Keynesian Revolution and Neoclassical Economics: Key Words and Concepts Flashcards
Marginal Efficiency of Capital (MEC)
Definition: The expected return on investment projects, decreasing as risk increases.
Context: Introduced by Keynes to explain investment decisions under uncertainty.
Relevance: A key determinant of investment alongside interest rates.
Liquidity Preference Theory
Definition: Interest rates are determined by money demand and supply, not savings and investment equilibrium.
Motives for Money Demand:
- Transaction: Payments for goods and services.
- Precautionary: For unexpected expenses.
- Speculative: Investment opportunities.
Relevance: Central to Keynes’s critique of classical economics.
Phsycological Law of Consumption
Definition: As income increases, consumption rises but at a slower rate (MPC < 1).
Context: Basis for Keynes’s aggregate demand curve.
Relevance: Explains why demand may not match supply, leading to unemployment.
Say’s Law
Definition: “Supply creates its own demand.”
Key Idea: Classical belief in market self-correction via flexible interest rates.
Relevance: Critiqued by Keynes for ignoring demand-side dynamics.
Effective Demand
Definition: Point where aggregate demand equals aggregate supply, determining output and employment.
Relevance: Central to Keynes’s theory of employment and output determination.
Involuntary Unemployment
Definition: Occurs when labor supply exceeds demand due to wage rigidity or insufficient aggregate demand.
Relevance: Critique of the classical assumption that all unemployment is voluntary.
Uncertainty
Definition: Future outcomes with unknown probabilities, unlike calculable risks.
Relevance: Influences investment decisions, confidence, and market instability.
Keynesian Revolution
Key Ideas:
Introduction of macroeconomics as a distinct field.
Focus on aggregate demand in determining employment.
Government intervention as a stabilizing force.
Critique of Classical Economics:
Labor market analysis ignored wage rigidity.
Insufficient explanation for unemployment during the Great Depression.
Classical Theory of Employment
Key Concepts:
Employment determined by labor supply and demand.
Market-clearing mechanism adjusts real wages to equilibrium.
Types of Unemployment:
Voluntary: Workers refuse equilibrium wages.
Involuntary: Labor supply exceeds demand due to wage rigidity.
Limitations:
Does not account for aggregate demand failures.
Keynes’s Critique of Classical Economics
Key Points:
Rejects labor market as sole determinant of employment.
Emphasizes goods market and aggregate demand.
Introduces nominal wage rigidity and the concept of effective demand.
Impact: Shifted focus from individual markets to the economy as a whole
Investment and Confidence
Key Ideas:
Investment depends on MEC and interest rates.
Confidence and long-term expectations play a significant role.
High uncertainty leads to reduced investment and economic instability.
Keynes’s Insight: Interest rates alone cannot restore confidence.
Neoclassical Synthesis
Key Contributions:
IS-LM Model (Hicks): Combines Keynesian and classical ideas.
Short-run wage rigidity leads to Keynesian results.
Long-run flexibility supports classical equilibrium.
Critiques:
Overlooks Keynes’s deeper insights on uncertainty and liquidity.
Keynesian Recommendations
Policy Implications
Keynesian Recommendations:
Fiscal policy to stimulate demand during recessions.
Public spending to offset low private demand.
Limits of Monetary Policy:
Confidence and uncertainty reduce effectiveness.
Fiscal policy is more direct in addressing demand shortfalls.
Aggregate Supply and Demand
Key Concepts:
Aggregate Supply Curve: Output levels for varying employment.
Aggregate Demand Curve: Consumption and investment levels.
Effective Demand: Determines employment and output.
Key Insight: Employment depends on demand, not just labor market equilibrium.
