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No government and a closed economy in Keynes. It might have been that Keynes analysed the whole world. Or the analysis could be extended to open economy. James Meade extended it to open economy.
Only at point A will the level of expenditure that the economy wishes to spend equal to the level of output.
We assume investment is exogenously given. The rate of interest is also given. Savings and investment are brought into ewuilibrium by the national income Y.
Lets assume the average propensity to save arises
So national income falls. Classical writers said:
So investment will rise as interest rate falls. So this is a good thing. Not by Keynes.
For a given monetary situation Keynes thought there is a unique interest rate. Let s asssume that the interest rate falls (increase in supply of money or decline in demand).
dY/dI=I/(1-c) s.t. 1-MPP
So the multiplier is equal to 4 if c=0.75.
But dI=dS. So the increase in investment would be self funding as the savings rise.
1944 this fundamental orthodox was included in Beveridge report.
Unemployment- given that economy had no supply side constraint (capital, labour) and no inflation.
In that case Y1 can be anywhere
Y* is full employment. So the agregate demand was insufficient to accomondate the full empployment.
In his policy writing Keynes suggested fiscal intervention. The policy that shifts up the E function. G-T discretionally fiscal policy is the deliberately modifying of govn. deficitit. So fiscal policy iis this case can be seen as a demand management. In above case demand can be boosted, in inflationary case demand management can be used to cool down the economy. Fiscal policy would be contractionary.
So government increses spending, the effects are similar to the increased investment.
Fiscal policy multiplier - dY/dG=1/(1-c)
C=a+c(Y-T) T-taxes
The lower the T the higher will be consumer expenditure and measured nationl income.
T=tY t-marginal tax rate.
Friedeman called early Keynesians fiscalists. But the general theory does not mention fiscal policy, Keynes only mentions monetary policy.
Keynes took over the quantity theorists assumtion about Ms=M bar (exogenous).
The demand for money Md=kPY according to the cambridge approach. Keynes accepted that but told this is no the complete picture. The Md should also include interest rate. So Md could be split to 3:
1. transactionary - like monetary
2. precautionary. You can put 1st and 2nd together
3. asset demand for money - liquidity preference L(r). Md=kPY + L(r). This meant how many bonds you like to hold. If you have higher liquidity prefference you hold more money.
Interest was determined in the money market. The rate of interest was a monetary phenomenon.
Classical economists differenced between Rn (natural) and Rm (market interst rate). Rm can be influenced in the short-run.
When APS rises (=S/Y) income falls. So the actual saving does not rise:
Reason for that is that the flow of investment is given. Rate of interest is the outcome of portfilio decisions.
The attraction to hold money is its liquidity. It can be exchanged to other goods with minimum goods. There are als bonds, that are illiquid. They pay a rate of interest - they yield income.
Liquidity prefference deponds on the rate of interest that equates M bar=Ms and B bar=Bd.
If people want to hold more money:
They cant hold more as Ms is given. So the price of bonds drops and they become more profitable.
If monetary authorities like to influence aggregate demand (e.g. stimulate it to elliminate unemployment). So they do open market operations:
This assumes that the authorities can actually bid down the interest. This is very hard and the effect can be very small. Or investsment and APC (feel good factor) go up. So monetary authorities can increase Ms but the increase in Exp. is not certain.
ISLM approach:
Let us assume that Ms increase decreases r and increases investment and consumption and national income. But as Y rises the nominal amount of money demanded rises. So the rate of interest sets down to somewhere in the middle. The new interest will be lower than r1 and higher than r2 , but we can't determine precisely. That is why we need ISLM method.
Here government must keep the interest rate constant, so central govn. specially takes steps to revert changes.
National accounting system must make different between ex ante (desired) and ex post (realised and actual outcome).If Y line falls and firms don't realise that and produce as before. So there is a involuntary accumulation or overproduction. That is unplanned investment. Then they cut their scale of output.
Relax assumption of closed economy.
Goveernment expenditure is injection. Taxes are withdrawals and endogenous
Exports are injection and imports are withdrawals
1. rate of interest is purely monetary thing
2. real wage is sticky
3. increase of Ms will not lead directly to inflation
Keynes did not belileve that if the desire to invest rises then it can't crowd out itsself. He didn't believe in the full employment level of output. But assumed perfect competition when arguing against Classical. Said S=f(r,Y) not only r, so shifts in S and I occur independently. Classical said S*=f(r,Y*), this is only one possible explanation. Classical theory neglected stock equilibrium. In Keynes interest rises only because increased Y increases Md, thus after a shift in I savings will increase, but equilibrium with a higher r. Keynes turned away from the flow (invesstment) to the stock of bonds.
Deficiency of aggregate demand. Effective demand - the sum of expenditure plans when there are yet no supply side constraints.
Y<Y* - people dont want to produce-Keynes
Nowadays the constraint is inflation.
E(output)=C+I
Keynes= +ve relationship between the level of consumption and the level of real national income. This is called consumption function
each increment would not beconsumed completly dC/dY<I
c=MPC=dC/dY
S=Y-(A-cY)=-A+(I-c)Y
A-constant
I-c=MPS
Levels of income above Y1 there is saving
1. Lterm state of confidence by entrepreneurs (state of lterm expectations, the state of animal spirits)
2. The rate of interest.
Investment schedule is unstable.
We assume that the rate of interest is given (monetary policy), and business confidence 5s same.
The amount spent on goods must equal to the value of output.
The volume of production will adapt itself to the variations in demand for goods and services (no. over-underproduction) -> Income expenditure method.
1. Liquidity preference Bulls - interest is low, high liquidity preference, bears opposite. Rate is the reward for being illiquid.
2. Interest is a measure of uncertainty concerning future. Money does not commit.
1. Transactions+Precautions demand dependent on money income
2. Ms exogeneous
When business confidence falls and I decreases then interest remains the same (no change in the money market occurs, instead when there is overall pessimism Md might rise rising interest!). Now there is excess of savings. This is unstable and Y starts to fall and as a result Md and S will fall. A new interest is set between the initial and the one predicted by classical.