Wednesday, May 23, 2012

Keynes' lesson on aggregate demand

I just reread Lord John Maynard Keynes' chapter on effective demand, Book 1 Chapter 3, in The General Theory on Employment, Interest and Money. In it, Professor Keynes states that while the "marginal disutility of labor", i.e., the labor supply curve, gives an upper limit to the output of a society, output is sometimes constrained before it reaches this point, where full employment would prevail.

This is the part where Lord Keynes introduces the basic logic underlying the "Keynesian Cross", which is merely a diagram which indicates the level of output given a certain level of investment and the marginal propensity to consume, which is represented by "c" in the equation of the Keynesian multiplier in my recent post "Money velocity versus the Keynesian multiplier". The following graph represents the Keynesian Cross in all its glory.

According to the basic formulae of this simplistic model, output is represented by the equations:

Y = C + I

C = c0 + cY

Investment is taken as fixed and a portion of consumption of fixed, but there is a component which depends upon the level of output. According to Keynes, this is what determines the level of output and employment when full employment has not been reached. This is a very simple model, but has a basic lesson. Full employment does not automatically prevail at all times. Such is a good lesson for today, as I tried to demonstrate in "A quick glance at the big picture", "Why intervention is necessary" and "A case for expansionary federal fiscal policy". At this point, my positions may have changed somewhat, but I more or less support a spaghetti test to the U.S. economy's current problems: Let's throw it against the wall and see if it sticks (fiscal stimulus, monetary stimulus, quantitative easing, NGDP targeting, currency devaluation, anything that has a reasonable chance of working).

Soon I intend to discuss an area of disagreement that I have with Lord Keynes.

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