Krugman: The key to Keyness contribution was his realization that liquidity preference the desire of individuals to hold

d liquid monetary assets can lead to situations in which effective demand isnt enough to employ all the economys resources. Effective demand The main argument of the General Theory (GT) is that the amount of employment depends on the level of aggregate demand. Keynes uses the economists supply and demand apparatus which relates the cost to employers of employing N number of workers (supply) to employers expected sales proceeds from employing that number (demand). Equilibrium is reached when buyers are expected to purchase just enough at profitable prices to justify businesses hiring the number of workers necessary to produce the output. This point, where the curves of aggregate supply and aggregate demand intersect, is the point of effective demand. Keyness break from classical thought was to show that the point of effective demand might not be the point of full employment. Keynes broke up aggregate demand (or employers expected income) into 2 components: consumption demand and investment demand. Consumption was the stable element, investment the unstable element. Y = C + I In the short run, the propensity to consume is a fairly stable proportion of current income. 0 < MPC < 1 Given a propensity to consume of less than one, the gap between consumption and production must be filled by investment if full employment is to be maintained. The classical economists assumed that savings always flow into investment at the going interest rate. Keyness novelty was to treat saving as a subtraction from consumption, but not as a fund for investment. o Paradox of thrift: if everyone saves more, firms will sell less and output will fall, unless the inducement to invest is increasing at the same time. The more thrifty society is, the more difficulty it will have in maintaining full employment. The burden of maintaining full employment in a society that saves part of its income falls on investment demand the demand for new capital equipment. For Keynes, investment depends on the marginal efficiency of capital (MEC) the expected rate of return over the cost of buying capital goods. If MEC is above the interest rate, investment will increase; if it is below it, it will fall. o The MEC can alternatively be defined as the present value of a projects expected returns at the discounted interest rate. Thus MEC is the demand price of capital. Given the propensity consume and the inducement to investment (determined jointly by the MEC and the interest rate), the amount of employment is uniquely determined

Quantities, not prices, adjust

Classical economists assumed that aggregate supply the money cost of production adjusts quickly and flexibly to changing expectations of profitable sales, keeping the economy at full employment. That is, if sales are down, prices will adjust down easily so that all of the output can be sold. Keyness denial that this necessarily happens is the crux of his denial of Says Law. o Suppose that employers expected sales proceeds from employing N number of workers falls below the cost of employing that number. In Keyness model, they reduce the cost of production by laying off workers. This reduces the total demand in the economy. It is not the fall in wages, but the fall in employment that eliminates the excess supply of output. o This is equivalent to saying that the excess of saving over investment is eliminated by the fall in income. Income = Consumption + Saving Output = Consumption + Investment Saving = Income Consumption If S > I, in order to return to equilibrium S = I, real income must fall. When investment starts to fail, what stops the economy from running all the way down? The answer is that the impoverishment of the community tends to eliminate the excess saving relative to investment that caused the downturn in the first place. In equilibrium, saving must equal investment. If these two tend to be unequal, the level of activity will be changed until they are restored to equality. Output and not price adjustment is the main mechanism by which the economy reaches a new position of equilibrium. If the propensity to consume is known say 90 percent of current income it is possible to show through the income multiplier that expansions and contractions of income converge to fixed point in which saving and investment are equal. The concept of underemployment equilibrium encapsulates Keyness main claim that the market economy lacks an internal effective mechanism for righting itself after a major crisis.

Uncertainty of expectations How can aggregate demand fall short of productive capacity? Why does the market system often fail to provide employment for all those seeking work? The main intuition behind the GT is that the disturbing forces are greater and the self-correcting forces weaker than orthodox theory supposed. Uncertainty plays a crucial part here. Its main effect is on the inducement to invest. Investment has long been recognized as a volatile element of capitalism, but this volatility has been absent from long-run theorizing favoured by classical economists. Volatility was considered a short run problem minor deviations from the path given by the fundamental market forces.

Keynes inserted money into his account of the investment process. In the modern economy, investment is mainly carried out though financial markets. Keyness explanation of volatility of investment turned on the forces making for instability in the financial markets. Keyness account illustrates the contradictory character of financial innovation: by making investment more liquid, the stock market reduces the proportion of their resources that people will want to hold in cash, but by the same token, it enlarges the scope for speculation and thus makes economic life more volatile.

The stickiness of wages and interest rates The classical belief that the economy was self-regulating rested not just on the absence of uncertainty in the investment market, but also on the existence of automatic adjustment mechanisms. The chief of these mechanisms was flexible wages. Keynes rejected the view that unemployment was due to labour pricing itself out of jobs. He thought that even with fully flexible money wages, there could be involuntary employment. An increase in employment requires a rise in employers expected income. But an all-round reduction in money wages reduces prices proportionally, and leaves employers expected income unchanged. That is, it will not succeed in reducing workers real wages. A fall in money wages would only be favourable to employment if by reducing the proportion of money in the economy needed to pay wages it led to a fall in interest rates (people do not desire to hold cash as much, or there is little demand for money as insurance against uncertainty) But this could not be relied on. Liquidity preference theory of the interest rate: The greater peoples desire to hold cash, the higher the rate of interest they will charge for parting with it. Keynesian theory of employment Keyness objected to the classical assumption that employment is determined by the real wage, without regard to aggregate demand conditions in the goods market. In Keynesian theory the real wage is determined by employment, not the other way around. Employment is determined by the quantity of output that firms want to produce, given the existing technology. In turn, desired output is a function of aggregate demand for goods. Figure 7 It is no longer true that the real wage can be determined independently as a result of bargaining between workers and employers. Any adjustment in the nominal wage would lead to a proportional change in price, leaving the real wage unchanged. Involuntary employment may emerge from equilibrium, with no automatic force guaranteeing that full employment be restored. Figure 9. Under this view, a cut in nominal wages that is not accompanied by an expansion in aggregate demand will leave output, employment and the real wage unchanged, and will leave no impact in employment.