Page 78 - DECO201_MACRO_ECONOMICS_ENGLISH

Unit 4: Theories of Income, Output and Employment: Keynesian Theory

In the wake of The General Theory, governments around the world dramatically increased Notes
their levels of public spending, partly for social reasons - to set up welfare states to deal
with the consequences of high unemployment - and partly because Keynesian economics
underlined the importance of governments having control of significant chunks of the
economy.
For a considerable time it seemed to work, with inflation and unemployment relatively
low and economic expansion strong, but in the 1970s Keynesian policies came under fire,
particularly from monetarists. One of their main arguments was that governments cannot
"fine-tune" an economy by regularly adjusting fiscal and monetary policy to keep
employment high. There is simply too long a time lag between recognising the need for
such a policy (tax cuts, say) and the policy taking effect. Even if policy-makers speedily
identify the problem, it takes time for laws to be drafted and passed, and more time still
for the tax cuts actually to drip through the wider economy.
Ironically, however, Keynes enjoyed a major comeback in the wake of the 2008 financial
crisis. As it became clear that cuts in interest rates would not be enough to prevent the US,
UK and other economies falling into a recession, economists argued that governments
should borrow money in order to cut taxes and boost spending. That is precisely what
they did, in what was widely seen as a serious break with the previous 25 years. Against
all odds, Keynes was back.

Source: www.telegraph.co.uk

Self Assessment

State whether the following statements are true or false:

1. In a consumption function, C= a+ bY, the value of b represents the autonomous spending.
2. Sum of MPC and MPS must always be equal to 1.
3. Injections are fresh inflows into expenditure stream.
4. The value of the multiplier is equal to 1/MPC.
5. The government participates in the economy directly through monetary policy and
indirectly through the fiscal policy.
6. Expenditure by the government is assumed to be an autonomous expenditure.

4.2 Effective Demand

In the Keynesian theory, employment depends upon effective demand. Effective demand results
in output. Output creates income and income provides employment. Since Keynes assumes all
these four quantities, viz. effective demand (ED) output (O), income (Y) and employment equal
to each other, he regards employment as a function of income.
Effective demand is determined by two factors, the aggregate supply function and the aggregate
demand function. The aggregate supply function depends on a number of production conditions,
which do not change in the short run. Since Keynes assumes the aggregate supply function to be
stable, he concentrates his entire attention upon the aggregate demand function to fight depression
and unemployment. So, employment depends on aggregate demand, which in turn is determined
by consumption demand and investment.
Aggregate Demand (AD) is simply total demand for final goods and services in the economy.

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