Keynesian approach

KEYNESIAN APPROACH
DEEPIKA MISHRA
BBA – A ( 2nd SEM )

INTRODUCTION
JOHN MAYNARD KEYNES is often referred to as father of macro economics.
His pioneering work “ The General Theory of Employment, Interest and
Money” published in 1936, provided a completely new approach to the
modern study of macro economics. It served as a guide for both
macroeconomic theory and macroeconomic policy making during the Great
Depression and the period later. The General Theory was a beginning of a
new school of thought in macroeconomics which was referred to in later
period as Keynesian Revolution in macroeconomic analysis. The notion of
“effective demand” and its influence on economic activity was the central
theme in Keynes's Theory of Effective Demand. Keynes was the first
economist to advocate the role of government especially fiscal policy, as the
primary means of stabilizing the economy.

MEANING OF AGGREGATE DEMAND
The concept of aggregate demand (AD) refers to the total demand for
goods and services in an economy. AD is related to the total expenditure
flow in an economy in a given period. It consists of the following:
 Consumption demand by the households (C )
 Investment demand, i.e., demand for capital goods (I) by the business
firms.
 Government expenditure (G)
 Net income from abroad (X – M).
Thus symbolically,
AD = C + I + G + (X-M)

KEYNE’S THEORY OF AGGREGATE
DEMAND
According to Keynes full employment is not a normal situation as
stated in the Classical theory. He argued that economy's equilibrium
level of output and employment may not always correspond to the
full employment level of income. It is possible to have
macroeconomic equilibrium at less than full employment. If current
level of aggregate demand (expenditure) is not adequate to purchase
all the goods produced in the economy (i. e . a situation of excess
supply) then output will be cut back to match the Keynes's theory of
the determination of equilibrium income and employment focuses on
the relationship between aggregate demand (AD) and aggregate
supply (AS). level of aggregate demand.

KEYNE’S THEORY OF AGGREGATE
DEMAND
According to him equilibrium employment (income) is determined by the
level of aggregate demand (AD) in the economy, given the level of
aggregate supply (AS). Thus, the equilibrium level of employment is the level
at which aggregate supply is consistent with the current level of aggregate
demand. The theory believes that "demand creates its own supply" rather
than the Classical claim of "supply creates its own demand".

AGGREGATE DEMAND FUNCTION
Aggregate demand or what is called aggregate demand price is the amount of
total receipts which all the firms expect to receive from the sale of output
produced by a given number of workers employed. Aggregate demand
increases with increase in the number of workers employed. The aggregate
demand function curve is a rising curve. It can be seen that total expected
receipts is D1L1 at OL1 level of employment. Total expected receipts increase to
D2L2 with increase in the level of employment to OL2. OLf is the full employment
level. Initially the aggregate demand function (ADF) rises sharply as increase in
the number of employment leads to increase in society's expenditure, thereby,
increasing producer's expected sales receipts. There is no much increase in
employment, income, expenditure and therefore producer's expected sales
receipts as the economy reaches near full-employment. The ADF curve
becomes perfectly elastic (horizontal) as the economy reaches near full-
employment.

AGGREGATE DEMAND FUNCTION
Aggregate Demand In Keynes’ theory of income determination is society’s
planned expenditure. In a laissez-faire economy it consists of consumption
expenditure (C)and investment expenditure (I).
Thus AD = Planned Expenditure = C + I
where,
C = f (Yd)and Yd is level of disposable income (Income minus Taxes)
I is exogenous in the short run.
The short-run aggregate demand function can be written as
AD = C + I

AGGREGATE SUPPLY FUNCTION
Aggregate supply is determined by physical and technical conditions of
production. However, these conditions remain constant in the short run. As
such, given the technical conditions, output in the short run can be increases
only by increasing employment of labour.
Aggregate supply or what is called aggregate supply price is the amount of
total receipts which all the firms must expect to receive from the sale of
output produced by a given number of workers employed. In other words,
aggregate supply price is the total cost of production incurred by producers
by employing a certain given number of workers. Obviously, aggregate
supply price increases with increase in the number of workers employed.
The aggregate supply function curve is a rising curve and at full
employment (OLf) it becomes perfectly inelastic (vertical).

AGGREGATE SUPPLY FUNCTION
It can be seen that aggregate supply price or the cost of production is S1L1 at
OL1 level of employment. It increase to S2L2 with increase in the level of
employment to OL2. Initially, the aggregate supply function (ASF) rises slowly
as labour is abundant thereby leading to slow increase in the cost of
production. Larour cost rises sharply as the economy reaches near full-
employment. The ASF therefore rises sharply and at full employment (OLf) it
becomes perfectly inelastic (vertical).

Determination of Equilibrium Level of
Employment
According to Keynes equilibrium level of employment (income) in the short
run is determined by the level of effective demand. The higher the level of
effective demand, the greater would be the level of income and
employment and vice versa. As discussed above the ADF shows the amount
of total receipts which all the firms expect to receive from the sale of output
produced by a given number of workers employed and the ASF shows the
amount of total receipts which all the firms must expect to receive from the
sale of output produced by a given number of workers employed.
Entrepreneurs expand output as long as there are opportunities to make
profits.

Employment

Employment
It can be seen that up to OL level of employment, aggregate demand price
is greater than aggregate supply price (ADF > ASF). Producers expect
greater returns than the cost of production. As such, producers expand
output up to OL level of employment. Thus at any level of employment up
to OL, there would be expansionary tendency in the economy and therefore
rise in the level of employment.
Beyond OL level of employment, aggregate demand price is less than
aggregate supply price (ADF < ASF). Producers expect less returns than the
cost of production. As such, producers prefer to cut down output. Thus at
any level of employment beyond OL, there would be contractionary
tendency in the economy and therefore fall in the level of employment.

Employment
At OL level of employment aggregate demand price equals aggregate
supply price (ADF = ASF). Now there is no tendency towards economic
expansion or contraction. Thus OL is the equilibrium level of employment.
Point 'E' is called the point of effective demand. It represents that level of
aggregate demand price that is equal to aggregate supply price and thus
reaches short run equilibrium position.
It can be seen that equilibrium point 'E' is established at less-than-full
employment equilibrium and there is LLf amount of involuntary
unemployment in the economy. It is important to note that according to
Keynes this unemployment is due to deficiency of aggregate demand. At full
employment level there exist a gap between the full-employment level of
aggregate supply price and the corresponding level of aggregate demand
price.

Role of Fiscal Policy in achieving Full-
Employment Equilibrium
According to Keynes, full-employment can be achieved by removing the
gap between aggregate supply price and aggregate demand price.
However, he rejected the Pigouvian wage-cut solution to pull the ASF
downwards to achieve full-employment. This, according to him, would
further lower the aggregate demand, if the income of potential customers is
reduced. The economy, in short, will be caught in a vicious circle of high
unemployment and low demand. On the other hand, the policy to push the
ADF upwards will push the economy into a virtuous cycle of high demand
and high employment.

It can be seen that the gap between the full-employment level of aggregate
supply price and the corresponding level of aggregate demand price is now
filled by shifting the ADF upwards to ADF'. The economy is now at full-
employment equilibrium point E' and equilibrium employment is OLf.
Keynes argued that adequate economic stimulus to shift the ADF upwards
can be created through:
1. The Monetary Policy: A reduction in interest rates
2. The Fiscal Policy: A rise in government expenditure

However, to Keynes, monetary policy would be less effective under the
conditions of economic depression. It is a situation when community's
liquidity preference curve is absolutely elastic (horizontal). Therefore, interest
rate, which is already at low levels, cannot be lowered further through the
expansion of money supply. Thus, expansionary monetary policy would fail
to generate economic stimulus by picking up investment. On the other
hand, expansionary fiscal policy would be more effective to achieve upwards
shift in the aggregate demand and thereby full employment and output.
Keynes developed the theory of investment multiplier to explain the impact
of government expenditure on income and employment. The short-run
aggregate demand function can now be written as:
AD = C + I + G, where G is government expenditure.

Keynesian approach

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