Keynes' Model of Output and Employment

Keynes' Model of Output and Employment

Income Flow

• National Income (NI) represents income payments for factors of production such as wages, rent, interest, and profit. It reflects the total income earned by all resource suppliers in an economy.

• Aggregate Expenditure (AE) represents the total spending on goods and services in an economy. It includes consumption, investment, government spending, and net exports.

Circular Flow

• In national income accounts, total spending (AE) always equals total supply (NI). This equality is a fundamental concept in macroeconomic accounting.

• AE = NI

Income Flow Diagram

• Leakages reduce income flow (savings, taxes, imports). These are diversions of income that are not spent on domestically produced goods and services.

• Injections increase income flow (investments, government expenditures, exports, transfer payments). These are additions to the circular flow of income and expenditure.

Leakages and Injections

• Leakages:

  • Savings (S): The portion of income not spent on consumption.

  • Taxes (T): Payments to the government.

  • Imports (M): Spending on goods and services produced abroad.

• Injections:

  • Investments (I): Spending by firms on new capital goods.

  • Government Expenditures (G): Spending by the government on goods and services.

  • Exports (X): Spending by foreigners on domestically produced goods and services.

  • Transfer Payments (TP): Payments from the government to individuals, such as social security or unemployment benefits.

Private Closed Economy

• Leakages: Savings (S)

• Injections: Investments (I)

AE and NI

• AE and NI are not always equal in the market because of leakages and injections. These discrepancies lead to changes in inventory levels.

• They become equal in national income accounts with the category of unplanned investment. This ensures that total expenditure is always equal to total income when accounting for changes in inventories.

• I = \text{planned investment} + \text{unplanned investment}

• If AE > NI,inventories decrease (negative unplanned investment). This indicates that demand exceeds production.

• If AE < NI, inventories increase (positive unplanned investment). This indicates that production exceeds demand.

• When AE = NI, inventories are constant (unplanned inventories = 0). This is the equilibrium condition.

Planned vs. Unplanned Investment

• Planned investment: Intended investment in plant, machinery, inventories, and residential real estate. This is the investment that firms plan to make.

• Unplanned investment: Unintended changes in inventories. This arises due to unexpected changes in sales.

  • Positive unplanned investment: Due to surpluses; AE < NI, Investment < Savings in a private closed economy. Firms have unsold goods, leading to increased inventories.

  • Negative unplanned investment: Due to shortages; AE > NI, Investment > Savings in a private closed economy. Firms sell more than expected, leading to decreased inventories.

National Income Accounts

• In national income accounts, AE = NI always. This is achieved by including unplanned investment in the accounting.

• I = \text{Planned Investment} + \text{Unplanned Investment}

Macro-Equilibrium

• AE = NI (total demand = total production/supply, unplanned investment = 0). This is the equilibrium condition where the total demand in the economy equals the total supply.

• Therefore, I = IP (planned investment). At equilibrium, actual investment equals planned investment.

Leakages = Injections

• Leakages: Savings (S), Taxes (T), Imports (M)

• Injections: Investments (I), Government Expenditures (G), Exports (X), Transfer Payments (TP)

Macro-Equilibrium in Private Closed Economy

• I = S

Macro-Equilibrium: Neoclassical View

• Aggregate Demand (AD) = Aggregate Supply (AS) with full and efficient employment of land, labor, and capital goods. This view assumes that the economy will naturally move towards full employment.

• Requires flexible prices. Prices adjust to ensure that markets clear and resources are fully employed.

Macro-Equilibrium: Keynesian View

• Equilibrium is possible where AE = NI, but not necessarily at full employment of all resources. The economy can be in equilibrium below full employment because of insufficient demand.

Keynes' Policy

• Advocates government intervention to secure equilibrium at full employment and price stability. Government spending and taxation policies can be used to influence aggregate demand.

Neoclassical Policy

• How to secure full employment equilibrium. Emphasis on policies that promote flexible prices and wages.

Keynes: Background

• Great Depression in the 1930s with 25% unemployment over five years. This historical context heavily influenced Keynes's economic theories.

Great Depression: Neoclassical Theory

• Dominant theory argued unemployment was temporary. The neoclassical economists believed that the economy would self-correct.

• External factors (government, labor unions) fixed wages, preventing them from reaching equilibrium. These rigidities prevented the labor market from clearing.

• Unemployment was considered voluntary (people not wanting to work at lower wages). People were choosing not to work at the prevailing wage rates.

• But wages were going down, challenging this view. The fact that wages were falling but unemployment remained high contradicted the neoclassical explanation.

Great Depression: Crisis in Neoclassical Theory

• Theory couldn't explain recessions. The prolonged and severe unemployment of the Great Depression could not be explained by the existing theories.

• New approach developed by economists like Michael Kalecki and John Maynard Keynes: macroeconomic approach. This new approach focused on aggregate variables and the role of demand in determining economic outcomes.

Keynesian Model of Output and Employment

• Keynes noted a significant flaw in the neoclassical theory: the assumption that aggregate demand would always be sufficient to ensure full employment. He argued that during the Great Depression, there was a persistent deficiency in aggregate demand, leading to prolonged unemployment and economic stagnation. This insight formed the basis of his model, which emphasized the role of government intervention to stimulate demand and restore full employment.