Keynes and the Keynesians:
John Maynard Keynes of Cambridge
(England) the intellectual giant of the 20th century who died in
1946 is considered to be the founder of macroeconomics. Classical economists
were of the opinion that nothing could go wrong in the macro economy because of
wage price flexibility real GNP would always equal natural output in the long
run. Great Britain was experiencing
severe and continuous depression since 1925. Keynes saw the failure of
classical ideas of equilibrium at full employment. Keynes presented his ideas
in the form of a book called “General Theory of Employment, Interest and Money”
commonly known as General Theory. Keynes argued that it was useful to look at
broad macroeconomic concepts such as total consumption and total investment. He
provided new explanation for the causes of widespread unemployment and showed
the cure implied by his theory.
The main analytical innovation
of Keynes’ General Theory was to develop an alternative concept of equilibrium
that allowed modified version of supply and demand analysis. Keynes argued that
aggregate demand was not always equal to aggregate supply and that widespread
unemployment was caused by insufficient aggregate demand. He argued that
aggregate demand intersects aggregate supply at a level of real GNP far below
natural output. Natural output is the level of total output of goods and
services that would be produced if everyone had correct information about wages
and prices and labour supply equalled labour demand. Natural output is related
to a concept called the Natural Rate of Unemployment (NRU) Natural output is
the highest value of real GNP consistent with the stable rate of inflation. It
is shown as a vertical line in aggregate demand and aggregate supply diagram.
It was quite in contrast with the classical theory which assumes a state of
ideal coordination between AD and AS and even more importantly, the AS would be
just equal to natural output at which full employment was guaranteed. In
Keynes’ analysis prices were not the equilibrating variable instead quantity of
aggregate output did the equilibrating Instead of determining the employment by
the by the condition that supply and demand of labour were equal Keynes imposed
the condition that quantity of out[put produced equals quantity demanded. If at
any time there is unemployment in the economy Keynes advocated the policy of
raising the aggregate demand. Thus he forcefully advocated the demand
management policies to achieve full employment level in the economy. Keynes
recommended the government intervention in the economyespecially through fiscal
policy.
Keynesians on the other hand
apply Keynes’ economic principles to the management of macro economy. During
1940s and 1950s Keynesians tried to understand the important macroeconomic
relationships such as aggregate consumption function on the basis of the study
of microeconomic relationships. They developed new statistical techniques and
use of computers helped to develop more rigorous theories. Keynesian economists
believed that up until natural output the aggregate supply curve was flat and
fairly stable. As long as aggregate demand intersects aggregate supply curve below
natural output level, government should enact fiscal policy to boost aggregate
demand so that it intersects near natural output level. The Keynesian
economists believe that inflation would be fairly stable over time. Thus, the
object of macroeconomic policy as visualised by Keynesians should be to achieve
the level of natural output on the short run and stimulating growth in the long
run. Keynesian policies were fairly successful in managing economies and
keeping inflation and unemployment under control. But after 1960s inflation
showed an upward movement. In the 1970s world economy experienced the first oil
shock and simultaneous increase in inflation and unemployment with decrease in
real output. This forced economists to rethink and search alternative policies
to deal with the new phenomenon which was named as stagflation. In the late
1960s monetarists led by Milton Friedman provided an alternative to Keynesian
economics.
Also see Contoversies in Macroeconomics (3) Keynesians v/s Monetarists:
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