This document provides an overview of John Maynard Keynes and the development of his economic theories. It discusses Keynes' background and education, as well as his major works that broke from classical economics. Specifically, it outlines Keynes' critique of the classical labor market theory, interest rate theory, and demand for money theory. It then explains Keynes' alternative theories regarding these topics. The document also summarizes Keynes' concept of aggregate demand and supply, the multiplier effect, and his views on fiscal and monetary policy to stabilize economies and reduce unemployment.

1. Keynesian Economics:
Revolution and
Counterrevolution
• John Maynard Keynes (1883-1946)
– Son of John Neville Keynes author of
Scope and Method of Political
Economy (1891)
– Studied Math at Cambridge, resulted
in Treatise on Probability (1921)
– Attracted into economics by Marshall
– Brief period at the India Office
– Returned to Cambridge at Kings
College
– Worked mainly on monetary policy
– Involved in post WWI peace
conference and critical of the settlement

2. J. M. Keynes
– The Economic Consequences of the
Peace (1919)
– Tract on Monetary Reform (1923)
– Treatise on Money (1930)`
– Break with neoclassical theory
– The General Theory of Employment,
Interest and Money (1936)
– Focus on employment levels and the
possibility of an unemployment
equilibrium
– General Theory—it includes full
employment equilibrium as a special
case
– Keynes a member of the Bloomsbury
Group of artists, writers, and
intellectuals

3. Keynes’ Critique of the
“Classical” Postulates: I
• The Classical Labour Market
– In classical and neoclassical
economics the demand and supply
of labour determines the real
wage rate
– Cannot be involuntary
unemployment in equilibrium
N
W/P S
D
w
n
D’
w’
n’

4. Labour Markets
• The Keynesian Labour Market
– Wage bargaining is about money
wages not real wages
– Wage bargaining cannot
determine the real wage as price
level changes may occur
– Workers react differently to a
cut in real wages caused by price
level increases than to cuts in
money wage rates
– Workers resist money wage cuts
– Importance of relative position,
no union will want to accept
wage cuts in case others do not

5. Keynesian Labour
Market
N
Money wages
S
D
w
n
D’
n’
Involuntary employment exists because of
downwardly inflexible money wage rates.

6. Keynes’ Critique of the
Classical Postulates: II
• The Classical theory of the
interest rate, savings and
investment
– The real interest rate is
determined by savings and
investment
– The real interest rate co-ordinates
saving and investment
– What is saved will be spent in the
form of investment expenditure

7. Classical Interest Rate
Theory
Real i rate
S & I
S
I
i
S’
i’
If the desire to save rises, interest rates fall
and investment increases.

8. Keynesian Theory of
Interest, Savings and
Investment
• The interest rate is a monetary
phenomenon determined in the
money market
• Savings primarily a function of
income and not very responsive to
the interest rate
• Investment determined by the
interest rate but, more importantly,
by the state of business
expectations
• The amount people wish to save at
full employment levels of income
may not equal the level of
investment planned by businesses

9. Keynesian Theory of
Interest, Savings and
Investment
i
Money i rate
i is determined in the money market
Both S and I are interest inelastic
I can shift in due to adverse expectations so
That at i FE levels of S > I
I
S at FE
I’

10. Keynesian Critique of
Classical Postulates: III
• Classical Theory of the Demand
for Money
– Demand for money for
transactions purposes
– M = PTk
• Keynesian Theory of the
Demand For Money
– Demand for money for
transactions and as an asset
– At certain times people may
rather hold their assets as money
than as stocks or bonds

11. Keynes and Say’s Law
• Keynes’ critique of the classical
savings/investment theory and the
classical demand for money theory
constitute a rejection of Say’s law
• At full employment all income is not
necessarily spent as desired saving
may exceed desired investment or
people may wish to increase their
money holdings
• If this happens there is
underconsumption in the sense that
FE Agg S > Agg D

12. The Keynesian Model
• Short run analysis, organization,
technology and capital stock taken as
given
• Aggregation of Marshallian
concepts
• Aggregate supply and aggregate
supply price
• Agg supply drawn as a function of
employment
• Agg supply price is the amount of
income factors would have to earn to
maintain that level of employment

13. Aggregate Demand
• Aggregate demand or aggregate
demand price
• Agg D drawn as a function of
employment
• As employment rises so does
income and expenditure but
expenditure rises by less than
income
• The equilibrium level of
employment is where Agg D =
Agg S and this may or may
not be full employment

14. Consumption and
Savings
• Keynes lists numerous factors both
subjective and objective that might
affect the “propensity to consume
out of income”
• Keynes argues that consumption
primarily a function of real income
• Propensity to consume and the
marginal propensity to consume
• The consumption function—
consumption as a function of
income
• Keynes thought MPC would tend to
decline with income but usually
drawn as constant

15. Consumption and
Savings
• APC = C/Y
• MPC = ΔC/ΔY
• C = a + bY where b =MPC
C
Y
450
or C = Y
C = a+ bY
a
Slope = b
y yFE

16. Consumption and
Savings
• What is not consumed out of
income is saved
• Y = C + S
• APC + APS = 1
• MPC + MPS = 1
S
Y
S
-a
y yFE

17. Consumption and
Savings
• Important to note that Keynes
thought of the consumption
function as very stable
• Changes in consumption and
savings due to movements
along the consumption function
(due to changes in income) not
due to shifts in the consumption
function (which would be
caused by changes in the
propensity to consume out of
income)

18. Investment Expenditure
• Investment depends on
interest rate and the expected
future earnings from the
investment
• These are long term
expectations
• Lack of a rational basis for
expectations of earnings a long
time in the future
• State of expectations has a
conventional basis only and can
change quite quickly

19. Equilibrium Income
For an equilibrium Agg D = Agg S
Y = C + I
450
C
C + I = Agg D
Agg D
Yy*
C
S
At y* Agg D = Agg S and S = I
However y* need not be FE
If FE > y* then Aggs > Agg D and S > I
Firms will find inventories accumulating and will
reduce employment and income until S = I
FE

20. The Multiplier
– Changes in autonomous
expenditures, such as investment, will
have a multiplied impact on income
– Initial expenditure change will affect
incomes by that amount
– Income change will then affect the
consumption expenditures of those
affected (by change in income x MPC)
– This will affect other peoples’ incomes
and will alter their expenditures in the
same way
– Ultimate effect will be the change in
autonomous expenditure times the
multiplier where M = 1/(1 – MPC)

21. Implications of the
Analysis so Far
• Equilibrium is where Agg D = Agg
S
• The consumption function is stable
but the investment function is not
• Investment prone to shifts due to
changes in business expectations
• Shifts in I have multiplied effect on
income
• Economic instability due to real not
monetary factors
• To complete the model need to look
at interest rate determination in the
monetary sector

22. Money and Interest
Rates
• Savings depend on income but there
is still a choice of how to hold ones
savings
• Desire to hold bonds vs money
• Liquidity preference
– Transactions demand for money
– Precautionary demand for money
– Speculative demand for money
• Speculative demand is an asset
demand
• Will hold money if bond prices
expected to fall and bonds if bond
prices expected to rise

23. Money and Interest
Rates
• Will expect bond prices to fall if
interest rates are expected to rise and
vice versa
• Different people may have different
expectations but when interest rates
are at very low levels most people
will expect a rise rather than
another fall and will want to hold
money rather than bonds

24. Money and Interest
Rates
• Speculative demand for money
and the liquidity trap
i
M
LP
i
Spec Demand
Trans and Precautionary Demand
Ms

25. Adjustment Processes to
Full Employment?
• If y* is at less than FE does
anything happen to drive the
economy back to FE?
• If wages and prices are inflexible
downwards then nothing happens
• If wages and prices are flexible
downward then the price level will
fall
• This will increase the real money
supply, reduce i rates, increase
investment and increase Agg D and
income
• Keynes Effect

26. Limitations to the
Keynes Effect
• The Keynes effect will likely
not be powerful enough to
move the economy back to full
employment
• Liquidity trap—increase in
real money supply may
simply be absorbed into
speculative balances
• Interest inelasticity of
investment
• Deflation would cause adverse
shifts in business expectations

27. Policy Implications
• Prolonged recessions due to
insufficient Agg D
• Low and stable interest rates to
encourage private investment
• “Keynesian” policy after WWII
became use of fiscal policy
(government expenditure and tax
policy) to maintain low levels of
unemployment

28. LM and IS Curves
• IS curves shows all the
combinations of i and y that will
give I = S
• As i falls, I rises, so to maintain
I = S income will have to be
higher
• LM curve shows all
combinations of i and y that will
give Md = Ms (for a given Ms)
• As i falls, speculative demand
for money rises, so to maintain
Md = Ms, income will have to
be lower to reduce transactions
demand

29. LM and IS Curves
• LM and IS curves
Y
i
IS
LM
y
i

30. Patinkin, Pigou, and the
Real Balance Effect
• Critique of Keynes’ view that there
could be an unemployment
equilibrium
• Based on the idea that with flexible
wages and prices unemployment
will lead to falling prices and an
increase in the value of money
balances
• Eventually people will cease trying
to increase their money holdings
and will increase consumption
• Does not rely on interest rate
declines or investment expenditure

31. Real Balance Effect
Y
i
LM
y*
IS
IS’
FE
Fall price level at y* leads to increase in the
Real value of peoples’ money holdings,
Eventually shifting the IS curve rightwards

32. Patinkin
• Patinkin’s argument was similar but
explicitly included the labour
market

33. Inflation and the Phillips
Curve
• The standard Keynesian models
did not incorporate the price
level
• Low unemployment policy
began to cause inflation
• A. W. Phillips (1958) empirical
study on the relationship
between unemployment and
% change in wage rates
• Phillips curve led to notion of
an unemployment/inflation
trade off

34. Phillips Curve
unemployment
Rate of change in wages
0
5%
Idea of “buying” lower unemployment
With higher rate of inflation

35. Phillips Curves and
Expectations
• Difficulty with the trade off idea is
that inflation seemed to get worse
• Notion of inflationary expectations
being built into the next round of
wage bargains
• Keeping unemployment below the
“natural rate” (consistent with zero
inflation) results in the long run in
accelerating inflation
• Long run Phillips curve is vertical
at the natural rate
• Rational expectations

36. The Policy Debate
• Keynesians who favored low
unemployment targets argued
for further government
intervention in the form of
wage and price controls
• Many countries experimented
with wage and price guideposts
or controls in the 1960s and 70s
• The policy alternative came
from the Monetarists
• Milton Friedman and Chicago

37. Friedman and
Monetarism
• Friedman’s critique of
Keynesian economics had
several dimensions
• Consumption expenditure
responds to changes in
permanent income not
temporary changes in income
• Monetary factors have
greater significance than
Keynes or the Keynesians
allowed
• Studies in the Quantity Theory
of Money 1956

38. The Great Depression
• The classical or neoclassical theories
implied full-employment.
– After all, if there are any unemployed
people they would offer to work for less
and, therefore, get hired. The wage would
keep decreasing till all willing workers are
hired. If the wage occasionally gets stuck at
too high a level, unemployment would
result. However, such episodes would be
brief because the presence of the
unemployed would push wages down.
• But the Great Depression (1929-39) was
a period of prolonged high
unemployment that the classical theory
could not explain.
• Therefore, it was the Great Depression
that exposed a major weakness in the
classical theory.

39. Wage Rigidity
• Keynes argued that wages
might not be driven down by
the unemployed.
– Wages in some cases are fixed
by long-term contracts.
– Moreover, workers suffer ‘wage
illusion’.
• That is, they would refuse to accept
wage cuts but happily accept price
increases even though both these
changes reduce the purchasing
power of the wage (or, the real
wage).

40. uselessness of Wage
Reductions
• Moreover, Keynes made an informal
argument that even if the wage fell,
there was no guarantee that the
unemployed would be hired.
– If wages fell, the workers would be
poorer and would cut back on their
shopping.
– This would lead to a fall in the prices
of goods.
– As a result, businesses would not find
it viable to hire more workers;
• although wages have fallen, the lower
prices of manufactured goods would still
make it hard to hire workers.

41. Effective Demand
• As wage reductions could not be relied
upon to encourage more hiring by
businesses, some other strategy was
needed.
• Keynes suggested expansionary fiscal
policy —also called ‘pump priming’—
as the cure.
• If the government starts spending more
—on, say, new roads and bridges—this
would directly create more jobs and
reduce unemployment.
• If the government cuts taxes, people
would have more spending money and
would go shopping.
• This would raise the prices of goods
and induce businesses to hire the
unemployed.

42. Thrift makes the
multiplier smaller
• The indirect multiplier effect of fiscal
policy was shown to depend on the
attitudes of consumers.
• The less thrifty they were the bigger
would be the number of additional jobs
created by expansionary fiscal policy.
• If workers are free spenders by nature,
then any group of newly hired workers
would go on a spending binge and this
would create a large number of additional
jobs for the unemployed.
• If workers are thrifty by nature, their
shopping would be pretty tame and only
a small number of additional jobs would
be created.

43. Expansionary Monetary
Policy
• Keynes also proposed
expansionary monetary policy
as a cure for unemployment.
• This idea was based on a new
theory of the demand for money
called liquidity preference.

44. Monetary Expansion
• The equality of the supply and
demand for money then implied
that a country’s central bank
could reduce interest rates by
increasing the money supply.

45. Monetary Policy
• The neoclassical theory of investment
had argued that investment increases
when interest rates fall and vice versa.
• Therefore, if the central bank
increased the money supply by
printing more money and lending it to
borrowers, the interest rate on
borrowed money would decrease.
• This in turn would increase
investment spending by businesses.
• This would increase the production of
capital equipment for businesses and,
thereby, reduce unemployment.

46. Stabilization Policy
• Thus, we see that Keynes had
proposed two cures for
unemployment:
– expansionary fiscal policy, and
– expansionary monetary policy.
• However, of these two cures,
Keynes preferred expansionary
fiscal policy and had doubts
about the effectiveness of
monetary policy.

47. Doubts about monetary
policy
• First, Keynes argued that at especially low
interest rates a liquidity trap may appear.
– That is, the demand for money may become
infinitely elastic and, therefore, it may no
longer be possible to reduce interest rates by
printing more money.
• Second, even if you reduce interest rates,
investment spending by businesses may not
increase.
– Business investment is determined basically
by expectations—optimistic or pessimistic
“animal spirits”—and only slightly by the
interest rate.
– Therefore, when the economy is in trouble,
even if the central bank succeeds in reducing
interest rates, the businesses may be so
pessimistic that they may not boost
investment spending. And if that happens, no
new jobs would get created.

48. Founder of
Macroeconomics
• Keynes is regarded as the
pioneer of macroeconomic
theory and policy