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Keynesian Theory

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Keynesian Theory, in technical economic terms, refers to a macroeconomic framework originally developed by John Maynard Keynes in The General Theory of Employment, Interest and Money (1936). It emphasizes aggregate demand (AD) as the principal driver of output and employment in the short run, especially during periods of economic slack.

Core Technical Components of Keynesian Theory:

1. Aggregate Demand Determines Output (Y)

Keynes rejects Say’s Law (supply creates its own demand). Instead, he posits that effective demand—the level of demand for goods and services at which firms are willing to produce—is what determines the level of output and employment.

Formally:

\[ Y = C(Y - T) + I(r) + G + NX \]

Where:

  • \(Y\): national income (output),
  • \(C\): consumption, a function of disposable income (\(Y - T\)),
  • \(I\): investment, a decreasing function of the real interest rate \(r\),
  • \(G\): government spending (exogenous),
  • \(NX\): net exports (often omitted in closed economy models),
  • \(T\): taxes (can be fixed or endogenous).

2. Consumption Function

Consumption is modeled as a linear function:

\[ C = C_0 + c(Y - T) \]

Where:

  • \(C_0\): autonomous consumption,
  • \(c\): marginal propensity to consume (MPC), \(0 < c < 1\).

3. Investment and Interest Rate: IS Curve

Investment \(I\) is sensitive to the interest rate:

\[ I = I_0 - b \cdot r \]

This forms part of the IS curve, which captures goods market equilibrium:

\[ Y = C(Y - T) + I(r) + G \Rightarrow \text{IS: } Y = f(r) \]

4. Liquidity Preference and Money Market: LM Curve

Keynes introduced liquidity preference to model the demand for money:

\[ M^d = L(Y, r) \]

Where:

  • \(M^d\): demand for money,
  • \(L_Y > 0\): transactions demand (positively related to income),
  • \(L_r < 0\): speculative demand (negatively related to interest rate).

Money supply \(M^s\) is set by the central bank. The LM curve satisfies:

\[ M^s = L(Y, r) \Rightarrow r = g(Y) \]

5. Multiplier Effect

Increases in government spending or investment cause an amplified increase in output via the Keynesian multiplier:

\[ k = \frac{1}{1 - c} \Rightarrow \Delta Y = k \cdot \Delta G \]

This operates under the assumption of idle resources and price rigidity.

6. Price and Wage Stickiness

Keynes assumed nominal rigidities, such as sticky wages and prices, implying that markets do not clear instantly, and involuntary unemployment can persist.

7. Equilibrium with Unemployment

Unlike classical models where labor market clears at full employment:

\[ W/P = MPN(L) \]

Keynes shows equilibrium can occur below full employment, due to insufficient aggregate demand.

8. Paradox of Thrift

Increased saving reduces consumption, lowering aggregate demand and possibly decreasing total savings in equilibrium—a counterintuitive outcome.

9. Policy Implications

  • Fiscal Policy (via \(G\) or \(T\)) is potent in managing demand.
  • Monetary Policy may be ineffective in a liquidity trap (\(r \to 0\), \(dL/dr \to \infty\)).
  • Stabilization policies are essential to maintain full employment.

📌 Formal Summary: IS-LM Model (Closed Economy, Short Run)

\[ \begin{cases} Y = C_0 + c(Y - T) + I_0 - b r + G \quad \text{(IS)} \\ M/P = L(Y, r) \quad \text{(LM)} \end{cases} \]

Solving this system yields the short-run equilibrium values of \(Y\) and \(r\). Generalizations include the AD-AS framework, Phillips Curve, and extensions into New Keynesian DSGE models.

Let me know if you want the open economy case (Mundell-Fleming), dynamic extensions (Keynesian cross in discrete or continuous time), or New Keynesian refinements (price stickiness via Calvo pricing).

References