Keynesians - Introduction

Keynesian economists are, not surprisingly,
so named because they are advocates of the
work of John Maynard Keynes (if only all
economics was that easy!). Much of his work
took place at the time of the Great
Depression in the 1930s, and perhaps his best
known work was the 'General Theory of
Employment, Interest & Money' which was
published in 1936.

In this section we look more generally at the
work of Keynesian economists. Follow the
links below or at the foot of the page to
find out more detail about what they believed
in and the policies they proposed.

* Beliefs
* Theories
* AS & AD
* Policies
* Virtual Economy policies

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Keynesians - Beliefs

Keynes didn't agree with the Classical
economists!! In fact the easiest way to look at
Keynesian theory is to see the arguments he gave
for Classical theory being wrong. In essence
Keynes argued that markets would not automatically
lead to full-employment equilibrium,
but in fact the economy could settle in
equilibrium at any level of unemployment. This
meant that Classical policies of non-intervention
would not work. The economy would need prodding if
it was to head in the right direction, and this
meant active intervention by the government to
manage the level of demand. Follow the links in
the navigation bar at the foot of the page or in
the side panel to find out more detail on the sort
of policies this may involve.

Keynesian beliefs can be illustrated in terms of
the circular flow of income. If
there was disequilibrium between leakages and
injections, then classical economists believed
that prices would adjust to restore the
equilibrium. Keynes, however, believed that the
level of output (in other words National Income)
would adjust. Say, for example, that there was for
some reason an increase in injections (perhaps an
increase in government expenditure). This would
mean an imbalance between leakages and injections.
As a result of the extra aggregate demand firms would
employ more people. This would mean more income in
the economy some of which would be spent and some
saved (or paid in tax). The extra spending would
prompt the firms in the economy to produce even
more, which leads to even more employment and
therefore even more income. This process would go
on, and on, and on, and on until it stopped! It
would eventually stop because each time income
increased, the level of leakages (savings, tax and
imports) also increased. Once leakages and
injections were equal again, equilibrium was
restored. This process is called the Multiplier
effect.

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Keynesians - Theories

Keynes argued that relying on markets to get to full employment was not a good
idea. He believed that the economy could settle at any equilibrium and that
there would not be automatic changes in markets to correct this situation. The
main Keynesian theories used to justify this view were:

* The labour market
* The market for loanable funds (money market)
* The Multiplier
* Keynesian inflation theory
Monetarist
The labour market

Keynes didn't have the same confidence in the labour market as Classical
economists. He argued that wages would be 'sticky downwards'. In other words
workers would not be happy about taking wage cuts and would resist this. This
would mean that wages would not necessarily fall enough to clear the market
and unemployment would linger. We can see this in the diagram below:


[The labour market] [@@]


When the demand for labour falls from D1 to D2 (maybe due to the onset of a
recession), the wage rate should fall, so that the market clears. However,
Keynes argued that because wages were sticky downwards, this would not happen
and unemployment of ab would persist. This unemployment he termed demand
deficient unemployment.

The market for loanable funds (money market)

Classical economists were of the view that savings would need to be increased
to provide more funds for investment. Keynes disputed this assumption - once
again because he had less faith in markets as the economics 'miracle cure'. He
argued that any increase in savings would mean that people spent less. This
would mean a decrease in aggregate demand. This would just make things worse and
firms would be even less inclined to invest because they would find the demand
for their products decreasing. He felt that investment depended much more on
business expectations.

The Multiplier

Any increase in aggregate demand in the
economy would result, according to Keynes, in an even bigger increase in
National Income. This process came about because any increase in demand would
lead to more people being employed. If more people were employed, then they
would spend the extra earnings. This in turn led to even more spending, which
led to even more employment which led to even more income which then led to
even more spending which then led to ................. The length of time this
process went on for would depend on how much of the extra income was spent
each time. If the initial recipients of the extra income saved it all, then
the process would stop very quickly as no-one else would get their hands on
the extra income. However, if they spent it all the knock-on effects of the
extra spending would carry on for some time.

Therefore the higher the level of leakages, the lower the Multiplier would be.
The precise formula for calculating the multiplier is:

Multiplier = 1
-------------------------------------------------
1 - Marginal propensity to consume

Keynesian view of inflation

The key to the classical view of inflation was the Quantity Theory of Money
. This theory revolved around
the Fisher Equation of Exchange :


MV = PT

where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place

Keynes once again rejected this theory (you may be getting the idea that he
didn't agree much with classical economics!!). He argued that increases in the
money supply would not inevitably lead to increases in inflation. Increasing M
may instead lead to a decrease in V. In other words the average speed of
circulation of money would fall because there was more of it about.

Alternatively, the increase in M may lead to an increased in T (number of
transactions), because as we have seen Keynes disputes the assumption that the
economy will find its own equilibrium. It may be in a position where there is
insufficient demand for full-employment equilibrium
, and in that case increasing
the money supply will fund extra demand and move the economy closer to full
employment.

Keynesians tend to argue that inflation is more likely to be cost-push
inflation or from excess levels of
demand. This is usually termed demand-pull inflation



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Keynesians - AS & AD

Keynes didn't distinguish between the
short-run and the long-run as Classical
economists tend to. He argued that the
economy could settle at any equilibrium level
of income at any time, and it was the
government job to use appropriate policies to
ensure that this equilibrium was a good one
for the economy. This can be illustrated on
an aggregate supply and demand diagram:



[Aggregate supply and demand] [@@]


The economy could settle at any of the 4
equilibria shown (Q1 - Q4). Clearly Q1 is not
a very desirable equilibrium as the level of
output is very low and there would be high
levels of unemployment. Nevertheless this
situation could, according to Keynes, persist
in the long-term unless the government did
something to stimulate the economy. This
something would have to be some sort of
reflationary policy, which boosted the level of aggregate demand
(see the next section on policies for more
details on the type of policies that could be
used). As aggregate demand grows so does the
level of output, but as the economy nears
full employment the dark spectre of inflation
emerges - in other words the price level
starts to increase! This inflation is due to
an excess level of demand and so is called
demand-pull inflation.
At the same time there will be increased
pressure on the labour market as nearly
everyone has a job, and so wages will begin
to rise as firms have to offer more to get
the people they want. This in turn will cause
costs to increase, and result in cost-push
inflation.

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Keynesians - Policies

The other sections about Keynesians show that they
believe that the economy can settle at any equilibrium.
This means that they recommend that the government gets
actively involved in the economy to manage the level of
demand. You will then be stunned to learn that these
policies are known as demand-management policies.

Demand management means adjusting the level of demand
to try to ensure that the economy arrives at full
employment equilibrium. If there is a shortfall in
demand, such as in a recession (a deflationary gap)
then the government will need to reflate the economy. If there is
an excess of demand, such as in a boom, then the
government will need to deflate the economy.

Reflationary policies

Reflationary policies to boost the level of economic
activity might include:

* Increasing the level of government expenditure
* Cutting taxation (either direct or indirect) to
encourage spending
* Cutting interest rates to encourage saving
* Allowing some money supply growth

The first two policies would be considered expansionary
fiscal policies,
while the second two are expansionary monetary policies.
The impact of them should be to reduce aggregate demand
and therefore the level of output. The diagram below
shows this:



[Reflationary policies] [@@]


The reflationary policies have boosted the level of
output from Q1 to Q2. The impact on the price level has
been small, though if demand increased any more it may
well be inflationary.

Deflationary policies

Deflationary policies to dampen down the level of
economic activity might include:

* Reducing the level of government expenditure
* Increasing taxation (either direct or indirect) to
discourage spending
* Increasing interest rates to discourage saving
* Reducing money supply growth

The first two policies would be considered
contractionary fiscal policies,
while the second two are contractionary monetary policies.
The impact of them should be to reduce aggregate demand
and therefore the level of output. The diagram below
shows this:



[Deflationary policies] [@@]


The initial level of aggregate demand was inflationary
- prices were increasing rapidly. However, the
deflationary policies have reduced demand to AD2 and
thus reduced the level of inflation.