Keynesian Approach
The Keynesian approach to output and employment determination, developed by economist John Maynard Keynes during the Great Depression, contrasts sharply with the classical view. It emphasizes the role of aggregate demand in determining output and employment, asserting that the economy can be in equilibrium at less than full employment in the short run. This approach also stresses the importance of government intervention to stabilize the economy.
1. Key Assumptions of the Keynesian Approach:
- Involuntary Unemployment: Unlike the classical approach, Keynes argued that the economy can be in equilibrium with unemployment because wages and prices are sticky (i.e., do not adjust quickly).
- Insufficient Aggregate Demand: The economy may suffer from insufficient demand, leading to lower output and higher unemployment.
- Role of Expectations: Businesses’ investment decisions depend on their expectations about future economic conditions.
- Investment and Savings: Investment is not automatically equal to savings due to fluctuations in business confidence.
- Rigid Wages and Prices: In the short run, wages and prices do not adjust quickly to changes in demand and supply, leading to unemployment.
Keynesian View on Employment and Unemployment
- Involuntary Unemployment:
- Keynes argued that unemployment could exist even when wages and prices are flexible. Unlike classical economics, which assumes that any excess supply of labor (unemployment) would lead to a reduction in wages, Keynes believed that wages are “sticky” (do not adjust easily), especially in the downward direction.
- Involuntary unemployment occurs when people are willing to work at the prevailing wage rate but are unable to find jobs because total demand in the economy is insufficient to support full employment.
- Keynes argued that unemployment could exist even when wages and prices are flexible. Unlike classical economics, which assumes that any excess supply of labor (unemployment) would lead to a reduction in wages, Keynes believed that wages are “sticky” (do not adjust easily), especially in the downward direction.
- Underemployment Equilibrium:
- Keynes emphasized that economies can settle into an underemployment equilibrium, where the level of aggregate demand is insufficient to generate full employment. In such situations, businesses do not have enough demand for their goods and services to
2. Aggregate Demand and Aggregate Supply:
In Keynesian theory, the equilibrium level of output and employment is determined by aggregate demand (AD), which is the total demand for goods and services in an economy at different levels of income and output. The aggregate supply (AS) is the total quantity of goods and services that producers in an economy are willing to supply at different levels of prices.
3. Components of Aggregate Demand:
- Consumption (C): Household spending on goods and services.
- Investment (I): Business spending on capital goods, influenced by interest rates and business expectations.
- Government Spending (G): Public sector expenditure on goods, services, and infrastructure.
- Net Exports (X – M): Exports minus imports.
The formula for aggregate demand (AD) is:
AD=C+I+G+(X−M)AD = C + I + G + (X – M)AD=C+I+G+(X−M)
In the Keynesian framework, aggregate demand may fall short of the economy’s potential output, leading to underemployment and economic recessions.
4. Determination of Output and Employment:
- In the short run, Keynesian economics asserts that the level of national income and employment is determined by the level of aggregate demand.
- If aggregate demand is low, firms reduce output, leading to involuntary unemployment.
- The economy may not automatically adjust to full employment because of the liquidity trap (where interest rates are too low to encourage investment) and sticky wages (where wages do not fall easily in response to lower demand).
5.Equilibrium Output:
At equilibrium, aggregate demand equals aggregate output. However, this output level could be less than the full-employment level if aggregate demand is insufficient to absorb all of the economy’s potential output.
- Keynesian Cross Model: This model shows how equilibrium output is determined by the intersection of aggregate demand and the economy’s total production.
- If AD > Output, firms increase production and hire more workers, raising output and employment.
- If AD < Output, firms reduce production, leading to lower employment and output.
6. Liquidity Trap and Interest Rates:
- Keynes introduced the concept of a liquidity trap, where interest rates are so low that they cannot be lowered further to encourage investment. In such cases, monetary policy becomes ineffective, and fiscal policy (government spending and tax cuts) is required to boost aggregate demand.
7. Criticisms of the Keynesian Approach:
- Inflationary Bias: Keynesian policies of increased government spending and deficits may lead to inflation if aggregate demand exceeds the economy’s productive capacity.
- Crowding Out: Critics argue that increased government spending can lead to higher interest rates, reducing private investment (crowding out).
- Excessive Dependence on Fiscal Policy: Keynesian economics places significant emphasis on government intervention, which some believe could lead to inefficiencies and longer-term fiscal problems.
Role of Government in Keynesian Theory
Keynes believed that the government has a crucial role in managing economic cycles and stabilizing the economy. He argued that, during times of economic downturn, the government should step in to boost aggregate demand through fiscal policy (increased government spending and/or tax cuts) and monetary policy (lower interest rates and increased money supply).
- Fiscal Policy:
- Keynes recommended increased government spending (such as on infrastructure projects) to stimulate demand in a recession.
- Tax cuts could also help increase household income, thereby boosting consumption and aggregate demand.
- Keynes recommended increased government spending (such as on infrastructure projects) to stimulate demand in a recession.
- Monetary Policy:
- By lowering interest rates, central banks could encourage borrowing and investment, increasing demand.
- Quantitative easing (increasing the money supply) could also be used to stimulate the economy during periods of stagnation.
- By lowering interest rates, central banks could encourage borrowing and investment, increasing demand.
Role of Investment and the Multiplier in Keynesian Economics
In Keynesian economics, investment plays a crucial role in determining output and employment. The concept of the multiplier highlights how changes in investment or government spending can lead to greater changes in national income and employment than the initial amount spent. Here’s a detailed explanation of both concepts:
Role of Investment in Keynesian Economics
- Investment as a Driver of Aggregate Demand:
- Investment refers to spending on capital goods like machinery, infrastructure, buildings, and inventories by businesses. It is one of the components of aggregate demand (AD), alongside consumption, government spending, and net exports.
- In the Keynesian model, investment is a key determinant of economic output because it directly influences aggregate demand. When businesses invest more in capital goods, it stimulates demand for these goods, leading to more production, which in turn creates income and jobs. This leads to an increase in overall economic activity.
- Investment refers to spending on capital goods like machinery, infrastructure, buildings, and inventories by businesses. It is one of the components of aggregate demand (AD), alongside consumption, government spending, and net exports.
- Investment and Economic Growth:
- Higher investment levels generally result in increased production capacity and higher output in the long run. This not only raises the current level of economic activity but also improves the productive capacity of the economy, leading to sustained economic growth.
- However, investment is often subject to volatility because businesses decide how much to invest based on expectations about future demand and profitability. Therefore, investment can fluctuate due to changes in business confidence, interest rates, and government policies, impacting overall economic stability.
- Higher investment levels generally result in increased production capacity and higher output in the long run. This not only raises the current level of economic activity but also improves the productive capacity of the economy, leading to sustained economic growth.
- Impact of Investment on Output and Employment:
- In the short run, an increase in investment leads to higher demand for goods and services, which encourages firms to increase production, leading to higher output and employment. In the long run, sustained investment helps to maintain growth by expanding productive capacity and improving technological advancements.
- In the short run, an increase in investment leads to higher demand for goods and services, which encourages firms to increase production, leading to higher output and employment. In the long run, sustained investment helps to maintain growth by expanding productive capacity and improving technological advancements.
- Types of Investment:
- Private Investment: Investment by businesses in capital goods and infrastructure. This is usually influenced by factors like business confidence, interest rates, and expectations of future demand.
- Public Investment: Government spending on infrastructure, education, healthcare, etc., which can directly boost demand and create jobs.
- Foreign Investment: Investment by foreign businesses in domestic markets can stimulate the economy by creating jobs and improving production efficiency.
- Private Investment: Investment by businesses in capital goods and infrastructure. This is usually influenced by factors like business confidence, interest rates, and expectations of future demand.
The Multiplier Effect
The multiplier effect refers to the phenomenon where an initial change in autonomous spending (such as investment or government spending) leads to a larger overall change in national income or output.
How the Multiplier Works:
- Initial Injection of Spending:
- When there is an increase in investment, it results in increased demand for goods and services. For example, when a company builds a new factory, it purchases raw materials, hires workers, and contracts suppliers.
- When there is an increase in investment, it results in increased demand for goods and services. For example, when a company builds a new factory, it purchases raw materials, hires workers, and contracts suppliers.
- Income Generation:
- The money spent by the company on labor, raw materials, and other services becomes income for households and other firms. This income is then spent by recipients on consumption.
- The money spent by the company on labor, raw materials, and other services becomes income for households and other firms. This income is then spent by recipients on consumption.
- Subsequent Rounds of Spending:
- The income received by the workers and suppliers is spent on goods and services, which further increases demand in the economy. This process continues in multiple rounds as long as the income keeps circulating and being spent.
- The income received by the workers and suppliers is spent on goods and services, which further increases demand in the economy. This process continues in multiple rounds as long as the income keeps circulating and being spent.
- Total Increase in Output:
- The total increase in national income is larger than the initial increase in investment due to the continuous rounds of spending. The size of this total increase depends on the marginal propensity to consume (MPC), which is the proportion of income that households spend on consumption rather than save.