Chapter 3 The Keynesian

Economics
Keynesian economics is School of economics that was
named after British economist John Maynard Keynes.
Keynesian economics was the dominant school of
economics since 1940s to 1970s.
John Maynard Keynes (1883 –1946) is regarded as the
Greatest Economist of the twentieth century. He was
born in Cambridge, England in 1883.
• The founder of ‘macroeconomics’ as a separate
Brach of economics as we know it today.
• Keynes wrote so many books on economics and
related areas. Among all, his book published in 1936
under the tittle of “The General Theory of
Employment, Interest, and Money” brought a
dramatic changes in Academics as well as policy
making in economics.
3.1 John Maynard Keynes
(1883 –1946)
 3.1 J. M. Keynes
• His economic view influenced economic
policy of governments during his life
time and after his death.
• Keynes also played significant role in the
establishment of International Monetary
Fund (IMF) and the International Bank
for Reconstruction and Development
(IBRD), later named World Bank (WB).
• Keynes wrote many books; the most
famous was The General Theory of
Employment, Interest, and Money
 J. M. Keynes
• The birth of macroeconomics as a
coherent and systematic approach to
aggregate economic phenomena
traced back to the publication of this
book in 1936.
This book is organized into six Parts (or
Books as he named it)
• Book I: Introduction. This part contained
three chapters that focus on the problem of
unemployment, the critics on classical
economists and introduced the principle of
effective demand.
• Book II: Definitions and Ideas. Contained 4
 J. M. Keynes
• Book III: The Propensity to Consume. In this part the
principle of effective demand is thoroughly
explained and the concept of multiplier is
introduced.
• Book IV: discuss about Investment. In this part how
investment determined by expectations and interest
rate is discussed. The quantity of money and
liquidity preference, in turn, determine the interest
rate.
• Book V: Money,Wages and Prices. This part deal with
the functional relationship between employment,
prices and wages.
• Book VI: Short Notes. This chapter is about the Trade
or busness Cycle. This section illustrates the full
dynamics of the Keynesian model.
3.2 The Great Depression and
Keynesian
Economics
• Economics evolve over time in response to
economic crisis and real world problem. The
great depression is one example. The great
Depression showed the limitation of the
capitalism/ market economy to resolve
economic crisis as quickly as possible.
• The Great Depression (1929 – 1933) – was
the greatest economic crisis that hit the
capitalist world as never before. The crisis
had been so serious that many were forced
to question the fundamental assumptions of
classical/neoclassical economics. Market
 3.2 The Great ….
• Some suggested that the great depression is
the reason behind the evolution of new
ideas in economics because in trying to
explain ‘the why and how’ of it many came
new ideas and terms were introduced.
Macroeconomics and/or Keynesian
economics is one example.
• There are different views on what caused the
great depression, on how to solve such crisis
and why market forces fail to contain the
problem. Many of the axioms of
classical/neoclassical economics put to
question.
 3.2 The Great ….
The great depression is essentially an
economic recession characterized by:
fall in aggregate demand, Rise in
inventory, Fall in prices, Rise of
unemployment, Fall in investment.
This lead to question some of the key
presumptions of neoclassical school. The
analysis of classical/ neoclassical
economics based on the assumptions of:
• Adequacy of market forces (perfectly
functioning market mechanisms) to
adjust the economy
 3.2 The Great ….
• Wages and prices are perfectly flexible
• Money is neutral (has real effect)
The depression cast doubt on feasibility of
these presumptions. Keynes challenged
all these views of neoclassical economics
in the face of great depression
experienced at the time.
i. The price mechanisms failed to
correct /adjust the economy. The great
depression showed that
classical/neoclassical economics
presumption that the self adjusting
mechanism of the free market failed to
 3.2 The Great …
ii. According to Keynes, wages and prices are
not perfectly flexible. Hence, if are not perfectly
flexible, then there is a limitation to the extent the
economy adjust itself and undesirable state of the
economy (such as crisis) could perpetuate over
time.
Should People sit and wait until it go away or do
some thing to its aversion?- Keynes tried to show
alternative way of managing such crisis.
Classical economics assumed prices are perfectly
flexible, hence, any irregularity in the economy will
be resolved quickly. But this didn’t happen during
the great depression. Or one may ask “ for how long
one should wait until market correct itself”.
3.2 The Great ….
iii. Keynes rejected the full
employment assumption of the
classical school. full employment
equilibrium is not normal state of affairs,
rather it is very rare situation. He
introduced the concept of Equilibrium with
Unemployment.
Classical school also assumed full
employment – equilibrium. That is, the
economy always function at full
employment. Any Unemployment is either
temporary or is voluntary. Keynes showed
equilibriums with unemployment is
 3.2 The Great ….
iv. Causes of the Great depression: different
schools of thought suggest different explanation for
the cause of the great depression. According Keynes
the cause is lack of effective demand in the
economy.
The Great Depression and huge unemployment gave
unmistakable evidence that aggregate demand is not
always ensure full-employment of labour and full use
of productive capacity.
For Keynes the cause of unemployment is lack of
effective demand in the economy. According to
neoclassical school unemployment results when
there is excess supply of labour due to higher wage
level.
 3.2 The Great ….
By lowering wage, the unemployed workers will
get jobs and equilibrium between demand for
labour and supply of labour will be established in
labour market in long run.
• Keynesian economics suggested expansionary public
policies ( monetary and fiscal policies) to handle
crisis like the Great Depression (demand stimulus).
• The analytical structure of the General Theory of
Keynes rested on Three Pillars: The notion of
Effective Demand, the Multiplier mechanism
and the Theory of Interest rate.
• Effective Demand - is defined by Keynes as the
point of encounter of two curves: Aggregate supply
and Aggregate met.
 3.3 Effective Demand in The
General theory
Concept of effective Demand, Multiplier mechanism
and the theory of Interest rate are bases of Keynesian
economics .
According to Keynes, the level of employment in a country
depends on the level of effective demand. The Cause of
Unemployment is attributed to the deficiency of effective
demand.
• By ‘effective’ demand, Keynes meant the total demand
for goods and services in an economy at given level of
employment or that level of AD supported by actual level
of employment in the economy.
• The level of employment in the short run is determined
by the effective demand in the economy.
• Effective demand is determined by propensity to
consume, interest rate and marginal efficiency of capital.
 • N – number of
AS and AD curves employed workers by
entrepreneurs
D, C C
• C - is the total cost that
E D entrepreneurs expect to
have to bear if they
employ ‘N’ number of
workers.
• D - indicates how much
entrepreneurs expect to
earn by selling on the
market the product they
N*
hope to obtain through
N - employment the employment of N
workers
 Cont….
• Both curves express the point of view of
the same category of economic agents, the
entrepreneurs (not of two distinct groups of
buyers and sellers, consumers and
producers as in neoclassical economics).
• The ‘point of effective demand’ is the
point at which D = C. Thus, it is an
expected level of employment, and hence
of production, given entrepreneurs’ short
run expectations regarding costs and
revenue.
• Both expected costs and expected
proceeds increase with the number of
employed workers. Thus both functions are
 3.4 Important Elements of Keynesian Economics

• One of the most important contribution of

Keynes was to show how the capitalist or
market economy is subject to fluctuations.
• He effectively showed changes in
aggregate demand, will have impact on
real output and employment in short run.
He established the importance of
macroeconomic management of an
economy from demand side.
• He provided extensive theory on the
determination of the level of income
and employment in short run. Keynes
 3.4 Cont…
• The determination of interest rate – it
discuss how interest rate determined in the
money market.
• The liquidity preference theory – theory on
how demand for money or liquidity
determined.
• He also introduced the consumption
function with concept of propensity to
consume and derivation of macroeconomic
policy multiplier.
• The concept of effective demand and its
relation to business cycle. He argued
fluctuation of AD is the cause of business
 3.4 Cont…
• Keynes provide strong case for a positive role of
government in stabilizing the economy. Why
should government intervene in the economy and
what policy it should adopt to stabilize the
economy (check inflation, control business cycles,
raise level of national income, reduce
unemployment).
• The single most important aspect of Keynes
economist is his orientation toward policy.
Keynes used a different kind of theory, one that
might be called “realistic,” because it is a
compromise between a realistic and an analytic
approach. Where he brought in the role of public
policy intervention in the working the aggregate
economy.
 3.4 Cont…
• The Great Depression of 1930s had changed
the context within which society and
economists viewed the market. Prior to that,
the classical/neo-classical arguments in
favour of laissez-fair had been used to
discredit government intervention. Keynes
did not believe in the principles of laissez-
faire, which was assumed capable of
providing remedy for economic instability.
• The general political orientation of
economists in early 1900s was against
government involvement in the economy.
With the onset of the Depression, attitudes
began to change, many people felt that if the
 3.4 Cont…
• The classical argument for self-adjusting markets
had been effective argument in limiting government
intervention. But capitalist market system has
never adjusted smoothly and automatically to
full-employment equilibrium.
• Keynesian economics subsumed policy
argumentation and developed a model that had
built into it the need for activist government
policies.
• In this model, aggregate demand controlled the
level of income in the economy, and government
had to control aggregate demand through monetary
and fiscal policies.
 3.4 Cont…
• According to Keynes Government can and should
influence aggregate demand to counter economic
fluctuations, minimize unemployment and inflation.
Uses of government fiscal policy (spending &
taxation) and monetary policy (interest rate
targeting) to stabilize economy. Prior to Keynes
such policy interventions are not acceptable.
For classical/neoclassical school money is viewed as
neural; Money has no real effect (it has only nominal
effect). While Keynes maintained that money is not
neutral, it has real effect in the short run. Hence,
according to Keynes monetary policy could be used
as instrument to bring real change (on income and
employment) in the short run.
3.5 Determination of income &
employment in
Keynesian
• Keynes rejected ‘Say’s law’, that stated
‘supply creates its own demand’ (named
after French economist Jean -Baptiste
Say, 1767–1832).
• The classical school is accepted Say’s
Law. According to J. B. Say argued
overproduction and unemployment
could not persist ( that is, they are
temporary problems) because supply
creates its own demand.
• Keynes rejected the view supply will
create its own demand and argued in the
 3.5 Cont…

• According Keynes deficiency of demand

could lead to unemployment. Effective
demand is the sole determinant of
employment; and, unemployment is
result of lack of effective demand.
Effective demand expresses itself in
the spending.
• Thus, employment depends the level
of spending. To show this he
introduced number of new concepts
into the model (can be shown using
simple two sector Model constituting
two agents as decision makers,
 3.5 Cont…
• In his macroeconomic model, he introduced
concepts such as effective demand, consumption
function, propensity to consume, multiplier,
investment function, liquidity preference function,
conceived in aggregate terms, interact to determine
the level of national income and employment.
• Keynes divides AD into two components
consumption and investment (two sector model).
Employment depends on Effective Demand, i.e., the
sum of expenditure on consumption (C) and actual
expenditure on investment(I)
AD = C + I
• The volume of consumption in a country depends on
the consumption decisions of individuals.
 3.5 Cont…
• Keynes identified what determines
consumption expenditure of individual/
household. He assumed that
consumption shows a definite and fairly
stable functional dependence on
income.
• This functional relationship between
income and consumption is called by
Keynes the 'propensity to consume'
• Propensity to consume refers to the
tendency of individuals to make
consumption expenditure out of a given
level of income.
 3.5 Cont …
Hence, saving was a residual, varying in amounts with
changes in the levels of income.
• From propensity to consume, Keynes developed the
concept of Marginal propensity (MP), which shows
the marginal relationship between changes in
consumption expenditure and level of income.
<1 - is the MP C
- is autonomous consumption expenditure
– induced consumption expenditure. Consumption
expenditure out of current income/disposable income.
From the MP, Keynes derived another important
concept, the Multiplier, which shows the relationship
between output/income and components of
AD/expenditure.
 3.5 Cont…
>1
The multiplier links changes in the
components of AD with change in level of
employment/income.
Since at equilibrium aggregate income (Y)
equal to aggregate demand or expenditure
(C+I):
Y = C +I

= (+𝐼) …..2
……….1

……..3
 3.5 Cont…
and
• As shown in equation above, the multiplier is a
coefficient that measure the effect of changes
in investment on aggregate income.
• The greater the marginal propensity, the
greater will be the multiplier and the change in
national income as a results of change in
investment will be higher.
• Any policy that affect investment will affect the
level of income.
• This simple version of Keynes income model
extended into four sector model by including
public expenditure and the foreign sector.
3.6 The theory of interest rate
• Another important contribution of Keynes
is his theory about the determination of
interest rate.
• Interest rate is cost of investment funds.
• In classical economics interest rate is
determined the demand for funds
(investment) and supply of funds.
According to classical view households
will increasing their savings with rise in
interest rate while demand for investment
funds inversely related to interest rate.
• Another major departure of Keynes from
neoclassical / classical theory was his
 3.6 Cont…
• According to Keynes’s liquidity
preference theory, interest rate is a
monetary phenomenon that results
from the interaction of total demand for
money and its supply.
• The supply of money depends primarily
on the actions of the monetary authority
and the commercial banks in response
to the demand of individuals,
businesses, and government.
• According to Keynes, interest rate was
determined by the demand for and
 3.6 Cont…
• According to Keynes demand for money was
determined by three motives: transactions
motive, precautionary motive and speculative
motive.
• The level of demand for money is determined
by income and interest rate. Interest rate in
particular related with speculative demand for
many. Demand based on the other two motives
depend on level of income.
• in Keynes’s analysis, the interest rate equates
the demand for, and the supply of, money. In
the neoclassical analysis, interest rate equate
savings and investment.
 3.7 Keynes theory of investment
• investment refers to acquisition of new capital.
According to Keynes investment is a function
of marginal efficiency of capital (MEC) and
interest rate.
• MEC is expected return/profit from new
investment. According to Keynes, MEC is
inversely related with increase in the level of
investment. This is for two reasons:
i) MEC or expected return from investment fall
as the investment of a particular type of capital
increases; because the marginal yield of
investment falls as investment
increases(diminishing return to capital),.
 3.7 Cont…
ii) As demand for investment increased the cost of
investment will increase this will reduce marginal from
a given investment. Hence, Marginal efficiency curve is
downward sloping.
•The second determinant of investment is interest rate.
This is the cost of procuring investment funds, which
adversely affect demand for investment funds.
• Business cycles refer to short run fluctuations in
aggregate output and employment with altering
periods of boom and recession.
• In boom periods both output and employment are at
higher, whereas in recession periods both output and
employment fall and as a consequence large
unemployment will exist in the economy.
 3.8 Cont…
• According to Keynes cause of
business cycles is fluctuations in
aggregate demand.
• Instability of AD is due to volatility of
private investment.
• Hence, at is a demand side problem ,
it requires solution from the demand
side. Here that Keynes suggest the
role government in stabilizing the
economy through the manipulation
of AD via policy instruments.