General theory of employment-interest and money

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Read the following text and answer the questions below:

In matters of economic theory, Keynes was scarcely any clearer. His most famous work, \"The General Theory of Employment, Interest and Money\", published in 1936, is a difficult and confusing book. Keynes deliberately misrepresented the views of his opponents, crudely lumping their ideas together and calling them, mockingly, \"classical\" (ie, obsolete). That angered many of his peers--few of whom were the purblind scholastics of popular mythology. The resulting recriminations made clearheaded debate about the new theories nearly impossible. And since Keynes expounded the new ideas partly by contrasting them with a caricature of orthodox thinking (ie, with a theory that nobody actually believed), it made it harder to be sure what the new ideas were.

Keynes, you might say, therefore got what he deserved. His own theories were almost immediately reduced to a variety of competing caricatures. And avowed disciples, not critics, undertook this task.

The diagram on this page appears nowhere in the \"General Theory\", but is much the most familiar reduction of Keynesian thought. Anybody who has picked up an economics textbook since 1950 will recognize it. That this caricature takes the form of a diagram is no accident. The need to distil from the \"General Theory\" something that could be taught to one\'s students--few of whom could be expected to read or understand the great book itself--was paramount, especially for American academics. So, from the late 1940s, economists such as Paul Samuelson began to spread the Keynesian gospel in this form--the gospel according to the income-expenditure diagram.

The big question in macroeconomics is whether and how long high unemployment might persist in an economy. Whatever else Keynes believed, he undoubtedly believed that high unemployment can linger indefinitely if left untreated. And the income-expenditure diagram can indeed portray such\"equilibrium\". Those who require no convincing of this point can skip the next three paragraphs.

The chart plots aggregate income (ie, output) on the horizontal axis, and the components of aggregate expenditure (consumption, investment, government spending less taxes) on the vertical axis. For the economy to be in equilibrium, the diagram supposes, income must equal expenditure--which is true at all points on the line sloping up from the origin at 45deg.

The line D1 shows that consumption rises with income. (Investment is decided in some other way; for simplicity\'s sake, just add it on.) Even if income were zero, there would still be some consumption, paid for out of savings. So D1 crosses the vertical axis somewhere above the origin. Then, as income rises, consumption rises as well--but not one-for-one. This is again because of saving habits: out of every pound of extra income, people will spend, say, only 80p. So the line D1 slopes upwards at less than 45deg, crossing the 45deg line to give an equilibrium income of Y1.

In this \"model\" of the economy there is no reason to suppose that an income of Y1 will be high enough to sustain full employment. Suppose that the unemployment rate at Y1 is 10%. What could be done about that? The answer is simple: increase expenditure by means of fiscal policy. Lower taxes and/or higher public spending will push D1 up to D2. The new equilibrium would then be at Y2, where the unemployment rate is 5%. Note that the slopes of the lines depend entirely on the assumption about how much income is saved. Note also that, because of those slopes, a given change in public spending (the vertical distance between D1 and D2) will elicit a change in income (the horizontal distance between Y1 and Y2) that is bigger. This is the Keynesian \"multiplier\" at work. The greater the propensity to spend (ie, the steeper D1 and D2), the bigger the multiplier and the more powerful the effect of fiscal policy.

Discuss the limitations of this model as an explanation of the effects of government expenditure on GDP.

Reference no: EM1314313

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