Keynesian theory

Economic theory before Keynes

Economic theory before Keynes was mainly concerned with the behaviour of individual producers and consumers and with buying and selling transactions between them. A central concept was that of a well-informed market in which transactions are made by bargaining. In such a market demand is brought into line with supply by price adjustments so that anything offered for sale is in fact sold. The patterns of prices emerging in such markets serve as signals to producers concerning the preferences of consumers, in response to which producers make any necessary adjustments to the pattern of production. Surpluses or shortages could arise when tastes change or harvests are bad, but they would be temporary and would disappear in due course as a result of the normal working of markets. This was no more than an idealised description of the sort of behaviour that could be observed in the markets for internationally-traded commodities such as metals, wheat and coffee.

The next- and crucial - step was the assumption that what was true of the supply and demand for individual products would also be true of the total levels of supply and demand in the economy as a whole: namely that there could be no persistent shortages or surpluses. On this assumption, the explanation for any departure from that theoretical conclusion - the occurrence, for example of mass unemployment - must lie in deficiencies in the market mechanism, and the remedy must be the correction of such deficiencies.

The Keynesian model

The study of macroeconomics, to which Keynes made a major contribution, takes an entirely different approach. Instead of inferring the behaviour of the economy as a whole from what could be observed about individual behaviour, it deals directly with what can be observed about economy-wide totals.

The ultimate economy-wide total in macroeconomics is national income, which can be defined either as the total of the incomes of all the households in the country or - equivalently - as the total value of the output of all of its producers. National output is defined as being made up of "consumption goods" and "investment goods". Household income is taken to be either spent on consumption goods it is saved. Since total income must be the same as total output, the total of all the country's savings must be equal to the total that is spent on investments. Since, however, decisions to invest are not taken by the same people as make decisions to save, their initial plans could be inconsistent so there must be some mechanism that brings the actual savings and actual investment into equality.

Classical economic theory envisaged that mechanism as being a traditional market in which demand and supply are reconciled by price adjustments - the price in question being the interest rate. Keynesian theory assumes that the amount that is saved by a household depends more upon their income than upon the interest rate. That change of assumption makes a crucial difference to the way the economy is seen to work. In Keynesian theory, an excess of planned savings over planned investment leads, not to a an equalising fall in interest rates, but to a progressive fall in household incomes until that proportion of their income that constitutes their planned savings falls into line with planned investment . On that assumption, the economy does not have the "self-righting" property attributed to it. On the contrary, a disturbance could cause the economy to settle down to a level of national income and expenditure that could leave a substantial proportion of the country's productive capacity unused. On "classical" assumptions concerning the labour market, that would not lead to unemployment because wages would fall sufficiently to bring the demand for labour back into line with its supply, but in the Keynesian model wages are "sticky" downwards so that doesn't happen and unemployment follows.

The Keynesian model can be represented by a set of seven simultaneous equations as shown in the tutorials subpage, and a graphical representation (excluding its labour market component is provided by the IS-LM model.