When Keynes developed his model of the macroeconomy, he believed that markets were inherently unstable and this was essentially responsible for changes in the level of output (i.e. the business cycle). People were likely to engage in herd-like behaviour, sometimes acting somewhat against the benefit of the economy as a whole. For example, when there was a decrease in consumer confidence, people would have a natural inclination to increase their savings and this would lead to a fall in aggregate demand. This fall in aggregate demand would lead to an increase in the unemployment rate and a fall in living standards. Keynes called this the ‘paradox of thrift’ or the paradox of saving. Keynes’ theory led to the development of the ‘multiplier’. The basic premise was that when a component of AD is affected (in either a positive or a negative direction), there is likely to be a much larger impact on AD and real output. He described this as a chain reaction that occurred throughout the economy, such that increases (or decreases) in one sector of the economy, led to increased (or decreased) spending in the rest of the economy (via the core section of the circular flow model).

For example, imagine that there is a recession in one of Australia’s key trading partners e.g. Japan. The reduction in production in Japan, for example, would be an external shock for Australia and will have ramifications for the level of economic activity. With declining incomes in Japan, their demand for a wide range of goods and services will decline. They may choose to holiday less in Australia and the demand for export services such as tourism might decrease. The lower level of demand in the economy would encourage tourist operators to look at their production activities and they will recognise that their need for labour has decreased. This might lead to a reduction in hours worked or the number of employees who are hired. The reduced sale of accommodation therefore leads to a reduction in incomes; the business owner’s profits decrease and the workers’ wages are reduced (either from reduced hours or from unemployment). The secondary and subsequent round of effects is sometimes referred to as ‘induced’ spending.

The reduced level of activity in the tourism sector will also tend to flow through to other sectors in the economy. The fall in incomes for the hotel owner and the workers reduce their ability to purchase other goods and services offered for sale in the economy. They may spend less at nearby shops, which leads to a reduction of income for those shopkeepers and their employees. This reduces their willingness and ability to consume, and the cycle continues. Keynes therefore believed that governments needed to intervene in the economy so that these ‘induced’ changes were stabilised and the severity of the business cycle was reduced.

Keynes based his theory upon the key assumption of ‘sticky’ wages and prices in his model of the economy. When the economy experienced a decrease in aggregate demand for some reason, this would lead to a decrease in supply because producers would not want to produce goods that could not be sold in the market. The lower level of demand in the economy would lead to a decrease in the derived demand for labour and the unemployment rate would increase. In a fully flexible labour market, a higher unemployment rate should lead to a lower equilibrium wage rate because labour demand would have fallen relative to labour supply (labour is essentially less scarce). If wages were able to fall then the incentive to hire would return and the AS would increase. If wages were ‘sticky’, however, the equilibrium wage would not fall (workers may be on contracts or protected by minimum wages) and hence the unemployment would persist. Keynes also believed that even when there were unemployed resources and the economy was operating below full capacity, prices were also relatively sticky (firms would be reluctant to lower prices if their costs of production remained high).

Another key aspect of the Keynesian model is the emphasis on ’animal spirits’. This is a term used to describe the general level of optimism or pessimism that may be pervasive at different stages of the business cycle. During a downturn (as described above), there would be a change in both consumer and business attitudes to the future and this could last well into the future. People who have lived through a severe recession (or the Great Depression) may remember their suffering and this might encourage them to maintain high savings rates into the future. This is another reason that the economy could get ’stuck’ in a period of low or negative economic growth. Businesses would also tend to be operating their full capacity and have little reason to increase their investment spending.

This combined lack of flexibility in prices and wages and lack of animal spirits would mean that to get out of a recession, the government would need to compensate for the lack of private demand and stimulate the economy themselves (for example, by building infrastructure). The building of infrastructure would create a new source of income for a wide range of people. People would need to design, plan, build and maintain the infrastructure and this generates a new source of income for them. The recipients would then spend a portion of their income in the economy, generating extra economic activity in a number of other sectors. The size of the multiplier, and therefore the benefits of any change in government spending to alter the level of economic activity, is ultimately determined by the leakages and injections that an economy ordinarily experiences. If the marginal propensity to spend is high, then any increase in income will generate a significant increase in induced spending. If, however, recipients of the increased income like to spend a large portion of their income on imports then the size of the multiplier effect may be reduced.

The Keynesian approach to managing the economy went out of favour during the 1970s, ‘80s and ‘90s, with greater emphasis being placed on Aggregate Supply Policies (to be covered in Chapter 10). The Keynesian model was not equipped to deal with the supply side shocks and the existence of stagflation (high unemployment and high inflation simultaneously). It wasn’t until the Great Recession (which Australians refer to as the Global Financial Crisis), that policy makers started to, once again, focus on how the government could increase its level of intervention to managing the level of economic activity, using the Keynesian approach.

1. Identify one aggregate demand factor that could lead to an increase in economic activity.
2. Explain, with reference to the example used in question 1, why this change in AD might lead to an increase in employment and incomes.
3. Explain how the increase in incomes might lead to a new round of ‘induced spending’.
4. Why did Keynes’ assumptions about sticky wages and ’animal spirits’ lead to his conclusion that governments need to intervene in the market? (As an extra challenge, consider the case where there are excessively high rates of economic activity.)
5. Explain how an increase in the marginal propensity to consume might affect the magnitude of the multiplier effect in the economy.