Question

What is Keynes' contribution to macroeconomic equilibrium?

Answer 1

During the Great Depression of 1930s when classical economist prediction of full employment could not sustain the economies, it was Keynes who stepped in and gave a demand side analysis for the development of the economy and pushing them out of Great Depression:

1.)During Great Depression interest rates were at extremely low levels and a situation of liquidity trap existed. This implied that people preferred to hold money over bonds. In this situation it was not monetary policy but rather fiscal policy which was effective. This suggestion was given by Keynes.

2.)Keynes gave macroeconomic consumption function for the economy, which is given by C = C' + cY

where C' is autonomous consumption; c= marginal propensity to consume and Y= Income level in the economy

3.) Keynes suggested that full employment is not the norm in the economy. Rather involuntary unemployment exists in the labor market becuase of downard rigidity of wages in the labor market. Downward rigidity of wages occurs due to institutional factors, skill differences among workers.

4.) Money illusion occurs on part of workers so that labor supply decisions are not made on actual price level but exected price level. Expectations are based on past periods price levels.