Intermediate
Macroeconomics
Topic Four: Keynes vs. The Classical School
John
Maynard Keynes (the General Theory of Employment, Interest and Money –
1936)
Keynes
contribution to economic theory remains a matter of considerable debate.
Opponents
are convinced that Keynes was fundamentally mistaken (Hayek).
Keynesians
themselves are divided.
Keynes
– clear and unambiguous message
that with regard to the general level of employment and output there was no
invisible hand channeling self-interest into some social optimum.
Interpreting
the General Theory
There
are many interpretations of the book.
Why? According
to Bill Gerrard (1991) the reasons include:
1.
2.
3.
National
Income:
“National
income depends on the volume of employment.”
Involuntary
unemployment:
Central
Propositions:
Effective
Demand:
C
= household expenditures
I
= investment expenditures from firms
E
= C + I
What
Determines Consumption?
What
Determines Investment?
Keynes
called expected profits the marginal efficiency of capital.
Uncertain
Future:
Expectations
driven by “animal spirits” –
Irrational
optimism and pessimism, causing large swings in the state of business confidence.
Expectations
of the future profitability of investment are far more important than the rate
of interest
Business
Cycle Explanation:
Marginal
efficiency of capital
– violent fluctuations form the shocks which shift real aggregate
demand, that is, cause the main source of economic fluctuations in the real
economy.
Return
to the Consumption Function.
Marginal
Propensity to Consume (MPC) and the Multiplier:
MPC
= Change in C/
Change in Y
Multiplier:
any disturbance to investment expenditure will have a magnified impact on
aggregate output.
c
= marginal propensity to consume = Change in C/
Change in Y
Consumption
(C ) = (f)Y
Aggregate consumption is (mainly) dependent on the amount of aggregate income.
Change
in Y
= Change in I
(1/1-c)
The
size of the multiplier will depend on the value of c.
Spare
Capacity:
Employment
Multiplier:
Hence,
an increase in autonomous spending raises output and employment!
Interest
Rate Determination:
Also
differed with the Classical model
–
Liquidity
Preference
Demand
for Money:
Speculative
Demand for Money:
If
liquidity preference can vary, this undermines the classical postulate relating
to the stability of the money demand function.
This in turn implies that the velocity of circulation of money is liable
to vary.
Keynes
rejects the neutrality of money: