Keynes and Macroeconomics

Economists have postulated many ideas on microeconomics and the workings of economic systems over the past few centuries, but the idea of macroeconomics originated only in the 1930s with John Maynard Keynes. Macroeconomic theory is based on the notion of aggregates, which means a collection of all the goods and services produced in the economy, and which theoretically presents a picture of the state of the economy as a whole. Through such measurements as Gross Domestic Product (GDP) and the Consumer Price Index (CPI), then, the government and the Federal Reserve presumably know the direction in which the economy is moving, and can thus make fiscal and monetary policy decisions to either control inflation or increase employment. GDP is a measurement of all final goods and services produced in the United States, representing the level of total employment, and the CPI is an index of the price of a market basket of goods that represents the aggregation of all goods and is used to measure inflation. With these concepts in mind, Keynes and his students conjectured that the economy could be in equilibrium at less than full employment, that government could shift the demand curve using taxes and spending, and the central bank could also affect inflation and employment via monetary policy.

As an explanation for the long-lasting Great Depression of the day, Keynes proposed the theory that an economy’s supply and demand curves can be in equilibrium at less than full employment. He asserted that prices rose as employment rose to the point of full employment, after which prices would continue to rise without any increase in GDP. The Great Depression lasted, therefore, because the economy had been at equilibrium for several years and there was no incentive for aggregate demand to move anywhere, and therefore government needed to provide a stimulus to shift the demand curve to the right to reach full employment.

Consumer

Price

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G D P

In other words, the government’s job is to shift aggregate demand from AD to AD1, thereby generating more economic output and increasing equilibrium employment. It has to do this by affecting the different components of aggregate demand, the chief of these being the consumer demand for final goods and services, businesses investment in capital goods to create other goods and services, and the government’s demand for goods and services. AD therefore represents the components of GDP, which also includes the number of exports produced minus the number of imports. In short, AD (GDP) = C + I + G + (x – m).

In order to move the country out of a recession, according to Keynesian macroeconomic theory, the government must use fiscal policy incentives for the economy, the most important of these being the lowering of taxes and an increase of government spending. This reasoning states that a reduction in taxes boosts the individual’s disposable income, and therefore increases consumers’ demands for goods and services, thus stimulating the economy and generating more employment. But the government does not focus solely on increasing consumer demand through tax reduction, since an increase in government demand spending in the economy also helps enhance aggregate demand, aiding the positive shift of the AD curve.

In addition to increasing consumer and government demand through fiscal policy, Keynes’s hypothesis states that the government can use monetary policy to generate investment demand via the manipulation of interest rates. The Federal Reserve attempts to do this through Open Market Operations, in which it engages in the buying and selling of government bonds to manipulate the money supply. The inherent assumption behind monetary policy is that interest rates fall when the money supply increases. To pull the country out of a recession, for instance, the Fed buys bonds on the open market, thereby increasing banks’ monetary reserves and eventually augmenting the money supply, leading to lower interest rates. Since firms invest in capital goods when their profit from such investment will be higher than the current interest rate, investment demand rises as interest rates fall, thus increasing aggregate demand and moving equilibrium GDP towards full employment.

The macroeconomic theory, as Keynes proposed and upon which others have expounded, assumes that all goods and services in the economy may be compounded into one aggregate good to provide a picture of the movements of the economic world as a whole. When this amalgamation is accomplished, the resulting aggregate demand and aggregate supply curves show that the economy may be in equilibrium, with no incentive to change prices or production, at less than full employment. When total output is not enough to employ everyone, government steps in to shift aggregate demand to the right and increase equilibrium employment. It attempts this shift, for instance, through fiscal policy, lowering taxes and increasing government spending. Another way the government affects demand is through the Federal Reserve’s Open Market Operations, buying bonds to increase the money supply, thereby hypothetically lowering interest rates and boosting investment demand.