Lecture 7. Keynes’s General Theory
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1. Overview
2. Keynes’s General Theory
1. Overview
⑴ Keynes’s view
① Adam Smith’s “invisible hand” : because of flexibility in the labor market, high unemployment could not persist.
② The Great Depression of 1929 led to high unemployment persisting for more than ten years, and this assumption broke down.
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③ Keynes pointed out that a decline in aggregate demand is important for high unemployment.
④ In particular, among consumption (C), investment (I), and government spending (G), he emphasized the role of government spending.
⑤ Keynes favored a big government.
⑵ Assumption 1. Rigidity of price variables
① Keynes basically thought that price variables are rigid.
② In particular, he assumed that wages have downward rigidity due to factors such as the period of employment contracts and the influence of labor unions.
○ When there is excess demand for labor, nominal wages can rise easily.
○ When there is excess supply of labor, nominal wages cannot fall easily.
⑶ Assumption 2. Imperfect information
① Labor demand : a function of the real wage
② Labor supply : a function of the nominal wage
③ (Reference) In other words, he viewed workers as thinking mainly in terms of nominal wages, and thus falling into money illusion.
⑷ Assumption 3. Existence of idle capacity
① He viewed the economy as being in a recession, so even if output is increased up to the full-employment level, production costs do not rise.
② Even if aggregate demand increases and aggregate supply increases accordingly, the assumption that prices are fixed may still be valid.
③ If this is assumed in the extreme, a horizontal AS curve is derived.
⑸ Assumption 4. Principle of effective demand
① Basically, Keynes’s General Theory assumes an economic recession.
② Under a recession, sufficient production is not achieved due to a lack of aggregate demand.
③ He argued that if aggregate demand increases, idle capacity declines and national income (total output) increases without a rise in prices.
④ (Reference) In a boom, the level of national income can be determined by aggregate supply.
⑹ Keynes is suitable for recessions and the short run, while classical theory is suitable for booms and the long run.
2. Keynes’s General Theory
⑴ Step 1. Equilibrium in the goods market
① Consumption demand (C)
○ Disposable income : (Note) This means that it is possible to dispose of (use), not that it literally means “dispose.”
○ Absolute income hypothesis : In the simplified Keynesian model, autonomous consumption (C0) is set to 0.
○ Marginal propensity to consume (MPC, marginal propensity to consume) : the proportion by which consumption increases when disposable income increases by 1 unit.
② Investment demand (I)
○ Investment is broadly classified into equipment investment, construction investment, and inventory investment.
○ The classical school emphasized the interest rate, but Keynes emphasized entrepreneurs’ animal spirits and national income more.
○ Investment function
○ I0 : autonomous investment demand. Investment demand that occurs regardless of the interest rate or national income.
○ iY : induced investment demand. In the simplified Keynesian model, this is not included.
③ Government demand (G) and net exports (X-Q)
○ Government spending is determined by policy; it is constant regardless of national income, and its magnitude is given.
○ In the simplified Keynesian model, government demand and net exports are set to 0.
④ Aggregate demand curve (AD curve) : for the aggregate demand level E,
○ The aggregate demand curve is drawn as relatively flat : because the marginal propensity to consume is less than 1.
⑵ Step 2. Equilibrium in the money market
① Overview
○ (Reference) In the IS–LM model, the aggregate demand curve is derived by analyzing the goods market and the money market.
○ In Keynes’s General Theory, the aggregate demand curve can be derived from the goods market alone.
② Determination of the interest rate
○ (Reference) Interest rate determination in the classical school
○ Loanable funds theory : the interest rate is determined by the supply and demand for funds in the real sector (i.e., saving and investment are determined).
○ The IS curve is relatively flat; the LM curve is relatively steep.
○ Interest rate determination in the Keynesian school
○ Liquidity preference theory : Keynes viewed the interest rate as being determined by the demand and supply of money.
○ Keynes assumed a liquidity trap.
○ The IS curve is relatively steep; the LM curve is relatively flat.
⑶ Step 3. Aggregate supply curve : it is sufficient to satisfy either Assumption 1 or Assumption 2
① Assumption 1. Money illusion : When expected prices (Pe) and actual prices (P) differ, workers mistake a change in the nominal wage W = P·w for a change in the real wage (i.e., static expectations about the price level).
○ Labor supply : even if the price level rises, the labor supply curve does not change as long as workers do not revise their expectations.
○ Labor demand : firms, as labor demanders, face the real wage, so if prices fall, the labor demand curve shifts left.
○ Conclusion 1. Labor supply is a function of the nominal wage; labor demand is a function of the real wage.
○ Conclusion 2. Equilibrium employment is determined entirely by labor demand.
③ Assumption 2. Downward rigidity of nominal wages
Figure. 1. Downward rigidity of nominal wages
○ Reason 1. Labor contracts are not made continuously, but are concluded for fixed time periods.
○ Reason 2. In the labor market, workers do not accept reductions in nominal wages (downward rigidity in the labor market).
○ Reason 3. When quantities are small, there is idle capacity, so even if quantity increases, nominal wages do not increase (to be revised later).
○ Labor supply : because of downward rigidity in nominal wages, labor supply does not change even if prices fall.
○ Labor demand : firms, as labor demanders, face the real wage, so if prices fall, the labor demand curve shifts left.
○ Conclusion 1. Labor supply is a function of the nominal wage; labor demand is a function of the real wage.
○ Conclusion 2. Equilibrium employment is determined entirely by labor demand.
④ Aggregate supply curve (AS curve) : for the aggregate demand level E,
○ The aggregate supply curve is represented by a 45° line.
○ Reason : if there is demand for goods or services, supply is automatically met.
○ Once the potential national income level (Y*) is reached, the supply curve becomes vertical.
○ Potential national income level : the level of national income at full employment.
○ Reason : since the economy is already at full employment, even if aggregate demand increases, output cannot increase because there are no available resources.
⑷ Step 4. Determination of equilibrium national income
Figure. 2. Determination of equilibrium national income under Keynesian theory]
① In the simplified Keynesian model, government spending G and net exports X-Q are set to 0.
② Saving ＞ investment : investment decreases in the next period.
③ Saving ＜ investment : investment increases in the next period.
④ Saving = investment : production is unchanged; i.e., equilibrium is achieved.
⑤ Output gap : shown in orange. Equilibrium national income − potential national income.
⑸ Conclusion
① Interpretation 1. Boom and recession
○ Boom : prices increase. The excess effective demand is called the inflationary gap.
○ Why prices rise : as new capacity is expanded, unit supply costs increase.
○ Recession : the shortfall of effective demand is called the deflationary gap.
○ Keynes basically assumed an economic recession and diagnosed the cause as insufficient demand.
○ If government spending is increased, effective demand rises; thus, he thought that increasing it by the size of the deflationary gap would return the economy to a normal state.
○ (Reference) Keynes considered government spending to be the only solution in a recession.
② Interpretation 2. Multiplier theory
○ Multiplier : (increase in equilibrium national income) ÷ (increase in autonomous expenditure)
○ The multiplier equals the inverse of the slope of the Y vs. AD curve.
○ Algebraic interpretation : G increases → Y increases → Yd increases → Y increases → Yd increases → ···
③ Interpretation 3. Effect of government spending : for proportional tax T = tY and an exogenous variable G,
④ Interpretation 4. Paradox of thrift
○ When the economy is bad, each individual increases saving → this promotes (deepens) the recession.
○ An error where individual rationality does not coincide with rationality for society as a whole.
○ With similar logic to multiplier theory, if induced investment exists, national income decreases more quickly.
○ Case 1. Developing countries : because funds are scarce, saving is sufficiently transformed into investment, so saving is socially a virtue.
○ Case 2. Advanced economies / during a recession : due to a lack of investment opportunities, an increase in saving does not lead to an increase in investment. The paradox of thrift.
Entered: 2020.09.26 16:16