The Keynesian School

Introduction

Macroeconomics as a distinct field within economics emerged in the late 1930s as a response to John Maynard Keynes's General Theory of Employment, Interest and Money (1936/1973, referred to subsequently as GT). Keynes contrasted his views on the causes of depressions and persistent involuntary unemployment with those of his predecessors, whom he termed the classical economists. In Keynes's view, these economists assumed that the normal condition for a market economy is one of capital-accumulation-fueled growth with full employment of labor and capital, and that periods of high unemployment were rare and temporary deviations from the norm. Keynes wrote that this assumption is empirically incorrect because economies frequently experienced prolonged periods of high unemployment and below-potential output (recessions or depressions). He presents his model by developing a critique of three dimensions of the classical theory: (1) Say's law, (2) the quantity theory of money, and (3) continual clearing of the labor market at “full employment” (Gordon, 1115-1171).

Discussion

Keynes's informal model (informal meaning that he did not specify his model with a series of equations or represent it with a set of diagrams but, rather, mainly used verbal exposition) begins by seeing the classical economists as having all held the validity of Say's law of markets. Say's law denoted an argument that all income generated by production would be spent on purchasing the national product—either directly, as when workers' wages or capitalists' profits are spent on consumption, or indirectly, when capitalists' savings are borrowed by firms to finance purchases of new capital goods (DeLong, 83-94). In modern economic language, we say that the classical economists assumed that the level of aggregate demand (Keynes's innovative term) for products always equals the cost of producing them, including a return on their capital to the capitalists whose firms produce the products; in other words, aggregate demand is equal to aggregate supply. Because this would mean that firms would always be able to sell any quantity of goods they might produce, they would choose output levels based on their calculations of their profit-maximizing outputs. They would collectively find it profitable to employ as many workers as were willing to sell labor services at the going wage rates; full employment would result: The only unemployed workers would be those unwilling to accept the going wage rate, who were considered to be “voluntarily unemployed.” Keynes rejected this proposition; in his model, aggregate effective demand for the social product was quite likely to be less than the value of what would be produced if all workers willing to work were employed (aggregate demand could be less than aggregate supply at full employment) (Mankiw, 79-90). If the latter occurred, firms would reduce their employment and output levels until they arrived at the levels at which their sales rates equaled their production rates. So aggregate demand determines the level of actual output and employment, and significant and persistent involuntary unemployment can occur. The cause of recessions or depressions is inadequate aggregate demand. How could this occur? Keynes had a simple ...