CHAPTER FOUR: KEYNESIAN ECONOMICS

4.1. INTRODUCTION
Keynesian Economics is a term used to describe macroeconomic theories of the level of
economic activity using the techniques developed by John Maynard Keynes.

John Maynard Keynes is the chief representative and the founder of this school of thought. The
school began with the publication of Keynes’s The General Theory of Employment, Interest and
Money in 1936 and remains a major presence in orthodox economics today.

His system was based on a subjective psychological approach, and it was permeated with
marginalist concepts, including static equilibrium economics.

The Historical Background of the Keynesian School

Keynes' ideas were given added impetus by the Great Depression of the 1930s, the worst the
Western world had ever known. Yet the roots of his ideas can be traced back to before 1929.

The work of many economists, including that of Mitchell and his associates in the National
Bureau of Economic Research, was within the framework of aggregate economics, or
macroeconomics.

World War I and the economic controls enacted required an overall view of the economy. The
growth of large-scale industrial production and trade made the economy more susceptible to
statistical measurement and control, making aggregate approach more feasible than in the past.
In fact, his approach was increasingly necessary as the public became more eager for the
government to deal actively with unemployment.

Keynesian thinking also had its roots in the spreading concern about secular stagnation, or a
declining rate of growth. The mature private-enterprise economies in the Western world were
less vigorous after World War I than before.

The rate of population growth was declining; most of the world had already been colonized;
there seemed to be no room for further geographic expansion; production appeared to outrun
consumption as incomes and savings rose; and there were no new inventions like the steam

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engine, the railroad, electricity, and the automobile to stimulate new and vast capital
investments.

After the Great Depression began in the early 1930s, many economists in the United States
advocated policies that later would be called Keynesian.

Many economists were aware of the multiplier effect that increased government spending could
have on total spending and income. Some theorized that as the national income increased,
consumption expenditures rose less rapidly than total income, and saving increased more rapidly.
Wages were recognized as a source of demand for goods as well as a cost of production, and
cutting wages was frequently opposed as providing no real remedy for unemployment; this was
macroeconomic thinking. It was Keynes who provided the analytical framework that integrated
these ideas and touched off the "Keynesian revolution'" in economics.

Major Tenets of the Keynesian School

The major characteristics and principles of Keynesian economics are:

􀂃 Macroeconomic emphasis: Keynes and his followers concerned themselves with the
determinants of the total or aggregate amounts of consumption, saving, income, output, and
employment. They were less interested in how an individual firm decides on its profit-
maximizing level of employment.

􀂃 Demand orientation: Keynesian economists stressed the importance of effective demand

(now called aggregate expenditures) as the immediate determinant of national income, output,
and employment. Aggregate expenditures, said these economists, consist of the sum of
consumption, investment, government, and net export spending.

Firms collectively produce a level of real output that they expect to sell. But sometimes
aggregate expenditures are insufficient to buy all the output produced. As unsold goods
accumulate, firms lay off workers and cut back output. That is, effective demand establishes the
economy's actual output, which in some cases is less than the level of output that would exist if
there were full employment (potential output).

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􀂃 Instability in the economy: According to Keynesians, the economy is given to recurring
booms and busts because the level of planned investment spending is erratic. Changes in
investment plans cause national income and output to change by amounts greater than the initial
changes in investment.

Equilibrium levels of investment and saving—those that exist after all adjustments have occurred
—are achieved through changes in national income, as opposed to changes in the rate of interest.

Investment spending is determined jointly by the rate of interest and the marginal efficiency of
capital, or the expected rate of return above the cost on new investments. The interest rate
depends on people's preferences for liquidity and the quantity of money. The marginal efficiency
of capital depends on the expectation of future profits and the supply price of capital. The
expected rate of profit from new investment is unstable, and, therefore, one of the most important
causes of business fluctuations.

􀂃 Wage and price rigidity: Keynesians pointed out that wages tend to be inflexible downward
because of such institutional factors as union contracts, minimum wage laws, and implicit
contracts (understandings between employers and their workers that wages will not be cut during
downturns judged to be temporary). In periods of slack aggregate demand for goods and
services, firms respond to lower sales by reducing production and discharging or laying off
workers, not by insisting on wage cuts. Prices also are sticky downward; declines in effective
demand initially cause reductions in output and employment rather than declines in the price
level. Deflation occurs only under conditions of extremely severe depression.

􀂃 Active fiscal and monetary policies: Keynesian economists advocated that the government
should intervene actively through appropriate fiscal and monetary policies to promote full
employment, price stability, and economic growth.

To combat recession or depression, government should either increase its spending or reduce
taxes, the latter increasing private consumption spending. It also should increase the money
supply to drive down interest rates in the hope that this will bolster investment spending.

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To counter inflation caused by excessive aggregate expenditures, government should reduce its
own spending, increase taxes to reduce private consumption spending, or reduce the money
supply to raise interest rates, which will dampen excessive investment spending.

JOHN MAYNARD KEYNES (1883 - 1946)

Keynes was born in Cambridge, England, on June 5, 1883. His father was a distinguished
economist who thought political economy and logic and was also a Registrar of Cambridge
University for many years. Young Keynes graduated from Cambridge in 1905 in the
Mathematical Tripos and was influenced by Marshall & Sidgewick. In 1909, he started teaching
economics in Marshallian Tradition at King’s College.

He became a baron in 1942, and to those of his friends who criticized his accepting the title, his
joking defense was "I had to do it in order to get servants.”

In 1926 Keynes published a brief book entitled The End of Laissez-faire, in which he stated that
the evils of the day were the fruits of risk, uncertainty, and ignorance. Big business is often a
lottery in which some individuals are able to take advantage of ignorance and uncertainty. The
consequences are great inequalities of wealth, unemployment, disappointment of reasonable
business expectations, and impairment of efficiency and production. In 1946, he was appointed
as the Governor of the IMF and the International Bank for Reconstruction and Development.
Finally, he died on April 21, 1946.

His Works

Keynes was a prolific writer, and he published more than a dozen of books. However, the master
piece of Keynes which immortalized his name was his “The General Theory of Employment,
Interest and money” which came out in 1936 and caused what is known as “Keynesian
Revolution”.

Keynes started his work by distinguishing his own system from what he calls the Classical
Economics. The methodology of Keynesian economics may be distinguished from neoclassical
economics by its concern with aggregate behavior, especially the income generating effect of
total expenditure and the emphasis placed on the investment component in determining the level
of activity.

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The development of Keynesian theory has centered around three related topics: the stability of a
market system, the role of money and the long term dynamics of the market economy.

The Main Points of Keynes’ Work

1. Theory of Employment

Keynes was dissatisfied with the classical theory which ran in terms of say’s law of an automatic
adjustment towards full employment. They, thus, believed that there would not be any
unemployment in the economy owing to the operation of the forces of competition.

In this classical system frictional & voluntary unemployment could exist but no involuntary
unemployment. But Keynes argues that in the modern capitalist society, no economy is capable
to operate at full employment consistently. According to him, involuntary unemployed person
include those who would not be willing to work at a lower money wage.

For the Classicists, unemployment (or operation of an economy at less than full employment) is
the consequence of disequilibrium which will come to full employment automatically when the
market becomes at equilibrium. The greatest contribution of Keynes lies in the statement that
unemployment is possible even when the economy is at equilibrium. It is found that in terms of
Keynesian framework there will be an inherent tendency for level of income to settle at less than
full employment.

2. Theory of Wage

Keynes did not agree with classical economists thought that employment will increase owing to
wage reductions. The classical economists like Pigou claimed that the employers were ready to
offer more employment if the workers were ready to accept lower wages.

If there is unemployment, according to Classicists, it was only voluntary in the sense that
workers were not ready to accept lower wages, which correspond to their marginal productivity.

Keynes, however, maintained that Pigou’s argument was faulty in that it ignored the fact of
aggregate income.

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Note that both Keynes and Pigou agreed that the means to increase labor employment was to
reduce the real wage level and make it worthwhile for the employers to offer for employment.
But they differed as to the mechanism by which it could be done.

The classical economists believed that a single employer would offer more employment to
workers if they agreed to accept lower money wages. And they generalized to the whole
economy and asserted that a general lowering of money would be able to increase employment
in the economy. Keynes pointed out that the argument ignored the fact that when money wages
were reduced throughout the economy, there would be a reduction in aggregate demand also.

According to Keynes, wage reduction implies reduction of marginal cost which influences prices
to fall. Hence, real wage of the workers may not decrease. For Keynes employment can only
increase when there is a fall in the real wage of the workers, especially in the field of
consumption goods.

3. Theory of Consumption Function (Propensity to Consume)

Keynes’s formulation of the consumption function is considered as an important contribution to

the tools of economic analysis.

According to Keynes, the consumption function is the ratio of consumption to income. This
function taken for granted, the level of income is determined by volume of investment.

Consumption determines demand which in its turn, leads to the production of commodities as
well as capital. It is the lack of “effective demand” or lagging consumption that creates crises
and generate depression.

Keynes has asserted that the total income and the total expenditure of a nation are closely related.
I.e. the amount which the community would like to consume depends up on the expected income
for the period under consideration.

At very low expected income the amount which the community would like to consume would
exceed that income. [Keynes confines himself to short period only in which the change in
consumption is bound to lag behind the change in income].

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However as expected income rises, the planned consumption also rises, but not as fast as income.
In other words, the marginal propensity to consume (which is defined as the ratio of increase in
planned consumption to the increase in expected income) would be less than one; i.e. due to the
psychological tendency of people, when income increases expenditure on consumption goods
doesn’t increase proportionately.

On the basis of this assumption, Keynes takes up the analysis of the factors governing output and
employment. The economy which Keynes has in mind is a capitalist developed one but it is a
closed economy. According to Keynes, total income (Y) is comprised of the income earned
through consumption goods (C) and the income earned through investment goods (I).

i.e. Y = C + I

On the other hand, of the total income (Y), a part will be used for consumption (C) and the rest
for saving (S)

i.e. Y = C + S

Hence, Y = C + I, or Y – C = I

Y = C + S, or Y – C = S

I=S

Thus, it is clear that during any period of time, saving and investment consist of the flow of
income which the receivers are not spending on consumer goods.

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Figure 4-1 The Consumption Function

As national income increases, consumption also increases, but not by as much as the increase in
income. The slope (∆C/∆Y) of the consumption function C = f(Y) measures the marginal
propensity to consume.

4. Theory of Investment

Investment here refers to new investment or current investment. Recall that Keynes has assumed
that consumption depends primarily on real income. In other words, what Keynes called the
propensity to consume depends on income except under abnormal conditions like war, earth
quakes, strikes, revolutions etc. Given the propensity to consume, the level of output depends on
the inducement to invest, which in turn, determines the volume of investment; Y = f (Inv., c).
The inducement to invest depends upon the relation of the current rate of investment to the
marginal efficiency of capital; i.e., current investment is a function of marginal efficiency of
capital and interest rate.

The marginal efficiency of capital (MEC) has been defined as the ratio of the expected yield of
additional capital assets over a period of time to the supply price of the asset; i. e. MEC is a
measure of expected rate of return or profitability on new investment. The inducement to invest
will be strong if the value of an additional unit of capital exceeds its cost. The value of an
additional unit of capital depends on the marginal efficiency of capital and on the rate of interest
at which these expected annual reforms are discounted.

Apart from the marginal efficiency of capital, the disposition of investors is also affected by the
current rate of interest at which they obtain capital. In Keynesian terminology, the rate of interest
is the price paid for parting with cash or liquidity and using it for investment in assets. Interest,
thus, is determined by the liquidity preferences.

According to Keynes, the individuals’ preference for liquid assets, or liquidity preference, is
mainly: for daily transaction, for meeting contingent needs and for meeting business needs.

Obviously, the higher the liquidity preference, the higher will be the rate of interest and vice
versa. Similarly, with the fall in the quantity of money the rate of interest would rise and an
increase of it decreases rate of interest.

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One important comment, here, is the existence of liquidity trap a phenomenon which develops
when the rate of interest falls and touches the normal floor limit; i.e., the lower limit below
which it is not expected by the market to fall. This phenomenon of liquidity trap implies that
after the rate of interest has fallen to a certain level, liquidity preference may become virtually
absolute in the sense that almost everyone prefers cash to holding a debt which yields so low rate
of interest.

5. The Theory of Multiplier.

Keynes became famous for the development of the theory of multiplier which is so intimately
connected with the marginal propensity to consume. It is evident that the aggregate income of the
community is determined by the rate of investment together with the propensity to consume.

The basic idea of multiplier is in an economy each injection of money gives rise to a series of
new money.

The multiplier means that with a given consumption function, if net investment is increased (say
by government or some other public authority), a multiplier process will be introduced which
will cause an increase in income which will be a multiple of the initial net investment which
started the process.

The ratio of the increase in income to the initial increase in net investment causing that
investment is called by Keynes as multiplier.

For example, if an investment of $1million causes an increase in the total income by $3million,
the multiplier is 3, in case the increased income amounts to $2milliom, the multiplier is 2. The
multiplier is, thus, a number by which the increase in investment must be multiplied in order to
give the resulting increase in income.

The question is how and why the increase in the total income is more than incorporation to the
increase in the investment? The reason is that with each investment, the resultant expansion in
production and national income is much more than the primary investment. Apart from this,
increased income will be spent by the wage earners and by the recipients of profits and interest
leading to increased income to others in the economy. This increased income will go on
repeating like this. In case, with an increase in income, there is no increase in consumption, the

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multiplier effect will be zero. Thus, the amount of the multiplier is determined by the relative
proportions of spending and saving, out of increased income.

6. Theory of Prices.

In his analysis of price, Keynes agreed with the orthodox/classical view that increasing the
quantity of money in circulation leads to an increase in the price level. The basic difference
between Keynesian analysis & this classical analysis is regarding the process through which this
effect is caused (i.e., on the transmission mechanism). As a matter of fact, the classical quantity
theory of money failed to analyze the process through which the price would be affected.

Keynes tried to fill in the gap. The transmission mechanism according to Keynes is that an
increase in the supply of money is likely to increase the availability of funds. This increase in
money supply tends to lower the rate of interest and increase the demand for investment which
ultimately leads to an increase in income, employment and output. This increased output can
only be possible at an increasing cost, beyond a certain point, price will accordingly rise. It
would just be observed that Keynes has established the relation between quantity of money and
the price through output.

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4.6. Classical Economics Vs Keynesian Economics: A Comparison
Classical and Keynesian economics are two important schools of thought. Each school takes a
different approach to the economic study of monetary policy, consumer behavior and
government spending. A few basic distinctions separate these two schools.

Basic Theory: Classical economic theory is rooted in the concept of a laissez-faire economic
market. A laissezfaire--also known as free--market requires little to no government intervention.
It also allows individuals to act according to their own self interest regarding economic
decisions. This ensures economic resources are allocated according to the desires of individuals
and businesses in the marketplace. Keynesian economic theory relies on spending and aggregate
demand. Keynesian economists believe the aggregate demand is influenced by public and private
decisions. Public decisions represent government agencies and Private decisions including
individuals.

Government Spending: Government spending is not a major force in a classical economic

theory. Classical economists believe that consumer spending and business investment represents
the more important parts of a nation and economic growth. Too much government spending
takes away valuable economic resources needed by individuals and businesses. To classical
economists, government spending and involvement can retard a nation’s economic growth.
Keynesian economics relies on government spending to a nation’s economic growth during
sluggish economic downturns. Similar to classical economists, Keynesians believe the nation’s
economy is made up of consumer spending, business investment and government spending.
However, Keynesian theory dictates that government spending can improve economic growth in
the absence of consumer spending or business investment.

Short versus Long run: Classical economics focuses on creating long-term solutions for
economic problems. The effects of inflation, government regulation and taxes can all play an
important part in developing classical economic theories. Classical economists also take into
account the effects of other current policies and how new economic theory will improve or
distort the free market environment. Keynesian economics often focuses on immediate results in
economic theories. Policies focus on the short-term needs and how economic policies can make
instant corrections to a nation’s economy. This is why government spending is such a key

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component of Keynesian economics. During economic recessions and depressions, individuals
and businesses do not usually have the resources for creating immediate results through
consumer spending or business investment. The government is seen as the only force to end
these downturns through fiscal policies providing instant economic results.

Classicals follow the basic assumption that economy is in full employment. The wages and
prices are very flexible and there is no need of fiscal or monetary policy. The invisible hand
makes the economy self correctable. The Aggregate supply curve is vertical according to
Classicals and so any rise in aggregate demand will increase prices and not production. In
Classical Theory, Government has minimal role in the economy, and the macro-economy is self
adjusting; meaning consumers and businesses will correct any problems with the economy
automatically over time. Classical theory focuses on long-term goals.

Keynesian economics follow the basic assumptions that Economy may not be in full
employment in the short run. Wages are rigid and prices are sticky. Fiscal policy may be needed
to correct the disequilibrium or improve the efficiency of the economy. Aggregate supply is
upward sloping in the short run so a rise in aggregate demand may raise the production. In
Keynesian theory, Government has a large role in the economy, and focuses on short-term goals.

Keynes as a Critic of Classical Economics

Classical economists generally include Adam smith, Jeremy Bentham, T.R.Malthus, David
Ricardo, J.S.Mill, J.B.Say etc. But Keynes included, the neo-classical economists including
Marshall, Pigou and Edgeworth in the category of classical economists. Hence, Keynes criticised
the economic theories developed by these writes mainly Pigou. The main points of contrast
between the Keynesian and Classical theories of Income and Employment are discussed in brief
as under.

1. Unemployment
The classical economists explained unemployment using traditional partial equilibrium supply
and demand analysis. According to them unemployment results when there is an excess supply
of labour at a particular higher wage level. By accepting lower wage, the unemployed workers
will go back to their jobs and the equilibrium between demand for labour and supply of labour

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will be established in the labour market in the long period. This equilibrium in the economy is
always associated with full employment level. According to classical economists unemployment
results when the wage level of workers is above the equilibrium wage level and as a result there
of, the quantity of labour supplied is higher than quantity of labour demanded. The difference
between the two (supply and demand) is unemployment.

J. M Keynes and his followers, however reject the fundamental classical theory of full
employment equilibrium in the economy. They consider it as unrealistic. According to them full
employment is a rare phenomenon in the capitalistic economy. The unemployment occurs they
say when the aggregate demand function intersects the aggregate supply function at a point of
less than full employment level. Keynes suggested that in the short period, the government can
raise aggregate demand in the economy through public investment programmes to reduce
unemployment.

2. Say’s Law of Market:

Say’s Law “Supply creates its own demand” is central to the classic vision of the economy.
According to say the production of goods and services generates expenditure sufficient to ensure
that they are sold in the market. There is no deficiency of demand for goods and hence no need
to unemployed workers. According to him full employment is a normal condition of market
economy. J. M Keynes has strongly refuted. Say’s Law of Market with the help of effective
demand. Effective demand is the level of aggregate demand which is equal to aggregate supply.
Whenever there is efficiency in aggregate demand a part of the goods produced remain unsold in
the market which lead to general over production of goods and services in the market. When all
the goods produced in the market are not sold, the firms lay off workers. The deficiency in
demand for goods creates unemployment in the economy.

3. Equality between Saving and Investment:

Classical economists are of the view that saving and investment are equal at the full employment
level. If at any time flow of savings is greater than flow of investment, then the rate of interest
declines in the money market this leads to an increase in investment. The process continues till
the flow of investment equals the flow of saving. Thus according to the classical economists, the
quality between saving and investment is brought about through mechanism of rate of interest.

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J.M.Keynes is however of the view that equality between saving and investment is brought about
through changes income rather than the changes in interest rate.

4. Money and Prices

The classical economists are of the opinion that price level varies in response to changes in the
quantity of money. The quantity theory of money seeks to explain the value of money in terms of
changes in its quantity. J.M.Keynes has rejected the simple quantity theory of money. According
to him if there is recession in the economy and the resources are lying idle and unutilized an
increased spending of money lead to substantial increase in real output and employment without
affectively price level.

4.7. The Policy Implications of Classical Vs the Policy Implications of

Keynesians
Government spending: The classical model is often termed ‘laissez-faire’ because there is little
need for the government to intervene in managing the economy. The Keynesian model makes a
case for greater levels of government intervention, especially in a recession when there is a need
for government spending to offset the fall in private sector investment

Fiscal Policy: Classical economics places little emphasis on the use of fiscal policy to manage
aggregate demand. Classical theory is the basis for Monetarism, which only concentrates on
managing the money supply, through monetary policy. Keynesian economics suggests
governments need to use fiscal policy, especially in a recession.

Government borrowing: A classical view will stress the importance of reducing government
borrowing and balancing the budget because there is no benefit from higher government
spending. Lower taxes will increase economic efficiency. (e.g. at the start of the 1930s, the
‘Treasury View‘ argued the UK needed to balance its budget by cutting unemployment benefits.
The Keynesian view suggests that government borrowing may be necessary because it helps to
increase overall aggregate demand.

Supply side policies: The classical view suggests the most important thing is enabling the free
market to operate. This may involve reducing the power of trade unions to prevent wage

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inflexibility. Classical economics is the parent of ‘supply side economics‘– which emphasises
the role of supply-side policies in promoting long-term economic growth. Keynesian doesn’t
reject supply side policies. They just say they may not always be enough. e.g. in a deep
recession, supply side policies can’t deal with the fundamental problem of a lack of demand

4.8. Keynesian Economics and Underdeveloped Countries

Thus the assumption of on, which the Keynesian theory is based, are not applicable to the
condition prevailing in under developed countries. The following are the principal tools of the
Keynesian theory to test validity to underdeveloped countries.

Effective Demand: - Unemployment is caused by the deficiency of effective demands and to get
over it, Keynes suggested the stepping up of consumption and non-consumption expenditures in
an underdeveloped country lower; there is no involuntary unemployment but disguised
unemployment. Unemployment is caused not by lack of complementary resources. The concept
of effective demand is applicable to those economies where unemployment is due to excess
saving; But in an underdeveloped economy income levels are extremely low, the propensity to
consume is very high and savings are almost nil. Here, the problem is not one of raising the
effective demand but one of raising the levels of employment and per capita income in the
context of economic development “The economic progress consists of two distinct categories:-
one, where at a given level of economic development you more from full employment at the next
higher level of economic development. The Keynesian thesis is applies only to the first category.

Propensity to consume: - One of the important tools of Keynesian economics is the propensity
to consume which highlights the relationship between consumption and income when income
increases, consumption also increases but by less than the increment in income. This behavior of
consumption further explains the rise in saving as income increases. In underdeveloped countries
these relationships between income, consumption and saving do not hold. Peoples are very poor
and when their tendency to meet their tendency to meet their unfulfilled wants. The marginal
propensity to consume is very low. The Keynesian economics tells us that when the MPC
(marginal propensity to consume) is high, consumers demand, out put and employment increases
at a faster rate with the increase in income. But in an underdeveloped countries it is not possible
to increase the production of consumer goods due to the scarcity of co-operant factors, when

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consumption increases with the rise in income As a result, Prices rise instead of rise in the level
of employment.

Saving:- On the saving side, Keynes regarded saving as a social vice for it is excess of saving
that leads to a decline in aggregate demand. Again, this idea is not applicable to underdeveloped
countries because saving is the panacea for their economic backwardness underdeveloped
countries can progress by curtailing consumption and increasing saving, as opposed to the
Keynesian view of raising consumption and reducing saving. To underdeveloped countries,
saving is a virtue and not a vice.

Margining efficiency of capital: - According to Keynes, one of the important determinants of

investment is the Marginal Efficiency of Capital (MEC).There is an inverse relationship between
investment and MEC. When investment increases MEC is falls and vice versa. This relationship
is however not applicable to underdeveloped countries. In such economies, investment is at low
level and MEC is also low.

Rate of interest: - Of the motives for liquidity preference, the transaction and precautionary
motives are income elastic and they do not influence the rate of interest. It is only the demand for
money for speculative motive that affects the rate of interest. In underdeveloped countries, the
liquidity preference for transaction and precautionary motives is high and for the speculative
motive low. Therefore, liquidity preference fails to influence the rate of interest.

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