10 July 2012

Simple Keynesian Economics

One day I will find the time to write my pamphlet on an alternative economic strategy for the Labour party.

In the meantime here is one of the key ideas. In place of "crude Keynsianism", I want to offer simple Keynsianism. Keynes devised a complex and subtle theory which he laid out in a difficult book. I attempt to simplify his core idea as a base for policy prescriptions.

Simple Keynesianism can be explained in four steps and one diagram.  

These are the key steps:
1.      Income increases as employment increases.
2.      Income is the sum of consumption and investment.
3.      Consumption increases as income increases but not by as much.
4.      Investment decreases when entrepreneurs prefer to hold cash.

In step 1, income means the total of all income in the economy - ie wages and profit. Because everyone's purchases are someone else's income, income is equal to the total value of production. Step 2 means that everything which is produced is either consumed or used to contribute to future production. Investment, therefore, includes capital equipment, infrastructure, stocks of raw or finished goods and other working capital. Keynes used the term 'propensity to consume' to describe step 3. A society with a low income will use most of its income to meet immediate needs. A richer society will consume more in total but a lower proportion of income is spent on consumption. The first three steps are illustrated in figure 1.

A number of factors influence the level of investment, such as the expected return and the interest rate. Keynes innovation was to identify the importance of a psychological factor, 'liquidity preference' which means the desire to hold money rather than tie it up in investment.

In the diagram we have the economy a full employment (N0), with a high level of income (Y0) and consumption. Following an external shock, (for example a banking crisis) liquidity preference rises, which means that businesses postpone investment in order to hold more cash. Lower investment means lower income (Y1) which means lower employment (N1). At this lower level of employment consumption is also lower and so employment falls even further. The fall in employment means a fall in income which means another (smaller) fall in consumption. Employment continues to fall until a new equilibrium is reached, but now with employment (N2) and income (Y2) below their potential level.

That is it, the simple version of Keynes' theory of employment.

Perhaps a little algebra will help. Keynes says that income (Y) equals consumption (C) plus investment (I). Y = C + I.

At full employment Y0 = C0+ I0. When liquidity preference rises investment falls, let's say by the difference between Y0 and Y1. Now Y1 = C0 + I1. At Y1 the propensity to consume gives a level of consumption below C0. Thus consumption falls as does income and employment. At this lower level of income consumption falls again, and keeps falling until equilibrium is reached, Y2 on the diagram.

I have explained the simple Keynesian theory without mentioning the multiplier. In fact the explanation is there. A fall in investment caused a fall in income more than the initial cut in investment spending.
 My idea is to argue that Keynes theory is not about boosting government spending. It is primarily about increasing investment. Part of the investment will be by government but we need to start by looking at private sector investment as well.

My first question however is does this explanation do the job. Is simple Keynesianism sufficiently clearly explained and easy to grasp?

1 comment:

  1. This is really nice. The diagram is the height of perspicuity. Thanks!