Chapter 9

Economic
Fluctuations
and
Macroecono
mic Theory
3. The Great Depression and
Keynes
• During the Great Depression, world production dropped by about 30
% between 1929 and 1933, and the unemployment rate exceeded 25
%.
• Even though wages and prices were declining, there were no signs of
recovery.

• This exposed the flaws in the classical theory of self-adjusting markets

with full-employment
• John Maynard Keynes in 1936 wrote The General Theory of
Employment, Interest, and Money, which argued that economies can
fall into recessions and stay there for a long time, and that public
policy might help the economy recover more quickly.
3.1 The Keynesian Theory
• In The General Theory Keynes argues that Say’s Law was wrong.

• It is possible for an economy to have a level of demand for goods that

is insufficient to meet the supply from production.

• In such a case, producers will cut back on production, laying off

workers and thus creating economic slumps.
• The key to getting out of such a slump is to increase aggregate
demand, through greater consumption, government spending, or
investment.

• Recall: Aggregate demand in the economy is the sum of household

expenditures on consumption, business expenditures on investment,
government spending, and net foreign spending.
• (For our model here, we assume a very simple closed-economy with
no government)
Consumption
• In the Keynesian theory, every dollar increase in income is assumed to
result in a proportional increase in consumption.

• The number of additional dollars of consumption spending that occur

for every additional dollar of aggregate income is termed the
“marginal propensity to consume” (mpc).

• mpc = ∆C/∆Y
• mpc = ∆C/∆Y

• ∆ Greek letter ‘delta’ means ‘change in’

• mpc = ∆C/∆Y = (the change in C resulting from a change in Y) divided by

(the change in Y)

• Ex. If mpc is 0.8, it means for every 1$ increase in aggregate income,

households will spend an additional 80 cents in consumption. 20 cents
will be saved
• The number of additional dollars of saving that occur for every
additional dollar of aggregate income is termed the ‘marginal
propensity to save’, or mps

• The Keynesian consumption function also includes an “autonomous”

part not related to income, which can be thought of as a minimum
amount that people need to spend for basic needs.
• _ _
• C = C + mpc*Y, where C is autonous consumption and Y is aggregate
income
• In the Keynesian view, common sense suggest that the amount
people save depends mainly on their ability to save, based on their
incomes, as well as their needs and plans, rather than primarily on the
current interest rate.

• Also, in reality households and not just businesses are borrowers. If

interest rates are high, households will face higher costs for houses,
cars, etc, so increases in interest rates make it more difficult to save
• Simply Keynesian model just leaves out issue of interest rates entirely-
effects of interest rates on savings are too ambiguous
Investment
• Keynes thought that the most important factor in explaining
aggregate investment demand is the general level of optimism or
pessimism that investors feel about the future, or what he called
“animal spirits.” While the interest rate was somewhat important in
explaining the level of investment in normal times, it could be
ineffective in severe recession or depression.
• In a simple Keynesian model, all investment is considered
autonomous i.e.,

•I=𝐼
_
• In other words, the simply Keynesian model assumes investors intend
to invest whatever investors intend to invest.

• Of course in real world firms take into account interest rate, prices of
investment goods, accumulated assets and debt, willingness of
investors and banks to lend to them, etc.

• Keynes basically though interest rates matter some, but a low interest
rate not enough to motivate business firms to invest in building up
new capacity
Government Spending
• According to Keynes, the solution to business cycles lay in having the
government take more direct control of the level of national investment.

• Keynesian economics is defined as the school of thought, named after

John Maynard Keynes, which argues for an active government
involvement in the economy, to keep aggregate demand high and
employment rates up, though changes in government spending and
taxation
• Keynesianism strongly influence macro policy between 1940s-1960s- era
characterized by strong economy growth, low unemployment, low
inflation, increases in productivity and wages
3.2 Persistent Unemployment and
the Keynesian Labor Market Theory
• Assume that an economy that is initially at full-employment
experiences a drop in aggregate demand caused by a decline in
investment due to investor pessimism.
• Output, income, and spending contract until a new equilibrium is
reached that is far below the level of production required to provide
full employment for workers.
• Massive unemployment results.
Figure 9.10 A Keynesian Unemployment Equilibrium
• To say a macroeconomy is “in equilibrium” just means that output,
income, and spending are in balance. But achievement of an
equilibrium is not the same thing as full employment—the level at
which output, income, and spending balance may or may not be at
full employment.
• In Keynes’ view, there was nothing that would “naturally” or
“automatically” happen to pull an economy out of such a low-
employment situation.

• Since Keynes did not equate equilibrium with full employment, he

believed that there is often a need for action to stimulate aggregate
demand.
• The Keynesian perspective challenges the entire classical assertion
that unemployment results mainly from wage levels that are too high.
Rather, Keynes and his followers focus on the issue of insufficient
demand for labor—which they perceive as the direct result of
insufficient aggregate demand for goods and services.
3.3 The Multiplier
• The drop in investment spending leads to a drop in aggregate
demand, which leads directly to a contraction in output. Since
consumption depends on income, and income depends on aggregate
demand which depends on consumption, there are additional effects
which “echo” back and forth.
Figure 9.11 The Multiplier at Work
• We can summarize this with total change in Y (∆𝑌 )is related in the
following way to original change in investment (∆𝐼 )
• ∆𝑌= 1 ∆𝐼
1−𝑚𝑝𝑐

• where the expression 1/ (1−𝑚𝑝𝑐) is called the “income/spending

multiplier” or mult
• Example, lets assume investment drops so ∆𝐼 = 100, as in Figure 9.11
• If we assume marginal propensity to consume (mpc) is 0.8, then

• ∆𝑌 = 1 x (-100) = -500, in this case the multiplier is 1/(0.2) = 5,

(1-0.8)

This means initial decrease in intended investment cases, in the end, a

as ∆𝑌 = mult ∆𝐼
decrease in income that is five times its size, this can also be expressed
3.4 Comparing Classical and
Keynesian Views
• In the classical theory, an economy should never go into a slump as
any deficiency in aggregate demand would be quickly counteracted by
adjustments in the market for loanable funds.

• Hence, classical economists believed that government should

interfere in the economy as little as possible.
• In contrast, Keynes argued that any excess of “leakages” over
“injections” into the aggregate demand stream would lead to
progressive rounds of declines in consumption and income, until
savings are so low that a new, lower-output-level equilibrium is
established.

• He believed that in this situation some kind of government action was

required to get the economy out of its slump and to achieve a higher
equilibrium level.
• Paradox of thrift is the phenomenon that an increase in intended
savings can lead, through a decline in equilibrium income, to lower
total savings.

• Another classical belief, that greater savings would automatically lead

to greater investment, which in general would be good for the
economy, is also reversed in the Keynesian model.
4. Macroeconomic History and
Recent Developments
• 4.1 The Crisis of the 1970s and the Retreat from Keynesian Economics

• The government was largely blamed for many of the problems of the
1970s; too much regulation, high government spending, high taxes
and creation of too much money by the government were seen as the
key causes of the crisis.
• This led to a reorientation of the role of the government in the
economy and the revival of the idea that free-market economy would
drive out market inefficiencies and that a smaller government would
unleash private initiative and accelerate growth. •
• This view was promoted by Monetarists (notably Milton Friedman)
who argued that governments should be limited to allowing central
banks to keep the nation’s money supply growing on a steady path
and that deliberate efforts by the government to push unemployment
levels too low would only lead to inflation. This change in ideology has
led to a gradual shrinking of the government since the 1970s,
including decline in regulation of businesses and finance, cuts in social
welfare programs, privatization of public services, and a shift in tax
burden from corporations to the middle-class.
• Debates on the role of government in the economy have continued,
with macroeconomists at the classical end of the government
advocating for free-markets and smaller governments while those at
the Keynesian end of the spectrum supporting a more active
management of the economy by the government to keep
unemployment low and minimize economic fluctuations
4.2 Macroeconomics for the Twenty-
First Century
• The field of macroeconomics has evolved over time as new empirical
and theoretical techniques have been invented and as historical
events have raised new questions for which people have urgently
sought answers.

• The 2007-08 financial crisis, the persistence of substantial global

poverty, and the rising economic inequality across the world has
called into question the appropriateness of traditional ideas about
economic development.
• The environmental impact of fossil fuel-based economic growth and
the rising problems from climate change have become major focus of
economic, social and political concern, along with other
environmental issues.
• Reconciling ecological sustainability and restoration with full-
employment and growth in living standards is rising in prominence as
a macroeconomic issue.