KEYNESIAN THEORY OF INFLATION AND UNEMPLOYMENT
IntroductionAccording to the Keynesian theory, unemployment is mainly attributed to lack of sufficient aggregate demand for services and goods in a given economy since both creates opportunities for everyone interested in working. When demand for various commodities and services decline, the production of both the demand and services consequently declines, resulting in a decreasing demand for workers, and mass unemployment in the long run.
Any economy experiencing unemployment is marked by the situation where the total number of jobless individuals surpasses the number of available vacancies, such that even if all the available positions were to be filled, many citizens would still end up without work. Inflation, on the other hand, referrers increase in prices of products and services in any given economy, with a particular period duration. Essentially, when prices are high, amount of goods and services, which can be, bought using a particular amount of money becomes fewer (Burda & Wyplosz 1997).
Disequilibrium positions of inflation
Keynes disagrees with the economists of the classical argument. According to the argument by Keynes, market systems do not lead to automatic full-employment equilibrium (Warburton 1966). However, the economic systems could attain equilibrium at any range of unemployment. This implied that the interventionists’ policies would not apply. Keynesian argument can be represented in a circular flow of revenue (Warburton 1966). Extra aggregate demand within the economic system forces firms to absorb more employees. According to Keynes, markets are bound to exhibit disequilibrium of various forms (positions) of inflation, which have been pointed in the Keynesian theory of inflation.
According to Keynesian theory, equilibrium level of income is that aggregate level of demand equates to aggregate supply (Saleemi 1987). Aggregate demand represents total demand for consumer’s goods and producers goods. On the other hand, aggregate supply represents the total production of one year in any country. Aggregate demand may be indicated by C + I because C represents total expenditure of one year which is incurred on the purchase of consumers goods and I represents total investment in the particular year. Similarly, aggregate supply can be indicated by Y = C + S because the market value of the total p[roduction of one year is called national income may be divided into consumption and saving. In this way, national income will be determined at the point where following conditions will be fulfilled; aggregate demand = aggregate supply; total expenditure = total income; C + I = C + S; I = S. This can be explained by the help of the following diagram:
In the above diagram, along X-axis we have measured national income and employment level and along Y-axis consumption and investment. C curve is consumption curve which moves from left to right upwards. The assumption is that investment remains the same at all levels of income, so C + I curve will remain parallel to C.C + I curve indicates aggregate demand or the total expenditure at different levels of income. The income will be in equilibrium at the point where C intersects Y. in other words, aggregate demand is equal to aggregate supply or total expenditure is equal to total income when income is OM. From the point where Y and M intersect, to M, gives the effective demand since at this point, aggregate supply is equal to aggregate demand. If income is higher than OM, aggregate supply will be greater than aggregate demand and there will be overproduction. The profits of the producers will fall and they will produce less in the next year, so income will decrease. Similarly, if income is lower than OM, aggregate demand will be greater than aggregate supply and it will be profitable to produce more and more and as a result of this, income will increase. In this way, income will be determined at OM and this is the equilibrium level of income.
The equilibrium of income can also be explained by equality of savings and investment (Saleemi 1987). When income increases, saving also goes to increase, but again, the investment is assumed constant at different levels of income. The income will be the in equilibrium position where savings are equal to investment (Saleemi 1987).
Full employment is that situation of any country when all those persons who are willing to work and able to work are employed according to their abilities (Saleemi 1987). In this case, national income will be maximally out of the available resources. Inflationary gap amy be defined as an excess of anticipated expenditure over base prices of available output. When national income is at full employment, the expenditure on this production must be equal to it in order to maintain national income at full employment then this excessive expenditure is known as inflationary gap. If total expenditure in any year is less than the deficient expenditure is known as deflationary gap.
In the figure 31.4, the level of the national income is determined by the axis OX and the axis OY representing aggregate expenditure. Assuming that initially, the curves of aggregate expenditure, AE° intersects the line presented at 45 degrees at point E/, left line of full employment or potential revenue.
The economy indicates to be operating at equilibrium revenue level, $150 billion, below potential income, $250 billion. Therefore, a $ 100 billion income deficiency in aggregate expenditures is experienced. The realized shortfall in the national expenditure, of $100 billion, that is below the potential revenue (the full employment) is referred to as the re-cessionary Gap (deflationary gap).
Figure 31.5 above shows curve AE°, aggregate expenditure, intersecting at point E, with the aggregate curve of production (45 degree line), to the right side of the line of full employment FE. The graph indicates a $ 200 billion income level equilibrium level while the full employment is $100 billion. Inflationary gap develops when the equilibrium revenue exceeds potential income; the diagram indicates this at $100 billion. The additional $ 100 billion expenditure causes increase in prices in absence of the additional output generated.
Policies Necessary for checking the status of Inflation- Unemployment.
Regardless of its severity, Keynesian economists maintain that unemployment is a manageable situation, provided that three key measures are put in place by governments (Burda & Wyplosz 1997). These include engaging in deficit spending and controlling interests rates, and use of monetary policies.
Deficit spending is where a government seeks to reduce unemployment level by increasing its level of purchases. This measure is founded on the premise that when governments’ purchases output from business, they in turn create income in addition to encouraging consumers to spend more. This way, governments are able to create additional demand for output from businesses which leads to an increase in a country’s gross domestic product (GDP), and a significant increase in employment levels.
Governments can further reduce the rate of unemployment by controlling interest rates. The lower the interest rates, the higher the investment level, which act as a source of employment. Monetary policies help in maintaining a healthy balance between a nation’s interest rates and the aggregate money supply. One way in which monetary policies are used to create employment is through the lowering of interest rates to encourage investments.
Advantages and Disadvantages of Keynesian theory
The Keynesian theories were formulated in 20th century; for their relevance and popularity appears to have declined over the years, as new knowledge and ideas gradually took over (Burda & Wyplosz 1997). The following are some of the limitations which have rendered Keynesian theories increasingly in considerably irrelevant to modern economic situations:
One criticism which is repeatedly leveled at Keynesian model of unemployment is that attempting to reduce unemployment by lowering interests’ rates interventions increases rather than reducing unemployment because the markets are unable to respond effectively. Deficit spending on its part may require the imposition of higher taxation rates in the future, therefore burdening future generations who had nothing to do with the situation prevailing in years before.
According to Keynesian theory of unemployment, the decline of GDP below its potential level leads to the decline in inflation as suppliers seek to fill excess capacity. The main problem with this view however, lies in the difficulty of determining the real level of potential output, for it is largely unknown and often changes with time.
Advantages of Keynesian theory
Regardless of the many criticisms made against it, particular concepts in Keynesian economics are still applicable in modern conditions (Burda & Wyplosz 1997). In some cases, modern economies are still unable to realise their goal of full employment not so much because of their inability to produce but because of the absence of willing buyers to purchase what they produce.
In addition to the fact that some of the policies and ideas that Keynes put forth have been advanced by numerous scholars, he also provided generalized theories on the same, and they were adopted by economic and political establishments of his time..
The stimulus programs initiated by governments and which are already playing an important role in preventing worldwide decline owe their origin to Keynes; he often asserted that, when the private investors lose their credibility in the market, the most viable solution is for governments to subsidize and support new investments.
The Keynesian theories are one among very few works from the 20th century which are still highly relevant to the field of macroeconomics. The theories have been important in shaping peoples views about unemployment and inflation. According to Keynesian theory, an increase in unemployment levels results from a decrease in aggregate demand. Inflation is viewed as occuring from increased expenditure by governments and the private sector. The theory further, proposes counter measures for managing both unemployment and inflation.
And whereas the credibility of some of the Keynesian Economics (such as deficit spending) has frequently been questioned, a certain degree of it appears to have survived the test of time. Certain conconcepts such as those that are concerned with interest rates and monetary policies are still fairly usefull to scholars and policy makers today.
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