CHAPTER FOUR

THE KEYNESIAN ECONOMICS

4.1. Introduction
• This is the most significant schools of economic
thought. 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.
The Historical Background of the
Keynesian School
• The Great Depression of the 1930`s.
• The work of many economists was within the
framework of aggregate economics, or macro,
rather than the micro of the neo-classical school.
• The spreading concern about secular
stagnation(a condition of negligible/no or a
declining rate of growth in a market-based
economy).
 Major Tenets of the Keynesian School
• Macroeconomic Keynes and his followers
emphasis:
concerned themselves with the determinants of the total
or aggregate amounts of consumption, saving, income,
output, and 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 .
• 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.
Equilibrium levels of investment and saving exist after all
adjustments
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have occurred.
3
 Cont…
• 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).
• Prices also are sticky downward; declines in
effective demand initially cause reductions in
output and employment rather than declines in the
price level.
 Cont….
• 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.
 Which Tenets of the Keynesian School
Became Lasting Contributions?
• Numerous ideas developed by Keynes and his
followers towards the developments of contemporary
macroeconomics .
• Keynesian concepts such as the consumption function;
the marginal propensity to consume; the saving
function; the marginal propensity to save; the marginal
efficiency of capital; the transaction, precautionary,
and speculative demands for money; the multiplier; ex
post and ex ante saving and investment; fiscal and
monetary policy; IS-LM analysis.
 Cont---
• By the time of the Great Depression, Keynes had
become one of the world’s great economists,
perhaps its leading monetary theorist.
•However, even before 1920’s he held many then-
unorthodox views.
• His career, however, was by no means confined to
the academic cloisters(arch).
• As a result of his book Indian Currency and Finance
(1913) he was appointed to a Royal Commission to
examine Indian currency.
 Cont--
1) He provided an extensive theory of the determination of the
levels of income, output, and employment, as well as of the
price level which constituted his version of that analysis.
2) He had a more complex, and even quite radical, view of
saving than hitherto(previously) held.
• He argued that investment is financed not only by house
hold saving but also through bank credit and retained
earnings.
• Besides, the economic significance of any level of savings
depend on its relation to its correlative level of investment.
• That is, if saving exceeded investment, the level of
economic activity was likely to contract, and vice versa.
 Cont---

3)He argued that the role of the interest rate was not to equate
saving and investment but something like the demand and
supply of money, taking especial account of the demand to
hold money (liquidity preference).
4) He maintained that government spending was part of the
income mechanism and raised the theoretical and practical-
policy possibilities of using the relation of government
spending to taxation as a means of countering or
compensating for developments in the private sector
deemed undesirable, for example, unemployment and
inflation.
 Cont--.
• Keynes did not believe that existing economic theory,
with its strong laissez-faire bias, was capable of providing
the remedy for this over-whelming economic and social
malaise of the late 1920’s and early 1930s.
• The Marxists, he saw, were expressing confidence in their
founder's prediction that capitalism was doomed by its
inner contradictions, and were expecting its final collapse
at any moment. Keynes did not accept this view.
• In fact It could be urged that his General Theory is aimed
as much at disproving Marxism, as disproving the laissez-
faire approach.
• He recognized that unless a new economic theory could
be formulated, which gave hope to thousands of
disillusioned(disappointed) citizens, then Marxist
ideology might well triumph(success).
 The Great Depression

The classical or neoclassical theories implied full-

employment.
•After all, if there are any unemployed people they
would offer to work for less and, therefore, get hired.
•The wage would keep decreasing till all willing
workers are hired.
•If the wage occasionally gets stuck at too high level,
unemployment would result.
•However, such episodes would be brief because the
presence of the unemployed would push wages down.
 The General Theory of Employment
• John Maynard Keynes' "General Theory of
Employment, Interest and Money" (1936) is
one of the most influential works in economics.
In this book, Keynes challenged the classical
economic theories that had dominated the field
for centuries. Below is an outline of the key
concepts from his General Theory:
 The Nature of Employment

• Classical View: Prior to Keynes, classical economists

like Adam Smith and David Ricardo believed that
markets always clear (supply equals demand) and that
full employment is the natural state of the economy.
They argued that if there was unemployment, it was
due to temporary mismatches or frictions in the
market, which would resolve over time.
• Keynes' View: Keynes argued that the economy does
not always return to full employment. Instead, he
proposed that unemployment can persist due to
insufficient demand for goods and services.
 The Role of Aggregate Demand

Aggregate Demand (AD) is the total demand for goods and

services in an economy, which includes consumption,
investment, government spending, and net exports.
Keynes' Argument: Keynes argued that aggregate demand is
the driving force behind employment levels. If AD is insufficient,
businesses won't hire enough workers, leading to involuntary
unemployment. The level of AD can be influenced by factors
such as business confidence, government spending, and
investment, which can all fluctuate, especially in times of
economic instability.
The classical view, in contrast, argued that savings always
equaled investment in the long run, and that the economy would
naturally adjust to full employment.
 The Principle of Effective Demand

• Keynes introduced the concept of effective

demand, which is the total demand for goods and
services in the economy at different levels of
income and employment. If effective demand is
insufficient, the economy will not reach full
employment.
• This concept also led to the idea that government
intervention might be necessary to boost demand,
particularly during economic recessions.
 The Marginal Efficiency of Capital and Investment

• Keynes emphasized that investment is influenced by expectations of

future returns. The marginal efficiency of capital (MEC) refers to the
expected rate of return on investment in new capital goods (like
machinery and buildings).
• If businesses are uncertain about future demand, they will be less
willing to invest, even at low interest rates. This can create a situation of
low investment and low employment, which Keynes argued could
persist without intervention.
Interest Rates and Liquidity Preference
• Keynes also developed the theory of liquidity preference, which
describes how people prefer to hold their wealth in liquid forms (like
cash) rather than invest it, depending on interest rates.
• According to Keynes, the interest rate is determined by the demand for
and supply of money. When people expect economic uncertainty, they
may choose to hold cash instead of investing, which can further depress
demand for goods and services.
 The Role of Government and Fiscal Policy

• Keynes argued that during times of economic downturn,

the government could play a critical role in boosting
demand through fiscal policy. This could include
increasing government spending and lowering taxes to
stimulate economic activity.
• This was a major departure from classical economic
thought, which advocated for balanced budgets and
minimal government intervention.
• Multiplier Effect: Keynes introduced the concept of the
multiplier, where an increase in government spending can
have a greater impact on national income and employment
than the initial amount spent.
 Involuntary Unemployment

• Keynes rejected the classical idea that labor markets would

always clear and that unemployment was voluntary. He argued
that involuntary unemployment could exist, meaning that
workers who want to work at the prevailing wage rates may
not be able to find jobs because demand for goods and services
is too low.
The Paradox of Thrift
• In his General Theory, Keynes proposed that while individual
saving is good for a household, aggregate saving in the
economy can have a negative effect during times of recession.
If everyone saves more during an economic downturn, it can
reduce overall demand, leading to even higher unemployment.
This is known as the paradox of thrift.
 The "Animal Spirits" of Investors

• Keynes introduced the idea of animal spirits, a

term used to describe the instincts, emotions, and
psychological factors that drive business decisions.
• He argued that investment decisions are often
influenced not just by rational analysis, but by
confidence, uncertainty, and emotional factors that
can lead to economic cycles of boom and bust.
 Interest Rate and Money

• According to Keynes there are two important factors that

affect investment decision:
1) Expected return on the investment.
2) Rate of interest.
• The former constitutes the benefits from investing in new
plant and equipment; the latter constitutes the cost of
obtaining funds to purchase the plant and equipment.
• If the expected rate of return on investment exceeded
the interest rate, business firms will expand.
• However, if interest rates exceeded the expected rate of
return on investment, that investment will not take place.
• Thus, changes in expectations and changes in interest rates
lead to changes in business investment
 Cont---
• When business owners are optimistic about the
economy, they will expect high rates of return
on money used to build new plants and
equipment.
• Keynes in his famous pieces “General Theory”
he discussed how interest rate is determined.
• The interest rate was determined, according to
Keynes, in money markets where people and
businesses demand money and where central
banks control the money supply
 Cont--
• In general theory Keynes argued that interest rate is purely a
monetary phenomena determined by liquidity preference.
• Unlike the Classical economists where interest rate is
regarded as the main determinant of saving, Keynes argued
that it is income not interest rate which mainly affect the
saving decision and saving does not always respond
smoothly and easily to the change in demand for capital.
• To the transactions motive for holding money, Keynes
added the precautionary and speculative motives, the last
being sensitive to the rate of interest.
 .

• By introducing the speculative motive into the money

demand function, Keynes made the rate of interest
dependent on the state of confidence as well as the money
supply.
• Keynes disputed (uncertain) the view that the interest rate
would equilibrate savings & investment.
Keynes system
The formulation of Consumption function:
C =f (Y ), C=α+βY, he argued that consumption
determines demand in turn leads to production of
commodities as well capital.
 Cont--
 It is the lack of effective DD or lagging consumption
that creates crises and generates depression. He
conjectured that:
• (MPC)—is positive and less than one.
• Income is the main determinant.
• APC falls as income gets larger.
 Saving determination: S=f (Y ), This implies that
saving (S) also rises with income; it, too, is a positive
function of income. Like the MPC, the marginal
propensity to save (MPS) is greater than zero and less
than one.
 Cont---
 Investment: Keynes defined economic investment as the
purchase of capital goods. I=f(r),I=α-βr. The
inducement to invest depends on marginal efficiency of
capital and interest rate.
 Equilibrium income and employment: there is a high
correlation between national income and the level of
employment. Keynes, however, was concerned mainly
with the short run; he defended this emphasis with the
quip, “In the long run we are all dead.
 If we ignore the government and international trade, the
immediate determinants of income and employment are
 Cont---
• Y= C+I, and S = Y-C then, Solving the two equations
provides an alternative condition for equilibrium
income: S = I, the question now arises: why S = I?, if I
disappear owing to hoarding = total spending decrease
leads to a fall in Y and C. on the other hand if the entire
income is spent on C further expansion of employment
and I is not possible results smaller output and Y. Hence
a balance b/n C & I is essential. S is a part of income w/c
is neither hoarded nor is used for C. hence S must be
invested & that is why Keynes hold S=I.
 Policies to promote full employment and stability

• Keynes proposed a large government role to stabilize the

economy at a full employment level of national income.
To combat high unemployment, Keynes suggested ways
to increase aggregate expenditures. Because of liquidity
trap, monetary policy is not likely to be effective as a
way to reduce interest rates and increase investment
spending during a severe depression. i.e. Any new
money pumped into the economy by the central bank
will be held by people as idle balances rather than used
to buy bonds, and the interest rate will not fall.
 Cont---
• A second and more effective way to overcome
depression is for the government to undertake an
expansionary fiscal policy. Government
spending, like private investment, serves as a
source of aggregate expenditures. Such
spending, declared Keynes, could be increased,
thereby increasing aggregate expenditures and
producing a multiple increase in national income
 Keynes’ theory of liquidity Preference

• Keynes describes 'liquidity preference' (the

demand for money) as depending on three
motives
I) the transactions motive (the need to pay for
things - whether as consumer or businessman -
at short notice); the daily needs of life.
II) The precautionary motive (as a guard against
accidents, unemployment, ill health and all the
uncertainties of life); contingent needs.
 Cont---
III) The speculative motive (a readiness for
profitable opportunities). Business needs.
 Liquidity preference is preference of an
individual or group for cash over assets and
determine interest rate.
 Keynes argued, sensible wealth management
required that people hang on to some cash even
if they don’t need it for shopping.
 Cont---
• Moreover, Keynes’s liquidity preference idea
implied that the demand for money would be
inversely related to the interest rate.
• Keynes demonstrated that the pursuit of liquidity
(i.e., the desire for large cash holdings) could
cause a reduction in spending and thereby in
national income, production, and employment.
• He uses the idea of liquidity to drive a final nail
in the coffin of Say's Law, and demonstrates that
it was possible for people to save too much
 The concept of Multiplier

• Apart from the direct effects of expansionary fiscal

policy on employment, according to Keynes there
would also be a chain of indirect effects.
• If one set of unemployed workers get hired, they
would have some extra money in their pockets.
• Therefore, they would go shopping.
 Cont---
• This would induce businesses to hire some more
of the unemployed.
• These workers would, therefore, have some extra
shopping money and their shopping would
similarly create more jobs.
• And so on and on the process would go, creating
more and more jobs.
 Cont---
• As a result of this chain effect—called the
multiplier—a $10 million increase in government
spending would end up adding to GDP by not
$10 million but by a multiple of $10 million.
GDP=C+I+G+NX
• Ceteris paribus, the multiplier will be larger, the
larger the marginal propensity to consume.
• In another word, the less thrifty the workers were
the bigger would be the number of additional jobs
created by expansionary fiscal policy.
 Theory of Employment and Price

• In Keynes’ vision, the most serious consequence

of the economic crisis was represented by the fast
growing rate of unemployment which directly
affected the welfare and peace of society.
• For this reason, the main purpose of Keynes was
to solve once and for all the problem of
occupation and the solution proposed was a bold
one and apparently, innovative: the state had to
indirectly intervene in the economic activity:
by stimulating aggregate demand
by means of manipulating the interest rate and
control of monetary mass.
 Cont---
• In the theory of price, Keynes argued that the
level of prices on one market is determined by the
cost of production factors and production level
(SS).
• According to Keynes the level of wages, that is,
the price of labour is an essential factor in
establishing final price.
• The traditional microeconomics assumes prices
flexibility as an essential characteristic of general
equilibrium.
 Cont---
• The Walrasian general equilibrium model is based on
the prices ability to freely float until the supply and
demand are met on each particular market and, thus,
the entire economic system is in an equilibrium status.
• Keynes criticized this traditional assumption arguing:
 first that on a short term prices are not as flexible as the
traditional economics assumes and, second, prices
flexibility is not by far the most important condition for
general equilibrium.
• Keynes’s only argument why prices are not flexible in
the short term is b/c of the rigidity of nominal wage.
 Cont---
•For the classical economics, a nominal wage
falling will produce a cost cut and consequently,
a price reduction which will determine the
employment to increase.
•According to Keynes, classical economics is
relevant for individual industry and firm analysis,
valid for partial equilibrium and not general
equilibrium.
•Keynes argued that unemployment equilibrium
is normal.
•Economy operates less often than full
employment, since market do not clear.
 Wage Rigidity
•Keynes argued that wages might not be
driven down by the unemployed.
•Wages in some cases are fixed by long-term
contracts. Moreover, workers suffer ‘wage
illusion’.
•That is, they would refuse to accept wage
cuts but happily accept price increases even
though both these changes reduce the
purchasing power of the wage (or, the real
wage).
 Stabilization Policy
• Thus, we see that Keynes had proposed two
cures for unemployment:
– expansionary fiscal policy, and
– expansionary monetary policy.
• However, of these two cures, Keynes preferred
expansionary fiscal policy and had doubts
about the effectiveness of monetary policy.
 Doubts about monetary policy
• First, Keynes argued that at especially low interest rates a
liquidity trap may appear.
• That is, the demand for money may become infinitely elastic
and, therefore, it may no longer be possible to reduce interest
rates by printing more money.
• Second, even if you reduce interest rates, investment spending
by businesses may not increase.
• Business investment is determined basically by expectations-
optimistic or pessimistic “animal spirits”- and only slightly by
the interest rate.
• Therefore, when the economy is in trouble, even if the central
bank succeeds in reducing interest rates, the businesses may be
so pessimistic that they may not boost investment spending.
And if that happens, no new jobs would get created.
Classical Economics Vs Keynesian Economics
Classical
•Economy is always in full employment.
•Wage and interest flexibilities restores full
employment equilibrium, if disturbed.
•Monetary expansion may create inflation.
•Interest rate brings about equality between
Savings and investment
•Investment is interest elastic.
 Cont---
Keynesian
• Full employment equilibrium is an exception.
• General reduction in wages throughout the
economy can lead to fall in demand
• inflation will arise only after full employment
has been achieved.
• Savings & investment is influenced by level of
income and expected return on investment.
• Interest sensitivity of investment may not be
adequate.
 Cont---
•Classical place great emphasis on supply side
for establishing equilibrium.
•S & I decisions are made by same group of
people and interest rate brings about equality
between I &S
• Keynes treats supply (Y) as given and attaches
great significance to demand .
• S & I decisions are taken by different groups
of people changes in the economy are the result
of changes in income and expenditure and not
the rate of interest rate
 Cont---
•Classical economics focuses on long run analysis.
•Keynes emphasized on short run . “In the long run we are all
dead”
•In classical economics wage and prices are fully flexible in
order to clear markets rapidly.
• In Keynesian economics both price and nominal wages are
rigid In the short run.
•In classical world free market economies are always stable.
Tending towards full employment & full production
equilibrium
•In Keynesian economics, free market economies are unstable
•Equilibrium but no reason for full employment/full
production.
 Cont---

In Keynesian economics
• In a depression or recession, much
unemployment is involuntary.
• Economy operates less than full employment,
since market don’t clear.
• Government intervention is desirable to stabilize
the business cycle.
• (Fiscal and monetary policies but he cast doubt
on the effectives of monetary policy).
 Cont---
•Keynes believe that aggregate supply will always
adjust to Aggregate demand not vice versa.
•According to Keynes; Demand creates its own
supply and not supply which create its own demand
as it was the case in the Classical Say’s Law.
• Demand becomes much bigger driving force
•Under Classical system , however, government
had no role in management of the economy-
“Laissez faire” do nothing.
 Cont---
• Keynes analysis of wage and employment can be
regarded as revolutionary than classical.
• Keynes integrates the theories of money, employment
and interest with income/output theory and concept of
money is more dynamic than classical.
• Keynesian economics is more practical and effective
than the classical economics. It is institutional in the
sense that it gives due importance to institutional
factors explaining high rates of interest, inadequate
supplies of money, over saving, cumulative errors,
uncertainties, rigidities, etc..
 Policy Implication of Keynesian Economics

•In Keynesian economics the focus is on aggregate

demand.
•It focuses on the rate of spending in the economy.
Spending is what pulls forth the output, and thus
supports employment and incomes.
•Keynesian economics tells us that if we can
understand what determines the level of spending
(aggregate demand), we will know what determines
the level of employment and production; i.e. output
and income in the economy.
• Keynesian economics offers the government a
positive approach to overcome depression.
 Cont---
• Make total spending increase and the economy will
speed up.
• Increase government spending. Cut taxes so people and
businesses will have more money to spend. Permit the
money supply to expand.
• As the government and the businesses and people all
spend more, people will receive more income.
• As people’s incomes increase, their spending increases.
• The result will be prosperity. If ,on the other hand, the
economy overheats, soon the government will need to
cut down on its spending and raise taxes to keep the
boom from running away into inflation.
 Cont---
•The basic idea of the Keynesian proposal for
overcoming unemployment and depression was to
unbalance the budget.
•The government would reduce its “tax withdrawals”
from the income stream at the same time that it would
increase its “spending injections” into the income
stream.
•The idea was for the government to unbalance the
budget, run a deficit, create more money to finance its
expenditures, and thereby push more money into the
spending and income flow of the economy.
 Cont---
• The influence of the Keynesian theories on the
formulation of public policies in the various countries of
the world can hardly be over emphasized. His
contributions, chiefly relate to the solution of the
following problems: reparations, exchange rates,
international equilibrium, appropriate rate of interest,
central banking system, inflation, deflation and wastage
of economic resources and employment.
• Keynes suggest that sound policy of public finance should
aim: keeping the rate of interest as low as to force capital
to undertake investment risks in order to earn profits;
supplementing private inv`t by gov`t spending; and
adopting progressive taxing system.
 Cont---
•While Keynesian economics was widely
accepted in the 40s, 50s, 60s and 70s, a few
economists were speaking loud and clear against
Keynesian economics.
•They were arguing and building their case
against the whole idea of government fiscal policy
(of adjusting taxes and spending to influence the
economy).
•The leading challengers have been Milton
Friedman and his colleagues who make up the
Monetarist School (or the Chicago school) of
economic thought.
 Cont---
•According to Milton Friedman and his followers,
the government should never take any kind of
direct discretionary action to influence
employment or spending or wages or prices.
•The government should not do anything to try to
make the economy run better than it runs
naturally.
 Cont---

The monetarists take a long-run view, and assume

that the short-run ups and downs of the economy
(inflation, unemployment, etc.) are just short-run
conditions which the natural market forces will
work out in due time.
The Keynesian view of the economy is different
•The Keynesians accept the proposition that the
natural market forces are powerful. But do not
believe that these forces are sufficiently powerful to
guarantee healthy economy.
 Keynesian Economics and Underdeveloped Countries

• Keynes in his seminal work “ General Theory”

made some bold assumptions.
• This include the assumption he made with regard
to the attitude of labour, which does not seem
plausible to explain the situation in least
developing countries.
• But the major limitation of the applicability of
Keynesian economics in underdeveloped countries
arise out of its conclusion and policy implications.
 Cont---
•One policy implication that can be inferred from “General
theory” is the importance of direct progressive tax on
income.
• Keynes argued that such taxation policy is useful as it
reduce saving and increase consumption.
•The rise in total consumption demand will help to sustain
effective demand.
•Is it the need of underdeveloped countries to increase
effective demand through increased consumption or via
increased investment?. If it is the later, it is saving which
should be boosted not consumption. Therefore, adopting
 Cont---
•The essential task of underdeveloped countries is to increase
saving which is almost in opposite of the task of Keynesian
economics itself was addressed (i.e increasing aggregate
consumption). The administrative difficulties involved in the
imposition of such taxes in underdeveloped countries is also
immense.
•Another policy stand in Keynesian economics is building up of
surplus in balance of payment accounts.
•Keynes in General theory advocated the importance of having
positive BOP as it enable the country to invest abroad.
•But to do the country need to be in a possession of either the
currency of the country where the investment are to be made or
 Cont---
•Underdeveloped countries are, however, in shortage
of such foreign currencies which put the
applicability of Keynesian protectionist prescription
in underdeveloped countries is big question?.
•Keynesian theory of investment multiplier also
does not seem that applicable in economies of
underdeveloped country. This is because of some of
its unrealistic assumption (such as Automaticity in
supply of goods of various kind).
 Cont---

•In nutshell, most of the policy prescription of

Keynesian economics has little or no relevance
to the situation underdeveloped countries are
facing today.
Founder of Macroeconomics
•Keynes is regarded as the pioneer of
macroeconomic theory and policy.