The outline of our theory can be expressed as follows:
When employment increases aggregate real income is increased. The psychology of the community is such that when aggregate real income is increased aggregate consumption is increased, but not by so much as income. Hence employers would make a loss if the whole of the increased employment were to be devoted to satisfying the increased demand for immediate consumption.
Thus, to justify any given amount of employment there must be an amount of current investment sufficient to absorb the excess of total output over what the community chooses to consume when employment is at the given level. For unless there is this amount of investment, the receipts of the entrepreneurs will be less than is required to induce them to offer the given amount of employment.
It follows, therefore, that, given what we shall call the community’s propensity to consume, the equilibrium level of employment, i.e., the level at which there is no inducement to employers as a whole either to expand or to contract employment, will depend on the amount of current investment.
The amount of current investment will depend, in turn, on what we shall call the inducement to invest; and the inducement to invest will be found to depend on the relation between the schedule of the marginal efficiency of capital and the complex of rates of interest on loans of various maturities and risks.
Keynes, General Theory of Employment, Interest and Money, page 25
Keynesian economics was first put forth by John Maynard Keynes. Simply put, Keynesians believe that aggregate demand is the key player in macroeconomic issues such as unemployment. Prior to Keynes, economists generally believed that the invisible hand of the market can direct the economy to its full potential.
Keynesian economists, on the other hand, believe that the free market cannot emend itself completely because of its certain characteristics such as sticky wages and prices. Therefore it is necessary for the government to intervene in the free market, mainly by spending more money during recessions and lowering rates to increase demand.
Aggregate Demand (AD), the base on which most of Keynesian economists build their views upon, is the measurement of the sum of all final goods and services produced in an economy. Looks a lot like GDP, huh? That is because they are exactly the same, use the same equation, and increase or decrease together. The Keynesian equation for this term is:
AD = C + I + G + (X-M)
Here, the C stands for consumption, I is for investment, and G refers to government spending, while X and M are exports and imports, respectively.
Still confused? Well, Paul Krugman, Nobel Prize laureate in 2008 for his contributions to the new trade theory, has summarized the 4 key factors of Keynesian view in his column on New York Times:
– Economies sometimes produce much less than they could, and employ many fewer workers than they should, because there just isn’t enough spending. Such episodes can happen for a variety of reasons; the question is how to respond.
– There are normally forces that tend to push the economy back toward full employment. But they work slowly; a hands-off policy toward depressed economies means accepting a long, unnecessary period of pain.
– It is often possible to drastically shorten this period of pain and greatly reduce the human and financial losses by “printing money”, using the central bank’s power of currency creation to push interest rates down.
– Sometimes, however, monetary policy loses its effectiveness, especially when rates are close to zero. In that case temporary deficit spending can provide a useful boost. And conversely, fiscal austerity in a depressed economy imposes large economic losses.
Portrait of Keynes: ©David G. Klein