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 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


 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


 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                
 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

    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

 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


 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


 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.

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