Classical & Keynesian Economics

Samir K Mahajan

EX-ANTE AND EX-POST

Ex-ante means planned or intended or expected. For example, ex-ante investment means investment panned to be made during the year.

Ex-post means actual or realized. For example, ex-post investment means actual.

All variables in the theory of income determination are ex-ante variables.

AGGREGATE SUPPLY

Aggregate supply is the total supply of goods and services the economy planned to be produced by all production units in the economy as a whole during a given period of time. The value of this output equals the cost planned to be incurred on producing this output. The cost includes factor payments such as wages, rents, interests, profits etc which in turn forms factor income. Factor incomes are either consumed or saved.

Aggregate supply may be summarised as: AGGREGATE (or TOTAL) SUPPLY= TOTAL PRODUCT = TOTAL (FACTOR) INCOME= CONSUMPTION EXPENDITURE + SAVING

AGGREGATE DEMAND

Aggregate demand is the total demand for final goods and services that the economy as a whole plan to buy at a given level of income time during a given period of time. Aggregate demand equals total (planned) expenditure for final goods and services (consumption and investment goods).

The component of Aggregate Demand in an open economy are

o Private consumption Expenditure ( C)o Private investment Expenditure (I)o Government Expenditure (G)o Net Export i.e Export (X)– Import (M)

Thus,Aggregate Demand= Aggregate Expenditure= C + I G + (X – M)

SOME NOTIONS ABOUT EMPLOYMENT AND UNEMPLOYMENT

o Employment : Employment of a factor refers to its use in the process of production. Employment of labour is an important macro-economic variable. The term ‘employment’ has been synonymously treated with employment to of labour or workers. Worker is said to be employed when he is engaged in act of production.

o Unemployment: Unemployment (or joblessness) occurs when people are without work and actively seeking work.

o Voluntary unemployment: Voluntary unemployment exists when people have chosen not to work because their reservation about wage( the wage at which they want to work) is higher than the prevailing wage.

o Involuntary unemployment: Involuntary unemployment occurs when a person is willing to work at the prevailing wage yet is unemployed. In an economy with involuntary unemployment there is a surplus of labour at the current real wage.

o Full employment: Full employment in a very simple sense may mean that the total available supply of labour is completely absorbed in gainful employment. Full-employment may mean absence of involuntary unemployment. Classical economists argued that in the long-run the economy would automatically tend to move towards full-employment (absence of involuntary unemployment) and unemployment would be voluntary.

Classical Economics: Assumption of Full-Employment

The entire economic premise of the classical economists was based on the assumption of full-employment of labour and other economic resources. They concluded that under perfect competition in a free capitalist laissez-faire economy, forces (invisible hand) operate in the economic system which tend to maintain full-employment in the long run without inflation.

CLASSICAL ECONOMICS: SAY’S LAW OF MARKET

Say’s law of market lies at the centre of the classical notion of full employment. J B say, a French economist of the 19 th century introduced the theory of market which states that “supply creates it demand”.

Any productive process has generally two effects due to employment of factors of production such as: i. a certain output of goods and services results which is supplied to the market and ii. an income stream is generated on account of payments made by firms to the owners of factors of production and these factors incomes are spent on the goods produced and supplied. Thus according to Say’s law, all income is spent by the community, though there is a ‘leakage’ of saving in circular flow of income expenditure. Yet it argues that such saving is not a real leakage, but a sort of channelization in spending. That is, saving is another form of spending because to save means to intend to spend on producers goods i.e. investment. What ever is saved is automatically invested in productive activities. Thus, according to Say’s law, every additional output creates an additional income which creates an equal amount of extra expenditure.

Thus, increase in output = Increase in income = Increase in spending.

According to say, as every additional supply creates an additional demand, aggregate supply equals aggregate demand and there can be know general over production and general unemployment.

CLASSICAL ECONOMICS: IMPLICATION OF SAY’S LAW

o There is automatic adjustment (built-in stability) when supply creates its own demand. Hence there is no need of government intervention in the functioning of a in a free-enterprise capitalist economy.

o Since supply creates its own demand there is no possibility of any general overproduction or deficiency in aggregate demand. Aggregate supply always equal aggregate demand.

o When there is no general over-production, there is no general unemployment and free economy automatically attains equilibrium at full-employment level in the long-run.

o Supply creates its demand in real terms. Money is just a veil. Behind the flow of money there is real flow of goods and services. Change in money has no impact on the real economy’s prices of equilibrium at full-employment

o Saving-investment equality is brought about by the flexibility of interest-rate.

o Wage-flexibility in a competitive labour market tends to bring about full-employment of workers.

KEYNES’ CRITICISM AGAINST CLASSICAL THEORY

Keynesian economics is the outcome of J.M Keynes’ disagreement with the classicists who avowed a strong belief in the operation of market forces resulting automatic adjustment at full-employment level. Keynes in his masterpiece ‘The General Theory of Employment, Interest and Money’ laid a frontal attack on the doctrine of classical economics.

o Keynes considered the fundamental classical assumptions of full-employment equilibrium condition as rare and unrealistic and phenomenon. According to him, there is possibility of equilibrium at less than full-employment (underemployment) as a normal phenomenon.

o Keynes opposed the classical insistence on long-term equilibrium; instead he attached greater importance to short-term equilibrium. According to him, in the long run we are all dead.

o Classical economics rests on Say’s law of market which blindly assures that supply always creates its own demand and affirmed impossibility of general over production and disequilibrium in the economy. Keynes totally disagreed with this and stress the possibility of supply exceeding demand, causing disequilibrium in the economy and pointed out that there is no automatic self-adjustment in the economy.

o Keynes also attacked the classical theory in regard to saving and investment. He objected to the classical idea of saving investment-equilibrium through flexible rate of interest. To him saving-investment equality is brought about by changes in income rather than changes in interest rate.

Consumption function or propensity to consume studies the relationship between consumption expenditure and disposable income.

The concept of consumption function is based on Keynesian psychological law of consumption which states that as income of the community increases, its consumption expenditure will also increase but less than proportionately, because a part of the income is also saved.

The consumption function may be written as in the following equation:

C= f( Y ) C= Ca + Cm Y

Where Ca = autonomous consumption

Cm = mpc (marginal propensity to consume)

Y = disposable income = income after deduction of tax

CONSUMPTION FUNCTION OR PROPENSITY TO CONSUME

Keynes views saving as that part of income which is not spent on current consumption. Saving is the excess of disposable income over consumption. Thus saving function or propensity to save explains the relationship between saving and income.

Saving function can be expresses as :

S = Y – C

= Yd – Ca – Cm Y

= – Ca + Y – Cm Y

= – Ca + ( 1 – Cm) Y

Where, – C a = dissaving (negative saving) at zero level of income

( 1 – Cm) = marginal propensity to save

SAVING FUNCTION OR PROPENSITY TO SAVE

TECHNICAL ATTRIBUTES OF CONSUMPTION FUNCTION

o Average Propensity to Consume : Average Propensity to Consume (apc) is the ratio of total consumption expenditure to total disposable income.

i.e.

o Marginal Propensity to Consume : Marginal Propensity to Consume (mpc) is the ratio of change in total consumption expenditure to change total disposable income.

i.e. m

TECHNICAL ATTRIBUTES OF SAVING FUNCTION

o Average Propensity to save : Average Propensity to save (aps) is the ratio of total saving to total disposable income.

i.e.

o Marginal Propensity to save : Marginal Propensity to saving (mps) is the ratio of change in total saving to change total disposable income.

i.e. m

o Relationship Between apc and aps :

We have , We have, Y= C + S

or, o Relationship Between mpc and mps:

We have, Y = C + S

Differentiating with respect to Y, we get,

or, m

INVESTMENT FUNCTIONKeyes treated investment as real or physical investment such as spending on fixed assets or fixed capital goods (like machines, equipments), inventories etc which is used for further production. From the view point of economy, investment may be treated as autonomous investment and induced investment.

Autonomous Investment : Autonomous investment is independent of change in income, rate of interest, or rate of profit. Volume of autonomous investment is fixed at different level of income, and is affected by invention or discovery of new goods, change in size of population, change in consumer’s demand, research and development. Government investment expenditure are mostly autonomous in nature.

Induced investment: Induced investment are made with a view to earn profit and are influenced by level of income, and volume of profit. Keynes highlighted that induced to invest (I) depends on two determinants such as marginal efficiency of capital (e) and rate of interest (i).

i.e. , I = f (m.e.c. , i)

Marginal efficiency of capital (m.e.c) is the expected rate of return on capital goods , and is extremely volatile as it is affected by market optimism and pessimism in capitalist countries. Keyes views that in short-run interest rate is relatively a stable factor and does not change violently .

Given the rate of interest, m.e.c. is the most significant factor in determining inducement to invest. Private entrepreneur would be induced to invest , if there is positive gap between m.e.c. and rate of interest which in turn affect the volume of income and employment in an economy. Keynes believed that fluctuations in me.e.c . is fundamental cause of business cycles and income fluctuations in capitalist country.

INVESTMENT MULTIPLIER

The theory of investment multiplier establishes a precise relationship between initial increase increment of investment and the resulting increase in income and employment aggregate employment, income, given the marginal propensity to consume in short run. He views that investment multiplier is a direct function of mpc and vice-versa. On that basis, Keynes sets general formula for investment multiplier (K) as follows:

K =

Hence higher the value of mpc, higher is the value of multiplier and vice versa. Or lower the value of mps, higher the multiplier effect. Theoretically, when mpc=0, K=1 and when mpc =1, K = ∞ . How both these cases are rare phenomena. In normal cases, mpc can not be zero or one.

Given the multiplier effect (K), we can measure the resulting change in level of income (dY) by causes by an planned change in investment (dI) as follows:

dY = K. dI

Or,

KEYNESIAN THEORY OF EMPLOYMENT: THE PRINCIPLE OF EFFECTIVE DEMAND

The principles of effective demand lies at the heart of Keynes's General Theory of Employment. Keynes used the term ‘effective demand’ to denote total actual demand for goods and services ( both consumption and investment expenditure) by people in a community. The level of effective demand determines the level of employment which in turn determines the level of output and income in the economy.

Factors Determining Effective Demand: Effective demand refers to the level of demand which corresponds to equality between aggregate supply function (ADF) and aggregate demand function (ASF). Aggregate supply represents the minimum cost that must be covered by the entrepreneurs from a given level of employment. aggregate demand represents the maximum sale proceeds (revenues ) expected by the entrepreneur from the given level of employment.

According to Keynes, Aggregate supply is an increasing function of level of employment (N). Aggregate supply curve will be perfectly inelastic (vertical straight line) at a point where economy attains full employment. Thus, ASF = f(N)

With an increase in the level of employment (N), aggregate demand tend to rise and vice versa. Thus, ADF = f(N)

The Point of Effective Demand – Equilibrium level of Employment : The interaction between ASF and ADF determines the level of effective demand, employment and income. So long as ADF >ASF, the entrepreneur would be induced to provide increasing employment, and this would continue till both

ASF and ADF are equalised. The economy reaches equilibrium level of employment or point of effective demand when ADF =ASF.

In figure, the point of effective demand and equilibrium of the economy is attained at point E where ASF intersects with ADF. The point of effective demand (E) determines the actual or equilibrium level of employment (Ne ) and output. According to Keynes, the equilibrium between ADF and ASF does not imply that the economy is necessarily having full employment at this point rather it can and often does take place at less than full employment. To him ASF=ADF as full employment equilibrium is possible, if and only if investment is appropriately adequate to fill the saving gap emerging between income and consumption which is a rare phenomenon.

principle of effective demand contd.

Of the two determinants of level of effective demand, Keynes assumes that ASF is given in short run. Thus, he speaks little about ASF. Since ASF is given, the essence of Keynes's theory of employment is found in his analysis of ADF. Given aggregate supply, effective demand can be raised by increasing aggregate demand.

DETERMINATION OF INCOME: ANALYSIS OF KEYNESIAN CROSS AND EFFECT OF INCREASE IN EFFECTIVE DEMAND

The equilibrium level of output, income and expenditure is determined at the point where aggregate demand (AD) is equal to aggregate supply(AS).

At equilibrium, Aggregate Demand =Aggregate Supply ………………………….. (i)

Keynes assumes that level of aggregate supply is given in short period. Hence the level of aggregate demand determines the level effective demand and level of aggregate income . Let us assume simple two sector macro-economic model in which all savings are made by household, and there is no government spending and taxation. Thus such that aggregate demand is composed of two elements such as : consumption expenditure of households (C ) and the investment decision of the firms (I).

i.e. Aggregate Demand (AD) = Consumption + Investment ……………………………….. (ii)

Further, since for every possible level of output, an equivalent amount of money income is generated. Further, income is either spent or saved.

Thus, Aggregate Output = Aggregate Supply =Aggregate Income = Consumption + Saving ……….. (iii)

This is explained Figure-1. In upper portion of Fig-1, 45 degree line is the unity line which represents equality between total spending and total income (Income= Expenditure). Line C represents the consumption function. Consumption line C passes through the unity line at point ‘a’ at which the corresponding level of income is OY. Thus, ae is the saving gap. When business community incurs investment expenditure (I) , we get Aggregate Demand = C+I line which is parallel to the C line. Thus total expenditure or aggregate demand is OB which is equal to total income OY.

Figure-1

determination of income contd.Using equations (ii) and (iii) in equation (i), we get

Consumption + Investment = Consumption + Saving Or, Saving=Investment ---------------------- (iv )

Further, aggregate income (= aggregate output ) is in equilibrium where saving is exactly equal with investment. This is shown in lower portion of Figure-1 in which at point ‘e’ saving line intersect with investment line. Since saving amounts to a leakage in income spending, to maintain the flow of expenditure , an equivalent amount of investment is essential to match that leakage. It follows that saving-investment equality is fundamental condition of the equilibrium level of income which is called Keynesian cross. Thus, at equilibrium level of income , two conditions of equilibrium may be inferred

Aggregate Demand = Aggregate Supply Saving =Investment

Keynes views that the equilibrium level of income or effective demand, the economy is not necessarily full-employment equilibrium. Usually, it can be at any point of less than full-employment level. According to Keynes, Full-employment is a rare phenomenon.

Effect of Increase in Effective Demand on Income : Keynes’ theory suggest that level of employment and income can be raised through an uplift of effective demand by increasing aggregate demand. Since consumption expenditure tends to remain stable in the short period, level of aggregate demand can be raised by increasing investment expenditure.

determination of income contd.

If Investment is increased by additional autonomous investment ∆I , we have, Aggregate Demand = C + I + ∆I. With an increase in investment expenditure, total expenditure (aggregate demand ) would increase and total income would increase by the multiplier effect. This is shown in Figure-2.In Figure-2, point e represents the original aggregate demand (C+I) level determining OY level of income. With ∆I , the new level of aggregate demand shifts to C + I + ∆I and intersect with unity line at e/ which is the new equilibrium point at which the corresponding OY/. The lower portion of Figure-2 represents the Keynesian cross of Saving =Investment. With ∆I, the new investment curve is (I + ∆I) which intersect with the saving function at e/ which shows OY/ level of income.

It may be noticed that increase in income (∆Y=YY/ ) is in excesses of increase in investment (∆I ).

Figure-2.

determination of income contd.

Ref: D M Mithani and Internet