Next Chapter: Business Fluctuations in the Simple Keynesian ModelBy the 1930's many economists felt that there was a need for an economic theory to explain unemployment. It was John Maynard Keynes who set out to create such a theory. His basic idea was that unemployment might be caused by insufficient aggregate demand. This idea had been around since Malthus, though never very widely accepted. Keynes new step was to incorporate this idea in an equilibrium theory.
The new kind of equilibrium theory -- not at all like the Supply and Demand equilibrium -- was based on the interaction and essential identity of income and expenditure. In this framework, consumption expenditure is particularly important.
Keynes thought that there is a "psychological law" to the effect that an increase in income would result in an increase in consumption expenditure, but less than in proportion. We define the "marginal propensity to consume" as the additional consumption expenditure resulting from getting one more dollar of income. SO -- Keynes' so-called "psychological law" would mean that the marginal propensity to consume is less than one. This "marginal propensity to consume" interacts with the "autonomous" components of expenditure. We define as "autonomous" any component of expenditure that does not depend on income.
Equilibrium in a model of this kind is a condition in which income is equal to the sum of the expenditures. In the simplest model, every kind of expenditure other than consumption is treated as a given constant, so it is consumption that controls the outcome. Because of that, the equilibrium has a "multiplier" property -- the equilibrium income (aggregate demand) is a multiple of the "autonomous" components of expenditure.
We can look at this "equilibrium" from a number of points of view. Thinking in terms of inventory investment, the Keynesian equilibrium can be thought of as a situation in which business inventories are stable at a level businessmen find appropriate. This means that 1) in equilibrium, plans can go forward as people anticipate, 2) if the economy is temporarily away from equilibrium, inventory buildups or shortfalls will move it toward equilibrium, and 3) inventories become an important diagnostic for future changes in the economy.
Thus, the Simple Keynesian Model may provide a first approximation to the theory we need. But we have to reconsider many of its simplifying assumptions in the next chapters.
Next Chapter: Business Fluctuations in the Simple Keynesian Model
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