Keynesianism

5.1. What It Is

Keynes’s The General Theory.

5.2. Equilibrium in the Product Market

Although the spontaneous operation of the capitalist market can make investment equal saving, that equilibrium is not necessarily at the full-employment level. It can also be below full employment. In that case, the state needs to intervene in economic life to increase investment so that investment and saving are equal at the full-employment level.

Definition: national income = consumption + saving.

Equilibrium condition: investment = saving.

5.2.1. Consumption Function

Consumption function: consumption = c(income), meaning that when income rises, consumption also rises, but consumption rises by less than income.

Average propensity to consume: APC = consumption / income.

Marginal propensity to consume: MPC = change in consumption / change in income.

Both decline, but average > marginal.

Once consumption is known, saving can be calculated as national income - consumption.

Saving function: saving = s(income), meaning that as income rises, consumption increases by less and less while saving increases by more and more.

Average propensity to save: APS = saving / income.

Marginal propensity to save: MPS = change in saving / change in income.

Both increase.

5.2.2. Investment Function

Investment refers to increases in factories, equipment, and inventories.

Gross investment = net investment + depreciation of equipment.

Whether to invest is determined by the interest rate and the marginal efficiency of capital (expected rate of return). If the interest rate < the marginal efficiency of capital, invest; otherwise, do not invest.

Marginal efficiency of capital: the discount rate. The discount rate converts the expected returns of a capital good during its service life into present value so that the present value equals the cost of the capital good.

Marginal-efficiency-of-capital curve: investment quantity = i(interest rate), meaning that the higher the interest rate, the less the investment.

Marginal-efficiency-of-investment curve: investment quantity = i(interest rate), meaning that the higher the interest rate, the less the investment.

The difference between the marginal efficiency of capital and the marginal efficiency of investment lies in the effect of the interest rate.

Besides the interest rate, other factors affect investment: human factors (autonomous investment), changes in income (induced investment), and changes in investment caused by changes in income (the acceleration principle).

5.2.2.1. National Income

Income is determined by investment and saving.

Two sectors (households + firms):

Total expenditure = household consumption + firm investment.

Total income = household consumption + household saving.

Because total expenditure = total income -> firm investment = household saving.

Three sectors (households + firms + government):

Total expenditure = household consumption + firm investment + government expenditure.

Total income = household consumption + household saving + taxes.

Because total expenditure = total income -> firm investment + government expenditure = household saving + taxes.

Four sectors (households + firms + government + international trade):

Total expenditure = household consumption + firm investment + government expenditure + imports.

Total income = household consumption + household saving + taxes + exports.

Because total expenditure = total income -> firm investment + government expenditure + imports = household saving + taxes + exports.

5.2.2.2. Multiplier Theory

Used to explain how changes in investment cause changes in income.

When total investment increases, the increase in income is K times the increase in investment. This K is the investment multiplier.

Multiplier = 1 / (1 - marginal propensity to consume).

5.2.2.3. Acceleration Theory

Used to explain how changes in income cause changes in investment.

Capital-output ratio: the amount of capital required to produce one unit of output.

An increase in income causes investment to increase by v times. This v is the accelerator.

Accelerator = change in total investment / (current-period income - previous-period income).

5.2.2.4. IS Curve

The functional relationship between the interest rate and income under product-market equilibrium is called the IS curve.

On this curve, investment = saving.

5.3. Equilibrium in the Money Market

5.3.1. Demand for Money

People need money for three motives.

Transaction motive: hold some money to meet the needs of daily transactions.

Precautionary motive: hold some money to prevent unexpected expenditures.

Money demand from the transaction motive + precautionary motive = money demand from transaction motive + precautionary motive (income) = K * income = K * price level * real income.

Speculative motive: hold some money in order to seize opportunities to purchase interest-bearing assets.

Money demand from the speculative motive = money demand from the speculative motive (interest rate).

Money demand = money demand from transaction motive + precautionary motive (income) + money demand from speculative motive (interest rate).

5.3.2. Money Supply

Narrow money supply = coins + paper currency + bank demand deposits.

Broad money supply = narrow money supply + time deposits.

The money supply depends on national monetary policy and is unrelated to the interest rate.

Real money stock = nominal money stock / price index.

Real money stock m = money m1 used to satisfy transaction demand (transaction motive + precautionary motive) + money m2 used to satisfy speculative demand (speculative demand).

5.3.3. Equilibrium in the Money Market

Money demand is described by curve L, and money supply is described by curve m.

Every point on the LM curve represents money supply = money demand.

5.4. General Equilibrium of the Product Market and Money Market

The intersection of the IS and LM curves is the simultaneous equilibrium of the two markets.

5.5. Keynesian Economic Policy

Economic policy refers to guiding principles and measures formulated by the state or government to solve economic problems in order to improve economic welfare.

5.5.1. Full Employment

There are three kinds of unemployment: frictional unemployment (unavoidable), voluntary unemployment (unwilling to accept low wages, etc.), and involuntary unemployment (willing to accept low wages but still unemployed).

There is no contradiction between full employment and the simultaneous existence of frictional and voluntary unemployment.

5.5.2. Price-Level Stability

The price here is a general macroeconomic concept, not the price of a specific commodity in microeconomics.

The price level is described with price indexes, including the consumer price index (households) and the wholesale price index (firms).

Stability means that inflation does not occur.

5.5.3. Rapid Economic Growth

The sustained growth of per-capita output and per-capita income produced by society in Beijing-Tianjin-Hebei during a specific period.

Economic growth is measured by calculating the average annual growth rate of real gross national product over a certain period.

5.5.4. Balance of Payments Equilibrium

5.6. Fiscal Policy

5.6.1. Government Expenditure

Expenditures by governments at all levels.

By expenditure method, they can be divided into government purchases and government transfer payments.

5.6.2. Government Revenue

5.6.2.1. Taxes

By object of taxation: property tax, income tax, and commodity tax.

By method of taxation: direct tax and indirect tax.

By the proportion deducted from income: regressive tax, proportional tax, and progressive tax.

5.6.2.2. Public Debt

Government debt, including central-government debt (national debt) and local-government debt.

By maturity, it can be divided into short-term and medium- to long-term debt.