Keynesian Economics is a macroeconomic theory that came into existence after the fall of Classical Economics. It was given by John Maynard Keynes in order to understand the Great Depression of the 1930s. His theory focussed on aggregate demand and aggregate supply. This theory was the refutation to the classical economics.
Keynes theory of employment was based on the principle of effective demand. According to this, the level of employment in a capitalist economy depends on the effective demand. Unemployment is the result of deficiency of effective demand.
Keynes used the term aggregate demand price and aggregate supply price to explain effective demand.
Aggregate demand price refers to the amount of money which entrepreneurs expect to get by selling the output. It is basically the expected revenue from the sale of outputs at a certain level of employment.
Aggregate supply price on the other hand refers to the proceeds necessary for the sale of output at a particular level of employment. Basically each level of employment is related to a particular aggregate supply price.
The determination of effective demand is done by using aggregate demand price and aggregate supply price. The level of employment is determined when aggregate demand price is equal to the aggregate supply price. This level of employment is also the point of effective demand and here entrepreneurs earn normal profits.
Keynes also criticized the idea of excessive saving, unless it was for a specific purpose such as retirement or education. He saw it as dangerous for the economy because the more money sitting stagnant, the less money in the economy stimulating growth. Instead, he focussed more on investment and highlighted it’s role in determining the level of employment in the economy. According to him, aggregate demand function depends on the consumption function and investment function. A fall in any of these two functions result in unemployment. Thus it is the aggregate demand function which is the effective element in the principle of effective demand.
Keynesian economics focuses on demand-side solutions to recessionary periods. The intervention of government in economic processes is an important part of it. Keynesian theorists argue that economies do not stabilize themselves very quickly and require active intervention that boosts short-term demand in the economy.
Keynes also reformulated the Quantity Theory of Money. He criticised the classical idea of money being neutral. According to him money is the link between the present and the future. The Keynesian theory emphasises that the price level is in fact a consequence of aggregate demand or expenditure relative to aggregate supply rather than of quantity of money.
The multiplier effect was developed by Keynes’s student Richar Kahn. According to Keynes’s theory of fiscal stimulus, an injection of government spending eventually leads to added business activity and even more spending. This theory proposes that spending boosts aggregate output and generates more income. The magnitude of the Keynesian multiplier is directly related to the marginal propensity to consume. Keynes and his followers believed individuals should save less and spend more, raising their marginal propensity to consume