An illustrated guide to Keynesian theory based on the work of John Maynard Keynes. But besides saving, there are other leakages in the process of income generation which reduce the size of the multiplier. This explains the paradoxical feature of an economy gripped by recession. This refers to a situation when at a certain rate of interest the speculative demand for money becomes perfectly elastic. A part of the increment in income is used for paying back the debts which the people have taken from moneylenders, banks or other financial institutions. Therefore, the propensity to consume is stable. Keynesian economists justify government intervention through public policies that aim to achieve full employment and price stability.
Economic units hold a part of their wealth in the form of financial assets. Besides, at times there is a lot of excess or unutilized capacity in several industries in India due to the deficiency of aggregate demand. Another important assumption in the theory of multiplier is that excess capacity exists in the consumer goods industries so that when the demand for them increases, more amounts of consumer goods can be produced to meet this demand. As a result, the organization would start incurring losses; therefore would reduce the employment rate. The multiplier theory of Keynes helps a good deal in explaining this paradox. Consequently, the size of multiplier is smaller than that of simple Keynesian multiplier with a given fixed price level.
Let us study these two concepts in detail. In this theory, business owners use the most efficient practices to maximize. Since Keynes assumes all these four quantities, viz. This puts the task of increasing output on the shoulders of the government. Once set in motion, employment and income tend to rise in a cumulative manner through the multiplier process till they reach the equilibrium level.
Further, according to classical economists, savings determine investment which plays a crucial role in accelerating the rate of economic growth. Now suppose that expecting hard times ahead all people try to save more by the amount of Rs. But at a lower rate of interest higher bond price some bulls will become bears and positive demand for speculative balances will emerge. So, there is no deficiency in aggregate demand and hence no possibility of over-production and unemployment. Since unemployment results from the deficiency of aggregate demand, employment and income can be increased by increasing aggregate demand.
Indeed, the combined working of multiplier and acceleration, which is called super-multiplier, leading to manifold increase in output can take place in the growth process in the developing countries like India. He has criticized classical theory of employment in his book. Multiplier with Changes in Price Level: In our above analysis of multiplier with aggregate demand curve, it is assumed that price level remains constant and the firms are willing to supply more output at a given price. Then liquidity preference is analysed as behaviour towards risk under uncertainty. Through it Keynes made a part of the demand for money a declining function of the rate of interest, the latter a purely monetary phenomenon and the sole carrier of monetary influences in the economy. The multiplier is illustrated in Fig. This implies that supply creates a matching demand for it with the result that the whole of output is sold out.
British economist John Maynard Keynes spearheaded a revolution in economic thinking that overturned the then-prevailing idea that free markets would automatically provide full employment—that is, that everyone who wanted a job would have one as long as workers were flexible in their wage demands see box. For example, if marginal propensity to consume b is 0. Therefore the aggregate supply price varies according to different number of workers employed. In an economy, the employment level depends on the number of workers that are employed, so that maximum profit can be drawn. Thus, if we look at increment in investment from the viewpoint of dynamics of development and take a longer time horizon, multiplier effect of new investment in the developing countries can become a reality. The transactions motive gives rise to the transactions demand for money which refers to the demand for cash of the public for making current transactions of all kinds. Therefore, according to them, Keynesian multiplier did not operate in real terms in under developed countries and actually leads to the rise in price or inflationary conditions in them.
Further, it now became clear that the Government intervention, through the adoption of appropriate fiscal and monetary policies, can avert the collapse of the economy such as that happened during 1929-33. Later efforts to add other motives such as the finance motive by Keynes 1937 and Robertson 1938 and the diversification motive by Gurley and Shaw 1960 have not been successful. It is the demand for bearish hoards. Treasury official Harry Dexter White, Keynes is considered the intellectual founding father of the International Monetary Fund and the World Bank, which were created at Bretton Woods. The Great Depression had proved that market forces cannot attain equilibrium themselves; they need an external support for achieving it.
Rao, the existence of disguised unemployment in underdeveloped countries instead of Keynesian type involuntary open unemployment also prevented the working of multiplier in real terms. For example, during economic downturns uncertainty often erodes consumer confidence, causing them to reduce their spending, especially on discretionary purchases like a house or a car. But the money held for speculative motive M 2 is a function of the rate of interest r , i. Therefore, multiplier here is equal to 5. For this Government will pay wages to the labourers engaged, prices for the materials to the suppliers and remunerations to other factors who make contribution to the work of road-building. The result is a , diversified asset portfolio and a downward sloping asset demand curve for money with respect to r even at the micro level. If the market rate of interest rises to 5 per cent per year, the market price of the bond will fall to Rs.
Thus the amount held under these two motives M 1 is a function L 1 of the level of income Y , i. Imports are important leakage from the multiplier process and we have ignored them in our above analysis for the purpose of simplicity. The Keynesian theory of employment and income is also explained in terms of the equality of aggregate supply C+S and aggregate demand C+I. All these elements remain constant during the short-run. During the Great Depression of the 1930s, existing economic theory was unable either to explain the causes of the severe worldwide economic collapse or to provide an adequate public policy solution to jump-start production and employment. We can express this in a general formula. Also, as in Baumol-Tobin theory, the transactions demand for money also is interest elastic.