Keynesian View of Aggregate Supply

Meet the Economist - John Maynard Keynes

John Maynard Keynes was a British Economist who advocated that when there is an economic downturn or decrease in the overall levels of Economic Activity, Governments must intervene to stimulate economic activity. Keynes believed in Animal Spirits. Keynes used this idea to describe human emotion in decision-making. When consumer confidence is low due to poor economic conditions or uncertainty for future employment or income, the overall levels of consumption will decrease and will not recover by itself. This is because individuals and businesses will act irrational. Therefore, the only way to return levels of consumption (C) and investment (I) is for governments to inject money into the economy, through government spending (G). This Keynes believed, as we will look into later on, can lead to a multiplier effect.

Keynes was also famous for his expression "In the Long Run, we are all dead.". Keynes believed that the Economy does not correct itself and the social costs of leaving the economy to correct itself (such as high unemployment and increasing poverty, as was seen in the aftermath of the Great Depression) are too high for Governments to not do anything. Below we will look into more detail as to the assumptions that underpin the Keynesian view and why, in Keynesian Economists' view, Governments need to intervene.

Assumptions of the Keynesian View

As mentioned above, Keynes observed that during the Great Depression, the economies of many countries did not "correct" themselves as was advocated by Classical Economists at the time. Keynes believed that this was because of Wage/Price Inflexibility or what Keynes described as wages being "Sticky Downwards". This was to say, Keynes believed that whilst wages could increase but were unable to decrease due to Labour Market Rigidities. Some examples of Labour Market Rigidities today include:

National Minimum Wage Legislation
Power of Labour/Trade Unions
Legislation and Regulation

The above examples show how the labour market could become "rigid" or fixed and therefore try to explain why price/wages may be inflexible or Stickey downwards (unable to decrease past a certain level). As such, unlike in the classical view, in the Keynesian view, the macroeconomy can't correct itself and enter the long run and requires Government Intervention in order to recover from a recessionary gap.

Understanding the Shape of the Keynesian Model

Keynsian AS pt1.mov

This video will discuss:

The three sections of the Keynesian AS curve and the assumptions that underpins each of the sections

Macroeconomic Equilibrium in the Keynesian View

Keynsian AS pt2.mov

This video will discuss:

The Macroeconomic Equilibrium in the Keynesian Perspective
Why, from the Keynesian Perspective, the economy becomes stuck in a recessionary gap and doesn't enter the Long Run
Why, from the Keynesian Perspective, an economy will not experience inflation with an increase in AD until it reaches its full potential due to Spare Capacity

Keynesian view on the Business Cycle:

Keynesian Economists argue on one key fundamental idea. That is, the economy is not self-regulating as was presented by New Classical Economists. Instead, Government Intervention can help flatten out fluctuations of the business cycle. During booming or inflationary periods, Governments can increase interest rates, raise taxes, and/or reduce government spending, to reduce the overall levels of Aggregate Demand to a sustainable level.

On the other hand, during recessionary gaps, governments should intervene to increase the levels of Aggregate Demand. Keynes believed that due to "Animal Spirits", as an economy enters a recessionary gap, firms become more uncertain about the future, therefore may further lay off workers to reduce costs and remain profitable. As more and more households become unemployed, they continue to decrease consumer spending, which in turn reduces firms' revenues. Therefore, this leads to a negative cycle of increasing unemployment and lower consumer spending. This is why Keynes proposed the best way for Governments to return the economy back to its potential is for them to increase their deficit spending. Deficit spending (or a Budget Deficit) is when governments spend more than they receive in revenue. Governments can do this through tax cuts on households (income taxes) or firms (corporation taxes) or by directly increasing their own Government spending (G). However, when governments run budget deficits, they must increase their debt to do so. This can lead to problems regarding issues with Government Debt which will be discussed in more detail here.

A Closer Look at Consumption and Investment

Changes in Consumption

Disposable Income and Its Influence on Consumer Spending

Disposable income refers to the income available to households after taxes and other mandatory deductions have been accounted for. It represents the funds individuals can use for consumption and saving. Generally, as disposable income rises, consumer spending increases because households have more money to purchase goods and services. However, the extent of this increase depends on various factors, including consumer confidence and economic conditions.

The marginal propensity to consume (MPC) measures the proportion of additional income that households spend rather than save. A higher MPC suggests that a greater share of extra income is directed towards consumption, whereas a lower MPC indicates a preference for saving.

The Relationship Between Savings and Consumption

Savings and consumption are closely linked, as income is either spent or saved. The marginal propensity to save (MPS) represents the fraction of additional income that is saved rather than spent. Since disposable income is allocated between consumption and saving, an increase in savings generally results in lower immediate consumption. However, higher savings can lead to increased investment and future spending, stimulating economic growth in the long run.

The consumption function illustrates the relationship between consumption and income, showing how higher income leads to increased spending while a portion is also saved. Economic theories, such as Keynesian economics, highlight the importance of consumer spending as a driver of economic activity.

Changes in Investment

Distinction Between Gross and Net Investment

Investment refers to spending by businesses on capital goods such as machinery, infrastructure, and technology to enhance productive capacity. There are two key types of investment:

Gross Investment: This is the total amount spent on new capital goods before accounting for depreciation. It represents the overall increase in capital stock within an economy.
Net Investment: This is derived by subtracting depreciation (the wear and tear of capital assets) from gross investment. A positive net investment means the economy’s productive capacity is increasing, while a negative net investment suggests that capital stock is shrinking.

Influences on Investment

Investment decisions by businesses are influenced by several economic factors:

Keynes and ‘Animal Spirits’: Economist John Maynard Keynes introduced the concept of ‘animal spirits’ to describe the psychological and emotional factors that influence business confidence and investment decisions. Even in favourable economic conditions, pessimism or uncertainty can lead to reduced investment.
Access to Credit: The availability of credit from banks and financial institutions affects investment levels. When credit is easily accessible, firms are more likely to finance expansion. However, credit restrictions can limit investment opportunities.

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