Keynes and the Evolution of Macroeconomics

I believe myself to be writing a book on economic theory which will largely revolutionize not, I suppose, at once but in the course of the next ten years the way the world thinks about economic problems. -- John Maynard Keynes (1935)

Macroeconomics Prior to the Great Depression

Prior to the Great Depression of the 1930s, economists (now called classical economists) stressed the importance of production and paid little heed to aggregate demand. Says Law (named for a nineteenth-century French economist J. B. Say) was central to their analysis.

Says Law: The production (supply) of goods creates the purchasing power (demand) required to purchase the goods. Hence, deficient total demand could never be a problem as the production of goods always generates demand sufficient to purchase the goods produced; put another way, supply creates its own demand.

Macroeconomics Prior to the Great Depression

Classical economists believed that markets would adjust quickly and direct the economy toward full employment. The huge decline in output, prolonged unemployment, and lengthy duration of the Great Depression undermined the classical view and provided the foundation for Keynesian economics.

The Great Depression and the Keynesian View

Keynesian Explanation of the Great Depression

Keynesian economics was developed during the Great Depression (1930s). Keynesian theory provided an explanation for the severe and prolonged unemployment of the 1930s. Keynes argued that wages and prices were highly inflexible, particularly in a downward direction. Thus, he did not think changes in prices and interest rates would direct the economy back to full employment.

Keynesian Explanation of the Great Depression

Keynesian View of spending and output:

Keynes argued that spending induced business firms to supply goods & services. Hence, if total spending fell, then firms would respond by cutting back production. Less spending would lead to less output.

Macroeconomics Prior to the Great Depression

Says Law (named for a nineteenth-century French economist J. B. Say)
Says Law: supply creates its own demand.

Macroeconomics Prior to the Great Depression

Classical economists believed that markets would adjust quickly and direct the economy toward full employment. The huge decline in output, prolonged unemployment, and lengthy duration of the Great Depression undermined the classical view and provided the foundation for Keynesian economics.

Keynesian Explanation of the Great Depression

Keynes argued that wages and prices were highly inflexible, particularly in a downward direction. Thus, he did not think changes in prices and interest rates would direct the economy back to full employment.

Keynesian Explanation of the Great Depression

Keynesian View of spending and output:
Keynes argued that spending induced business firms to supply goods & services. Hence, if total spending fell, then firms would respond by cutting back production. Less spending would lead to less output.

The Basic Keynesian Model

The Basic Keynesian Model

In the Keynesian model:
as income expands, consumption increases, but by a lesser amount than the increase in income,
both planned investment and government expenditures are independent of income, and, planned net exports decline as income increases.

Aggregate expenditures

Planned Planned Planned + Planned + government + Net consumption investment Exports expenditures

Planned consumption
(trillions of $)

45 line

12 9 Dis-saving 6

Saving

3 45 3 6 9 12

(trillions of dollars)

Real disposable income

Aggregate Consumption Function

Keynesian Equilibrium

Keynesian Equilibrium
According to the Keynesian viewpoint, equilibrium occurs when:
Planned aggregate expenditures

Current output

When this is the case:

businesses are able to sell the total amount of goods & services that they produce, and, there are no unexpected changes in inventories, so, producers have no reason to either expand or contract their output during the next period.

Keynesian Equilibrium
Keynesian equilibrium can occur at less than the full employment output level.
When it does, the high rate of unemployment will persist into the future.

Aggregate demand is key to the Keynesian macroeconomic model.

Keynes believed that weak aggregate demand was the cause of the Great Depression.

Keynesian Equilibrium
When

Total aggregate expenditures

<

Current output

firms accumulate unplanned additions to inventories that will cause them to cut back on future output and employment.

When

Total aggregate expenditures

>

Current output

inventories fall and businesses respond with an expansion in output in an effort to restore inventories to their normal levels.

An Example of Keynesian Equilibrium

Planned investment plus Planned Tendency Total Output Planned aggregate Planned (real GDP) expenditures consumption government expenditures Net Exports of output $ 9.4 9.7 10.0

10.3 10.6

Recall: Planned Aggregate Expenditures = Planned Consumption plus Planned Investment plus Planned Government Expenditures plus Planned Net Exports.

< < = > >

$ 9.70 9.85 10.00

$7.1 7.3 7.5

$2.4 2.4 2.4

$0.20 0.15 0.10 0.05 0.00

Expand Expand Equilibrium

10.15 10.30

7.7 7.9

2.4 2.4

Contract Contract

In the Keynesian system, when total output is less than planned aggregate expenditures, purchases exceed output and inventories are depleted. Firms expand their output to rebuild their inventories to regular levels. When output is more than planned aggregate expenditures, output exceeds purchases, and inventories accumulate. Firms reduce output in order to reduce this build-up of excessive inventories. When planned aggregate expenditures equal total output, there is Keynesian macroeconomic equilibrium.

Aggregate Expenditures
Planned aggregate expenditures
(trillions of $)

Equilibrium
(AE = GDP)

10.0

5.0

45 5.0 10.0

Output
(Real GDP -trillions of $)

Aggregate expenditures will be equal to total output for all points along the 45 line from the origin. The 45 line maps out potential equilibrium levels of output for the Keynesian model.

Keynesian Equilibrium
Planned aggregate expenditures
(trillions of $)

Equilibrium
(AE = GDP)

Unplanned reduction in inventories

AE = C + I + G + NX

9.85

45 9.7

Output
(Real GDP -trillions of $)

At output levels below $10.0 trillion (for example 9.7) AE is above the 45 line expenditures exceed output and thus businesses sell more than they currently produce, diminishing inventories. expand output.

Keynesian Equilibrium
Planned aggregate expenditures
(trillions of $)

Equilibrium
(AE = GDP)

Unplanned reduction in inventories 10.15 9.85

AE = C + I + G + NX

Unplanned increase in inventories 45 9.7 10.3

Output
(Real GDP -trillions of $)

At output levels above $10.0 trillion (for example 10.3) AE is below the 45 line output exceeds expenditures and thus businesses sell less than they currently produce, increasing inventories. Businesses reduce output.

Keynesian Equilibrium
Planned aggregate expenditures
(trillions of $)

Equilibrium Keynesian equilibrium

(AE = GDP)

AE = C + I + G + NX
10.15 10.00 9.85

Full Employment
(potential GDP)

45 9.7 10.0 10.3

Output
(Real GDP -trillions of $)

Keynesian equilibrium exists where planned expenditures just equal actual output. Here that point is at $10.0 trillion. Full-employment for this example exists at $10.3 trillion. In the Keynesian model, macroeconomic equilibrium does not necessarily coincide with full-employment.

Keynesian Equilibrium
Planned aggregate expenditures
(trillions of $)

AE = GDP

10.3 10.0

AE2 AE1

Full Employment
(potential GDP)

45 10.0 10.3

Output
(Real GDP -trillions of $)

If equilibrium is less than its capacity, only an increase in expenditures (shift AE) can lead to full employment output. If consumers, investors, governments, or foreigners spend more and thereby shift AE to AE2, output would reach its full employment potential.

Keynesian Equilibrium
Planned aggregate expenditures
(trillions of $)

AS

AE = GDP

10.6 10.3 10.0

AE3 AE2 AE1

Full Employment
(potential GDP)

45 10.0 10.3

Output
(Real GDP -trillions of $)

Once full employment is reached, further increases in AE, such as to AE3, lead only to higher prices nominal output expands along the black segment of AE (those points beyond the full employment output level at $10.3 trillion) while real output does not.

The Keynesian View within the AD/AS Framework

Keynesian Equilibrium within the AD/AS Framework

When output is less than full-employment, the primary impact of an increase in aggregate demand will be an increase in output. When output is at or beyond the full- employment level, the primary impact of an increase in demand will be higher prices.

Keynesian Aggregate Supply Curve

Price Level

SRAS LRAS

Keynesian range P1

Full Employment
(potential GDP)

YF

Goods & Services

(real GDP)

The Keynesian model implies a 90, angle-shaped SRAS curve that is flat for outputs less than potential GDP YF due to downward wage and price inflexibility.
This flat range is referred to as the Keynesian range. Output here is entirely dependent on the level of aggregate demand.

Keynesian Aggregate Supply Curve Price

Level

SRAS LRAS

Keynesian range P1

Full Employment
(potential GDP)

YF

Goods & Services

(real GDP)

The Keynesian model implies that real output rates beyond full employment are unattainable. Both the SRAS and LRAS curves are vertical at full employment potential output.

AD/AS Presentation of the Keynesian Model: Polar Case

Price Level

SRAS LRAS

P2 =

P1

e1

e2

AD2 AD1
Y1 YF

Goods & Services

(real GDP)

Above are the polar implications of the Keynesian model. When output is less than capacity (e.g. Y1) an increase in AD (like from AD1 to AD2) expands output without an increase in the price level (P2 = P1).

AD/AS Presentation of the Keynesian Model: Polar Case

Price Level

SRAS LRAS

P3 P2 = P1

e3 e1 e2

AD3 AD2 AD1

Y1 YF

Goods & Services

(real GDP)

Increases in demand beyond AD2 (like from AD2 to AD3) lead to the higher price level P3, but real output remains constant.

AD/AS Presentation of the Keynesian Model: Relaxed Case

Price Level

LRAS SRAS
Relaxed assumptions: SRAS now turns from horizontal to vertical more gradually.

P2 P 1

e1

e2

AD1
Y1 YF

AD2
Goods & Services
(real GDP)

This Keynesian model relaxes the assumptions regarding complete short-run price and output inflexibility beyond YF. An unanticipated increase in AD with output below capacity leads mainly to increases in output (e.g. from

AD/AS Presentation of the Keynesian Model: Relaxed Case

Price Level

LRAS SRAS

P3

e3 e1 e2

P2 P 1

AD3 AD1 AD2

Goods & Services
(real GDP)

Y1

YF Y3

An unanticipated increase in AD with output at or beyond capacity leads mainly to increases in price level (e.g. from AD2 to AD3).

The Keynesian view of the Business Cycle

Keynesian View of the Business Cycle

Keynesians argue that a market economy, if left to its own devices, is unstable and likely to experience prolonged periods of recession.

Keynesian View of the Business Cycle

According to the Keynesian view of the business cycle, upswings and downswings tend to feed on themselves:

During a downturn, business pessimism, declining investment, and the multiplier principle combine to plunge the economy further toward recession. During an economic upswing, business and consumer optimism and expanding investment interact with the multiplier to propel the economy to an inflationary boom.

Keynesian View of the Business Cycle

The Keynesian view argues that wide fluctuations in private investment are a major source of economic instability. The theory suggests that a market-directed economy, left to its own devices, will tend to fluctuate between economic recession and inflationary boom.

Keynesian View of the Business Cycle

Regulation of aggregate expenditures is the crux of sound macroeconomic policy according to the Keynesian view. If we could assure aggregate expenditures large enough to achieve capacity output, but not so large as to result in inflation, the Keynesian view implies that maximum output, full employment, and price stability would be attained.

Evolution of Modern Macroeconomics

The Evolution of Modern Macroeconomics

Major insights of Keynesian Economics:

Market forces may fail to restore full employment quickly. During a serious recession, excess capacity and pessimism about the future are likely to slow the adjustment process. The responsiveness of aggregate supply to changes in demand will be directly related to the availability of unemployed resources. Fluctuations in aggregate demand are an important source of business instability.
Modern macroeconomics is a hybrid reflecting elements of both classical and Keynesian analysis as well as some insights drawn from other areas of economics.

Keynes theory in developed and developing economies like India

The Circular Flow Model

Understanding the economy as a series of continuous flows

The Simple Two Sector Model

Assume the economy is made up of two sectorsfirms and households. Firms produce products which they sell in the Product Market. Households buy products in the Product Market. Firms buy resources in the Resource Market. Households sell resources in the Resource Market.

The Simple Two Sector Model

The Two Sector Model

With a Financial Market Now assume that households do not spend all of their income, i.e., they save.
This represents a leakage from the circular flow.

Assume firms need capital to produce goods and services, thus they must engage in investment spending.
This represents an injection into the circular flow.

Financial intermediaries perform the function of bringing savers and investors together.

The Two Sector Model

With a Financial Market

The Three Sector Model

Our two sector model is not realistic in anything but the most primitive society. Lets assume we have a government sector. What do governments do?
They tax. (A leakage) They spend. (An injection)

How does the government affect our circular flow?

The Three Sector Circular Flow Model

The Four Sector Model

In the real world, no country exists in isolation. Nations of the world interact with one another by buying from and selling to each other. We buy imports from foreign countries. (A leakage) We sell exports to foreign countries. (An injection) Add imports and exports to our circular flow. How does the rest of the world affect the circular flow model?

The Four Sector Circular Flow Model

Consumption, Investment Function and Multiplier

1. Consumption Function and Psychological Law Consumption Function and Propensity to Consume Consumption function or propensity to consume refers to the general income consumption relationship. Symbolically, it can be expressed as C=f (Y). Consumption refers to the expenditure on consumption at a given level of income, while propensity to consume refers to the schedule showing consumption expenditure at various levels of income. Psychological Law of Consumption Psychological Law of Consumption contains the following three interrelated propositions(i) When aggregate income increases aggregate consumption also increases, but by a somewhat smaller amount. (ii) The increase in income will be divided in some ratio between saving and consumption. (iii) Both saving and consumption will increase as a result of the increase in income.

Schedule of Consumption Function

INCOME (Y) 0 50 100 150 200 250 CONSUMPTION (C) 20 60 100 140 180 220 Y=C
Saving

SAVING (S= Y-C) -20 -10 0 10 20 30

B
Dissaving

Income

Technical Attributes of Consumption Function

Average Propensity to Consume (APC) Average Propensity to Consume is defined as the ratio of absolute consumption to absolute income. APC= C/Y. Marginal Propensity to Consume (MPC) Marginal Propensity to Consume (MPC) refers to the ratio of small change in consumption to small change in income. MPC= change in Consumption/change in Income. c Properties of MPC c 1. MPC is greater than zero but less than one. c 2. MPC falls with successive increase in income. 3. MPC of the poor is greater than that of the rich.
INCOME

Factors Affecting Consumption Function

1. Subjective Factors: Subjective factors are endogenous or internal to economic system. According to Keynes, these factors are unlikely to undergo a material change over a short period of time except in abnormal or revolutionary circumstances. Psychology of Human Nature: There are eight motives which lead the individuals to refrain from spending out of their incomes. They are(i) To build the reserve for unforeseen contingencies (death, diseases,) (ii) To provide for anticipated future needs.( retirement, higher studies) (iii) To enjoy an enlarged future income by investing funds out of current income. (iv) To enjoy a sense of independence or not to depend on others. (v) To posses power or to get higher social or political status. (vi) To secure enough funds to carry out speculation. (vii) To bequeath a fortune.

(i) (ii) (iii) (iv) 2. (i) (ii) (iii) (iv) (v) (vi)

Institutional Arrangements: with respect to the behavior of business corporations and governments, Keynes listed the following four motives for accumulation: Enterprise- the desire to expand or to do big things. Liquidity- the desire to face emergencies successfully. Rising Income the desire to demonstrate successful management. Financial Prudence the desire to ensure adequate financial provisions against depreciation. Objective Factors: Objective factors that cause shift in consumption function are. Changes in Wage Level Distribution of Income Windfall Gains and Losses Fiscal Policy Changes in Expectations Rate of Interest

Investment Function
In Keynesian economics, investment means real investment and not financial investment. Real investment implies the creation of new machines, new factory buildings, roads, bridges, and other forms of productive capital, which directly generates new jobs and increases production. Real investment does not include the purchase of existing stocks, shares and securities, which is merely an exchange of money from one hand to another. Such an investment is simply financial investment and has no direct impact on the employment and output of the economy. Types of Investment 1. Induced or Private Investment Income 2. Autonomous or Public Investment 3. Planned Investment and Unplanned Investment 4. Gross and Net Investment: Gross Investment includes a) net investment and b) depreciation and Net Investment includes Gross Investment minus Depreciation
Investment

I I

Propensity to Invest 1. Average Propensity to Invest ( API): The ratio between aggregate investment and aggregate income. API= I/Y. 2. Marginal Propensity to Invest ( MPI): The ratio of change in investment to change in income.
I L I2 K I1 T Investment Investment I

I1

Y1 Income

Y1

Y2

Income

Marginal Efficiency of Capital (MEC) The MEC refers to the highest rate of return over cost expected from the employment of marginal or additional unit of a capital asset. In other words it means the expected rate of profitability of a brand new capital asset. The term MEC is related to the real and not financial investment.
Determinants of MEC

Prospective Yield: The prospective yield means the total net returns which an entrepreneur expects to obtain from selling the output of the capital asset over its life time. Running expenses are to be deducted from these returns. Supply Price: The Supply Price refers to the cost of production of a new capital good. The supply price is not the market price at which the capital asset is purchased, but is the price which would just induce a manufacturer newly to produce an additional unit of such assets.

Relation between MEC and Rate of Interest (i) When MEC = rate of interest, the effect on inducement to invest is neutral. (ii) When MEC > rate of interest, the effect on inducement to invest is favorable. (iii) When MEC < rate of interest, the effect on inducement to invest is un

Factors affecting MEC

Short-Run Factors 1. Nature of Demand, Price and Cost: If the entrepreneurs expect the demand for the product to rise, their prices to rise and the costs to decline, then the MEC will be high and the investment activity will be stimulated and vice-versa. 2. Propensity to Consume: Favorable shifts in consumption function cause favorable shifts in investment. 3. Changes in Income: 4. Changes in Liquid Assets: 5. Current State of Expectations: 6. Waves of Optimism and Pessimism. 7. Taxation. 8. Returns from Existing Capital

Long-Run Factors 1. Population 2. Development of New Territories 3. Technological Advancement 4. Supply of Capital Equipment 5. Economic Policy. Measures to Stimulate Private Investment 1. Tax Concessions. 2. Lowering Rate of Interest. 3. Government Spending. 4. Pump-Priming. 5. Reduction in Wage-Rate. 6. Price Policy 7. Abolition of Monopoly Practices. 8. Promotion of Research 9. Economic Planning

The Multiplier
The concept of Multiplier is an integral part of Keynes Theory of Employment. Keynes believed that an initial increment in investment increases the final income by many times. Keynes gave the name Investment Multiplier which is also known as Income Multiplier or simply Multiplier. Multiplier is expressed as K= Change in Income (Y)/ Change in Investment (I) According to Kurihara, The Multiplier is the ratio of change in income to the change in Investment. According to D.Dillard, Investment Multiplier is the ration of an increase in income to given increase in Investment In short the Multiplier tells us how many times the income increases as a result of an initial increase in investment.

 The multiplier tells us how many times the income increases as a result of increased investment. It applies to autonomous investment. There is closed economy. There is no change in the prices of commodities. There is no time lags. The MPC remains constant. The situation is less than full employment. The factors and resources of production are easily available. The view that a change in autonomous expenditures (e.g. investment) leads to an even larger change in aggregate income. An increase in spending by one party increases the income of others. Thus, growth in spending can expand output by a multiple of the original increase. The multiplier is the number by which the initial change in spending is multiplied to obtain the total amplified increase in income. The size of the multiplier increases with the marginal propensity to consume (MPC).

The Multiplier Principle

Expenditure stage Round 1 Round 2 Round 3 Additional income
(Rs)

Additional consumption
(Rs)

Marginal propensity to consume 3/4 3/4 3/4 3/4 3/4 3/4 3/4

1,000,000 750,000 562,500

750,000 562,500 421,875

Round 4
Round 5 All others

421,875
316,406 949,219

316,406
237,305 711,914

Total

4,000,000

3,000,000

For simplicity (here) it is assumed that all additions to income are either spent domestically or saved.

Relation between MPC and Multiplier Total Income = Total Consumption + Total Investment Or Y=C+I Or Change in Income = Change in Consumption + Change in Investment Or Change in Investment = Change in Income -- Change in Consumption By definition, Multiplier is K = Change in Income / Change in Investment Substituting the value of Change in Investment in K equation we get K = Change in Income / Change in Income -- Change in Consumption Dividing both the numerator and denominator by Change in Income, we have 1 Change in Income -- Change in Consumption K= Change in Income 1 K = 1-- Change in Consumption / Change in Income

Y= C + I
C+I+G
E1 I CONSUMPTION INVESTMENT

C+I

E0

0
INCOME

 The multiplier concept is fundamentally based upon the proportion of additional income that households choose to spend on consumption: the marginal propensity to consume (here assumed to be 75% = 3/4).

Here, a Rs 1,000,000 injection is spent, received as payment, saved and spent, received as payment, saved and spent etc. until

Leakages of Multiplier
Saving Debt Cancellation Imports Price Inflation Hoarding Purchase of old shares and securities Taxation Undistributed Profits

A Higher MPC Means a Larger Multiplier

MPC
9/10 4/5 3/4 2/3 1/2 1/3
1

Size of multiplier
10.0 5.0 4.0 3. 0 2.0 1.5

As the MPC increases, more and more money of every injection is spent (and so received as payment and then spent again, received as payment and spent again, etc.). The effect is that for higher MPCs, higher multipliers result. Specifically the relationship follows this equation:

M = 1 - MPC

Real-World Significance of The Multiplier

In evaluating the importance of the multiplier, one should remember:
taxes and spending on imports will dampen the size of the multiplier; it takes time for the multiplier to work; and, the amplified effect on real output will be valid only when the additional spending brings idle resources into production without price changes.