Following the Great Depression of the 1930s, most economists of the day were neither unable to explain the cause of the recession nor come up with a policy that would help avert the crises by offering employment and spearheading the production process (Coddington 23). It is out of this desperation that famous British economist John Maynard Keynes came up with his famous economic theory of economics. The Keynesian theory of Macroeconomics stems from the observation that free markets are unstable and cannot guarantee full employment or sustainability of the economy. It is out of this observation that Keynes pointed out that the overall demand in the economy is the sum total of all expenditure by the businesses, households and the government (Keen 149). This leads to a situation where the government is the main factor or driving force in any given economy. It regulates the performance of the economy through public policies. This can best be described by the following equation:
Y= C+I+G+(X-M) = G.D.P
The terms assume the following meanings:
(X-M)= Balance of trade Exports less imports
Keynesian economics can also be used to explain the relationship between expenditures and the real-income in the economy. The following graph helps to explain the nature of the relationship between the two variables.
Fig 1: graph of expenditure against Income as per the Keynesian macro-economics.
Based on the graph above, there is a linear relationship between expenses and the income levels in any given economy if the Keynesian economic model is something to go by. There is also an assumption that a positive correlation exists between the levels of consumptions and the real GDP of a given economy. This explains the famous quote expenses will always rise to meet income (Cate 87). The 45-degree line slope explains the fact that an increase in income will only lead to a rise in the expenditure but not to a level that is higher than the income level.
The graph thus shows that the equilibrium position of expenditure is at point Y where the total expenditure equals the total income. This is a true approximation of the real GDP of the economy as there are no surpluses or deficiencies in the economy. This can be seen at the point of intersection of the two lines: one representing the total income and the other the total expenditure in the economy.
The slope and position of the aggregate demand line in the Keynesian model is determined by different factors such as level of saving by the consumers as well as the level of supply in the economy (Hein et al 45). If the level of supply in the economy is high, then the overall demand in the economy tends to fall and in this case, the economy will be seen to be producing at a level above Y1 thus an indication of less demand in the economy. When the level of supply is less, the overall demand in the economy tends to rise and thus the position shifts to Y2 and all the movements thus prompts an action. The level of savings also affects the purchasing power of the consumers and this affects the demand. If the consumers are saving less, then their demand is high and thus affects the equilibrium position. The reverse is true if the saving is high, the demand is low and this affects the position of the equilibrium position in the same proportion.
One of the successes of the Keynesian economic model is its ability to explain the cause of some major global recession such as the one that happened during the periods of the 1930s. A recessionary gap arises at a point where the overall production in the economy does not match or equal the full-employment state in the economy. It thus appears when the production is at a lower level than the state of full employment production in the economy. The graph below illustrates the recessionary gap.
Fig 2 showing the recessionary gap in a given economy
LRAS: Long-aggregate supply curve which marks a state of full employment production in the economy.
AD: Aggregate demand
SRAS: Short-run aggregate supply curve shows a situation at which the aggregate demand curve intersect with the real production at a given price level. This marks a point where the real production falls at a level below the full employment level.
There are many ways to correct a recessionary gap in the economy. Keynesian economists propose policies such as fiscal and monetary policies to avert the crisis. In the case of fiscal policy, the government should come up with an expansionary fiscal policy that would help in managing the dangers of recession. On way of doing this is by increasing the level of government spending or lowering the taxes as a way of promoting production in the economy. This is one way of promoting the level of demand and purchasing power of the consumers thus ensuring that the economy is stable. The increase in aggregate demand after the increase in spending by the government helps to shift the demand curve to the right hence closing in on the recessionary gap.
Fiscal policies refer to all forms of government intervention to influence or control the economy by coming with ways such as using taxation laws or regulation of government expenditure (Arestis 96). The policy is much different from the monetary policy that uses financial instrument from a countrys financial regulatory bodies. The policies in the monetary policies are meant to influence the rate of economic growth by regulating the supply or demand for money in the economy. This could either be through interest rates or sale of government bonds and securities among others.
It is evident that an increase in the level of spending in the economy by the government will increase in the real GDP of the given economy. This is because the governments spending will result to high level of production in the economy thus leading to an increase in the aggregate demand and the level of full employment in the economy. The increase in the level of real GDP due to an increase in the level of government spending can best be explained by the multiplier effect in the case of the Keynesian economics (Keen 151). According to the multiplier effect, any form of spending by the government has the effect of increasing the aggregate demand in the economy by offering employment to the public. The money paid for the expenditure is then circulated in the economy by increasing demands for other things in the economy.
Arestis, Philip. "Fiscal policy: a strong macroeconomic role." Review of Keynesian Economics 1 (2012): 93-108.
Cate, Thomas, ed. An encyclopedia of Keynesian economics. Edward Elgar Publishing, 2013.Coddington, Alan. Keynesian Economics. Routledge, 2013.
Hein, Eckhard, and Engelbert Stockhammer, eds. A modern guide to Keynesian macroeconomics and economic policies. Edward Elgar Publishing, 2011.
Keen, Steve. "Debunking macroeconomics." Economic Analysis and Policy 41.3 (2011): 147-167.
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