Keynesian Perspective:

Economy can’t
Self-Regulate:
Why Did the Classical Perspective
Come Under Criticism:
► John Maynard Keynes, an English economist, changed how many
economists viewed the economy. Keynes’s major work, The General
Theory of Employment, Interest and Money, was published in 1936.
Just prior to its publication, the Great Depression had plagued many
countries of the world. Looking around at the world during that time,
one had to wonder whether the classical view of the economy
could be right. Unemployment was sky-high in many countries, and
many economies had been contracting.
 Continued:

► Where was Say’s law, with its promise that there would be no
general gluts? When was the self-regulating economy going to heal
itself of its depression illness? Where was full employment? And,
given the depressed state of the economy, could anyone any
longer believe that laissez-faire was the right policy? With the Great
Depression as recent history, Keynes and the Keynesians thought
that although their theory might not be right in every detail, they
certainly had enough evidence to say that the classical view of the
economy was wrong
 The Keynesian Counter Theories:

❖ Recall the four pillars we discussed about regarding the platform of

the Classical Perspective? Keynes challenged all four Classical pillars
with his own theories. Keynes challenged the four following pillars:
1) Say’s Law
2) Flexibility of Prices in all economic markets- wage, price and
interest rate
3) Economy is self-regulating
4) Laissez-faire is the right and sensible economic policy
 Countering Say’s Law:

► Classical Economist maintained that in a monetary economy higher

savings translated to lower interest rate, thus increasing investment
expenditure by the same magnitude, as fall in consumption
expenditure.
❖ Keynes countered that savings is not dependent not only on interest
rate, but also income level. Also, if people are saving with a fixed
goal in mind, higher interest rate may actually lead to lower savings.
He also mentioned that interest rate is not the only factor affecting
investment expenditure-business expectations play a crucial role in
influencing investment expenditure.
Countering Flexibility of Wage Rate:

► In contradiction to the Classical view, where a Recessionary Gap

led to surplus in the labor market and a consequent decline in wage
rate, Keynes said that wages can become, “sticky”, in the
downward direction-mainly because of Trade-Unions. This would
lead the economy to be stuck in a recessionary gap. Also, in
addition to Trade Union, Keynes (and his supporters-known as
Keynesian Economists),offered a different perspective regarding
how different markets have different speed of adjusting towards
long-run equilibrium. Labor Market takes a longer time to attain
long-run equilibrium, compared to stock market.
 Why Can Wage be Sticky:

► Keynes and Keynesian Economists have identified two primary

reasons for explaining why can wage be sticky (in downward
direction), in the labor market.
a) Wage-Contracts-employer and employees both supports wage
contracts to avoid frequent wage re-negotiations, workers’ strike
and wage security.
b) Efficiency Wage Models: models holding that it is sometimes in the
best interest of business firms to pay their employees higher-than
equilibrium wage rates.
Countering Flexibility of General
Price Rate:
► Keynes believed that the general price level (in the market for
goods and services) may not be flexible- specially in the downward
direction because not all sub-markets (industries) in the economy
are fully competitive (think of markets which are Oligopolistic or
Monopoly).
 The Middle Ground Between Classical
Perspective & Keynesian Perspective:

► If we are to recap between the two perspectives-we can

summarize as below:
❖ Classical perspective believed in flexible wage and general price
level.
❖ Keynes talked about inflexible wage and general price level.
❑ Some modern-day economists believe that it’s not about flexibility of
wage and price; rather it’s about the time taken for labor market
and market for goods and services to go towards long-run
equilibrium. Classical Economist believed that all the markets reach
equilibrium in relatively short time, where Keynes believed in the
opposite.
 The Simple Keynesian Model:

► Since Keynes didn’t support the Classical Perspectives, he strongly

opposed the, “Laissez-faire”, concept and advocated active
government initiatives, to move the economy from a recessionary
gap, & push it towards the long run equilibrium. With that intent he
developed the, “Simple Keynesian Model”, a model focusing on
consumption expenditure-or the, “C”, part of Total Expenditure. He
did so because consumption expenditure comprises the biggest
portion of Total Expenditure (Aggregate Demand). He basically
referred to fiscal policy (changes in government income and
expenditures) to influence Aggregate Demand.
 The Simple Keynesian Model:

► The model is based on a few assumptions:

1) The price level is assumed to be constant until the economy
reaches its full employment or Natural Real GDP level.
2) There is no foreign sector: the model represents a closed economy,
not an open economy. So total spending in the economy is the sum
of consumption, investment, and government purchases.
3) The monetary side of the economy is excluded.
 The Consumption Function:

► As mentioned before, the Keynesian Model is based on

consumption expenditure, and hence is a consumption
expenditure-based model; a critical part of the model is the,
“Consumption Function”
❖ The Consumption Function is in turn dependent on three
assumptions:
1) Consumption depends on disposable income (income minus
taxes).
2) Consumption and disposable income move in the same direction.
3) When disposable income changes, consumption changes by less.
 Continued:

❖ Consumption Function: the relationship between consumption and

disposable income. In the consumption function, consumption is
directly related to disposable income and is positive even at zero
disposable income.
❖ Marginal Propensity to Consume (MPC): the ratio of the change in
consumption to the change in disposable income.
❖ Autonomous Consumption: the part of consumption that is
independent of disposable income.
❖ Marginal Propensity to Save (MPS): the ratio of the change in saving
to the change in disposable income.
 The Multiplier:

► Multiplier: the number that is multiplied by the change in

autonomous spending to obtain the overall change in total
spending. The multiplier (m) is equal to 1/(1-MPC). If the economy is
operating below Natural Real GDP, then the multiplier is the number
that is multiplied by the change in autonomous spending to obtain
the change in Real GDP.
 Multiplier & Reality Checks:

1) The multiplier takes time to have an effect. In a textbook, going

from an initial increase in autonomous spending to a multiple
increase in either total spending or Real GDP takes only seconds. In
the real world, this process takes many months.
2) For the multiplier to increase Real GDP, idle resources must exist at
each spending round. After all, if Real GDP is increasing (output is
increasing) at each spending round, idle resources must be
available to be brought into production. If they are not available,
then increased spending will simply result in higher prices without an
increase in Real GDP. Simply put, GDP will increase, but not Real
GDP.
 The Simple Keynesian Model;
AD-AS Framework:
► Some Key Points:
❑ Change in autonomous consumption, investment or government
expenditure will raise level of aggregate demand by a multiplier
magnitude ( the reverse holds true as well).
❑ The price level is constant until economy reaches long-run level of
Real GDP (Natural Rate of Real GDP)-this indicates a horizontal
short-run aggregate supply curve.
❑ When the economy is in a recessionary gap, private sector may not
be active enough to push economy back to long-run equilibrium
(consumption expenditure and investment expenditure may not
respond to push up aggregate demand). Hence, government has
to step in and implement Fiscal Policy.
Keynesian Perspective: A Recap

1) The price level is constant until Natural Real GDP is reached.

2) The AD curve shifts if there are changes in C, I, or G.
3) According to Keynes, the economy could be in equilibrium and in a
recessionary gap too. In other words, the economy can be stuck in a
short-run disequilibrium/equilibrium situation.
4) The private sector may not be able to get the economy out of a
recessionary gap. In other words, the private sector (households and
businesses) may not be able to increase C or I enough to get the AD
curve move up to meet the LRAS curve.
5) The government may have a management role to play in the economy.
According to Keynes, government may have to raise aggregate
demand enough to stimulate the economy to move it out of the
recessionary gap and to its Natural Real GDP level.