How can a government be sure that its increase in spending would not be offset by a decrease in private saving? Keynes was unable to answer this question during his presentation in front of the Macmillan committee. In order to find answers, Keynes expanded his Keynesian cross model to include the rate of interest. Keynes argued that interest rates affected the quantity of production. Just as individuals save more when incomes are high, businesses invest more when the rate of interest is low. In order to make this argument he assumed that there was only one interest rate in the whole economy.
Keynes called the demand curve for investment as a function of the interest rate the marginal efficiency of capital. Lower interest rates encourage businesses to invest in themselves while high interest rates do not. A lower interest rate leads to an increase in national income. Keynes made three major breakthroughs. The first was the consumption function. The second was the marginal efficiency of capital. Keynes third breakthrough answered the question, “If the amount of total spending in the economy was determined by the balance between savings and investment at any interest rate, what determined the interest rate?” To answer this, he had to clarify the role of the quantity of money in the economy. The supply of money is determined by the central banks and they can change the supply by buying or selling bonds. When the central bank buys bonds it increases the supply of money and when it sells bonds it decreases the supply of money. Interestingly the price and yield of bonds move in opposite directions. Keynes describes a new use for money that he refers to as liquidity preference: a wish to hold assets in “liquid” form (money) in order to use this money to speculate by buying bonds when the time seems right to do so. The interest rate is determined by the need to make the demand for money equal to the supply of money.
In a time of crisis, the risk of failure makes the value of bonds decline and leads to bondholders to sell their bonds to get cash. The 2008 financial crisis is a good example of this. When bondholders sell their bonds, the interest rate rises. Those who borrow to invest must now borrow at higher interest rates and therefore will invest less leading to a decrease in output and employment. This is one of Keynes most important findings.
The demand for money is a function of both the interest rate and GDP. In order to maintain equilibrium in the money market where the supply and demand for money are equal, GDP and the interest rate must rise and fall together. The IS curve refers to the savings and investment curve. It shows different combinations of the interest rate and national product where savers and investors are content, and at which firms do not wish to change their level of production. The LM curve shows the interaction between liquidity preference and the money stock. It shows different combinations of the interest rate and national income where wealth holders are content to hold a give quantity of money In the IS-LM diagram, where the curves cross is a point in which both groups are content, and there is no pressure to change either the interest rate or GDP.
The interest rate must rise to crowd out private investment and the amount of crowding out is determined by the extent to which the interest rate rises (slope of the LM curve). Only if the LM curve is vertical is crowding out complete.
Economics Before Keynes
Prior to the Great Depression, Macroeconomics (the study of economies as whole) did not exist. The Marshallian analysis otherwise known as Micro-economics (the study of individual markets) was the only form of economics that existed . This chapter gives a brief explanation of Micro-economic analysis; the foundation being built upon the separation of supply and demand. Some of the key takeaways were: (Most we have covered in Principles or Intermediate)
- The quantity of a good or a service that is demanded generally increases when the price falls.
- Law of Supply – the higher the price, the higher quantity supplied
- Law of Demand – the higher the price, the lower quantity demanded
- Economists use price elasticity to describe the extent to which the quantity demanded rises when the price declines. A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. An inelastic good or service is one in which changes in price witness only to modest changes in the quantity demanded or supplied.
- Quantity (Q) is represented on the horizontal axis while Price (P) is represented on the vertical axis. Because the demand curve slopes down and supply slopes up (due to the law of diminishing returns), these two lines generally cross forming a point of equilibrium.
- Movements vs. Shifts – A movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa. A shift in a demand or supply curve occurs when a good’s quantity demanded or supplied changes even though price remains the same.
Under this micro economic “Marshallian” framework neither imbalances in the labor market nor imbalances in the market for savings had any effect on aggregate production. Keynes argued that an excess supply in savings would lead to a reduction in production. He faced vast opposition. The Marshallian tradition of micro economics was very powerful and Keynes had difficulty arguing his points while serving on the Macmillan Committee.
The General Theory
While working with the Macmillan Committee Keynes faced two main problems by the end of 1930. He had failed to provide any alternative to the poor performance of the gold standard and consequently had failed to explain how a rise in Bank rate would increase unemployment and how expanding public works would reduce unemployment. In order to answer both of these questions he made a few assumptions. He assumed a closed economy, restricted himself to the short run, and abandoned the assumption that prices are flexible. Keynes’s Treatise of Money (1930) was the key to his process of discovery. He began his discovery by arguing that savings and investing were done by different people. This brought an end to the Quantity Theory and allowed Keynes to come up with a better framework. A group of young Keynes followers (part of the Macmillan committee) known as the Circus formed to discuss the strengths and weakness’s of Treastise. The Circus concluded that it is primarily the variations in the level of output that bring savings into line with investment to re-establish the conditions of macroeconomic equilibrium. In economics, savings are defined as the difference between income and consumption. As income rises people can save some of their income and therefore saving rises with income. Keynes found that the national income of its citizens is equal to the production of firms and its government. Therefore savings equals investment plus government spending. Keynes concluded that savings rise with the national product and when savings rise, consumption falls and people buy fewer goods. Keynes was now able to explain how an increase in savings could cause unemployment.
With this he developed the Keynesian cross. The Keynesian cross is based on the condition that the components of aggregate demand (consumption, investment, government purchases, and net exports) must equal total output. It shows that the equilibrium is reached by a movement of GDP, and not by price changes.
Along with the Keynesian cross, The Paradox of Thrift is one of Keynes most important findings. The paradox simply states that the desire to save more does not increase savings, it decreases GDP. In many people’s minds, this is the essence of Keynesian economics. If consumers and businesses are not spending enough, the only entity that can spend more is the government. Keynesian policy requires the government to take up the slack and reduce employment by spending more. Under Keynes the meaning of unemployment changed as well. It changed to describe a new condition known as involuntary, or Keynesian unemployment. “Keynes argued that involuntary unemployment represented a failure in the product market, not a failure in the labor market. The problem did not lie in negotiations about wages or hours; it lay in the inability of hiring firms to sell their products. That, in turn, was the result of an excess of savings that reduced GDP.” To reiterate, the level of employment is determined by the level of output because that determines how many people entrepreneurs will want to employ to make the output that they are able to sell. This can all be related to the 2008 world financial crisis. Fixing our product market is crucial in fixing our unemployment problem.