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Keynesian theory applied to the global financial crisis


Unemployment in macro economic level is a serious socio-economic problem in the sense that it not only affects the families of unemployed but also have impact on economic resources like unemployed land or capital, achieving zero productivity for the increased opportunity cost.

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Some economist, basically classical economist believes that the unemployment or productivity need not to be cured through government intervention but cure itself by natural demand and supply position in the market. They argued that there could be some side effects if there is any external or government interference, which are unpredictable. But, other economist opposed this statement of self regulating economy and suggests that the government intervention is necessary to attain full productivity at a reasonable span of time. Therefore Keynesian theory was propounded byJohn Maynard Keynes, 20th century British Economist. Besides being an economist he was also held as a public administrator, writer and advisor to many non profit organisations and was a director of Bank of England. Also he was being an active farmer and investor. His theories, based on macro economics were primarily presented in ‘The General Theory of Employment, Interest and Money’, printed in 1936.

Keynesian theory

Keynesian economy throws light into the impact on macro economic decisions through government interference by taking monetary and fiscal policies of fundamental banking regulations and out put stabilization measures to moderate the downturn and dejection.

Keynes major criticism was against the classical economics theory based on demand and supply which emphasises on providing full employment holding elastic wage demands in short to medium term free markets. Keynes outlook was that the general economic activity can be established from the total demand in the market, focusing adequacy of total demand in attaining full employment and explains how insufficient total demand will lead to unemployment for a long period.

Keynesian theory expresses the correlation of total income and expenditure on the basis of employment and price level changes. Keynesian theory believe that in order to attain a real GDP deficit financing is necessary, for that government spending should be made. Only through proper spending tax can be reduced and will result insertion of GDP. It is explained that, in Keynesian theory of income and expenditure the actual level GDP available will be steady with the total expenditure. That is, if the actual GDP is not covered by the current total expenditure or spending, then the aggregate expenditure will be equal only when the point of actual GDP move forward with the decrease in output until total expenditure equals actual GDP.

Assumptions of Keynesian economy

Inelastic Prices:

Keynesian economist believes that the prices are not flexible; if an increase in price occurs it is averse for any cutback. For example, it is easy to hike salaries but fall will cause some opposition. So also increase in price of commodity will be an advantage to the producer but not to the consumer.

Efficient Demand:

Keynesian economics give importance to efficient demand. It is assumed that real household disposable income is based on the effective demand that can be achieved from full production, which is exactly opposite to Say’s Law, based on supply to achieve effective or efficient demand.

Investment and Savings Determinants:

Classical economics assumes that the current interest rates will have direct affect on the savings and investment of people. But, Keynesian economics believes that the savings of people are based on the disposable income available them and investments are made on the basis of anticipated profit from the venture. (Test whether the statement is true)

Classical Economy:

Classical economist states that the natural forces like demand and supply condition will normally control market and leads to equilibrium. Here separation of labour or wages and liberated market will eventually lean towards equilibrium to create open public awareness.

Assumptions of Classical Economy:

Elastic Prices:

It is assumed that since demand and supply are controlling the market the prices for labour or wages or commodities are elastic to market conditions. But when we consider this in real life situations it has been scrutinized that these are subject to market imperfections depending on the trade unions and laws prevailing in the market.

Savings and Investment:

It is assumed that the savings and investment are determined by the demand and supply forces in the capital market. Under elastic price conditions, if the savings succeed the investments, market conditions will automatically turn the investment equal to savings by decreasing interest rates up to the level till it reach equilibrium and wise versa if the investment exceeds the savings. In other words, savings and investment are based on the flexible interest rates lead to market equilibrium.

Say’s law:

Classical economy is based on the Say’s Law, it advocates that income derived from the total production should be sufficient to acquire whole out put that the economy has produced. In other words, it is assumed that the some total of production should be consumed from the income generated from that output. Here the emphasis is given to supply not to the demand.

Keynesian Income – Expenditure Model :

Keynesian income expenditure model explains that the consumption increases with increase in income but not as much as with their increase in income but based on the psychological law of behaviour. (Keynes, 1936, p.96)

The above statement can be derived from the Keynesian Consumption Function.

The consumption function expresses the relationship between national income (Y) and consumer spending (C) and explains how the consumer spending change with the change in national income. In order to describe consumption function, have to explain Marginal (mpc) and Average Propensity to Consume (apc) and Autonomous Current Income, Total Consumption (AC) and Total Expenditure (AE).

Marginal Propensity to Consume –

The ratio which measures the change in aggregate consumption upon change in national income is called marginal propensity to consume (mpc). In other words, it is an additional income that a family unit desire to consume. MPC runs between the range of 0 to 1, where ‘0’ is indicated as a natural income and level ‘1’ indicates that additional income generated and can be used for additional consumption.

Therefore, mpc = change in consumption = ∆ C

change in national income ∆ Y

For e.g. Suppose MPC is 0.5 and domestic income rose by £ 100, then household or domestic consumption will rise by £ 50.

Average Propensity to Consume

It expresses the ratio between total consumption (C) and total national income (Y).

Therefore, apc= total consumption = C

total national income Y

For e.g. Suppose APC is 0.5 and total national income rose by £ 100, then total consumption will rise by £ 50.

Autonomous or Free Income

It is sum total of Spending on Investment (I), Government (G) and Net Exports (NX). It is denoted as ‘A’. Hence A = C + I + G + NX.

The difference between general changes in equilibrium output to independent current income is known as multiplier and is computed in the formula, M = 1 / (1 – mpc) the multiplier is constant with change in mpc values.

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Aggregate expenditure is the sum total of expenditure incurred. It is to be noted that, with change in current national income and independent expenditure or spending will reflect the total expenditure and can be summed into the equation, AE = A + mpc (Y), where mpc is multiplied with ‘Y’, change in national income

Aggregate consumption is the total output consumed or used during the course of a year. It is the portion of change in actual income that is presently consumed and is denoted as, AC = C + mpc (Y)

The income – expenditure model can be explained in graphically, in the following diagram –

On the ‘y’ axis shows three stages of autonomous or independent expenditure, namely- A1, A2 and A3 which is equal to total expenditure curve AE1, AE2 and AE3 and that change with change in mpc values. On the ‘x’ axis shows the real national income or actual GDP, namely Y3, Y2 and Y1 which is opposite to ‘y’ axis showing aggregate expenditure. A straight line starting from zero at 45° degree angle passes through the intersection of Y3 and A3, Y2 and A2, Y1 and A1. Hence x and y axis intersects at a point called equilibrium point when national income ‘Y’ increases with positive direction, where real GDP is Y = AE (Income equals to aggregate expenditure).


Graphical illustration of Keynesian theory of income and expenditure model against say’s law:

On the y axis (diagram 2) showing the real GDP which is at start is a normal level, at Y1 level of actual GDP total expenditure intersects at AE1. When the autonomous expenditure or spending reduces A1 to A2 or AE3, forcing total expenditure to move from AE1 to AE2 or AE3 which equally corresponds to Y2 or Y3 at price level changes (P1 and P2), leading decline in total demand, AD1 to AD2. Mean while, the balanced real GDP at P1 (price) will fall towards Y1 to Y3 intersecting total demand of AD2 curve and SAS at the point P2 price level. The shift in aggregate expenditure from A1 to A3, but not directly to A2 which forms a new balanced level of actual GDP at Y2 price level which is lies lower that normal price level Y1.


Hence Keynes theory challenge the classical theory of say’s Law which give emphasis to supply, suggests that since price will not fall beyond a particular level, say P2 because any further decline in wages, forces the labours to resist and avert suppliers form increasing their supplies. Similarly, SAS curve will not move upwards leaving economy stagnant at Y2 (price level) leading to unemployment for both, labours and resources. Unemployment prevent from further purchase of goods and services as a matter of fact expected level of actual GDP could not improve because total expenditure curve stay fixed at AE2 level at P2 price level. From the above graph, it is evident that price elasticity to change in income is a perception of self-governing economy.


The application of Keynesian theory came to light that in 2007 Global Financial Crisis. Many well known persons who followed the classical theory had applied Keynesian theory of economics to stimulate their countries market from economic downturn, through low interest rates and active participation of government in building infrastructure facilities as investment options. Sometimes, in spite of proper government intervention the economy may not achieve full employment, Keynes in that case believe that in the long run the government stimulus plan that has taken for general equilibrium lead to achieve full employment in future. In other words, Keynesian

Keynesian theory suggests in order to attain full employment, aggregate or total demand (AD) should be at a retained level. An increase in AD will lead to price rices, rise in imports but reduce exports for the home country market. Where as decrease in AD will lead to deflation, so that government spending become necessary to cover market saturation. Therefore, Keynesian theory points out that it is government s responsibility to retain adequate AD in the market so as to achieve full employment, for that the government should make necessary planning through proper data analysis and imply necessary fiscal and monetary policies helping to gain economy into a ‘fine tuned engine’.


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