🏧History of Economic Ideas Unit 10 – Keynesian Revolution in Macroeconomics

Key Concepts and Theories

• Aggregate demand determines the overall level of economic activity in the short run
• Effective demand consists of consumption expenditure and investment expenditure
• Marginal propensity to consume (MPC) measures the proportion of additional income spent on consumption
  • MPC is less than 1, as some additional income is saved
• Marginal efficiency of capital (MEC) refers to the expected rate of return on investment
• Liquidity preference theory explains the demand for money based on three motives: transactions, precautionary, and speculative
• Multiplier effect amplifies changes in aggregate demand through successive rounds of spending
  • Multiplier is calculated as $1/(1-MPC)$
• Paradox of thrift suggests that increased saving during a recession can worsen the economic downturn

Historical Context

• Developed during the Great Depression of the 1930s, when classical economics failed to explain the prolonged economic downturn
• Keynesian economics challenged the classical assumption that markets automatically adjust to achieve full employment equilibrium
• The Great Depression saw high unemployment, deflation, and a severe contraction in output
• Classical economics advocated for minimal government intervention and believed in the self-correcting nature of markets
• Keynes argued that government intervention was necessary to stimulate aggregate demand and restore economic stability
• The Keynesian revolution marked a significant shift in economic thinking and policy-making

Major Contributors

• John Maynard Keynes, a British economist, is the primary architect of Keynesian economics
  • Published "The General Theory of Employment, Interest, and Money" in 1936
• Other notable contributors include Richard Kahn, who developed the concept of the multiplier effect
• Alvin Hansen, an American economist, popularized Keynesian ideas in the United States
• John Hicks and Paul Samuelson formalized Keynesian economics through the IS-LM model
• Post-Keynesian economists, such as Joan Robinson and Nicholas Kaldor, further developed and expanded Keynesian ideas

Keynesian Economic Model

• Focuses on the short-run relationship between aggregate demand and economic output
• Assumes prices and wages are sticky in the short run, leading to market disequilibrium
• Emphasizes the role of aggregate demand in determining the level of economic activity
  • Aggregate demand consists of consumption, investment, government spending, and net exports
• Keynesian cross model illustrates the relationship between aggregate expenditure and output
  • Equilibrium occurs when aggregate expenditure equals output
• IS-LM model integrates the goods market and the money market to determine equilibrium output and interest rates
• Phillips curve suggests a trade-off between unemployment and inflation in the short run

Policy Implications

• Keynesian economics advocates for active government intervention to stabilize the economy
• Fiscal policy, such as government spending and taxation, can be used to stimulate aggregate demand during recessions
  • Expansionary fiscal policy involves increasing government spending or reducing taxes
• Monetary policy, controlled by the central bank, can influence interest rates and money supply to stimulate or contract the economy
• Keynesian policies aim to smooth out economic fluctuations and maintain full employment
• Government investment in infrastructure and public works can create jobs and boost aggregate demand
• Progressive taxation and income redistribution can increase the marginal propensity to consume and stimulate economic growth

Criticisms and Debates

• Monetarists, led by Milton Friedman, criticized Keynesian economics for its focus on fiscal policy and neglect of monetary factors
• New Classical economists challenged the assumption of price and wage stickiness and emphasized the role of rational expectations
• Rational expectations theory suggests that economic agents form expectations based on all available information, limiting the effectiveness of policy interventions
• Crowding-out effect argues that increased government borrowing can lead to higher interest rates, reducing private investment
• Keynesian policies have been criticized for potentially leading to inflation and accumulation of government debt
• Supply-side economics emphasizes the role of incentives and tax cuts in stimulating economic growth

Impact on Modern Economics

• Keynesian economics has had a profound impact on modern economic thought and policy-making
• Many countries adopted Keynesian policies in the post-World War II era, leading to the "Golden Age of Capitalism"
• Keynesian ideas influenced the development of macroeconomic models and forecasting techniques
• New Keynesian economics combines Keynesian insights with microfoundations and rational expectations
  • Focuses on market imperfections, such as price and wage rigidities, to explain economic fluctuations
• Keynesian economics remains relevant in understanding and responding to economic crises, such as the 2008 global financial crisis
• Debate between Keynesian and other schools of thought continues to shape economic discourse and policy debates

Real-World Applications

• Keynesian policies were implemented during the Great Depression, such as the New Deal in the United States
  • Public works projects (Hoover Dam) and social welfare programs (Social Security) were introduced
• Post-World War II economic recovery in Europe and Japan was aided by Keynesian-inspired policies
• Keynesian stimulus measures were adopted during the 2008 global financial crisis
  • Governments increased spending and cut taxes to boost aggregate demand
• Quantitative easing, a form of monetary policy, has been used by central banks to stimulate economies during recessions
• Keynesian ideas influence the design of automatic stabilizers, such as unemployment insurance and progressive taxation
• Debates on fiscal stimulus and austerity measures often draw on Keynesian arguments
  • Proponents argue for increased government spending during downturns, while critics emphasize the importance of fiscal discipline