Keynesian economics developed against the background of the Great Depression of the 1930s. The effect of the Depression on the U.S economy can be seen in picture below, which shows the annual unemployment rates for the years 1929-1941. The unemployment rate rose from 3.2 percent of the labour force in 1929 to 25.2 percent in 1933, the low point for economic activity during the Depression. Unemployment remained at over 10 percent throughout the decade. Real gross national product fell by 30 percent between 1929 and 1933, and did not reach the 1929 level again until 1939.
U.S Unemployment Rate, 1929-1941
The British economist John Maynard Keynes, who write the book of General Theory of Employment, Interest and Money was the foundation of the Keynesian system, was more heavily influenced by events in his own country than those in the United States. In Great Britain, high unemployment started in the early 1920s and continued throughout the 1930s. High unemployment in Great Britain led to the debate among economists and policymakers over the causes and a true policy response to decrease unemployment. Keynes was one of the participant in this debate, during that he developed his revolutionary theory of macroeconomics.
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According to Keynes’s theory, high unemployment in Great Britain and the United States (as well as in other industrialized countries) was the result of a scarcity in aggregate demand. Aggregate demand was too low because of less in demand for investment. Keynes’s theory provided the basis for economic policies to overcome unemployment by stimulating aggregate demand. At the time of the Depression, Keynes agree with fiscal policy action, especially government spending on public works projects, to stimulate demand. More generally, the Keynesian theory advocates using monetary and fiscal policies to control aggregate demand.
Criticism of Keynesian against Classical View
Recognizing the weaknesses of the analysis carried out by experts of classical economics is an important boost to Keynes to undertake a new approach in his studying about the pattern of economic activities and also about how the level of economic activity and the level of national production that achieved is determined. In this effort, among others, Keynes showed some weaknesses of the classical economists view. Keynes did not approve of the most fundamental in the classical theory, namely that the use of full employment will always be created in the economy. Keynes argued the use of full employment is a rare condition, and it is caused due to deficiency of aggregate demand that exist in the economy. Differences of opinion among the very opposite of Keynes by classical economists is derived from their differences in the two following issues; Factors that determine the level of savings, investment and interest rates in the economy and the properties of docking between wage levels with the use of labour by employers.
Keynesian view about the level of savings and investment
Keynes did not agree with the view of classical economists who claimed that the saving rate and the investment rate is entirely determined by interest rates and changes in interest rates will lead to savings that created by the full level of employment will always be equal to the investment that made by the entrepreneurs.
Determinants of Savings
According to Keynes, the amount of savings by households is not dependent on the level of interest rates. The savings is especially dependent on the size of the household’s income level. The greater the amount of income received by a household, the greater the amount of savings would be made by household. Either the amount of household income does not increase or not decrease, a significant changes in interest rates will not cause a significant influence towards the amount of savings that will be made by the household. This means, in the opinion of Keynes, the amount of earned income by households will be the major determinant of the amount of savings that will be made by households, not the interest.
Determinants of Investment
Besides, Keynes did not believe that the amount of investment made by the entrepreneur is fully determined by the interest rate. Keynes still acknowledge that the interest rate plays a fairly decisive in the consideration of the entrepreneurs in investing. But in addition to these factors there are several other important factors, such as the state of the economy today, forecast future developments and technological developments extent applicable. If the level of economic activity in the present and in the future is to promote the economy is forecast to grow rapidly, so even if interest rates are high, the employer will do a lot of investment. Conversely, even though interest rates are low, investment will not be much done if capital goods are used in the economy at a rate much lower than the maximum capacity.
Keynesian view about the determinant of wage levels
The classical economists assume that assuming ceteris paribus, lower wages will not affect the marginal cost of production (cost to produce additional new products). However, according to Keynes, the decline in the wage rate will lower purchasing power. Decline in purchasing power will decrease spending and result in a decrease in the level of prices of goods and services. The fall in the level of demand for goods and services due to weak purchasing power will result in a reduction in production capacity, which means a reduction in the workforce. Thus the decrease in the wage rate cannot create full employment uses (Full Employment). Due to disagreements between Keynes with the above classical economists, Keynes also has its own view of the factors that determines a country’s level of economic activity. According to Keynes, determinants of a country’s economic activity is effective demand. Effective demand is the demand with the ability to pay for goods and services in the form of the economy. With the increasing amount of effective demand in the economy, increasing the level of production that will be achieved by the corporate sector. This situation by itself will lead to the increase in the level of economic activity, the use of labour and factors of production.
The classical economists based their predictions about full employment on a principle known as Say’s Law, the creation of French economist J. B. Say (1776-1832). According to Say’s Law, “Supply creates its own demand.” In other words, in the process of producing output, businesses also create enough income to ensure that all the output will be sold. In general, classical economists, notably Ricardo and Mill, gave support to Say’s Law, which they believed also held true for a monetary exchange economy. Money was nothing more than a convenient medium of exchange which enabled market participants to avoid the awkwardness and inconvenience of barter. If Say’s Law applies to a money-using economy, then the implication is that a market is guaranteed for whatever level of output is produced, although market forces will obviously lead to changes in the composition of aggregate output. If aggregate demand and aggregate supply are always guaranteed equality, then money is nothing more than a ‘veil’ covering the underlying real forces in the economy. Also, because of accepted in Say’s Law, they believed also that there was nothing to prevent the economy from expanding to full employment. As long as job seekers were willing to work for a wage that was no more than their productivity (their contribution to the output of the firm), profit seeking businesses would desire to hire everyone who wanted a job. There would always be adequate demand for the output of these additional workers, because “supply creates its own demand.”
Keynes’s Rejection of Say’s Law
Say’s Law, if accepted, makes macroeconomic demand management policies redundant. In the classical model a decision to refrain from current consumption is equivalent to a decision to consume more in the future. This decision therefore automatically implies that resources need to be diverted to the production of investment goods which will be needed to provide the flow of future consumption goods. An increase in saving automatically becomes an increase in investment expenditure via adjustment of the interest rate. In the classical model, saving is in effect just another form of spending. The principles underlying Say’s Law raised their head during discussions relating to anti-depression economic policy during the interwar period. Ralph Hawtrey, a strong advocate of the ‘Treasury View’, argued forcefully that public works programmes would be useless since such expenditures would simply ‘crowd out’ an equivalent amount of private spending. Such views only make sense in the context of a fully employed economy (Deutscher, 1990). A principal objective of writing the General Theory was to provide a theoretical refutation of Say’s Law, something Malthus over a century earlier had tried and failed to do. In Keynes’s model output and employment are determined by effective demand, and the operation of the labour market cannot guarantee full employment. The interest rate is determined in the money market rather than by saving and investment decisions. Variations in the marginal efficiency of investment bring about variations in real output via the multiplier effect and as a result saving adjusts to investment through changes in income. Hence in Keynes’s model any inequality between planned investment and planned saving leads to quantity adjustments rather than equilibrating adjustments of the rate of interest. By demonstrating the flaws inherent in wage and price flexibility as a method of returning the economy to full employment following a negative demand shock, Keynes effectively reversed Say’s Law. In Keynes’s world of underemployment equilibrium, demand creates supply!
Three Important Interpretations of Keynes
There are three important interpretations of Keynes which are the ‘hydraulic’ interpretation, the ‘fundamentalist’ interpretation, and the modified general equilibrium approach.
The ‘hydraulic’ interpretation
This is the orthodox interpretation of Keynes initiated and inspired by Hicks (1937), Modigliani (1944), Klein (1947), Samuelson (1948) and Hansen (1953). The IS-LM model formed the backbone of theorizing within this approach and it dominated thinking in the emerging neoclassical synthesis during the 1950s and 1960s. Samuelson’s famous textbook, Economics, first published in 1948, played a very important role here, popularizing Keynes with the aid of the 45° Keynesian cross diagram. Following Modigliani’s contribution, Keynesian economics was seen to be the economics of wage and price rigidities. The destabilizing impact of unstable expectations was played down in this approach. Although Keynesians such as Modigliani and Tobin worked on improving the micro foundations of Keynes’s model, a major weakness of hydraulic Keynesianism was the lack of a convincing reason for wage and price rigidities based on rational behaviour.
The ‘fundamentalist’ interpretation
This interpretation of the General Theory regards Keynes’s work as a frontal assault on neoclassical orthodoxy. Fundamentalists regard the influence of unstable expectations due to uncertainty as a key feature of Keynes’s work, particularly as expressed in Chapters 12 and 17 of the General Theory, where he discusses ‘The State of Long-Term Expectations’ and ‘The Essential Properties of Interest and Money’. Fundamentalists also point to Keynes’s (1937) Quarterly Journal of Economics article entitled ‘The General Theory of Employment’, which Keynes wrote in response to his critics, as evidence that the problems of decision making under conditions of uncertainty lay at the heart of his system. The key figures in this school include George Shackle (1967, 1974) and Joan Robinson (1962), although a very early statement can be found in Townshend (1937). Fundamentalists reject the hydraulic interpretation as a ‘bastardization’ of Keynes’s contribution. The ideas and development of this Post Keynesian school are explored in Chapter 8.
The modified general equilibrium approach
Coddington (1983) refers to this view as ‘reconstituted reductionism’ (reductionists are those economists whose method of analysis consists of ‘analysing markets on the basis of the choices made by individual traders’; see Coddington, 1983, p. 92). This approach initially received stimulus from Patinkin’s (1956) suggestion that Keynesian economics is the economics of unemployment disequilibrium and that involuntary unemployment should be viewed as a problem of dynamic disequilibrium. In Patinkin’s analysis, involuntary unemployment can exist in a perfectly competitive economy with flexible wages and prices. The emphasis given by Patinkin to the speed with which markets are able to absorb and rectify shocks shifted attention away from the degree of price and wage flexibility to the issue of coordination.