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:

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:

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

where:
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 employment.

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 .

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