2. can be regulated through income (Y) and
2. Effective demand is determined by aggregate demand function, as aggregate supply function is relatively stable.
3. Aggregate demand is made up of consumption demand and investment demand.
4. Consumption demand depends on income and propensities to consume. Propensities being fairly stable, it depends on the size of income only.
5. Income in shortrun depends on investment.
6. Volume of investment depends on rate of interest and marginal efficiency of capital. Rate of interest depends on liquidity preference and quantity of money while marginal efficiency of capital depends on cost of replacement (Cr) of the capital assets and their prospective yields.
Keynesian Theory has shown that equilibrium level of employment is usually short of full employment level, which corresponds to the vertical segment of ASF (Fig. 3.1). It is underemployment equilibrium.
From Table 3.3, it is clear that demand deficiency can be rectified by increasing consumption expenditure or by converting savings into investment. Consumption expenditure (C) can be regulated through income (Y) and the propensities to consume (APC and MPC).
For this, an in-depth analysis of consumption expenditure (C) is called for. This is done in where consumption is portrayed as a function of income (Y) and the propensities to consume. In the same way, an in-depth analysis of investment expenditure (I) is must so that savings (S) may be converted into it.
This is done in where investment (I) is portrayed as a function of the rate of interest (r). Equilibrium level of income (Y) calls for the equality of Savings (S) to Investment (I), or more generally, for that of withdrawals (W) to injections (I).
Equilibrium such as this is known as the Goods Market Equilibrium, forming a major segment of the general equilibrium. The other segment is the Money Market Equilibrium.
Money Market Equilibrium is as important for the general equilibrium as is the Goods Market Equilibrium. This is so because money market influences both – the rate of Interest, r, and the general price- level, P. Rate of interest (r), in turn, influences investment (I), which in turn, determines Output (Y).
For instance, if rate of interest (r) is lower than the Marginal Efficiency of Capital (MEC), as is clear from Table 3.3, Savings (S), in all likelihood, would get converted into Investment (I). A higher investment implies a higher output, a higher employment, a higher income and a lower price level in the long run.
Rate of interest, as is clear from Table 3.3, is governed by the forces of demand and supply of money. To ensure that the rate of interest (r) is lower than the marginal efficiency of capital (MEC), demand for liquidity (money form of assets) has to be kept low while supply of it, high in general.
An indirect way of doing the same is to raise the marginal efficiency of capital (MEC) high enough, so that the rate of interest automatically falls below it. Managing the MEC for this purpose would require a high prospective yield of the capital and a low supply price of it, as may be evidenced from Table 3.3.
A high prospective yield requires, among other things, a high level of demand for the outputs. When demand is low, MEC can’t be high enough to exceed the rate of interest. As a result, the savings component of the withdrawals (leakages) would increase and so would the unsold stocks of the goods.
The same would be the effect when consumption is low. Such demand deficiencies lead to depression. The Great Depression of Thirties that gripped Europe for a decade was caused by the demand deficiencies. That was the reason why Keynes emphasized a high level of demand or effective demand as the only remedy to depression.
This will almost wind up the Keynesian Theory. Subsequent chapters will be devoted to issues related to institutions and their policy matters that tend to influence the simultaneous equilibrium of money and goods markets in an economy.
Such institutions are, first, the monetary institutions comprising the bank of issue, the Central Bank, and a number of collaborating institutions like the commercial banks, also called the financial institutions; and, second, the government departmental and non- departmental organizations that intervene into the process of general equilibrium through their regulatory fiscal and foreign trade policies. We will discuss them in under the heads of the monetary, fiscal and foreign trade policies respectively.
The reader can see that Keynesian Theory is a highly logical formulation on which the foundations of Macroeconomics are laid. Macroeconomics, thus, is a science, not a pandora’s box of policy tools with little or no logical foundations to which a large number of books have reduced it. No wonder, the beginners in the discipline resort to mugging instead of grasping the underlying concepts of a science such as this.