THE KEYNESIAN MODEL

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Keynes’ criticism of classical theory

• Keynes argues that Micro economics assumptions are not applicable to Macro Economic situations, because:

– Macro is not just the sum of micro, – For example, it is good for an individual to save, but if the

entire population saves, then it affects total demand in the economy.

– If total or aggregate demand falls, then goods are not sold, and this discourages investors.

– Private Investment will fall, and as investment falls, output, income and employment also falls.

– The result: the economy may go into a recession.

Savings and Consumption

• Neo-classical economics called for higher S, assuming that all S is automatically invested.

• Keynes pointed out that unlike Neo-classical assumption, savings are not automatically invested.

• This is because those who save are different from those who invest.

• Also he pointed out that saving is a leakage from the income stream, it is a form of hoarding, or money not spent. He called it “Liquidity Preference”.

• Hence increase in Total Savings leads to decrease in Total Consumption, and of Effective Demand at the Macro level

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Savings as leakage

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INCOME Rs.50,000

Consumption Rs.35,000

Savings = Rs.15,000

Although income generated is Rs.50,000, not all of it is used for consumption expenditure.Savings, or hoarding of cash leads to fall in the amount of cash sent back into circulation at the Macro Level.

Savings and Consumption

• Further, Consumption demand is a function of Income, as Income increases, Consumption also increases but not at the same rate.

• C =f(Y) • C < Y.• Since Y = C + S, as Y , S also .• Savings are thus a function of Income, not of the

rate of interest alone. • S =f(Y), as NY increases, total savings also

increase.• But there is no guarantee that this S = Investment.

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Investment • Keynes analysis of Investment was

different from the Neo-classical theory.• Investment = Autonomous (Government) Investment

+ Induced (Private) Investment.• Autonomous Investment is not motivated by profit.• Induced Investment is affected by expected profit.

Profits increase if there is sufficient consumption (Effective D) in the economy.

• Thus expected profit has a greater impact on Induced investment than rate of interest.

• Neo-classical theory had assumed that Investment is affected by rate of interest alone.

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Investment and Savings

• If Q = Rs.1000, Y = Rs.1000, C = Rs.800, and S = Rs.200.

• But Investment need not be only Rs.200.• Entrepreneurs may invest more than 200,

say Rs.300, or may invest less, say Rs.150.

• If they invest less, it leads to recession.• If they invest more, it leads to expansion.

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Impact of reducing wage rate

• Keynes did not agree with Pigou, that fall in w-rate will increase employment at the macro level. It can do so at the micro level.

• But if all wages fell in an economy, then total income will fall.

• When income falls, consumption demand also falls.• When consumption demand or effective demand falls,

it discourages private investment.• So investment falls, leading to fall in employment.• Therefore wage cuts leads to greater unemployment

and recessionary trends.

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Investment = Saving

• Keynes pointed out that those who save need not be those who invest.

• Investment is done independently by entrepreneurs.• It is not limited by level of savings by households.But:• Investment leads to increase in NY, • When NY then Savings . • So causation is from ex ante I ex post S. • The causation is from Investment to Savings, not

Savings to Investment. • This is an important causation shown by Keynes.

Investment is equal to Savings, ex post and is the cause of Savings.

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Instability of Capitalist Systems

• Investment = Autonomous (Government investment) + Induced (Private) investment.

• Induced Investment is highly unstable.• If total D falls, expenditure falls, and private sector does

not have the incentive to Investment.• Recessions and Inflation are common in capitalist

economies.• Even if there is equilibrium, it can be at less than full

employment.• Laissez faire is not possible, government must take up

measures to revive the economy.