Question

Analyze the compenents of aggregate demand in Keynes's General Theory.Use the related functions and diagrams.Why is aggregate demand unstable in absence of government stabilization policies in Keynes's view?

Answer 1

Abstract

Let us understand the implication of Keynesian Theory in following ways :

As per the Keynesian Theory it is given more emphasis on Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports.

Consumption can change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels.

Keynes' view of saving and investment was his most important departure from the classical outlook. It can be illustrated using the "Keynesian cross" devised by Paul Samuelson.

Short Summary of Above Diagram

The horizontal axis presents total income and the Blue curve shows C (Y ), the propensity to consume, whose complement S (Y ) is the propensity to save: the sum of these two functions is equal to total income, which is shown by the broken line at 45°.

The horizontal blue line I (r ) is the schedule of the marginal efficiency of capital whose value is independent of Y. Keynes interprets this as the demand for investment and denotes the sum of demands for consumption and investment as aggregate demand plotted as a separate curve.

Aggregate demand must equal total income, so equilibrium income must be determined by the point where the aggregate demand curve crosses the 45° line. This is the same horizontal position as the intersection of I (r ) with S (Y ).

The equation I (r ) = S (Y ) had been accepted by the classics, who had viewed it as the condition of equilibrium between supply and demand for investment funds and as determining the interest rate.

But so far as they had had a concept of aggregate demand, they had seen the demand for investment as being given by S (Y ),

since for them saving was simply the indirect purchase of capital goods, with the result that aggregate demand was equal to total income as an identity rather than as an equilibrium condition. Keynes takes note of this view

The equation I (r ) = S (Y ) is accepted by Keynes for some or all of the following reasons:

• As a consequence of the principle of effective demand, which asserts that aggregate demand must equal total income.
• As a consequence of the identity of saving with investment (Chapter 6) together with the equilibrium assumption that these quantities are equal to their demands.
• In agreement with the substance of the classical theory of the investment funds market, whose conclusion he considers the classics to have misinterpreted through circular reasoning.

B) The Keynesian perspective focuses on aggregate demand. The idea is simple which exaplain that firms produce output only if they expect it to sell.

Thus, while the availability of the factors of production determines a nation’s potential GDP, the amount of goods and services actually being sold, known as real GDP, depends on how much demand exists across the economy.

• Aggregate demand is the sum of four components: consumption, investment, government spending, and net exports.

• Consumption can change for a number of reasons, including movements in income, taxes, expectations about future income, and changes in wealth levels.

• Investment can change in response to its expected profitability, which in turn is shaped by expectations about future economic growth, the creation of new technologies, the price of key inputs, and tax incentives for investment.

• Investment can also change when interest rates rise or fall.