What caused Keynes to put aggregate demand at the center of economics? What were the consequences?
John Maynard Keynes chose to place Aggregate Demand at the center of economics due to its heavy influence on levels of employment. His theory of Aggregate Demand was developed following the Great Depression in order to challenge the classicist way of thinking. Keynes was perplexed as to why the economy remained fixed at the bottom of the trade cycle, coupled with heavy unemployment throughout the 1920s and 30s.
Aggregate demand is the total demand for all goods and services produced in an economy in a given period of time at all possible price levels. It is made up of five components- Consumer spending, Investment, Government spending, Exports and Imports (C+I+G+(X-M)). Consumer spending is the biggest component of AD, this is because it has the heaviest impact on changing levels of real GDP. Consumer spending can be influenced by levels of real incomes, taxes, interest rates, wealth (value of assets), confidence (expectations of inflation) and the supply of money. Despite this Keynes affirmed that interest rates in fact had no weight in influencing levels of consumption, yet in fact make it costly for individuals to borrow, thus worsening levels of investment due to falling confidence of yielding a good return. Keynes deemed it impossible for consumption to ever exceed income or become negative; he believed that higher earning consumers have more disposable income to spend on goods and services and greater confidence to do so with. However households with higher incomes may have greater propensities to save due to greater yields of return from interest and new found security from a safety blanket preventing future problems such as unemployment or illness leaving serious financial problems. Keynes further believed that if savings surpassed investment, a recession would be guaranteed. Contrasting to the classical view that falling investments will forthwith reduce interest rates and incentivize rising investments once more, thus returning the economy to equilibrium, creating full employment.
Keynes strongly disagreed with the classicist theory of employment, he believed full employment was an unusual rare occurrence. Disputing, that in fact the equilibriums level of output and employment may not always resemble the economy’s income level to full employment. Stating that macroeconomic equilibrium was achievable below full employment, for example, in a situation of excess supply, output will adapt to match AD and achieve an economic balance.
Keynes’s reasoning behind the prolonged period of unemployment during ‘The Great Slump’ was the shortage of overall demand as a result of the wipe out of millions of investors during the Wall Street crash. He wrote that ‘the fundamental cause of the trouble is the lack of new enterprise due to an unsatisfactory market for capital investment. Since trade is international, an insufficient output of new capital-goods in the world as a whole affects the prices of commodities everywhere and hence the profits of producers in all countries alike.’
Prices of goods and services were below the costs of producing them and industrialists were unable to sell without creating a loss thus lengthening the slump. Additionally, during a recession confidence is low and consumers turn to saving their money, solely spending on day to day necessities (milk, bread). As a result, firms invest less in response to the fallen demand for their products, without investments there will be no innovation in technology and no boost to AD creating economic growth. Subsequently Keynes believed that state intervention was essential to moderate busts and stabilize the economy, this could be achieved by subsidizing firms in order to prevent them operating at a loss, provide more jobs for those seeking work, incentivize investments and most importantly increase output. Therefore, Keynes primarily supported a mixed economy, mainly operated by private companies with Government intervention now and again in order to create a fiscal stimulus. The accelerator effect also shows that if Government spending increased economic growth, investments would rise as a result thus complementing the private sector rather than crowding out.
The Keynesian models concerning Aggregate Demand also include the multiplier effect – first introduced by Richard F. Kahn in 1931, this is the multiple change in real output as a result of an injection (Investments, Government spending & Exports) into the circular flow. It is dependent on an economy’s propensity to import, save and tax, it is also effected by levels of spare capacity for growth and crowding out (Government spending having no impact on AD). The size of the multiplier is generally quite small, however during a recession it is greater due to the underutilization of resources.
The problem with Keynes’s theory was that it was a short term one, he was unconcerned by future employment levels, he famously wrote ‘this long run is a misleading guide to current affairs. In the long run we are all dead’. During the deep recession in the late 1920’s he thought the solution was to create a fiscal stimulus by increasing government expenditure.
In the following diagram, one can see the increase in demand, boosting output from Y – Y2, thus creating economic growth through rising RGDP. However, it also creates inflationary pressure due to the increase in the price level from P – P2. Furthermore, the increased spending will worsen the Governments budget deficit placing the country in greater debt. Additionally, this may cause crowding out, having further negative impacts on the levels of private sector investments, thus failing to bring the economy out of a recession as investments are a component of AD. However, Keynes failed to acknowledge the classicist view of crowding out and as a result his theories may have resulted in political consequences of increased state control over the economy. Subsequently there may be further economic difficulties if the Government makes corrupt spending decisions.
Keynes also believed that monetary policy was ineffective in stimulating demand, he disagreed with the orthodox statement that supply creates demand, he believed that demand was the determent of the level of output. Keynes disagreed with the classicist view that unemployment was caused by supply-side policies, for example real wage unemployment, structural unemployment and fiscal unemployment. Real wage unemployment occurs when the real level of wages is higher than the equilibrium point creating excess supply (as shown in diagram on left), the classicist solution for this is to cut wages. However, a wage cut may result in a fall in consumer spending due to the reduced income and as a result AD falls creating negative economic growth. Keynes disagreed with this policy and thought the solution for this was for the Government to intervene in order to boost AD rather than depending on wage cuts. As shown in the following diagram unemployment rose dramatically after 1929 this was due to Roosevelt and Hoovers idea to increase trade union power creating real wage unemployment during the Great Depression.
So overall, the main reasons for Keynes placing Aggregate Demand at the center of economics were because he thought the supply-side policies were inadequate in aiding unemployment, he thought unemployment was caused by a lack of demand within an economy. He believed the solution for ending the great slump of the 1920s -30s was to use expansionary fiscal policy in order to offset the drop in the spending of the private sector. However, this could have a negative result as the Government may have greater power and strength as a result of this fiscal stimulus. Furthermore, the Government may have to borrow from the private sector in order to finance this increase in spending and it may result in crowding out, in addition to a budget deficit.