Macroeconomic Equilibrium in the Keynesian Model

Before The Great Depression started, economists mistakenly thought unemployment was just a minor problem related to the standard changes economy suffers throughout the years. However, beginning in 1930, developed countries started suffering one of the worst economic crises the world had ever seen.

Many economists had troubles trying to explain the reason behind the high levels of unemployment and the persistent economic crises.

The Great Depression was one of the most prominent and unexpected hits the American economy suffered. For instance, in 1929, it was active even when unemployment was only 3.2%. However, it was in October of the same year when the stock exchange exploded, and with that, corporative actions dropped down to two-thirds of the value it had in 1928. A significant part of the world succumbed and got trapped in a macroeconomic equilibrium where the real GDP levels were hugely lower than those from the nominal GDP.

Due to this, in The Great Depression’s worst part in the USA, one in four workers was unemployed. This situation was the starting point for the emergence of new economic theories, leaving behind the classic ones related to the aggregated fluctuations.

One of the most significant contributions came from a British economist, John Maynard Keynes. According to his projection, many reasons could exist to believe an economy could get stuck in equilibrium where the product’s level would be lower than their unemployment levels.

Keynes defended an equilibrium’s existence within an economy with massive unemployment. But not only that, but he also projected that an economy with full employment levels would be hugely unstable, making it very likely for it to fall once again into a depression.

Before this book was published, economic sciences were based on the equilibrium between demand and supply. However, Keynes’ proposal was found in other equilibrium, one between income and expenses, and between rent and aggregated demand.

John Maynard Keynes was the oldest of three siblings of a family that was based in Cambridge. He studied economics at Cambridge University and wrote several books, such as “Treatise on Money” and “Treatise on Probability.” However, in 1936, Keynes published his famous book, “The General Theory of Unemployment, Interest, and Money.” The basic idea was that insufficient aggregate demand was the cause of unemployment. This was an innovative idea, and it went against the currently used theories for that time.

It was in that same year where the “Keynesian revolution” started. The Keynesian fiscal policy was implemented in 1940 in the United States and a year later in Great Britain. Many have discussed how Keynes’ theory can only be applied to an isolated event like The Great Depression, while others say his work is at the same level as other authors, like Karl Marx or Adam Smith.

Keynesian Equilibrium

According to the Keynesian model, the macroeconomic equilibrium is only achieved when a balance between aggregate production and aggregate expenditures exist. The Keynesian model also states that both forces will remain the same; nothing will change until an outside event has an intervention.

Before going further, it is necessary to explain the aggregate forces concepts.

Aggregate Forces

As mentioned previously, two opposing forces must be in balance in order to achieve the Keynesian model’s macroeconomic equilibrium. These are explained below.

Aggregate Production

Aggregate production is the final quantity of goods and services produced by an economy in a given period, which is generally one year.

Aggregate Expenditures

According to Keynes, aggregated expenditures are the key to economic activity. In other words, what families, businesses, and the government think about purchasing is what determines what the businesses will end up producing.

For instance, when a family thinks of purchasing a car or installing new home appliances around the house, they take the decision after considering it for a long time. They take into consideration the family’s long-term situation as well. Said purchases are the main factors of aggregated expenditures.

The four aggregated expenditures are the following:

  • Consumption expenditures are represented by the letter “C.”
  • Investment expenditures are represented by the letter “I.”
  • Government purchases are represented by the letter “G.”
  • Finally, the net exports. They are represented by the “(X – M)” formula.

Considering all these factors, the equation used to represent aggregate expenditures is:

AE = C + I + G + (X – M)

With all of this being said, it is necessary to point out two crucial facts:

  • The equilibrium is maintained by aggregate production. Therefore, if aggregate expenditures are unequal to the aggregate production levels, the aggregate production fluctuates to restore the balance.
  • Again, the Keynesian macroeconomic equilibrium only considers the balance given by the equality of aggregate production and aggregate expenditures. Other aggregate markets are excluded from this. What this says is that the Keynesian equilibrium does not automatically generate favorable full employment levels.

Other Key Points

Keynesian economics is based on two fundamental premises. The first one says it is more likely for the aggregate demand’s movements to be the leading cause of an economic event in the short-term as a recession. The second says that salaries and prices may be rigid, and therefore, they can cause unemployment in a financial crisis.

Rigid Salaries and Prices are those that do not suffer a diminution as a response to low demand levels. Neither they increase whenever the demand levels are higher.

Types of Macroeconomic Equilibrium

There are two types of macroeconomic equilibrium:

  • Short-run: It happens when the demanded quantity of real GDI is equal to its supply quantity.
  • Long run: It happens when the aggregated offer does not reflect the real production; it reflects another potential or long-term one. In this case, potential production and aggregated demand are the variables that determine the level of prices.

Basic Elements of the Keynesian Analysis

The Keynesian model’s main premise is explaining why recessions and depressions occur while offering specific solutions to reduce their effects. With this being said, when it comes to recessions, two principles need to be considered:

First:  The aggregated demand is never high enough to provide businesses an incentive so that they can hire enough workers and reach full employment.

This first element says that recessions originate whenever the domestic and business sectors’ demand is lower than the production obtained when the workforce is used at its fullest.

Second: Macroeconomics can only be adjusted slowly to the demand’s changes due to the rigid salaries and prices. This is because the latter ones do not react to the demand’s differences, whether it increases or lowers.

What did Keynes propose precisely?

According to the neoclassic model, unemployment exists in a free market. According to their production capacity, people are unemployed because they’re requesting a salary that’s too high. This model says these people could find a job if they reduce their salary expectations. Due to the minimum salary’s inexistence, unemployed people could find a job easily because employers would hire more people.

By using this model, reflecting on the Great Depression’s state would be too challenging. However, by using the Keynesian model, we could conclude that the problem is that, sometimes, production levels lower than what’s necessary, and that’s why unemployment occurs. Since unemployed people do not acquire goods and services, businesses do not hire more people because there is not enough demand.

The Keynesian model proposes to increase the Government or Public Purchases (G) so that employment increases, creating even more employment opportunities until an equilibrium point is reached.

Conclusion

The Keynesian model was harshly criticized by Milton Friedman several years later due to the correct functioning of the demand’s expansion, which generates inflation on multiple occasions. However, in most countries worldwide, government purchases have been increased to improve the economic situation.

The indebtedness the state needs to spend more than it earns provokes that, in the future, a debt must be repaid (hence the zero deficit policies). Due to this, Keynes’ phrase, “In the long run, we are all dead.”

In the latest years, Keynesian and neo-Keynesian economists have been reemerging, and they are taking a well-earned in our everyday lives. An excellent example of this is Paul Krugman, who won the Nobel Prize in Economic Sciences.

One of the main advantages of this instrument is that comparing it to the analysis that only studies one market can conclude that the former is limited. The macroeconomic equilibrium theory allows us to recognize the effects that certain adjustments may have on the economy.

Keynes’ work originated a critical repercussion. Some of his followers have tried to formalize a Keynesian model mathematically. However, although Keynes had studied statistics and other fields related to mathematics, he did not agree with “mathematizing” the economy, unlike many of his followers.

To this day, the Keynesian model is criticized, with many new books and studies being published each day. It is evident that the model had a great repercussion, and it will keep being like that in the future.

As of now, it is still being used to explain multiple phenomenons that occur in today’s economy.

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