Keynesian Economics Principles

• Effective demand and its impact on economic activity are central to Keynes's Theory of Effective Demand.
• Keynes refuted the Classical theory, arguing that the market mechanism doesn't automatically lead to full employment.
• Keynes advocated for government intervention, particularly through fiscal policy, for economic stabilization.

Meaning of Aggregate Demand

• Aggregate Demand (AD) represents the total demand for goods and services in an economy
• AD = C + I + G + (X - M)
  • C = Consumption demand by households
  • I = Investment demand (capital goods) by businesses
  • G = Government expenditure
  • X – M = Net income from abroad

Keynes's Theory of Aggregate Demand

• Keynes argued full employment isn't the normal state, unlike what Classical theory suggests.
• The economy can reach equilibrium at less than full employment.
• If aggregate demand is insufficient to purchase all goods, output will be reduced.
• Equilibrium employment results when aggregate supply aligns with the existing level of aggregate demand.
• The theory posits that "demand creates its own supply", contrasting with the Classical view of "supply creates its own demand".

Aggregate Demand Function

• Aggregate demand price refers to the total receipts firms expect from selling output based on a given number of workers
• Aggregate demand increases with more workers, resulting in a rising curve.
• The aggregate demand function (ADF) increases sharply initially as employment increases, leading to higher societal expenditure and producer sales receipts.
• The ADF curve plateaus (becomes perfectly elastic) as the economy nears full employment due to diminishing increases in employment and expenditure.

Aggregate Supply Function

• Aggregate supply depends on the physical and technical conditions of production.
• In the short run, output can only be increased by employing more labor, assuming technical conditions are constant
• Aggregate supply price represents the total receipts firms must expect from selling output based on the number of workers employed.
• The aggregate supply function curve rises, becoming perfectly inelastic (vertical) at full employment (OLf).
• The aggregate supply function (ASF) increases gradually initially due to abundant labor and slow cost increases, but labor costs rise sharply as the economy approaches full employment.

Determination of Equilibrium Level of Employment

• Keynes stated equilibrium employment in the short run is determined by effective demand.
• Higher effective demand leads to more income and employment, and vice versa.
• The ADF indicates the total receipts firms expect from selling output based on the number of workers employed, while the ASF shows the receipts firms must expect.
• Entrepreneurs will increase output as long as there are opportunities to profit.
• Producers expand output up to the point OL, where aggregate demand price exceeds aggregate supply price.
• Beyond OL, aggregate demand price is less than aggregate supply price, leading producers to cut back output
• OL represents the equilibrium level of employment where aggregate demand price equals aggregate supply price.
• Point 'E', also know as the point of effective demand, signifies the equilibrium position where aggregate demand price equals aggregate supply price.
• The equilibrium point 'E' is established at less-than-full employment equilibrium, resulting in involuntary unemployment.
• Keynes attributes this unemployment to deficient aggregate demand.
• At full employment, a gap exists between the full-employment levels of aggregate supply price and aggregate demand price.

Explore core tenets of Keynesian economics. Understand Keynes challenge to classical theory. Learn about the role of aggregate demand and government intervention in stabilizing the economy.