KEYNESIAN

ECONOMICS
 John Maynard Keynes
• He spearheaded a revolution in economic
thinking that overturned the then-prevailing
idea that free markets would automatically
provide full employment—that is, that
everyone who wanted a job would have one
as long as workers were flexible in their wage
demands.
• He argued that inadequate overall demand
could lead to prolonged periods of high
unemployment.
Keynesian description of how the economy
works:

• Aggregatedemand is influenced by
many economic decisions—public and
private.
• Private sector decisions can sometimes
lead to adverse macroeconomic
outcomes, such as reduction in
consumer spending during a recession.
• Prices, and especially wages, respond slowly to
changes in supply and demand
• resulting in periodic shortages and surpluses,
especially of labor.
• Changes in aggregate demand, whether
anticipated or unanticipated, have their
greatest short-run effect on real output and
employment, not on prices.
• Keynesians believe that, because prices are
somewhat rigid, fluctuations in any
component of spending—consumption,
investment, or government expenditures—
cause output to change.
The Keynesian Critique of the Classical
System

• Until the Great Depression, classical

economics was the dominant school
of economic thought
• Adam smith, credited by many as the
founder of classical economics
believed the government should
intervene in economic affairs as little
as possible
The Keynesian Critique of the Classical
System

• John Maynard Keynes asked, “If

supply creates its own demand,
why are we having a worldwide
depression?”
• JohnMaynard Keynes advocated
massive government intervention
to bring an end to the Great
Depression
The Keynesian Critique of the Classical
System
• Keynes asked the question. “What if
savings and investment were not
equal?”
• If savings were greater than
investment, there would be
unemployment
• Not everything being produced would
be purchased
• Keynes disputed the view that the interest rate
would equilibrate savings & investment
• Keynes maintained that
• Saving and investment are done by different
people for different reasons
• Most saving is done by individuals for big
ticket items
• Investing is done by those who run a business
and are trying to make a profit
• They will invest only when there is a
reasonably good profit outlook
• Even when interest rates are low, business
firms won’t invest unless it is profitable for
them to do so
• Keynes questioned whether wages
and prices were downwardly
flexible, even during a severe
recession
• Studies have indicated that prices
are seldom lowered and that wage
cuts (even as the only alternative to
massive layoffs) are seldom
accepted
• Keynes pointed out that even if
wages were lowered, this
would lower worker’s incomes,
consequently lowering their
spending on consumer goods
• Keynes concluded that the economy
was not always at, or tending toward a
full employment equilibrium
• Keynes believed three possible
equilibriums existed
• Below full employment
• At full employment
• Above full employment
As an economy
works its way Modified Keynesian Aggregate Supply Curve
out of a
depression, 180

output can be 160

raised without 140

L-RAS
120
raising prices,
100
so the aggregate
80
supply curve is
60
flat.
40

20

0
0 1 2 3 4 5 6 7 8 9 10
Real GDP (in trillions of dollars)
However, as
resources
Modified Keynesian Aggregate Supply Curve
becomes more
fully employed 180

and bottlenecks 160

140
develop, costs L-RAS
120
and prices begin 100
to rise. When 80

this happens the 60

aggregate supply 40

curve begins to 20

curve upward. 0
0 1 2 3 4 5 6 7 8 9 10
Real GDP (in trillions of dollars)
When we Modified Keynesian Aggregate Supply Curve

reach full 180

employme 160

nt (at a 140
L-RAS
real GDP 120

100
of $6 80

trillion), 60

output 40

cannot be 20

0
raised any 0 1 2 3 4 5 6 7
Real GDP (in trillions of dollars)
8 9 10

further
AD1 represents
aggregate demand Three Aggregate Curves
during a recession
180
or depression
160 L-RAS

AD2 crosses the 140

long-run aggregate 120

supply curve at full 100

employment 80

AD3
60

40

AD3 represents 20 AD1 AD2

excessive demand 0
0 1 2 3 4 5 6 7 8 9 10
Real GDP (in trillions of dollars)
 The Keynesian System
• Keynes stood Say’s law on its head
• Keynesian theory can be summarized
with the statement, “ Demand creates its
on supply”
• Keynes maintained that aggregate demand
is the prime mover of the economy
• Aggregate demand determines the level of
output and employment
• Business firms produce only the quantity of
goods and services they believe consumers,
investors, governments, and foreigners will plan
to buy
The Ranges of the Aggregate Supply Curve

Aggregate
supply

Keynesian
range

Real GDP
 The Keynesian Aggregate Expenditure Model
The Consumption and Saving Functions
When
9
consumption (C)
is greater than 8
Saving
disposable 7 C

income (DI), 6
savings is
5
negative Dissaving
4

3
When disposable
(DI) income is 2

greater than 1
consumption (C),
0
savings is positive 0 1 2 3 4 5 6 7 8 9 10
Disposable income (in trillions of dollars)
 The Keynesian Aggregate Expenditure Model
The Investment Sector
Real GDP (in trillions of dollars)
When C + I 9

represents aggregate 8
C+I
demand, how much is 7 C

equilibrium GDP 6

4
Answer: Approximately
3
$7.0 trillion
2

1
45û
0
0 1 2 3 4 5 6 7 8 9 10
Real GDP (in trillions of dollars)
 Aggregate Demand Exceeds
Aggregate Supply
• When aggregate demand exceeds
aggregate supply the economy is
in disequilibrium
• Output is increased in response
• Eventually, the economy approaches
full capacity followed by price
increases
 Aggregate Demand Exceeds
Aggregate Supply
• It appears that there are two ways
to raise aggregate supply
• By increasing output
• By increasing prices
• By doing this, aggregate supply is
raised relative to aggregate
demand and equilibrium is restored
• When aggregate supply exceeds
aggregate demand the economy is in
disequilibrium
• Inventories rise and output is decreased
• Workers are laid off, further depressing
aggregate demand as these workers cut
back on their consumption
• Eventually, inventories are sufficiently
depleted
• In the meantime, aggregate supply has
fallen back into equilibrium with
aggregate demand
 Summary: How Equilibrium Is
Attained
• When the economy is in disequilibrium, it
automatically moves back into
equilibrium
• It is always aggregate supply that adjust
• When aggregate demand is greater than
aggregate supply, aggregate supply rises
• When aggregate supply is greater than
aggregate demand, aggregate supply
declines
 Summary: How Equilibrium Is
Attained
• Aggregate demand (C + I) must equal
the level of production (aggregate
supply) for the economy to be in
equilibrium
• When the two are not equal,
aggregate supply must adjust to
bring the economy back into
equilibrium
 Keynesian Policy Prescriptions
• The Classical position summarized
• Recessions are temporary because the
economy is self-correcting
• Declining investment will be pushed up
again by falling interest rates
• If consumption falls, it will be raised by
falling prices and wages
• Because recessions are self-correcting,
the role of government is to stand
back and do nothing
 Keynesian Policy Prescriptions

• Keynes’s position was that

recessions are not necessarily
temporary
• The self-correcting mechanisms
of falling interest rates and
falling prices and wages might be
insufficient to push investment
and consumption back up again
 Keynesian Policy Prescriptions
• Therefore
it is necessary for the
government to intervene by spending
money
• How much money? As much money as it
takes
• When the government spends more money,
that’s not the same thing as printing more
money. Generally it borrows more money and
then spends it
• Keynes would have prescribed
lowering aggregate demand to bring
down inflation