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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
but they work to obtain the income required to purchase the desired goods and services. KEYNESIAN VIEW OF THE GREAT DEPRESSION Mainstream economic thought before Keynes emphasized the importance of supply-side aspects of macroeconomic system. a general overproduction of goods relative to total demand is impossible since supply or production creates its own demand. Say’s law is based on the view that people do not work just for the sake of working. then business firms would respond by cutting back production which in turn led to less spending and less output and employment. For example. He believed that spending induced business firms to supply goods and services. The classical economists were also aware of this possibility. which was completely a demand side approach. a farmer’s supply of wheat generates income to meet the farmer’s demand for clothes.Macroeconomics INTRODUCTION Macroeconomic analysis is a modern development in the subject of economics. This chapter presents the Keynesian view of output and employment and explains its influence on modern macroeconomic analysis. They had faith in Say’s Law of Markets. as we have seen. the orthodox thinking was that market adjustments would automatically guide an economy to full employment within a relatively short period. 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). The reasoning is as follows: in excess supply the prices of goods would fall. In case of any discrepancies between demand and supply the mechanism of wage-price flexibility would come into play automatically. interest (I) and profits (P). which had dominated economic thought and policy before and during the Great Depression. This reasoning of the classical economists seemed reasonable before the 1930s. the prolonged high unemployment rates that gripped the Western private enterprise economies during the Great Depression (1930) undermined the credibility of this thinking. but they believed the labor surplus would drive down wages. Keynes rejected the classical view and offered a completely new concept of output determination. Keynes rejected traditional and orthodox economics. shoes. According to this law. Interest and Money (1936). 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. The capacity to purchase the desired products is generated by the production process in the form of wages and salaries (W). Keynes and his followers rejected this view. and in excess demand the prices of products would rise.M Keynes’ General Theory of Employment. rent (R). This has paved the way for J. In aggregate they thought demand would always be sufficient to purchase whatever the goods and services are supplied or produced. However. From this he argued that if total spending fell due to pessimistic or unfavorable expectations about future. The classical economists did not concern themselves with demand issues. particularly in a downward direction in modern economies characterized by large corporate sectors 162 . As we said. Prior to the Great Depression of the 1930s. They did not realize that a general overproduction of goods or ‘glut’ was possible. In this work he developed a new economic analysis which brought about a revolution in economic thought and policy. reducing costs and lowering prices until the surplus was eliminated and the economy was directed to full employment within reasonable time. They argued that wage-price flexibility is an impossible proposition. capable of explaining the prolonged unemployment of the period. Similarly the supply of cloth generates the purchasing power with which cloth manufacturers and their employees demand the farmer’s wheat and other desired goods and services. automobiles and other desired goods.
Aggregate Supply.(9.(9. THE KEYNESIAN MODEL In the Keynesian system also.. capable of assuring full employment.. government spending and net exports – is less than the economy’s full capacity output. the money market and the goods market. But the theory is new and Keynes’ contribution lies in giving macroeconomic analysis a new turn. This was how Keynes explained the Great Depression highlighting the drawbacks of self-regulating private enterprise economies. investment..5) = w Y N w P Where.1) …. In the Keynesian framework equilibrium takes place at a less than full employment level of output... Keynes also introduced a completely different concept of equilibrium.3) .. 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 . The Keynesian model can be represented by the following set of equations. ii..(9. which is the full employment level of output.. The business sector will produce only the quantity of goods and services it believes households (i. assumed to be rigid in the short run general price level . When aggregate expenditure is deficient. Money Market M = KPY + L (r) Where. no person is totally original in any pursuit of knowledge. Price Level and Employment: Macroeconomic Equilibrium in the Keynesian Model and powerful trade unions. domestic consumers and investing community)..(9. His theory includes some propositions of the classical school it seeks to replace. the economy consists of three basic markets: the labor market.. If this aggregate expenditure – consumption. Every new theory makes use of some bricks of the demolished building. i. Keynes’ is no exception... as believed by classical economists. government and foreigners will plan to buy.4) = = = = output or income employment nominal wage.. Labor Market y = f (N) dY w = dN P ND = W f w wP …... However. 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..e. 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. output will fall short of its potential capacity.. The result is that the actual output will be less than capacity output which in turn results in prolonged unemployment and decline in output. there are no automatic forces.2) .(9.
. the real difference between the classical model and the Keynesian model lies in the assumption of rigid money wages. more workers might be willing to work at that real wage than the firm’s wish to employ. Goods Market S = f (r) I = f (r) S=I Where..e.. MPL = W/P.. (9.4) above.Macroeconomics iii. Instead of assuming that the real wage adjusts automatically to bring about equality of demand for and supply of labor. It only means that they adjust slowly. there are some similarities and certain deviations. 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.. 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. Now let us consider some points relating to wage rigidity. the consequent labor demand might not equal labor supply at that real wage.. As real wages rise the firm lays off workers.. relative to the general price level. money wages will not adjust rapidly in a downward direction. w = w and employment is demand determined N = ND with f(ND) = w /P. S = Savings I = Investment r = Rate of Interest (Y = C + I Y–C=I ∴Y – C = S ∴ I = S) . For any price level P0 business firms employ workers to such an extent where the marginal product of labor equals the real wage. With regard to money stock. the Keynesian model assumes that nominal wages (W) is rigid downward and a predetermined variable in the short run.) Therefore. In the Keynesian model. Keynes added one important dimension of demand for money i. 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. for the purposes of transactionary and precautionary motives. (9. 164 .. (9. ii. At least in the downward direction we could still say that labor supply function depends upon the real wage as in (9.7) . iii. Inflexible money wages need not be interpreted to mean that nominal wages do not adjust at all. with the classical system explained in the earlier chapter. and not a constant.. as against classical treatment of money as a medium of exchange.. This means that overtime is cut back and low skilled and non-essential staff are paid-off. In case a firm responds to a change in the price level by adjusting the nominal wage of its workers. It is not a rapid flexible adjustment mechanism as we have seen in the classical model. then there is a possibility that the firm will get a reputation of poor industrial relations. In case real wages are sluggish to adjust because nominal or money wages are inflexible.8) If we compare the Keynesian system as shown in the above system of equation..6) . how can the businesses respond? i. However.. the model assumes that velocity is a variable.. The difference is especially in the case of labor supply function and demand for money function. The consequence of this assumption is that.. For example.
Figure 9. workers are willing to work. compared to the classical case.e. the money wage (W 0) does not adjust but remains fixed at W0. At the new real wage (W0/P1) the demand for labor falls back to N1. Price Level and Employment: Macroeconomic Equilibrium in the Keynesian Model Therefore. Figure 9. N2 – N1. business firms will not wish to hire as many workers. if the money wage rate is W0 and the price level is P0 and if the real wage.1.2 165 . W0/P0 is the full employment level of real wage. for example. In this case. sticky downwards. as shown in Figure 9. This means that the real wage will rise to (W0/P1). But from the point of view of individuals supplying labor or business firms employing labor it need not be rational. i.Aggregate Supply. We say that money wages are ‘sticky’. Unemployment is equal to the difference between the supply of labor N2 and the demand for labor N1. From the total economy’s point of view it would appear to be rational to have perfectly adjusting money wages. 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.1 Unemployment can therefore arise because money wages are inflexible i. This is an example of individual rationality not squaring up with collective rationality. At the new real wage (W0/P1). then the labor market is in equilibrium. But the higher real wage brings forth an increase in the supply of labor to N2. At a higher real wage. Suppose now the price level falls from P0 to P1.e.
Since nominal wages are assumed flexible upwards. But. the increase in the price level is less. the labor demand together with the production function determines the aggregate supply (AS) curve.. N0 (W/P)0. and Y0. As before. Suppose the nominal money supply is then doubled. employment is not at this intersection but is demand determined. and not constant as assumed by the classicals.. With the smaller increase in aggregated demand. the increase in the price level is less than proportional to the increase in the money supply. Given the nominal wage. 9. CLASSICAL VERSUS KEYNESIAN ANALYSIS OF INCOME DETERMINATION Only three differences are revealed in the formal structure of the two systems of macro analysis. this may lead to an employment level which is less than full employment equilibrium level. Hence. the increase in the price level will not be proportional to the increase in the money supply even if money wages are flexible.Macroeconomics Figure 9.e. In case the income velocity of money is variable as maintained by Keynes. the increase in the price level is less than proportional to the increase in the money supply. both output and the price level increase. as a result.. Hence. In general. with velocity constant. Now. Since the aggregate demand (AD) curve cuts the aggregate supply curve at less than full employment output level i.9) With the increase in the money stock. The aggregate supply curve. Does the price level increase in proportion to the increase in money stock? We have the original relationship to consider this question. unemployment exists.2. the price level (P0) and the real wage (W/P)0. Since unemployment existed before the increase in money supply. With the nominal wages rigid downwards at W 0 the aggregate supply curve is positively sloped for price levels less than P1. is AS0 W in Figure 9. This in turn implies the corresponding equilibrium levels of output (Y0). Suppose initially aggregate demand is AD0 and aggregate supply is AS0 in Figure 9. let us consider the effect of an increase in money supply on the price level when the classical assumptions are altered. (i) Keynes rejected the neo-classical function of supply of labor and assumed rigid wages (W = w ) for situation of less than full employment.2. If aggregate demand is AD0. with money wages rigid downward. (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. the price level doubles. Y0. Suppose the nominal money stock increases..2 contains a graphical analysis of Keynesian model of income determination.4 there are a few differences. Keynes assumed that money wages were rigid downwards and that income velocity of money was a variable. if people decide to hold part of the increase in the real money supply in the form of idle balances. M = kPY . As shown above. and the price level from P0 to P1. the velocity of money decreases and aggregate demand does not increase by as much. aggregate demand increases from AD0 to AD1. While these diagrams are similar to Figure. 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. We know. (ii) Keynes added the speculative demand for money L(r) to the neo-classical 166 . the equilibrium values of the variables are P0W0. the aggregate supply curve will be perfectly price inelastic at the full employment level of output Y1 = Y for prices greater than P1.(9. based on the earlier analysis. that the aggregate demand curve shifts from AD0 to AD1 if the velocity of money is constant and.
vi. To Keynes saving was a private virtue and a public vice. on the other hand. Classical economics was a microeconomic analysis which the orthodox economists tried to apply to the economy as a whole. iii. Keynes. But Keynesian analysis is general equilibrium analysis. He regarded the rate of interest as a purely monetary phenomenon. which is valid in the case of individual industry. stressed the importance of deficit budget during deflation and surplus budget during inflation along with cheap money and dear money policies respectively. They believed in the balanced budget policy. favored the policy of wagecut to solve the problem of unemployment. The fundamental flaw in Pigou’s analysis is that he applied partial equilibrium analysis. The classical school thus ruled out the possibility of overproduction.” The classical economics was based on the laissez-faire policy of selfadjusting economic system with no government intervention. on the other hand. On the other hand. Keynes. v. Keynes approach to economic problem was dynamic rather than static. He was thus a practical economist whose models clarify both inflationary and deflationary episodes and prosperous and depressed economies. “the revolution was solely the development of a theory of effective demand. Keynes propounded the opposite view that “demand creates its own supply”. Many economists consider his analysis less than adequate for meeting such special problems like cyclical forecasts and controls. But Keynes discarded the policy of laissez-faire and he favored state intervention. They could not explain the turning points of the business cycle satisfactorily and generally referred to boom and depression. To Klein. i. ii. viii. Keynes real contribution to business cycle analysis lies in his explanation of turning points of the cycle. The classicists artificially separated the monetary theory from the value theory. The classical analysis was based on Say’s law of markets that “supply creates its own demand”. a wage-cut policy increases unemployment instead of solving it. Pigou. But Keynes opposed such a policy both from the theoretical and practical points of view. integrated monetary theory and value theory through the theory of output. workers are not prepared to accept a cut in money wage. These three theoretical innovations constitute Keynes denial of the neo-classical automatic mechanism generating full employment. one of the foremost classical economists. it has its own weaknesses and failures. 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.Aggregate Supply. Theoretically. adopted the macro approach to economic problems. The classicists emphasized the importance of saving or thrift in capital formation for economic growth. Keynes. The classical economists failed to provide an adequate explanation of the cyclical phenomena. S = S(Y). His notion of underemployment equilibrium is indeed revolutionary reflecting real life situation. In this field as opined by Mrs. The classicals believed in the existence of full employment in the economy and a situation of less than full employment was regarded as abnormal. Practically. on the other hand. Despite the theoretical and practical significance of the Keynesian theory. 167 . “Keynesian revolution commands the field”. The classical economists being the votaries of Laissez-faire policy had no faith either in fiscal policy or in monetary policy. iv. ix. Keynes considered the existence of full employment as a special case. vii. Joan Robinson.
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. aggregate demand will be increased via an interest induced increment in the 168 . Figure 9.Macroeconomics persistent inflation. maintenance of full employment booms. Keynes not only attempted to integrate monetary and value theory. But Keynes asserts that the relationship in fact is an indirect one through the mechanism of rate of interest. Keynes’ attack on the traditional separation of value theory and monetary theory. In making this transition. THE GENERAL THEORY AS A MONETARY THEORY From the viewpoint of monetary theory two fundamental issues are presented in the General Theory. but also brought the theory of interest into the realm of monetary theory. In quantity theory M V = P T . The figure 9. The first impact of an increase in the quantity of money will be on the rate of interest. The general theory represents a transition from a monetary theory of prices to a monetary theory of output. How far the rate of interest will fall depends upon the strength of the community’s liquidity preference. there is a direct relationship between quantity of money and price level. nonlinear structural relations and macro functional distribution. Emphasis on the demand for money as an asset alternative to other yield bearing assets. 2. secular growth. If the increase in quantity of money does push down the interest rate.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. 1.
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. Secondly.. The remuneration of all the factors entering into marginal cost will not change in the same proportion. 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. Lastly. Price Level and Employment: Macroeconomic Equilibrium in the Keynesian Model investment demand. Keynes rejection of neutrality of money is closely linked with his monetary theory of interest. Keynes formulated his theory of interest explicitly in ‘stock’ terms.10) .. ii. However. employment will change in the same proportion as the quantity of money. v.” However. there will be diminishing. It will be recalled that the traditional loanable funds theory of interest was formulated in “flow terms”.. The model may be represented by a system of three equations in three unknown variables. Keynes employed the Marshallian short run analysis as a substitute for dynamic analysis.(9. Eventually marginal costs (essentially wage costs) will rise and consequently prices will also change. Hence in Keynesian analysis. some commodities will reach a condition of inelastic supply while there are still unemployed resources. the General Theory includes the neo-classical theory of quantity of money MV = PT as a special case. v.11) 169 .(9. iii. In the Keynesian system money is neutral in two situations: (a) situation of full employment and (b) special case of the liquidity trap. Assuming there are unemployed resources in existence.Aggregate Supply. Effective demand will not change in exact proportion to the quantity of money. the increased aggregate demand will lead to an increase in output and employment. iv. Since resources are not homogeneous. i. returns as employment gradually increases. Thirdly. M = M1 + M2 = L1 (Y) + L2 (r) iii. cost conditions will also change. both the accumulation of real capital and the accumulation of debt are excluded from explicit considerations. Y=C+I C = α + βY .. Fourthly. ii. The wage-unit will tend to rise before full employment has been reached.. Dillard. “it is through the theory of output that value theory and monetary theory are brought into juxtaposition with each other”. Keynes wrote “so long as there is unemployment. and when there is full employment prices will change in the same proportion as the quantity of money. ending the so-called chain causation. Since resources are not interchangeable.. Keynes explained the existence of a liquidity preference for money.. Keynes considered that the following possible complications would qualify the preceding statement: i. Keynes did not formulate a theory of expectations.. As stated by Prof. Instead he only discussed the conventions and habits of thought governing the formation of these expectations. As output increases. iv. and not constant.
(9.. Second. Firstly. .12) Equation (9.10) depicts the equilibrium condition in the commodity market. It denotes C as a linear function of income (Y). I0. can be measured only when we take into account all the parameters (interrelations) of the model. Y increases. Once the equilibrium value of the Y is known. This is a case of interdependence which non-mathematical theory has difficulties in handling.11) is the only behavioral equation in the truncated basic model. equilibrium level of income (Y) Where.. changes in (Y) will be caused by changes in parameters.4 170 . the total effect on (Y). By substituting (9. The interrelations are as follows: Y= When I increases. of a change in the exogenous variable. Equation (9. C will also increase.12 states that investment is a known constant and it becomes exogenous thereby reducing unknown variables to two. Since C = f(Y). Equilibrium value will be intersection of the (C + I) function and 450 line.10)... we get Y Y– β Y Y (1 – β ) Y = = = = (α + β Y) + (I 0 ) α + I0 α + I0 1 1β − ( α + I0 ) The equilibrium of the income (Y) is given by the solution: 1 (α + I0).Macroeconomics I = I0 Yt = Ct + It Yt – Ct = It ∴ Yt – Ct = St ∴ I = S. Equation 9.12) in (9. Y C I α β = = = = = output or real income consumption expenditure investment expenditure intercept of the consumption function slope of the consumption function or MPC. Then we have to find equilibrium values of the C and Y.11) and (9. Figure 9. It is the equation of 450 line. we can substitute 1β − it in the linear consumption function to find the equilibrium value of (C).
..14) Subtracting (9... The magnitude of ( ∆ Y) in the new equilibrium is given by the equation ∆ Y = (1/(1 – β ) ∆ I..e.... i is the slope of the linear investment function or the Marginal Propensity to Invest (MPI) i.20) . I0 is autonomous investment. namely the MPC (β). Equation (9. Y=C+I+G+X–M C = α + β (Y – T) I = I0 + iY M = C + mY T = T0 + tY G = G0 X = X0 . only one important incomeinduced change is explicitly stated. It can be derived from the model. (9. The original equilibrium is Y0. An Expanded Model Without changing its basic logic.... ΔY 1 = ΔI 1− β This equation shows that (β).. ΔY = 1 1β − ∆ I or.(9. which shows the total ( ∆ Y) induced by ( ∆ I) after taking into consideration of income-induced ( ∆ C) [(C = f(Y)] via the MPC ( β )..(9. We must take into consideration all the income induced changes in the system. To find out equilibrium value of income we have to substitute all functions in equation (9...(9.. Equation (9..21) states that government spending (G) and exports (X) are known constants.Aggregate Supply.. we get the difference between (Y0) and (Y1) which is ∆ Y.15).. The purpose of introducing the variable (X – M) into the model is to show the relationship between national income and foreign trade. Other income-induced changes could be introduced into the multiplier analysis in more generalized models..18) .(9... (Y0) will increase by ( ∆ Y) to (Y1)..13) ..(9......21) The purpose of introducing variable (T) into the model is to take into consideration the “built-in stabilizers” in the government budget...13) from (9... which indicates the income induced part of the investment.15) ...20) and (9.19) is the tax receipt function..17) . Y1 is Y + ∆Y= 1 1β − (α + I 0 ) + 1 1β − ( ∆ I) .. The 1 equation ∆ Y = ∆ I is derived as follows: (Iβ) − The original equilibrium income: Y= 1 (α + I 0 ) 1β − The new equilibrium income after ∆ I..... the truncated model could be expanded to include other induced changes in the system. Equation (9...19) . In this simple basic model..... The equilibrium value of C is C1 when investment expenditure increased from (I0) to (I0 + ∆ I). ∆ I/ ∆ Y.. Price Level and Employment: Macroeconomic Equilibrium in the Keynesian Model The above interrelationships lead us to an analysis of “instantaneous multiplier”..18) is the import function...... 171 ...16) ......(9... or MPC (∆C/∆Y) is the crucial determinant of the size of the multiplier.(9.(9. The multiplier shows the total effect of change in (I) on (Y).14)...
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). 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. whether in its basic simple form or in its more generalized form. In order to show that income equilibrium requires both commodity and money market equilibrium. A change in any parameter or exogenous variable will lead to a change in (Y).5 172 . multiplier includes the four induced changes in the system. diagram 9. The Keynesian model. It is a famous IS-LM model. In this generalized form. The total effect of such change on income (Y) can be measured by the multiplier i.e. 1/(1 – β – i + β t + m). Further.Macroeconomics Y = α + β [Y– (T0 + tY )] + I0 + iY + G0 + X0 – (C + mY) = α + β Y – β T0 – β tY + I0 + iY + G0 + X0 – C – mY ⇒ Y– β Y + β tY – iY + mY= α – β T0 + I0 + G0 + X0 – C Y (1 – β + β t – i + m) = α – β T0 + I0 + G0 + X0 – C Y= 1 1β +βt i + m − − (α – C + I0 + G0 + X0 – β T0) This is the solution or the reduced form of the simultaneous equations. taking into account the quantity of money and rate of interest.5 explains that the equilibrium rate of interest is determined by both real (IS) and monetary (LM) forms. 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. it is necessary to expand the model to include an analysis of money market equilibrium. Figure 9. The familiar Hicks-Hansen restatement of Keynes’ theory highlights this point.
The increase in r will discourage further investment. 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. So the multiplier effect is smaller in the case of M than in the case of flexible M . The reason is that the increase in income (Y) following the increase in (I) will cause the interest rate (r) to rise. Thus one of the challenging tasks in post-Keynesian economics is to incorporate price level changes into the Keynesian system.Aggregate Supply. Prices therefore would rise as the volume of employment increases.6 AS = W N = = aggregate supply (GNP) money wage rate volume of employment 173 . Sidney Weintraub in 1956. The theoretical framework was laid down by Prof. 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. Simultaneously. In a static framework the conditions of diminishing returns means increasing costs as output expands. The price level is implicit at each point on the AS function. 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. This is shown by the widening gap between aggregate supply (AS) function and the total wage bill line (WN). Price Level and Employment: Macroeconomic Equilibrium in the Keynesian Model 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. if the stock of money remains constant. Figure 9.
Permanent Income Hypothesis – Milton Friedman Absolute Income Hypothesis – Joan Tobin and Arthur Smithis Life Cycle Hypothesis or MBA Hypothesis – Modigliani.e.e. Solow Massel. 3. Haberler. but it was Prof. direct investment in education and health. the redistribution of income will in turn affect AD via the consumption pattern of three major income groups i. Technological unemployment once again became the focus of public attention. thwarting the Keynesian remedies. A two-fold relationship between AD and AS and distribution of income is envisaged by Prof. It led to various economists to search for explanations other than that of demand shortage. rentiers and profit recipients – resulting in shrinking AD. generates this effect. results in the impressive rise in the real earnings per worker. The Relative Income Hypothesis – Duesenbery 2. and rate of interest is independent of quantity of money) could be validated by using the real balance effect as an equilibriating mechanism. namely “demand shortage”. 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. The Real Balance Effect It is one of the important theoretical innovations since the publication of the General Theory. “structural” and “technological”. 4. Secondly. in equilibrium. the quantity theory conclusions (i. Since the end of the Korean war. the real balance effect could eliminate the classical and neo-classical dichotomy between the value and the monetary theories.The concept was originated by Prof. Example. From various studies it is concluded that the problem is a juxtaposition of three types of unemployment. Technological changes cause obsolescence of 174 .Macroeconomics The aggregate demand (AD) function is not independent of the distribution of income. A more complete investment function must pull the parameters out of Ceteris Paribus and ascertain the effects of each of them on investment. a new type of unemployment problem has been identified. 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. 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. In the mid 1950s. 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. Bumberge Ando. During the period of late 1957 to 1964 in the USA unemployment averaged nearly 6%. Patinkin who employed it to validate the basic conclusions of classical and neoclassical theory. money is neutral. which by its excess over demand. Technological and Structural Unemployment Keynesian economics addresses itself mainly to the problem of “demanddeficient” unemployment. Weintraub and Davidson: (i) the increase in AD will lead to a redistribution of income in favor of profit recipients via the price increase. Fabricant and others attempted to measure the respective contribution of investment and technical progress to output growth. Theories of Consumer Behavior 1. Firstly. (ii) on the other hand. wage earners. 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”. Prof.
If not so. Price Level and Employment: Macroeconomic Equilibrium in the Keynesian Model skills and thereby produces some mismatching between available workers and jobs which we call “structural unemployment”. and an inadequate growth of AD – perhaps due to skewed distribution of purchasing power. labor force growth. 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. 175 . However. by raising output per worker.Aggregate Supply. technological change is one of the principal sources of growth. The paramount need is for public and private policies to be conducive to a high-employment economy.
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