Keynesian Model

A Primer on the Simple Keynesian Model

In contrast to neoclassical thinkers, Keynesians assume that markets function imperfectly, and that individual maximizing behavior in the presence of uncertainty can lead to socially irrational outcomes.

The Keynesian school believes that understanding economic fluctuations requires not just studying the intricacies of general equilibrium, but also appreciating the possibility of market failure on a grand scale.

Keynesians believe that there are no inherent or inevitable reasons why savings should equal investment, or why market forces should result in full employment. In the Keynesian world view, prices do not adjust quickly and economic adjustment takes place primarily through changes in output and employment.

For most Keynesians, the role of an economist is to develop policies which nudge the economy towards full employment — and not to waste time developing Walrasian general equilibrium models which are relevant only in the long run (if at all).

Keynes operated on the assumption, borne of dramatic real-world experience, that market forces can easily generate perverse and socially undesirable outcomes such as extended and deep depressions Opens in new window.

For him, this alone was enough to jettison the idea of the self-adjusting, market-clearing economic model. In a letter to John Hicks Opens in new window, he observed that Walras’s theory Opens in new window and all others along those lines are little better than nonsense.’

The standard neoclassical response to Keynesian macroeconomics is to question the microfoundations. How can it be that markets do not clear? What is preventing gains from trade taking place?

Rather than assuming that prices do not adjust quickly and efficiently, neoclassical economists demand to know what is causing such market failure.

Neoclassical economists challenge Keynesians to provide adequate microfoundations, that is, logically consistent, underlying economic arguments in support of the argument that a less than full-employment equilibrium is possible.

New Keynesian macroeconomics arose in response to this challenge, providing a set of alternative narratives as to why prices are sticky.

However, one does not need to adopt such alternative micro-foundations to think like a Keynesian macroeconomist:

all one needs to do is assume that people do not necessarily have the right information, that they may react to it more emotionally than rationally when they have it, and that this can cause huge swings in investment and in the financial sector which reverberate through the economy.

Keynes was not trying to develop a perfect mathematical model — he was trying to give policy makers a set of tools for thinking about how to get economies out of recessions and to deal with fickle and unpredictable financial markets and nervous investors.

The General Theory

Although Keynes produced several major works, Keynesian economics is associated primarily with The General Theory of Employment, Interest and Money Opens in new window, which appeared in 1936 in the aftermath of the Great Depression Opens in new window.

Unlike his Treatise on Money Opens in new window (1930), which explored the problem of economic fluctuations rather than extended depressions, the General Theory was a specific response to the dire economic situation of the time. As Skidelsky notes:

To read the book in an empty landscape is no longer possible, indeed it was not possible then. It appeared at the tail end of the greatest depression in modern history, and straightway became a central part of the argument about what caused it and what could be done to cure it, and prevent further depressions in the future.

The Great Depression was a serious, unparalleled economic disaster. The immediate cause was the US stock market crash on ‘Black Thursday’, 24 October 1929, but this was preceded by another acknowledged cause: overheated asset prices and tight monetary policy (which was an attempt to stem the tide of stock market speculation).

When the stock market bubble burst in the context of this constrained demand, the financial crisis amplified its way through the real economy. The USA economy sunk into a protracted depression, experiencing massive retrenchments and bankruptcies on a wide scale.

The shock reverberated across international boundaries, especially in Europe, but also in many developing countries including India. It took the Second World War Opens in new window to rid the world finally of the recessionary fall-out.

India and the Great Depression

India’s experience of the Great Depression was profoundly shaped and exacerbated by British colonial policy. The decline in global demand and the rise of trade protectionism had a crippling effect on Indian exports (including cotton). Export revenues fell, prompting a balance of payments crisis.

Whereas other agricultural producers such as Brazil and Australia reacted by depreciating their currencies and expanding government spending, the British reduced government spending in India, raised taxes and forced the country to sell gold reserves to meet the ‘home charges’ imposed by Britain on the colony. These policies led to widespread protests and were instrumental in creation of the Indian Central bank in 1935.

Writing in the 1930s, it is hardly surprising that Keynes rejected the neoclassical market-clearing model. He argued that it was largely irrelevant to ‘the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience.’

Keynes believe that the neoclassical vision of perfectly functioning markets leading to full employment was a ‘special case’ only, whereas his unemployment equilibrium was the more ‘general’ case — hence Keynes’s General Theory.

Like the orthodox economists of the time, Keynes believed that individuals were capable of rational economic thinking.

However, in contrast to standard perfect-competition analysis, he argued that economic decision-making, particularly as it pertained to investment, was profoundly structured by imperfect information, business confidence, risk and, most importantly, uncertainty.

Business people, in his opinion, operated in an uncertain murky world where information was often unavailable or too expensive (in terms of time and effort) to obtain—and where decisions were often made on the basis of emotions or gut instincts.

Under these conditions, Keynes insisted that it was incorrect to depict the macroeconomy as being driven towards some socially optimal full-employment position by Adam Smith’s invisible hand Opens in new window.

Today’s New Keynesians have explored further the issue of decision-making under conditions of uncertainty and imperfect information. There is work showing that if you remove the assumption of perfect rationality Opens in new window, then less than perfect economic outcomes will result.

Akerlof, for example, argues that it is often rational for economic agents to be near-rational, that is, to operate according to good rules of thumb rather than invest extra time and money in getting better information.

An economy Opens in new window full of near-rational individuals working in a context of less than perfect competition could very well end up in a Keynesian world of strong fluctuations in output and employment.

Keynes started out with the assumption that the circular flow of income had many leakages and that especially in times of insecurity, income can be hoarded, either in cash or by banks fearing to lend to risky borrowers. In such conditions, savings will exceed investment and aggregate demand (i.e., total expenditure) will fall short of aggregate supply (AS)—and thus Says law would no longer hold.

Keynes believed it was the duty of government to counter the failings of market processes through judicious application of economic policy. This, of course, implies a faith in the ability of civil servants to understand the macro picture, and act reasonably and appropriately— an idea which has earned Keynesianism much criticism from both the left and the right.

Whether justified or not, Keynes’s General Theory provided a theoretical rational for the interventionist demand-management economic policies that have become associated with Keynesianism.

The General Theory is the most influential economics book ever written, with the possible exception of Karl Marx’s Capital. Yet many of Keynes’s ideas were poorly developed, obscurely expressed, and often consisted of little more than throw-away lines. As a result, economic theorists have been arguing ever since about what Keynes ‘really meant’, and even what Keynes ‘should have meant’. (They have been doing the same with Marx, but that is another story.)

Because The General Theory is long, complex and difficult to understand, Keynes’s theories have entered into standard economic texts via interpreters. The earliest of these was Hicks, who in1937 published his very famous summary of Keynes’s ideas in terms of an IS–LM framework Opens in new window. Reading this has subsequently become a rite of passage for all aspirant economists.

Textbook interpretations are inevitably simplifications that give priority to some ideas over others. Nevertheless, Keynes’s most powerful and clear idea—namely that an economy can come to rest at a less than full-employment equilibrium owing to a deficiency in aggregate demand—can be represented in terms of a simple model of income determination, or in terms of a simple model of AS and aggregate demand.