Keynesian Approach of Macroeconomics

After reading this chapter, you will be conversant with: Keynesian view of the Great Depression The Keynesian Model Classical Versus Keynesian Analysis of Income Determination

Post-Keynesian Developments in the Analysis of Income and Employment

Macroeconomics

INTRODUCTION
Macroeconomic analysis is a modern development in the subject of economics. Prior to the Great Depression of the 1930s, as we have seen, the orthodox thinking was that market adjustments would automatically guide an economy to full employment within a relatively short period. However, the prolonged high unemployment rates that gripped the Western private enterprise economies during the Great Depression (1930) undermined the credibility of this thinking. This has paved the way for J.M Keynes General Theory of Employment, Interest and Money (1936), capable of explaining the prolonged unemployment of the period. In this work he developed a new economic analysis which brought about a revolution in economic thought and policy. Keynes rejected traditional and orthodox economics, which had dominated economic thought and policy before and during the Great Depression. This chapter presents the Keynesian view of output and employment and explains its influence on modern macroeconomic analysis.

KEYNESIAN VIEW OF THE GREAT DEPRESSION

Mainstream economic thought before Keynes emphasized the importance of supply-side aspects of macroeconomic system. The classical economists did not concern themselves with demand issues. They had faith in Says Law of Markets. According to this law, a general overproduction of goods relative to total demand is impossible since supply or production creates its own demand. Says law is based on the view that people do not work just for the sake of working, but they work to obtain the income required to purchase the desired goods and services. The capacity to purchase the desired products is generated by the production process in the form of wages and salaries (W), rent (R), interest (I) and profits (P). For example, a farmers supply of wheat generates income to meet the farmers demand for clothes, shoes, automobiles and other desired goods. Similarly the supply of cloth generates the purchasing power with which cloth manufacturers and their employees demand the farmers wheat and other desired goods and services. Classical economists believed that it was possible to produce too much of same type of goods (implying full employment) and not enough of other type (implying no overproduction). In case of any discrepancies between demand and supply the mechanism of wage-price flexibility would come into play automatically. The reasoning is as follows: in excess supply the prices of goods would fall, and in excess demand the prices of products would rise. They did not realize that a general overproduction of goods or glut was possible. In aggregate they thought demand would always be sufficient to purchase whatever the goods and services are supplied or produced. This reasoning of the classical economists seemed reasonable before the 1930s. The Great Depression and its adverse impact on world economy undermined the classical view and provided the foundation for the Keynesian analysis of the Great Depression, which was completely a demand side approach. As we said, Keynes rejected the classical view and offered a completely new concept of output determination. He believed that spending induced business firms to supply goods and services. From this he argued that if total spending fell due to pessimistic or unfavorable expectations about future, then business firms would respond by cutting back production which in turn led to less spending and less output and employment. The classical economists were also aware of this possibility, but they believed the labor surplus would drive down wages, reducing costs and lowering prices until the surplus was eliminated and the economy was directed to full employment within reasonable time. Keynes and his followers rejected this view. They argued that wage-price flexibility is an impossible proposition, particularly in a downward direction in modern economies characterized by large corporate sectors 162

Aggregate Supply, Price Level and Employment: Macroeconomic Equilibrium in the Keynesian Model

and powerful trade unions. Keynes also introduced a completely different concept of equilibrium. In the Keynesian framework equilibrium takes place at a less than full employment level of output. The Keynesian view of less than full employment or less than full capacity output could be explained as follows: Aggregate expenditure or aggregate demand leads to current level of output and employment. The business sector will produce only the quantity of goods and services it believes households (i.e. domestic consumers and investing community), government and foreigners will plan to buy. If this aggregate expenditure consumption, investment, government spending and net exports is less than the economys full capacity output, output will fall short of its potential capacity, which is the full employment level of output. When aggregate expenditure is deficient, there are no automatic forces, as believed by classical economists, capable of assuring full employment. The result is that the actual output will be less than capacity output which in turn results in prolonged unemployment and decline in output. This was how Keynes explained the Great Depression highlighting the drawbacks of self-regulating private enterprise economies. However, no person is totally original in any pursuit of knowledge. Every new theory makes use of some bricks of the demolished building. Keynes is no exception. His theory includes some propositions of the classical school it seeks to replace. But the theory is new and Keynes contribution lies in giving macroeconomic analysis a new turn.

THE KEYNESIAN MODEL

In the Keynesian system also, the economy consists of three basic markets: the labor market, the money market and the goods market. It was maintained that the operation of the forces of supply and demand in each of these markets would finally account for the kind of equilibrium conditions prevailing for an economy. The Keynesian model can be represented by the following set of equations. i. Labor Market y = f (N) dY w = dN P ND = W f w wP ...(9.1) ...(9.2) ......(9.3) .....(9.4) = = = = output or income employment nominal wage, assumed to be rigid in the short run general price level .....(9.5)

= w Y N w P

Where,

ii.

Money Market M = KPY + L (r) Where, M K P Y = = = = quantity of money fraction of income that is demand to be held in costs balances general price level output or income 163

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iii.

Goods Market S = f (r) I = f (r) S=I Where, S = Savings I = Investment r = Rate of Interest (Y = C + I YC=I Y C = S I = S) ...... (9.6) ...... (9.7) ..... (9.8)

If we compare the Keynesian system as shown in the above system of equation, with the classical system explained in the earlier chapter, there are some similarities and certain deviations. The difference is especially in the case of labor supply function and demand for money function. Instead of assuming that the real wage adjusts automatically to bring about equality of demand for and supply of labor, the Keynesian model assumes that nominal wages (W) is rigid downward and a predetermined variable in the short run, w = w and employment is demand determined N = ND with f(ND) = w /P. With regard to money stock, the model assumes that velocity is a variable, and not a constant. The consequence of this assumption is that, as against classical treatment of money as a medium of exchange, for the purposes of transactionary and precautionary motives, Keynes added one important dimension of demand for money i.e. demand for money for speculative purposes L(r) which is inversely related to the interest rate (even in Keynesian system money is neutral in the situation of full employment and liquidity trap.) Therefore, the real difference between the classical model and the Keynesian model lies in the assumption of rigid money wages. At least in the downward direction we could still say that labor supply function depends upon the real wage as in (9.4) above. For any price level P0 business firms employ workers to such an extent where the marginal product of labor equals the real wage, MPL = W/P. However, the consequent labor demand might not equal labor supply at that real wage. For example, more workers might be willing to work at that real wage than the firms wish to employ. In the classical model this situation would automatically lead to a fall in the nominal wage till labor demand increases enough to absorb all available workforce. In the Keynesian model, money wages will not adjust rapidly in a downward direction. Now let us consider some points relating to wage rigidity. In case real wages are sluggish to adjust because nominal or money wages are inflexible, how can the businesses respond? i. There tends to be an implicit agreement or contract between a business firm and its key employees not to adjust money wages rapidly in a downward direction. In case a firm responds to a change in the price level by adjusting the nominal wage of its workers, then there is a possibility that the firm will get a reputation of poor industrial relations. As real wages rise the firm lays off workers. This means that overtime is cut back and low skilled and non-essential staff are paid-off. Inflexible money wages need not be interpreted to mean that nominal wages do not adjust at all. It only means that they adjust slowly, relative to the general price level. It is not a rapid flexible adjustment mechanism as we have seen in the classical model.

ii. iii.

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Aggregate Supply, Price Level and Employment: Macroeconomic Equilibrium in the Keynesian Model

Therefore, for example, if the money wage rate is W0 and the price level is P0 and if the real wage, W0/P0 is the full employment level of real wage, as shown in Figure 9.1, then the labor market is in equilibrium. Suppose now the price level falls from P0 to P1. This means that the real wage will rise to (W0/P1). In this case, compared to the classical case, the money wage (W 0) does not adjust but remains fixed at W0. We say that money wages are sticky. At the new real wage (W0/P1) the demand for labor falls back to N1. At a higher real wage, business firms will not wish to hire as many workers. But the higher real wage brings forth an increase in the supply of labor to N2. At the new real wage (W0/P1), workers are willing to work. Unemployment is equal to the difference between the supply of labor N2 and the demand for labor N1, i.e. N2 N1. Figure 9.1

Unemployment can therefore arise because money wages are inflexible i.e. sticky downwards. Why do not money wages adjust rapidly in order to bring the labor market back into equilibrium at full employment? This is a complex question to answer. Some reasons are cited above in relation to the sticky wages. From the total economys point of view it would appear to be rational to have perfectly adjusting money wages. But from the point of view of individuals supplying labor or business firms employing labor it need not be rational. This is an example of individual rationality not squaring up with collective rationality. Figure 9.2

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Figure 9.2 contains a graphical analysis of Keynesian model of income determination. While these diagrams are similar to Figure. 9.4 there are a few differences. (i) The aggregate supply curve is designated W to convey that in the Keynesian case the position of the curve depends upon the nominal wage. (ii) In the labor market though a demand curve and supply curve have been shown, employment is not at this intersection but is demand determined. As shown above, this may lead to an employment level which is less than full employment equilibrium level. The aggregate supply curve, with money wages rigid downward, is AS0 W in Figure 9.2. If aggregate demand is AD0, the equilibrium values of the variables are P0W0, N0 (W/P)0, and Y0. Given the nominal wage, the labor demand together with the production function determines the aggregate supply (AS) curve. Since the aggregate demand (AD) curve cuts the aggregate supply curve at less than full employment output level i.e. Y0, unemployment exists. This in turn implies the corresponding equilibrium levels of output (Y0), the price level (P0) and the real wage (W/P)0. With the nominal wages rigid downwards at W 0 the aggregate supply curve is positively sloped for price levels less than P1. Since nominal wages are assumed flexible upwards, the aggregate supply curve will be perfectly price inelastic at the full employment level of output Y1 = Y for prices greater than P1. Now, let us consider the effect of an increase in money supply on the price level when the classical assumptions are altered. In general, Keynes assumed that money wages were rigid downwards and that income velocity of money was a variable, and not constant as assumed by the classicals. Suppose the nominal money stock increases. As before, aggregate demand increases from AD0 to AD1, and the price level from P0 to P1. Does the price level increase in proportion to the increase in money stock? We have the original relationship to consider this question. M = kPY .....(9.9) With the increase in the money stock, both output and the price level increase. Since unemployment existed before the increase in money supply, with velocity constant, part of the increase in the money supply is reflected in an increase in the price level and the remainder in an increase in output. Hence, the increase in the price level is less than proportional to the increase in the money supply. In case the income velocity of money is variable as maintained by Keynes, the increase in the price level will not be proportional to the increase in the money supply even if money wages are flexible. Suppose initially aggregate demand is AD0 and aggregate supply is AS0 in Figure 9.2. Suppose the nominal money supply is then doubled. We know, based on the earlier analysis, that the aggregate demand curve shifts from AD0 to AD1 if the velocity of money is constant and, as a result, the price level doubles. But, if people decide to hold part of the increase in the real money supply in the form of idle balances, the velocity of money decreases and aggregate demand does not increase by as much. With the smaller increase in aggregated demand, the increase in the price level is less. Hence, the increase in the price level is less than proportional to the increase in the money supply.

CLASSICAL VERSUS KEYNESIAN ANALYSIS OF INCOME DETERMINATION

Only three differences are revealed in the formal structure of the two systems of macro analysis. (i) Keynes rejected the neo-classical function of supply of labor and assumed rigid wages (W = w ) for situation of less than full employment; (ii) Keynes added the speculative demand for money L(r) to the neo-classical 166

Aggregate Supply, Price Level and Employment: Macroeconomic Equilibrium in the Keynesian Model

transactions and precautionary demand for money (kPY) and (iii) Keynes assumed that income would be a far more important determinant of saving (consumption) than the neo-classical rate of interest, S = S(Y). These three theoretical innovations constitute Keynes denial of the neo-classical automatic mechanism generating full employment. i. The classicals believed in the existence of full employment in the economy and a situation of less than full employment was regarded as abnormal. On the other hand, Keynes considered the existence of full employment as a special case. His notion of underemployment equilibrium is indeed revolutionary reflecting real life situation. The classical analysis was based on Says law of markets that supply creates its own demand. The classical school thus ruled out the possibility of overproduction. Keynes propounded the opposite view that demand creates its own supply. To Klein, the revolution was solely the development of a theory of effective demand. The classical economics was based on the laissez-faire policy of selfadjusting economic system with no government intervention. But Keynes discarded the policy of laissez-faire and he favored state intervention. Pigou, one of the foremost classical economists, favored the policy of wagecut to solve the problem of unemployment. But Keynes opposed such a policy both from the theoretical and practical points of view. Theoretically, a wage-cut policy increases unemployment instead of solving it. Practically, workers are not prepared to accept a cut in money wage. The classicists emphasized the importance of saving or thrift in capital formation for economic growth. To Keynes saving was a private virtue and a public vice. The classical economists failed to provide an adequate explanation of the cyclical phenomena. They could not explain the turning points of the business cycle satisfactorily and generally referred to boom and depression. Keynes real contribution to business cycle analysis lies in his explanation of turning points of the cycle. In this field as opined by Mrs. Joan Robinson, Keynesian revolution commands the field.

ii.

iii.

iv.

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vi.

vii. The classicists artificially separated the monetary theory from the value theory. Keynes, on the other hand, integrated monetary theory and value theory through the theory of output. He regarded the rate of interest as a purely monetary phenomenon. viii. Classical economics was a microeconomic analysis which the orthodox economists tried to apply to the economy as a whole. Keynes, on the other hand, adopted the macro approach to economic problems. Keynes approach to economic problem was dynamic rather than static. The fundamental flaw in Pigous analysis is that he applied partial equilibrium analysis, which is valid in the case of individual industry. But Keynesian analysis is general equilibrium analysis. ix. The classical economists being the votaries of Laissez-faire policy had no faith either in fiscal policy or in monetary policy. They believed in the balanced budget policy. Keynes, on the other hand, stressed the importance of deficit budget during deflation and surplus budget during inflation along with cheap money and dear money policies respectively. He was thus a practical economist whose models clarify both inflationary and deflationary episodes and prosperous and depressed economies.

Despite the theoretical and practical significance of the Keynesian theory, it has its own weaknesses and failures. Many economists consider his analysis less than adequate for meeting such special problems like cyclical forecasts and controls, 167

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persistent inflation, maintenance of full employment booms, secular growth, nonlinear structural relations and macro functional distribution.

THE GENERAL THEORY AS A MONETARY THEORY

From the viewpoint of monetary theory two fundamental issues are presented in the General Theory. 1. 2. Keynes attack on the traditional separation of value theory and monetary theory. Emphasis on the demand for money as an asset alternative to other yield bearing assets.

The general theory represents a transition from a monetary theory of prices to a monetary theory of output. In making this transition, Keynes not only attempted to integrate monetary and value theory, but also brought the theory of interest into the realm of monetary theory. The figure 9.3 illustrates that the Keynesian theory of money and prices recognizes a higher degree of interdependence among the relevant variables in the system than the quantity theory (MV = PT) does. In quantity theory M V = P T , there is a direct relationship between quantity of money and price level. But Keynes asserts that the relationship in fact is an indirect one through the mechanism of rate of interest. Figure 9.3: Keynes Monetary Analysis and Chain of Causation Keynes Chain of Causation Changes in the quantity of money (M)

Changes in the rate of interest (r)

Monetary theory of interest

Theory of money and prices

Changes in aggregate monetary demand (E)

Monetary theory of output and employment

Changes in total output (Y)

Value theory

Changes in marginal costs including money wage rates

Changes in prices The chain causation as shown in the diagram above is as follows. The first impact of an increase in the quantity of money will be on the rate of interest. How far the rate of interest will fall depends upon the strength of the communitys liquidity preference. If the increase in quantity of money does push down the interest rate, aggregate demand will be increased via an interest induced increment in the 168

Aggregate Supply, Price Level and Employment: Macroeconomic Equilibrium in the Keynesian Model

investment demand. Assuming there are unemployed resources in existence, the increased aggregate demand will lead to an increase in output and employment. As output increases, cost conditions will also change. Eventually marginal costs (essentially wage costs) will rise and consequently prices will also change, ending the so-called chain causation. However, the General Theory includes the neo-classical theory of quantity of money MV = PT as a special case. Keynes wrote so long as there is unemployment, employment will change in the same proportion as the quantity of money; and when there is full employment prices will change in the same proportion as the quantity of money. However, Keynes considered that the following possible complications would qualify the preceding statement: i. ii. iii. iv. v. Effective demand will not change in exact proportion to the quantity of money. Since resources are not homogeneous, there will be diminishing, and not constant, returns as employment gradually increases. Since resources are not interchangeable, some commodities will reach a condition of inelastic supply while there are still unemployed resources. The wage-unit will tend to rise before full employment has been reached. The remuneration of all the factors entering into marginal cost will not change in the same proportion.

As stated by Prof. Dillard, it is through the theory of output that value theory and monetary theory are brought into juxtaposition with each other. i. Keynes rejection of neutrality of money is closely linked with his monetary theory of interest. In the Keynesian system money is neutral in two situations: (a) situation of full employment and (b) special case of the liquidity trap. Secondly, Keynes separated the demand for money into two separate components: transactions demand which was assumed to be income elastic and liquidity preference demand or speculative demand which was assumed to be interest elastic. M = M1 + M2 = L1 (Y) + L2 (r) iii. Thirdly, Keynes explained the existence of a liquidity preference for money. Keynes did not formulate a theory of expectations. Instead he only discussed the conventions and habits of thought governing the formation of these expectations. Fourthly, Keynes formulated his theory of interest explicitly in stock terms. It will be recalled that the traditional loanable funds theory of interest was formulated in flow terms. Lastly, Keynes employed the Marshallian short run analysis as a substitute for dynamic analysis. Hence in Keynesian analysis, both the accumulation of real capital and the accumulation of debt are excluded from explicit considerations.

ii.

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POST-KEYNESIAN DEVELOPMENTS IN THE ANALYSIS OF INCOME AND EMPLOYMENT

Algebraic Formulation of the Truncated Keynesian model The truncated model is the basic Keynesian idea depicted by the Keynesian diagonal cross diagram. The model may be represented by a system of three equations in three unknown variables. Y=C+I C = + Y .....(9.10) .....(9.11) 169

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I = I0 Yt = Ct + It Yt Ct = It Yt Ct = St I = S, equilibrium level of income (Y) Where, Y C I = = = = = output or real income consumption expenditure investment expenditure intercept of the consumption function slope of the consumption function or MPC.

.....(9.12)

Equation (9.10) depicts the equilibrium condition in the commodity market. It is the equation of 450 line. Equation (9.11) is the only behavioral equation in the truncated basic model. It denotes C as a linear function of income (Y). Equation 9.12 states that investment is a known constant and it becomes exogenous thereby reducing unknown variables to two. Then we have to find equilibrium values of the C and Y. Equilibrium value will be intersection of the (C + I) function and 450 line. By substituting (9.11) and (9.12) in (9.10), we get Y Y Y Y (1 ) Y = = = = ( + Y) + (I 0 ) + I0 + I0 1 1 ( + I0 )

The equilibrium of the income (Y) is given by the solution: 1 ( + I0). Once the equilibrium value of the Y is known, we can substitute 1 it in the linear consumption function to find the equilibrium value of (C). Firstly, changes in (Y) will be caused by changes in parameters. Second, the total effect on (Y), of a change in the exogenous variable, I0, can be measured only when we take into account all the parameters (interrelations) of the model. The interrelations are as follows: Y= When I increases, Y increases. Since C = f(Y), C will also increase. This is a case of interdependence which non-mathematical theory has difficulties in handling. Figure 9.4

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The above interrelationships lead us to an analysis of instantaneous multiplier. The multiplier shows the total effect of change in (I) on (Y). It can be derived from the model. The original equilibrium is Y0. The equilibrium value of C is C1 when investment expenditure increased from (I0) to (I0 + I), (Y0) will increase by ( Y) to (Y1). The magnitude of ( Y) in the new equilibrium is given by the equation Y = (1/(1 ) I, which shows the total ( Y) induced by ( I) after taking into consideration of income-induced ( C) [(C = f(Y)] via the MPC ( ). The 1 equation Y = I is derived as follows: (I) The original equilibrium income: Y= 1 ( + I 0 ) 1 The new equilibrium income after I, Y1 is Y + Y= 1 1 ( + I 0 ) + 1 1 ( I) ......(9.13)

..... (9.14)

Subtracting (9.13) from (9.14), we get the difference between (Y0) and (Y1) which is Y. Y = 1 1

I or,

Y 1 = I 1 This equation shows that (), or MPC (C/Y) is the crucial determinant of the size of the multiplier. We must take into consideration all the income induced changes in the system. In this simple basic model, only one important incomeinduced change is explicitly stated, namely the MPC (). Other income-induced changes could be introduced into the multiplier analysis in more generalized models. An Expanded Model Without changing its basic logic, the truncated model could be expanded to include other induced changes in the system. Y=C+I+G+XM C = + (Y T) I = I0 + iY M = C + mY T = T0 + tY G = G0 X = X0 .........(9.15) .........(9.16) .........(9.17) .........(9.18) .........(9.19) .........(9.20) .........(9.21)

The purpose of introducing variable (T) into the model is to take into consideration the built-in stabilizers in the government budget. I0 is autonomous investment. i is the slope of the linear investment function or the Marginal Propensity to Invest (MPI) i.e. I/ Y, which indicates the income induced part of the investment. Equation (9.18) is the import function. The purpose of introducing the variable (X M) into the model is to show the relationship between national income and foreign trade. Equation (9.19) is the tax receipt function. Equation (9.20) and (9.21) states that government spending (G) and exports (X) are known constants. To find out equilibrium value of income we have to substitute all functions in equation (9.15). 171

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= + [Y (T0 + tY )] + I0 + iY + G0 + X0 (C + mY) = + Y T0 tY + I0 + iY + G0 + X0 C mY

Y Y + tY iY + mY= T0 + I0 + G0 + X0 C Y (1 + t i + m) = T0 + I0 + G0 + X0 C Y= 1 1 +t i + m ( C + I0 + G0 + X0 T0)

This is the solution or the reduced form of the simultaneous equations. A change in any parameter or exogenous variable will lead to a change in (Y). The total effect of such change on income (Y) can be measured by the multiplier i.e. 1/(1 i + t + m). In this generalized form, multiplier includes the four induced changes in the system. The Keynesian model, whether in its basic simple form or in its more generalized form, deals mainly with the commodity market equilibrium. It says nothing about the roles of money or the rates of interest in the determination of equilibrium income. In order to show that income equilibrium requires both commodity and money market equilibrium, it is necessary to expand the model to include an analysis of money market equilibrium.

A Linear Version of the Hicks-Hansen Model

The General Theory is both a theory of the determination of income and employment and a monetary theory. The familiar Hicks-Hansen restatement of Keynes theory highlights this point, taking into account the quantity of money and rate of interest. It is a famous IS-LM model. First it indicates that the equilibrium level of real income (Y) and equilibrium level of rate of interest (r) are simultaneously determined by four functional relations: the saving function and investment function in the commodity market (IS) and demand for money and supply of money in money market (LM). Further, diagram 9.5 explains that the equilibrium rate of interest is determined by both real (IS) and monetary (LM) forms. Figure 9.5

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It should be noted that the multiplier for a change in (I) with a constant stock of money is smaller than the multiplier for a change in the stock of money. The reason is that the increase in income (Y) following the increase in (I) will cause the interest rate (r) to rise, if the stock of money remains constant. The increase in r will discourage further investment. So the multiplier effect is smaller in the case of M than in the case of flexible M . The figure shows that the actual income change from Y0 to Y2 following a shift in (IS) curve is dampened by the rise in rate of interest from r0 to r1. The dampening effect of r is indicated by the distance (Y1 to Y2). The Aggregate Supply Function The General Theory as a theory of income and employment ignores the problem of a changing price level. Thus one of the challenging tasks in post-Keynesian economics is to incorporate price level changes into the Keynesian system. The theoretical framework was laid down by Prof. Sidney Weintraub in 1956. The price level is implicit at each point on the AS function. In a static framework the conditions of diminishing returns means increasing costs as output expands. Prices therefore would rise as the volume of employment increases. Simultaneously, the rise in prices would redistribute income in favor of the recipients of the profits at the expense of the wage-earners and fixed income groups. This is shown by the widening gap between aggregate supply (AS) function and the total wage bill line (WN). Figure 9.6

AS = W N = =

aggregate supply (GNP) money wage rate volume of employment 173

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The aggregate demand (AD) function is not independent of the distribution of income. A two-fold relationship between AD and AS and distribution of income is envisaged by Prof. Weintraub and Davidson: (i) the increase in AD will lead to a redistribution of income in favor of profit recipients via the price increase. (ii) on the other hand, the redistribution of income will in turn affect AD via the consumption pattern of three major income groups i.e. wage earners, rentiers and profit recipients resulting in shrinking AD. The Real Balance Effect It is one of the important theoretical innovations since the publication of the General Theory.The concept was originated by Prof. Haberler, but it was Prof. Patinkin who employed it to validate the basic conclusions of classical and neoclassical theory. Firstly, the real balance effect could eliminate the classical and neo-classical dichotomy between the value and the monetary theories. Secondly, the quantity theory conclusions (i.e. in equilibrium, money is neutral, and rate of interest is independent of quantity of money) could be validated by using the real balance effect as an equilibriating mechanism. Patinkin criticized Keynes for overlooking two important points: (i) the direct influence of the real balance effect on the Aggregate Demand and (ii) supply side of the commodity market, which by its excess over demand, generates this effect. Theories of Consumer Behavior 1. The Relative Income Hypothesis Duesenbery 2. 3. 4. Permanent Income Hypothesis Milton Friedman Absolute Income Hypothesis Joan Tobin and Arthur Smithis Life Cycle Hypothesis or MBA Hypothesis Modigliani, Bumberge Ando.

Theory of Investment: Integration of Financial and Acceleration Theories Keynes formulation of the theory of investment in terms of the functional relationship between investment expenditure and rate of interest has been criticized by a number of Post-Keynesian writers for its Ceteris Paribus function like his consumption function. A more complete investment function must pull the parameters out of Ceteris Paribus and ascertain the effects of each of them on investment. The resultant outcome is integration of financial and acceleration theories of investment. The role of profits in the determination of investment has been emphasized by empirical studies. Investment in Human Capital A second landmark of the Post-Keynesian theory of investment is the group of studies devoted to investment in human capital. Example, direct investment in education and health, results in the impressive rise in the real earnings per worker. Technical Progress Vs Investments as a Source of Economic Growth The third landmark of Post-Keynesian theory of investment is connected with the question of technical progress versus investment as a source of economic growth. In the mid 1950s, Prof. Solow Massel, Fabricant and others attempted to measure the respective contribution of investment and technical progress to output growth. Technological and Structural Unemployment Keynesian economics addresses itself mainly to the problem of demanddeficient unemployment. Since the end of the Korean war, a new type of unemployment problem has been identified. During the period of late 1957 to 1964 in the USA unemployment averaged nearly 6%. It led to various economists to search for explanations other than that of demand shortage. Technological unemployment once again became the focus of public attention, thwarting the Keynesian remedies. From various studies it is concluded that the problem is a juxtaposition of three types of unemployment, namely demand shortage, structural and technological. Technological changes cause obsolescence of 174

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skills and thereby produces some mismatching between available workers and jobs which we call structural unemployment. However, by raising output per worker, technological change is one of the principal sources of growth. If not so, it opens a gap in demand and thereby causes demand shortage unemployment. Present problem of unemployment is a product of an interaction between rising productivity, labor force growth, and an inadequate growth of AD perhaps due to skewed distribution of purchasing power. The paramount need is for public and private policies to be conducive to a high-employment economy.

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