CHPTER Two: THE KEYNESIAN SCHOOL OF THOUGHT

INTRODUCTION
The Keynesian system of ideas is one of the most significant schools of economic thought in 20 th
century. The school begun with the publication of “General theory of Employment, Interest and
Money”. Of Marald Keynes in 1936 and remains a major thought in orthodox economics today.
It arouses out of the condition of the time such as great depression and failure of the neo classical
school theories. Keynes idea succeeded in short time, in revolutionizing the entire thinking
process in economics. For this reason it is termed as “Keynesian Revolution”. It is also called as
“New economics” because he integrated the economy as incorporating both physical and
monetary aspects, Furthermore, he introduced the techniques of presenting economy in terms of
international income and employment and the determinant of demand and supply functions
rather than individual price determination. It stimulated investigations of price determination in
which the neutrality or money was questioned and income-expenditure approach was brought to
the force.
The school was criticizing many of principles and theories of neo-classical thought. Keynesian
economics advocates a mixed economy; predominantly private sector, but with a large role of
government and public sector. The school argues that private sector decisions sometimes lead to
inefficient macroeconomic outcomes and hence advocates active policy responses by state. The
policy response includes monetary policy actions by the central bank and fiscal policy actions by
the government with the major emphasis on the latter.

The school of thought served as economic model during the latter part of the Great Depression,
World War II, and the Post-War Golden Age of Capitalism, 1945–1970, though it lost some
influence following the stagflation of the 1970s. As a middle way between laissez-faire
capitalism and socialism, it has been and attacked from both the right and the left. In this
chapter, we will see the works of Keynes and basic historical background of the Keynesian
thought.

Major tenets, Validity, beneficiaries of the Keynesian school

I. Major tenets of the Keynesian school
Some of the major notions of Keynesian school of thought are as follows:
1. Macroeconomics emphasis: Keynes and his followers concerned with the
determinants of total or aggregate amounts of consumption, income, saving, output
and employment.
2. Demand orientation: Keynesian objective was to analyze the determination of
output and employment in the economy. Keynesian stressed the importance of
effective demand (now called aggregate expenditure) as the immediate determinant
of national income, output and employment. He used the concepts of aggregate
supply function and aggregate demand function to compute effective demand. He
assumes given techniques of production, resources and factors cost per unit, then
the amount of employment both in each individual firms and industry in the
aggregate, depends on the amount of proceeds which the entrepreneurs expect to
receive from the corresponding output. If the aggregate supply comes from the
employment of N men, then aggregate supply function is given by Z: f(N).
Similarly, let D be the proceeds which the entrepreneurs hope to receive if they
employ N men, then aggregate demand function become D: f(N). The level at
which D intersect Z will be termed as effective demand. It has a range of values and
any specific value.

For him aggregate expenditure consists of the sum of consumption, investment,

government spending and net export. That is, effective demand establishes the
economy’s actual output that would exist if there were full employment (potential
output). Hence, effective demand is composed of four quantities; the amount which
the community is expected to spend on consumption and the amount which it is
expected to spend on new investment,amount government expected to spend, and
expenditure on export. Full employment is that level of economic activity beyond
which the real output and therefore employment cannot be increased for whatever
reasons. Firms produce a level of output that they expect to sell. But aggregate
expenditure is insufficient on the part of economic agent to buy all the output
produced. As unsold output accumulate, firms lay off the workers and cut back
output.
3. Instability in the economy: according to Keynesians, the economy experience
recurring booms and bursts as the level of planned investment spending is erratic.
Change in investment plans causes national income and output to change by amount
greater than the initial changes in investment. Equilibrium level of investment and
saving can be achieved through change in national income. Investment spending is
determined jointly by the rate of interest and marginal efficiency of capital (MEC),
or the expected rate of return above the costs on new investments. The MEC
depends on the expectation of future profits and supply price of capital. Interest rate
depends on people’s liquidity preference and quantity of money in the system. The
expected rate of profit from new investment is unstable and therefore one of the
most important causes of business fluctuations.
4. Wage and price rigidity: Keynesians pointed out that wages tend to be inflexible
downward because of institutional factors such as union contracts, minimum wage
laws, implicit contract between workers and employers. Hence, economic
agents/firms respond to changes in demand by changing level of employment and
output rather wages. Accordingly, in the period of slack aggregate demand firms
respond to lower sale by reducing production and laying down workers not by
cutting wages. Prices are also sticky downward. The decline in effective demand
initially causes reductions in output and employment rather than declines in the
price level.
5. Active fiscal and monetary policy: Keynesian advocated that the government
should intervene in operation of the economy actively through appropriate fiscal
and monetary policies to promote full employment, price stability and economic
growth. For instance, to combat recession or depression, government should either
increase its spending or reduce taxes as they induce effective demand. Government
should also increase the money supply to derive down interest rate to bolster
investment. To counter inflation government should reduce its own spending
through increasing taxes that reduce private consumption spending, or reduce the
money supply to raise interest rate which will dampen excessive investment
spending.
Keynes and his contribution
CONSUMPTION FUNCTION
The system of ideas that Keynes developed in the General Theory consists of several interrelated
elements, the first of which is the consumption function. According to him, the amount which the
community would like to consume depends upon the expected income for the period under
consideration. Keynes used a “fundamental psychological law” to explain the relationship
between consumption and income. The fundamental psychological law depends on a prior from
our knowledge of human nature and from the detail facts of experiences. The general psychology
of the people is that when they find an increase in aggregate real income, there is a tendency to
increase aggregate consumption too but not with the same rate. The basic reason for these lies in
the psychological constitutions of the community in which the member get accustomed to the
existing levels of consumptions. This psychological law is a statement of common experience
based up on three propositions:
 When aggregate income increases consumption expenditure also increases. The reason is
that as a person’s income increases, more and more wants are satisfied.
 When income increases the additional income is spent between consumption and saving.
It is also a common experience that when income increases, people spend only a portion
of their additional income and save the remainder.
 When income increases, both consumption and saving increase, but consumption
increases less than proportionately.

The three propositions form Keynes’ psychological law of consumption and it is based on the
following assumptions: (i) the habits of people regarding spending do not change. The propensity
to consume is assumed to be stable. That is, there are only income changes, whereas the other
variables like price movements, income distribution, growth of population etc., remain more or
less constant. (ii) The conditions remain normal and there are no abnormal conditions like
hyperinflation or war. (iii) laissez-fair economy.

With this Keynes explained the concepts of propensity to consume namely average propensity to
consume (APC) and marginal propensity to consume (MPC).The average propensity consume is
the ratio of absolute consumption to absolute income i.e., C/Y. Marginal propensity to consume
is the ratio of change in consumption to change in income. It is positive and less than one,
MPC=C/Y and 0<MPC<1.The other component of personal income is saving. According to
Keynes saving is a positive function of income. S=f(Y).The marginal propensity to save (MPS)
is greater than zero and less than one.( MPS=S/Y and 0<MPS<1) Then MPC+MPS=1. Keyns
believe that consumption function is a fairly stable one, and with marginal propensity to
consume less than one, it follows that with increasing income, the gap between income and
consumption would widen as expected income increases.

According to Keynes two principal factors; the subjective factors and objective factors influence
consumption function. The subjective factors are endogenous or internal and objective factors
are exogenous or external to the economic system. The subjective factors are the psychological
nature of human race. There are eight psychological individual motives, which determine
individuals spending. They are: the desire to keep reserves for emergency, the desire to provide
for old age and sickness, the desire to enjoy an enlarged future income through interest and
appreciation, the desire to improve standard of living, the desire to have financial independence,
the desire to do forward trading and speculation, the desire to bequeath a fortune, the desire to
satisfy a purely miserly instinct. They are the outcome of individual and business motives. These
subjective factors remain constant during the short run and keep the consumption function stable.

The objective factors are ; change in the wage level, windfall gains or losses, change in the fiscal
policy, changes in expectations, changes in the rate of interest, financial policies of corporations,
holding of liquid assets, the distribution of income, attitude toward saving, duesenberry
hypothesis, selling effort, changes in relative Prices, change volume of wealth, demographic
factors, permanent income, consumer durables, wealth effect, etc.
INVESTMENT
Keynes made distinctions between economic and financial investment, which consists of
purchase of stocks, bonds and other financial instruments. He defined economic investment as
the purchase of capital goods. To Keynes investment refers to real investment which adds to
capital equipment. Real investment is to be increased to maintain stable national income growth.
It is real investment that leads to increase in the level of income and production by increasing the
production and purchase of capital goods. Financial investment is not investment as it does not
represent directly purchase of capital goods. Financial instruments simply are alternative
depositories for people’s saving.

Business undertakes investment with expectation that they will add to profits. When a business
buys a piece of capital equipment, it purchases the right to the series of perspective returns which
it expects to earn from selling its output after deducting the running expenses during the life of
the asset. Keynes called it marginal efficiency of capital. Marginal efficiency of capital (MEC)
refers to the expected profitability of a capital asset (new investment). It may be defined as the
highest rate of return over cost expected from the additional unit of a capital asset.

The size of the expected income stream gain depends on the productivity of the piece of capital,
the price at which the firm can sell the added output, wage and material expense that result from
using a piece of capital. In other word, the MEC in turn depends on two factors: the prospective
yield of the capital asset and the supply price of the capital asset. The prospective yield of a
capital asset is the total net return from the asset over its life time. The supply price of an asset is
the cost of producing a brand of new asset of that kind and not the supply price of an existing
asset. It is referred to as replacement cost. The marginal efficiency of capital is the percentage of
expected return from a given investment on a capital asset. For instance, if the supply price of a
capital asset is Br. 20,000 and its annual yield is Br. 2000, then the marginal efficiency of this
asset is 2000/20000 x100 which is equal to 10 percent.

For him, MEC equal to the rate of discount that makes the present value of the series of expected
returns just equal to the supply price of the capital asset.This may be put in the form of an
equation. This is expressed mathematically as,

……………………………3
Where Ks is the supply price of capital, R i is the expected return in a particular year, R 1 R2…. ….. Rn
are the prospective yields or the series of expect annual returns from the capital asset in the years
1, 2….n, and r is the rate of discount. From the above equation there is an inverse relationship
between the supply price and MEC. Given the income flow, the higher the supply price of the
capital asset, the lower will be the rate of discount. The various factors that bring about shifts in
MEC are: endogenous factors and exogenous factors. In this way, discounted prospective yields
of capital asset can be brought into equality with the current supply price. This leads to an
inverse relationship between investment and interest rate. Investment will take place only if the
net prospective yield of an asset is greater than its supply price.
The short run factors are:
 Expected demand: If the demand for the product is expected to be high in future, the
MEC will be high and investment will increase. On the other hand, if the demand for
the product is expected to decline in future the MEC will be low and investment will
fall.
 Current and future costs and prices expectation: Businessmen while making
expectations take into account the current state of affairs regarding costs, prices,
returns etc. If expectations are high, the MEC is bound to be high for new projects of
investment. If the costs are expected to decline and if the prices are expected to
increase, the expectation of the producer will go up. On the other hand, if the costs
are expected to go up and prices are to decline the MEC will receive a set back and
the investment will be less.
 Propensity to consume: If the propensity to consume is more then the volume of
investment will be more and vice versa.
 Changes in income: An increase in the level of income will stimulate investment
while a decrease in the level of income will discourage investment.
 Level of confidence: During period of optimism the businessmen over estimate and
boost the MEC of capital assets. During period of pessimism they under estimate and
reduce the MEC of capital assets.
The long run factors which influence the MEC are as follows:
 Population growth: A rapidly growing population means a rapid increase in the
demand for all types of goods.
 Development of new areas: When a new area is developed, heavy investments in all
fields such as agriculture, industries, electricity, housing etc., are to be undertaken.
 Technological factors: New invention or new discovery may necessitate the
installation of new machineries in the industrial enterprise and encourage investment.
  Productive capacity of this industry: If the existing capacity is fully utilized then any
further increase in demand will be met by making fresh investment on new capital
equipment.
 Level of current investment: If the existing level of investment is already high, there
will be little scope for further investment and vice versa.

LIQUIDITY PREFERENCE THEORY

Keynes liquidity preference theory propounded how rate of interest is determined. In Keynesian
terminology the rate of interest is the price paid for parting with cash or liquidity and using it for
investment in assets. It is the price which equilibrates the desire to hold wealth in the form of
cash with the available quantity of cash. In the Keynesian sense the rate of interest is determined
by the demand for and the supply of money.

Supply of money: the total quantity of money in the country for all purposes at any time. It is
one determinants of the rate of interest. Though, the supply of money is a function of the rate of
interest yet it is considered to be determined by the monetary authorities. The supply of money is
taken as perfectly inelastic or it is fixed. With a fall in the quantity of money, the rate of interest
would rise.

Demand for money: the demand for money is the second determinant of interest rate. Keynes
coined a new term liquidity preference by which his theories of interest is the desired to hold
cash. The preference of an individual or a group of individuals to hold cash as assets is known as
liquidity preference. The rate of interest is, thus, the price paid to individual for parting with his
liquidity preference. The higher the liquidity preference, the higher will be rate of interest. And
the lower the liquidity preference, the lower will be the rate of interest that will be paid to the
cash holders. This preference may be for meeting: -
 The daily needs of life or the ‘transaction motive
 Contingent needs; and
 Business needs which chiefly influenced by the strengths of the speculation motive
 I. Transaction Demand for Money
It is the demand by firms and individuals, households of holding money to finance day-to-day
transactions. People are paid wages weekly or monthly. But they spend every day a particular
amount of cash. Hence, they have to keep certain amount of money to carry on their day to day
activities. The business motive refers to the needs of the firm to keep cash in order to meet their
current needs like payment of wage, purchase of raw materials, transport charges etc. The
amount of money which consumers need for transactions purpose mostly for buying and selling
of goods and services depends on the level of their money income, their spending habits and the
time interval after income is received. Given their spending habits and the duration of the pay
period, the higher the money income, the higher will be the amount of money which will be
required for the transaction purpose. Symbolically, M= f(Y) Where M is the transaction demand
for money and Y is income. Consequently, the transactions demand for money and the level of
money income are positively correlated.

According to Keynes, the transaction demand for money was interest inelastic. This is because
unlike the idle money, the money needed to meet the transaction motive cannot be invested for a
long period even if the rate of interest is high. The transaction demand for money is not
responsive to change in interest rate up to certain limit. It is, however, possible to expect the
transactions demand for money to vary inversely with changes in the rate of interest. If people
are willing to invest money it should be done for a very short period. Therefore, unless the
interest is the highest, transaction demand for money will not be responsible to the changes in the
rate of interest.

I. Precautionary Motive
Apart from demanding money for transaction purposes, individuals and businessmen require
money to meet unforeseen contingencies. One finds it convenient to hold some cash on which he
can lean readily when some unforeseen need arises; like sickness, accidents, fire, theft, and
unemployment. There is the demand for money which arises out of uncertainty and the desired
not to be caught short of ready cash. The amount of cash needed for these motives depends on
the psychology of the individual, his views about the future level of income, etc. This demand
for money is also likely to depend on national income: the higher the total value of transactions,
 the more money will be needed to guard against unexpected transactions. Both the transaction
and precautionary motives for holding cash depend on income. Keynes put them together. Rate
of interest also influence the precautionary demand. The rate of interest is the opportunity cost of
holding money. Thus, if interest rate rises, consumers and firms may be tempted to reduce their
precautionary holdings and hold interest-bearing assets instead.

II. Speculative Motive

The third and the most important motive is the speculative demand for money. It was in his
analysis of the speculative demand for money that Keynes differed fundamentally from his
predecessors. It is the demand for money as a financial asset part of a wealth portfolio. People
keep cash because they want to take advantage of the changes in the prices of bonds and
securities. Keynes argued that individuals would have some expectations or conceptions of the
‘normal” rate of interest. The amount of cash which the people wish to hold for speculative
purpose depends on the expected change in the rate of interest. L = f(r) where L is the speculative
demands for money and “r” is the expected change in the rate of interest. The higher the rate of
interest, the less shall be the demand for money in the form of idle cash balances and vice-versa.

If the people expect the price of the bonds and securities to rise, they like to purchase them with
the money they have. On the other hand, when people feel that the prices of bonds and securities
are going to fall in the future they will keep more cash. The rate of interest is inversely related
with the price of bonds and securities. If the prevailing interest rate is low, the theory predicts a
low demand for bonds and consequently, a higher demand for speculative money balance. In this
way, Keynes derived an inverse relationship between the rate of interest and the speculative
demand for money.

The Concept of Liquidity Trap

Keynes liquidity theory explains the implication regarding the infinite interest elasticity of the
liquidity preference curve. The liquidity preference curve represents the demand for money
arising out of transaction, precautionary and speculative motives. At low rate of interest, people’s
liquidity preference increases so much so that even an appreciable increase in the supply of
money does not result in the further reduction of rate of interest. An important inference from
liquidity trap is that the rate of interest cannot be reduced below a certain level even though such
a reduction is essential. It is because of this liquidity preference we would find that the rate of
interest would not fall to zero.

Keynes re-analyzed the effect of the interest rate on investment. In the classical model, the
supply of funds (saving) determined the amount of fixed business investment. Since all savings
was placed in banks, and all business investors are in need of funds, went to banks, the amount
of savings determined the amount that was available to invest. To Keynes, the amount of
investment was determined independently by long-term profit expectations and to a lesser extent
by the interest rate. The latter opens the possibility of regulating the economy through money
supply changes, via monetary policy. Under conditions such as the Great Depression, Keynes
argued that this approach would be relatively ineffective compared to fiscal policy. But during
“normal" times, monetary expansion can stimulate the economy.

MULTIPLIER
The concept of multiplier was first developed by R.F. Kahn. Keynes borrowed this concept from
him and developed income and investment multiplier. To him, investment multiplier expresses
the relationship between an initial increase in investment and the final increase in national
income. Multiplier is the ratio of a change in income to a change in investment. That is K=
I/Y and, where Y= income, K= multiplier I= investment. The value of multiplier depends on
marginal propensity to consume. The ratio between an increment of investment and the resultant
increment of the total income, the creation of one gives rise to a number of waves. Similarly, in
economy each injection of money gives rise to a series of new money. The multiplier is, thus, a
number by which the increase in investment must be multiplied in order to give the resulting
increase in income. If investment of Birr 1 causes an increase in the total income by Birr.3, then
the multiplier is 3. In case the increased income amount to Br 2 is the multiplier is 2. Thus
multiplier, in short, is a numerical co-efficient, indicating how great an increase in income result
from each increase investment.

How and why the increase in the total income is more than proportionate to the increase in the
investment? Because, with each investment, the expansion in production and national income is
much more than the primary investment. A pan of increased income will be spent by the wage
earners and by the recipients of profits and interest. Increase in receipt also increased income to
others in the economy. If the total of these secondary incomes was immediately spent, the
increase in second income would be so rapid at each turn-over that it would result in
maximization of income and full employment. Thus increased income will again be spent and
the process will go on repeating. If the process continues. At each step, the increase in spending
is smaller than in the previous step, so that the multiplier process tapers off and allows the
attainment of equilibrium. This story is modified and moderated if we move beyond a "closed
economy" and bring in the role of taxation. To him tax payments at each step reduces the amount
of induced consumer spending and the size of the multiplier effect.

Keynes explained that neither savings nor investments are functions of interest rate. Savings
depend on the capacity of interest of the people to save and this capacity is determined by
income. So S= f(y) and not interest rate. Just if the rate of interest is high, people will not starve
and save money when their are low. Investment is also not a function of interest rate, the rate of
return or profit which determines the investment. Investment is a function of MEC and not so
mere interest rate flexibility cannot bring about an between savings and investment.

The concept of multiplier establishes a precise relationship between aggregate income and the
rate of investment (which is function of marginal propensity to save), assuming the marginal
propensity to consume remain the same. The multiplier explains the level of employment
expected from a given fluctuation in investment. This concept gives an insight into the working
of the economy and the part played by the psychological desire among men to save or consume.
To him, savings during depression are likely to make depression worst and reduce the level of
income. High consumptions and high investment should, however, go hand in hand and should
not compete with each other. This is why Keynes thought that government spending on
productive purposes may produce or multiplied increase in employment.

The concept of multiplier plays an important role in understanding the nature of cyclical
fluctuations in income and other macro variability, the process of income propagation and policy
making. To Keynes knowledge of multiplier is of supreme importance not only in analyzing the
course of business cycles but also in devising an ant cyclical policy to smoothen the business
fluctuation in the working of the economy. The concept of multiplier has brought about a
revolution not only in economic theory but also in policy making at the state level.
SAVING -INVESTMENT EQUALITY
The simple Keynesian model of income and employment determination can be studied either
through the aggregate income or expenditure approach. According to Keynes, there is
definitional equality between saving (S) and investment (I). In economy, income (Y) is
distributed between consumption (C) and saving (S). Investment is that portion of the aggregate
output which is in excess of the aggregate value of consumption goods. Likewise, saving is the
excess of income over consumption expenditure. Hence, saving must be equal to investment. In
so far as both are equal to the excess of output and income over consumption expenditure. The
equality of saving and investment is
Y= C+S => I= Y-C => S= Y-C
an essential prerequisite for the establishment of equilibrium the economy. The economy will be
in a state of equilibrium where saving is equal to investment, because what the community
withdraws from the aggregate income in the form of saving, added to it in the form of investment
expenditure. The equality between saving and investment is the resultant of changes in the level
of income. If investment exceeds saving, then income will rise till the saving out of the
increased income is equal to the increased investment. If, on the other hand, investment
decreases, the income will also decrease till the saving out of the reduced income is equal to the
diminishing investment.

In a situation, where S= I the level of economic activity remains stable as the producers are left
with no valid grounds to change the volume of output and employment in the economy. To
Keynes, excessive saving, i.e. saving beyond planned investment, was a serious problem that
encourages recession or even depression. Excessive saving results perhaps due to falling
consumer demand, over-investment in earlier years, or pessimistic business expectations, etc.
This may be because of falling investment, if saving does not immediately fall in steps
investment, liquidity. Equilibrium may not necessarily be at full employment level. It may be at
level less than full employment. It is quite possible for the saving-investment equality to be
established at the underemployment equilibrium level of the economic system.
THEORY OF MONEY AND PRICES

The classical economists had rigidly separated the monetary theory from the general economic
theory. For them, the monetary theory was only the theory of prices. According to them,
monetary expansion led straight to an increase in the price level, without affecting out put, and
employment in existence. It is on this account that they established a direct link between
monetary expansion and the price level.The same thought were there with Keynes before 1930s.
Keynesian analysis of price is quite close to classical analysis. They agree with the orthodox
views that increase in the quantity of money in circulation leads to an increase in the price.

It was in 1930 that his old conception of the monetary theory underwent a change. From a
monetary theory of prices, he shifted to a monetary theory of output. He reformulated quantity
theory and spotlighted the process of causation and the factors determining the value. Keynes has
differed from traditional economists in the process through which this effort is caused. Keynes
tried to fill the gap. He pointed out that there existed only an indirect relationship between price
and the quantity of money. The changes in the quantity of money are influenced by the rate of
interest, which in turn, affected investment, income, output and prices. Monetary expansion led
first to an increase in the output. As the output continues to expand, certain new factors come
into existence which leads to a rise in costs. The rise in costs due to the inelastic supply of
certain factors of production. The net result is that a successful integration of the quantity theory
of money with the theory of output and the theory of value.

According to him, the finding out of the exact process through which the quantity of money
affects the price level, would involve the following measures;
a) Finding the relation between money and aggregate demand
b) Assessing the effect of changes in aggregate demand on output and
c) Taking into account, the change in the wage rates.
Increase in the supply of money is likely to increase the availability of funds to a certain extent,
for speculative purposes. An increase in money supply tends to lower the rate of interest and
increase the demand for investment, which ultimately leads to an increase in income,
employment and output. This increased output can only be possible at an increasing cost beyond
a contain point. Wages form the most important constituent of the cost of production. During the
period of expanding output, labor will become increasingly scarce and the wage rates will be
depending on the bargaining capacity of the laborers.

It may be possible that a change in money wage rates may cause a change in the investment.
Neo-classical theory supports that the two main costs that shift demand and supply are wage and
money. Through the distribution of the monetary policy, demand and supply can be adjusted. If
there were more labor than demand for it, wages would fall until hiring began again. If wage
rate decline, the rate of real investment can be affected in three Ways: in the first instance, affect
the business confidence. The individual businessmen may think that a cut in the money wage rate
reduces their costs. On the other hand, a cut in wage rates and prices increase the real burden of
the debt of the entrepreneurs. A cut will stimulate demand for exports and lead to increased
consumption of home goods as compared to foreign goods. This would result in an increase in
the real investment and finally in the real income and total employment in the currently.
Similarly, the marginal efficiency of capital is not changed by a change in money wage rat.

A rise in money wage rates would lead to an opposite situation. It may be possible that these
effects may be neutralized by corresponding change in the wage rates of exchange rates in other
countries. A change in the money wage rates, prices and money incomes brings out a change in
the demand for cash balances for transportation purpose, in the same direction. If the quantity of
money in circulation remains the same, a reduction in the money wage rates would leave a larger
supply of money to satisfy the demand for cash balances. The rate of interest would fall and thus,
the rate of real investment would increase. Likewise, an increase in money rate would increase
the interest rate and diminish the rate of real investment. This is how Keynes could justify the
relationship between money wage rates in a closed economy.

The problem of greater depression was differently interpreted by classical and Keynesian .To
classical theory, economic collapse as simply a lost incentive to produce. To Keynes, the
determination of wages is more complicated. First, he argued that it is not real but nominal
wages that are set in negotiations between employers and workers, as opposed to a barter
relationship. Second, nominal wage cuts would be difficult to put into effect because of laws and
wage contracts. Even classical economists admitted that these exist. However, to Keynes, people
will resist nominal wage reductions, even without unions, until they see other wages falling and a
general fall of prices.

Keynes also argued that to boost employment, real wages had to go down: nominal wages would
have to fall more than prices. However, doing so would reduce consumer demand, so that the
aggregate demand for goods would drop. This would in turn reduce business sales revenues and
expected profits. Investment in new plants and equipment already discouraged by previous
excesses and would then become more risky, less likely. Instead of raising business expectations,
wage cuts could make matters much worse. Further, if wages and prices were falling, people
would start to expect them to fall. This could make the economy spiral downward as those who
had money would simply wait as falling prices made it more valuable rather than spending.

KEYNES THEORY OF TRADE CYCLES

Keynes developed the theory of trade cycle thought it was not a complete theory of trade cycles.
According to Keynes, fluctuations in economic activities are related to demand. More
specifically to effective demand which is composed of consumption and investment expenditure.
Therefore, changes in total expenditure, i.e., consumption and investment expenditures affect
effective demand and bring about fluctuation in economic activity. As consumption expenditure
is more or less stable, it is the fluctuation in investment expenditure which is responsible for
change in output, income and employment. These fluctuations are termed as Trade cycle for
Keynes.

Investment depends on rate of interest and marginal efficiency of capital. Since rate of interest is
more or less stable, marginal efficiency of capital determines investment. Efficiency of capital
depends on two factors; prospective yield and supply price of the capital asset. An increase in
MEC will create more employment, output and income leading to prosperity. On the other hand,
a decline in MEC leads to low employment and fall in income and output,hence it results in
depression.

Trade cycle can be described and analyzed in terms of the fluctuations of the marginal efficiency
of capital relative to the rate of interest. During the period of expansion businessmen are
optimistic. MEC is rapidly increasing and rate of interest is sticky. So entrepreneurs undertake
new investment. As process of expansion continues, cost of production increases due to scarcity
of factors of production. This will lead to a fall in MEC. Further, price of the product falls as a
result of abundant supply leading to a decline in profits. This leads to depression. As time passes,
existing machinery becomes worn out and has to be replaced. Surplus stocks of goods are
exhausted. As there is a fall in price of raw-materials and equipment, costs fall. Wages also go
down. MEC increases leading to recovery.

INFLATION
Keynes reformulated quantity theory of money based on his new version of the quantity and
based on the realistic assumption of underemployment. For him unemployment was the rule, and
full employment is an exception. It was on account of the existences of underemployment that an
expansion of money supply at the initial stages did not result in rise in the price level. Keynes
argued inflation as a phenomenon after full employment. An expansion of money supply before
point of full employment will increase output and employment up to full employment. The price
level will increase as the expansion of money supply is continued beyond point of full
employment. Inflationary arise in the price level can not take place before the point of full
employment. The general tendency for price can not take place before full employment.

A. Inflationary Gap
Keynes introduced the concept of inflationary gap with his pamphlet ‘How to pay for the war’
published in 1940. The inflationary gap is defined by Keynes as an excess of planned
expenditure over the available output at pre-inflation level prices. The inflationary gap is the
amount by which aggregate expenditure (anticipated expenditure) would exceed aggregate
output at the full employment level of income.

On the supply side, it is assumed that the value of gross national product is Br. 360 at pre
inflation prices. Out of this total output if government takes away output equivalent to Br. 150
for war purposes, then only Br.210 worth of output available for civilian consumption. Hence,
the actual value the available output for civilian consumption is Br. 210.
On the demand side, suppose that the gross national income at the existing price level is Br. 400.
If out of the national income, the government takes away Br.100 by way of taxes, then the total
disposable income left with the community is Br. 300. Assuming that the community pays
another sum of Br.30 by way of saving then the net disposable income would be Br.270. This is
the actual amount of money income which is available to the community for spending purposes.
In other words, this represents the total amount of anticipated expenditure. Thus, Br. 270 is the
amount to be spent on the available output worth of Br. 210, thereby creating an inflationary gap
of Br. 60. Inflationary gap emerged due to the excess of net disposable income over the available
output at constant prices. To illustrate the concept, Keynes, take example of war time economy
which is generally a full employment level. In the economy the value of gross national
product(Y) is determined by the aggregate consumption expenditure (C) plus private net
investment (I) plus government expenditure on goods and services (G).

B. Monetary policy and fiscal policy

Keynes also deals with economic policies to be adapted to the economy. He presented two
policies: monetary policy and fiscal policy. Monetary policy is policy related to interest rate,
money supply. Keynes was in favor of cheap money policy because he was afraid of idle stocks
of capital. This policy may encourage capital-intensive production in a situation where there is
surplus labor; the need of hours is to save more capital, by capital saving devices. Deficit
financing is one of the methods of utilizing idle capital through the cheap money policy. This
deficit financing is to pull the economy out of depression.

Theory of Employment and under employment equilibrium

Unlike the classical macroeconomic theory in which the real and monetary sector of the
economy reminded dichotomized, in the Keynesian model they are integrated and forming parts
of a compact whole. To classical, the economy is always in equilibrium; disequilibrium is short
run phenomena in a sense that economy can adjust it self and return to equilibrium. Different
sectors of the system remain tied together and all the variables are determined together. The
classical are of the view that the rate of interest is the equilibrating mechanism between saving
and investment. When S is greater than I, rate of interest brings about equality between the two.
They argue that rate of interest and wage-price flexibility ensures equilibrium at full
employment. The classical also suggested wage cut was a remedy for unemployment. Whenever
there is unemployment, wages should be reduced which will bring about a fall in cost and prices.
The existence of unemployment regarded as a disequilibrium position in the economy.

It was Keynes who gave a systematic account of under employment equilibrium. To him,
capitalist system can attain equilibrium at less than full employment level. The concept of under
employment equilibrium can be analyzed with the help of two approaches: Front Door Approach
and Back Door Approach

Front Door Approach: It is assumed by classical that whatever is earned is spent on

consumption and saving so that there will be full employment in the economy. But Keynes
pointed out; there is a deficiency in aggregate demand. Consumption depends on MPC and
income. Investment depends on MEC and rate of interest. According Keynes the level of
employment is determined at a point where aggregate demand is equal to aggregate supply. But
this point is not at point where full employment equilibrium can be attained. The equality
between aggregate demand and supply takes place at less than full employment level.

Back Door Approach: In this approach under employment equilibrium is analyzed through S
and I. According to the classical the equality between S and I is brought about by changes in rate
of interest and income.
Uncertainty and expectation
According to Keynes expectations are means by which the changing future influences the
present. Expectations are certainly the dominant factor that influences investment decision.
Because the MEC is based on the expected income to be derived from the use of an additional
unit of capital. Expectations have vagueness about events partly because they cannot be fitted in
a precise way into the framework of investment theory and future economic developments.

Keynes draws a distinction between short-term and long-term expectations. Short-term

expectations are concerned with the price that a producer or manufacturer expects to get for his
finished goods. These expectations relate to production or projects conceived and executed
within the framework of existing plant and equipment. These expectations are formed at the
time when the producer undertakes the production of the good. The short-run expectations are
formed by projecting recent experience a little ahead, i.e., a short distance into the future. Such
expectations are continuously revised though gradually on the basis of information. Keynes
argues the short-term expectations are mainly determined by the events of most recent past. The
entrepreneurs, as a rule, presume that the recently realized prices, output and employment levels
will continue and hence, expect short future.

As far as the long-term expectations are concerned, they deal with what the firm expects to earn
through the acquisition of additional capital equipment over a longer time horizon. It is these
expectation which are most germane to the problem of investment spending. Keynes maintains
that the long term expectations are based in part on the existing facts which are assumed to be
known more or less for certain such as the size of the existing stock of capital, and the intensity
of the consumer demand for goods and services which require a large amount of capital for
production. It includes future changes in quality and the quantity of the stock of capital assets,
future shifts in consumer tastes, and the strength of effective demand for the goods produced as a
result of new investment in capital equipment, and in part on the future events which can only
predicted with more or less confidence. We do not possess definite knowledge about this.
Keynes asserts that long-term expectations are psychological in character, and are formed partly
by projecting the facts of the existing situation into the future.

According to Keynes, the key element is the degree of confidence of entrepreneurs has in their
own forecasts. If the entrepreneurs have confidence in their own forecasts, expectations will be
stable; otherwise there will be instability in the state of expectations.

. ROLE OF FISCAL POLICY

Keynes′ theory suggested that active government policy could be effective in managing the
economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what
has been called counter cyclical fiscal policies. These are policies which acted against the tide of
the cycle. On one hand deficit spending when a nation's economy suffers from recession or when
recovery is long-delayed and unemployment is persistently high. On the other hand, suppression
of inflation in boom times by either increasing taxes or cutting back on government outlays. He
argued that governments should solve problems in the short run rather than waiting for market
forces to do it in the long run as in the long run we are all dead.

This contrasted with the classical and neoclassical economic analysis. Keynes argued that, fiscal
stimulus (deficit spending) could accentuate production. But there was no reason to believe that
this stimulation would outrun the side-effects which "crowd out" private investment. Fiscal
stimulus, first, would increase the demand for labor and raise wages, hurting profitability;
Second, a government deficit increases the stock of government bonds, reducing their market
price and encouraging high interest rates making it more expensive for business to finance fixed
investment. Thus, efforts to stimulate the economy would be self-defeating.

The Keynesian response is that such fiscal policy is only appropriate when unemployment is
persistently high and above what is now termed the Non-Accelerating Inflation Rate of
Unemployment, or "NAIRU". In that case, crowding out is minimal. Rather, private investment
can be "crowded in": Fiscal stimulus raises the market for business output, raising cash flow and
profitability, spurring business optimism. To Keynes, this accelerator effect meant that
government and business could be complements each other rather than substitutes . Second, as
the stimulus occurs gross domestic product increased and hence raising the amount of saving,
helping to finance the increase in fixed investment. Finally, government investment in public
goods which will not be provided by profit-seekers will encourage the private sector's growth.
That is, government spending on such things as basic research, public health, education, and
infrastructure could help the long-term growth of potential output. Keynes also presented the
positive and negative effect of fiscal policy.

He looked at various fiscal policy instruments such as taxes, transfer payments, governments
expenditure and soon: To him, direct progressive tax is highly desirable. It will increase
consumption and reduce individual savings as tax payers begin to feel that there is no incentive
for earning more. It will badly affect savings and investment. But there is another way in which
the progressive tax system can help. Taxes realized from high income groups go to state
exchequer and are transferred to the low income group. That is, the money collected is spent on
the schemes of common benefit. This help to maintain total effective demand at a time when
economy is threatened by diminishing investment opportunities.

Deficit spending is not Keynesianism. Keynesian recommends counter-cyclical policies to

smooth out fluctuations in the business cycle. An example of a counter-cyclical policy is raising
taxes to cool the economy and to prevent inflation when there is abundant demand-side growth,
and engaging in deficit spending on labor-intensive infrastructure projects to stimulate
employment and stabilize wages during economic downturns. Classical economics, on the other
hand, argues that one should cut taxes when there are budget surpluses, and cut spending or
increase taxes during economic downturns. Keynesian economists believe that adding to profits
and incomes during boom cycles through tax cuts, and removing income and profits from the
economy through cuts in spending and/or increased taxes during downturns, tends to exacerbate
the negative effects of the business cycle. This effect is especially pronounced when the
government controls a large fraction of the economy, and is therefore one reason for fiscal
conservatives advocate a much smaller government.

He believed that under capitalistic system, the economy was at equilibrium at a point below the
full employment point. It would require strenuous efforts on the part of the government to
achieve a new equilibrium point at higher levels employment. Labor cost is a variable cost to
private enterprise but it is a constant or overhead cost to government. Hence, the government
cannot permit the unemployed people to starve. Thus, the more productive the projects
undertaken by the state, the greater would be the contribution of the government in increasing the
welfare of the society. Any increase in employment will help in increasing the effective demand
of the people and especially, during depression.

According to Keynes, if the government wants to achieve quick results in the field of
investments and employment, it must resort to borrowing rather than taxation. Taxation will be a
brake to spending and thus, decline the level of consumption in the country. Any expenditure out
of borrowing results in increasing the effective demand of the people. This is what has generally
been termed as ‘deficit financing’. He laid emphasis, among others, on propensity to consume,
MEC, saving, investment, and full employment. He suggested four things, socializations of
investment, taxation to equalize the wealth and incomes of individual, control over bank credit,
and control over the rate of interest. According to him, the state will have to exercise a guiding
influence of the propensity to consume partly through its scheme of taxation, partly by fixing the
rate of interest. He conceived, the influence of banking policy of the rate of interest will not be
sufficient by itself to determine the optimum rate of interest. Therefore, some what
comprehensive socialization of investment is means of securing an approximation to full
employment.

In the domain of fiscal measures, Keynesian concept of deficit spending has been the most
popular. Keynes suggest that a sound policy of public finance for great depression must aim at :
(a) keeping the rate of interest as low as possible so as to force capital to undertake investment
risks in order to earn profits; and (b) supplement private investment by government spending;
and (c) adopting progressive tax system which would adversely affect savings and thus, help in
maintaining the level of consumption in the country. He suggested that during the period of
depression, the government invest its money in productive enterprises such as construction of
dams, roads, bridges, hydro-electric projects etc. so that unemployed persons might get
employment and their purchasing power might increase which would necessarily create demand
for commodities.
Government spending and increased purchasing power would induce private enterprisers to
invest their money in industrial undertakings and businesses. Investors in all parts of the country
would follow suit. Thus, pump-priming would remove the evil effects of depressions and create
employment and restoring the normal conditions of the economy. The influence of the concept
deficit spending has been enormous on public policies in Great Britain, United States and other
European countries. His influence on the British economic policies was very great because his
thought and advice mould the policies concerning indebtedness, gold standard, nation-wage
level, central bank rate etc. During the New Deal period, America followed the Keynesian
pattern of policy. This also found a place in the budgetary policies of the under developed
countries during the last two or three decades. Almost all the big countries resorted to deficit
financing to booster up industrial activity and to raise the 1evel of national income.

Keynes′ ideas influenced Franklin D. Roosevelt's view that insufficient buying-power caused the
Depression. During his presidency, Roosevelt adopted some polices of Keynesian economics,
especially after 1937. The success of Keynesian policy can be seen at the onset of World War II,
which provided a kick to the world economy, removed uncertainty, and forced the rebuilding of
destroyed capital. Keynesian ideas became almost official in social-democratic Europe after the
war and in the U.S. in the 1960s.