball and Romer 1991)3 discussed below, that price setting is subject to some form of coordination failure along the lines of the familiar kinked demand curve model of oligopoly. Two other reasons that proved popular were the notion that output prices were based on costs and the notion that there is some kind of implicit contract with customers that price won't increase when the market is tight.

       They do not believe that money is neutral and believe that the business cycle can partially be explained by changes in aggregate demand. The sticky nature of prices means any change in demand does not lead to an automatic or rapid change in prices; it can lead to a change in output or employment. This position is distinct from the new classical economics, which shares the rational expectations assumption, but assumes prices adjust more quickly and as a result that only unanticipated changes in aggregate demand have a real effect.  The main specific policy implications of Keynesian theory is that when business investment is inadequate to achieve full employment, a compensatory fiscal policy, in the form of federal deficit spending, can pinch-hit and "stimulate" the economy with a similar multiplier effect. But there is no precise guide to the effective size of the multiplier, or the amount of federal deficit spending, which is needed. As a result, the unspecific expression, "stimulate the economy," is now generally used, instead of a more precise quantitative prescription, for both monetary and fiscal policy. This is itself a significant indication of the inadequacy of traditional Keynesian theory for a true economic science or precise policy guide. Because Keynesian policy grew out of the Great Depression, when there was inadequate total spending, the fiscal policy emphasis has tended to be on the spending aspect rather than the associated deficit, which provides an outlet for financial saving when private borrowing is inadequate. (A typical example of this complex and is referring to Reagan's economic policies as "military Keynesianism"). These are among the many reasons why there is now no professional or political agreement on the economically appropriate size of the federal deficit. Because of the financial gap in the investment perspective, the credit-money confusion, and its other conceptual confusions, Keynesian analysis is oversimplified in its spending/income aspects, exaggeratedly complex in its money and credit perplexity, and increasingly outdated and irrelevant politically and educationally.

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     Another problem with the Keynesian framework is that one of the largest components of externally financed net investment, and one of the types of investment most affected by interest rates, is owner-occupied housing. But except in periods of rapid inflation of housing prices this type of investment tends to be motivated more by income/affordability than by business-type profitability calculations. (Partly for accounting convenience, but undoubtedly influenced by the Keynesian analytical model, the NI accounts put all housing together, implicitly in the business sector.) Moreover, in both the NI accounts and Keynesian theory, household investment in cars, furniture, appliances, etc. is treated as consumption, with the consumer borrowing which finances it being netted it is against positive financial saving in the NI concept of personal saving. Thus, this investment and the way it is financed -- which is often quite important to the actual behavior of the economy -- is implicitly treated as unimportant. (This may have been one reason why Keynes emphasized the term propensity to consume, to correspond with the NI accounts, rather than propensity to save, which would be assumed to mean financial saving.)

     The reality today is that for the vast majority of families the 'propensity to consume" is to a very significant extent determined by the "propensity" -- and the ability -- to borrow. And this depends as much on financial terms of credit (including government credit regulations) as on any consumer psychological "propensity." Thus, a more stable, and for many analytical purposes more useful, "consumption function" is consumption out of income, the total consumer spending minus consumer net borrowing. (For credit-financed investment, debt amortization payments tend to play a role similar to that of depreciation allowances for internally financed investment.) . But one thing still remains a fact that the Keynesian model is still the one of the most generally used model for macroeconomic analysis and policy.

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Future Of The Keynesian Ideas

      For 25 years after World War II the blend of Keynesian ideas with traditional forms of capitalism proved extraordinarily successful. Western capitalist countries, including the defeated nations of World War II, enjoyed nearly uninterrupted growth, low rates of inflation, and rising living standards. Beginning in the late 1960s, however, inflation erupted nearly everywhere, and unemployment rose. In most capitalist countries the Keynesian formulas apparently no longer worked. Critical shortages and rising costs of energy, especially petroleum, played a major role in this change. New demands imposed on the economic system included ending environmental pollution, extending equal opportunities and rewards to women and minorities, and coping with the social costs of unsafe products and working conditions. At the same time, social-welfare spending by governments continued to grow; in the U.S., these expenditures (along with those for defense) account for the overwhelming proportion of all federal spending. The current situation needs to be seen in the perspective of the long history of capitalism, particularly its extraordinary versatility and flexibility. The events of this century, especially since the Great Depression, show that modified “mixed” or “welfare” capitalism has succeeded in building a floor under the economy. It has so far been able to prevent economic downturns from gaining enough momentum to bring about a collapse of the magnitude of the 1930s. This is no small accomplishment, and it has been achieved without the surrender of personal liberty or political democracy.

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      1. Keynes, The General Theory of Employment, Interest, and Money.
      2. Blinder, A. 1991, " American Economic Review Papers and Proceedings, vol. 81, No. 2, May, pp. 89-100.
      3. Ball, L. and Romer, D. 1991, "Sticky Prices as Coordination Failure" American Economic Review, vol. 81, no. 3 pp. 539-552.


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