Keynes- Principle of effective demand Flashcards
What did Keynes disagree could be guaranteed in a developed economy?
An economy shouldn’t expect to achieve full labour employment
Why did Keynes criticize orthodox theory that by reducing real wages employment would rise? (3)
Partial equilibrium ignores effect of reduced AD from consumer spending
Reduced spending causes price level to fall with nominal wages therefore real wage rate is unchanged
Investment will also fall due to reduced capital utilisation decreasing AD further
Deflation causes delay of purchases and increases real value of debt
What fallacy do partial equilibrium’s create?
Fallacy of composition
Keynes suggestion to increase employment
Injection of demand
Principle of effective demand (4)
Investment need not be sufficient to ensure full employment
Consumption is a fraction of NI so saving increases with increased NI
Income is determined by investment demand
Todays investment raises tomorrow’s capital stock in hope of higher output that the market will absorb
What is the active element of the economic system
Investment not savings but in equilibrium I=S
What is investment based on?
‘Animal Spirits’ Confidence and expectation based on incomplete knowledge
What is consumption based on?
A known quantity, current income
2 Things shown by multiplier
An initial investment can stimulate much greater economic growth
Investment creates economic volatility
Role of IR to Keynes (2)
Adjust cost of investment to control AD however may not be possible to achieve full employment through monetary policy only
To equate the demand for liquidity to the supply of money
Role of money to Keynes
Store of value not just payment
Guard against uncertainty (determination to maintain a buffer can create the liquidity trap)
How could the unemployment equilibrium be normal for advanced economies
Demand for money increases with income per capita
Savings grow faster than income (especially when there’s inequality
As capital stock grows profitable opportunities diminish
What is the warranted rate of investment?
The rate at which the economy is neither heading for a boom or depression
When will unsustainable debts arise from growth in tax revenue
When the real Interest rate>Growth of income
What explains the end of boom and bust cycles?
Boom ends when wages and IR increases to the point where eroded profits kills investment
Bust ends when reduced WR and IR restore profitability
