Keynes – Chapters 4-5

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.

– Timmy