Keynesian Revolution and Neoclassical Economics (L5) Flashcards
What were the key contributions of the Keynesian Revolution to economic theory?
Key Points:
Introduced macroeconomics as a distinct field, focusing on the economy as a whole.
Critiqued classical economics, especially its labor market analysis and reliance on wage flexibility.
Emphasized the role of aggregate demand in determining output and employment.
Highlighted the inadequacy of Say’s Law and the need for government intervention to stabilize the economy.
Revolutionized the understanding of money, seeing it beyond just a medium of exchange.
How does Keynes’s concept of effective demand differ from classical labor market theories?
Key Points:
Classical theory: Employment determined by labor supply and demand; assumes real wages adjust to clear the market.
Keynesian theory: Employment determined by the point of effective demand, where aggregate supply equals aggregate demand.
Critique of Classical Approach:
Nominal wage rigidity prevents real wage adjustments.
Aggregate demand failures lead to involuntary unemployment.
Explain the Marginal Efficiency of Capital (MEC) and its role in Keynes’s investment theory.
Key Points:
MEC: Expected rate of return on investment projects.
Investment decisions depend on comparing MEC with interest rates.
Uncertainty influences long-term expectations and MEC:
Greater uncertainty reduces confidence and investment.
Keynes emphasized the fragility of investment decisions under uncertain conditions.
How did Keynes critique the Classical Theory of Employment?
Key Points:
Rejected the assumption of labor market equilibrium determining employment.
Emphasized nominal wage rigidity and its impact on real wages.
Stated employment is determined in the goods market, not the labor market.
Critiqued Say’s Law and the reliance on flexible interest rates to balance savings and investment.
What is the Liquidity Preference Theory, and how does it contrast with the Classical Loanable Funds Theory?
Key Points:
Liquidity Preference Theory:
Interest rates are determined by money demand and supply.
Three motives for money demand: transaction, precautionary, speculative.
Loanable Funds Theory:
Interest rates determined by savings and investment equilibrium.
Keynes argued this works only under full employment.
Key difference: Liquidity preference highlights the role of uncertainty in determining interest rates.
What are the policy implications of Keynes’s General Theory?
Key Points:
Advocated for active fiscal policy to stimulate aggregate demand during recessions.
Recommended public spending to offset low private investment and consumption.
Stated monetary policy (interest rate adjustments) is less effective due to:
Uncertainty reducing investment responsiveness.
Liquidity traps where low-interest rates fail to stimulate demand.
Discuss the concept of involuntary unemployment in Keynesian economics.
Key Points:
Occurs when labor supply exceeds demand due to insufficient aggregate demand.
Contrasts with voluntary unemployment in classical theory, where workers reject equilibrium wages.
Caused by:
Nominal wage rigidity.
Firms producing based on effective demand, not full employment.
Policy response: Increase aggregate demand through fiscal intervention.
How does Keynes’s theory address the role of uncertainty in investment decisions?
Key Points:
Distinguished between risk (calculable probabilities) and uncertainty (unknown probabilities).
Investment depends on long-term expectations, which are fragile under uncertainty.
Highlighted the role of confidence and animal spirits in driving investment decisions.
Stated that fluctuations in confidence lead to economic instability (booms and busts).
What is the significance of the IS-LM model in the Neoclassical Synthesis?
Key Points:
Combines Keynesian insights with classical economics.
IS curve: Equilibrium in the goods market.
LM curve: Equilibrium in the money market.
Short-run: Keynesian results hold due to wage rigidity.
Long-run: Classical results prevail with wage flexibility.
According to Keynes, why is fiscal policy more effective than monetary policy during recessions?
Key Points:
Fiscal Policy:
Directly increases aggregate demand through government spending.
More reliable under conditions of uncertainty.
Monetary Policy:
Limited by liquidity traps where low interest rates fail to stimulate investment.
Relies on confidence, which is fragile during recessions.
What is Say’s Law, and how did Keynes challenge it?
Key Points:
Say’s Law: “Supply creates its own demand.”
Classical assumption that excess supply is absorbed by increased savings and investment.
Keynes’s Critique:
Savings do not automatically equal investment; aggregate demand failures can persist.
Effective demand determines output, not supply-side dynamics.
Rejected reliance on flexible interest rates for equilibrium.
How does Keynes’s concept of aggregate demand differ from classical economics?
Key Points:
Aggregate Demand (Keynesian):
Composed of consumption and investment (AD = C + I).
Determined by marginal propensity to consume (MPC) and investment influenced by uncertainty.
Classical Approach:
Assumes demand always equals supply through flexible prices.
Key Difference: Keynes emphasized demand shortfalls as a cause of unemployment.
Explain the differences between voluntary and involuntary unemployment in economic theories.
ey Points:
Voluntary Unemployment (Classical):
Workers refuse to accept equilibrium wages.
Involuntary Unemployment (Keynesian):
Workers willing to work at prevailing wages, but jobs are unavailable due to insufficient aggregate demand.
Caused by wage rigidity and demand-side issues.
Policy Focus:
Classical: Wage flexibility.
Keynesian: Stimulating aggregate demand
How did Keynes redefine the role of money in economic theory?
Key Points:
Classical View: Money as a medium of exchange; neutral in the long run.
Keynesian View:
Money influences demand and investment decisions.
Introduced liquidity preference theory: demand for money driven by transaction, precautionary, and speculative motives.
Emphasized uncertainty’s role in holding money for liquidity.
What is the Psychological Law of Consumption, and why is it significant?
Key Points:
Psychological Law: As income increases, consumption increases but at a slower rate (MPC < 1).
Significance:
Explains why aggregate demand may lag behind income growth.
Provides a basis for understanding savings and their impact on the economy.
Policy Implication: Government spending can offset shortfalls in private consumption.
What is the importance of the point of effective demand in Keynesian theory?
Key Points:
Definition: The intersection of aggregate supply and aggregate demand curves.
Determines:
Total output.
Employment levels needed to produce that output.
Contrasts with Classical Theory:
Classical: Employment determined by labor market equilibrium.
Keynesian: Employment determined by effective demand.
What role does uncertainty play in Keynes’s theory of investment?
Key Points:
Uncertainty: Future outcomes with no calculable probabilities.
Investment depends on:
Long-term expectations.
Confidence levels, which fluctuate based on market psychology.
Implications:
High uncertainty leads to reduced investment.
Confidence cycles drive economic instability (booms and busts).
Interest rates alone cannot mitigate uncertainty.
How does the IS-LM model interpret Keynes’s General Theory?
Key Points:
IS Curve: Goods market equilibrium (investment = savings).
LM Curve: Money market equilibrium (liquidity preference = money supply).
Short-run: Captures Keynesian wage rigidity and demand failures.
Long-run: Assumes classical wage flexibility and full employment.
Critique: Oversimplifies Keynes’s deeper insights on uncertainty and liquidity.
What are the limits of monetary policy in addressing recessions?
Key Points:
Relies on reducing interest rates to stimulate investment.
Keynes’s Critique:
Investment depends on confidence, not just interest rates.
Liquidity traps render monetary policy ineffective when interest rates are low.
Alternative: Fiscal policy directly increases aggregate demand.
How does Keynes’s theory differ from the Classical Theory in terms of policy recommendations?
Classical Policy:
Focus on market self-correction.
Emphasis on wage and price flexibility.
Keynesian Policy:
Advocated for government intervention.
Fiscal stimulus to address demand shortfalls.
Monetary policy secondary to confidence and uncertainty considerations.
