[La leçon d’économie numéro 26 du Pr Amath Ndiaye] JM Keynes and economic policy

Par Pr Amath Ndiaye UCAD-FASEG.

The crisis of the 1930s, which began with the financial crash of 1929, marked a turning point in economic history. This is a period of global economic crisis, the consequences of which are a significant drop in demand and massive unemployment.

In the general theory of employment, interest and money (1936), John Maynard Keynes shows that classical and neoclassical theories are incapable of explaining this crisis and providing solutions. Thus, he will begin a theoretical renewal by highlighting the limits of economic regulation by markets. State intervention, for him, is legitimate to revive the economy and reduce unemployment.

Basic concepts of Keynesian theory

Critique of Say’s law– Say’s law (Classical school) says that supply creates its own demand. All the money earned from the sale of a product is used by the producer to purchase other products. This is a circuit in which currency only serves to facilitate exchange. Keynes contests this proposition: money is not only required to make exchanges but also as a “precaution” (the uncertainty of the future pushes one to keep money aside) and by “speculation” (money is put aside in case a good opportunity arises). A certain part of income is therefore not automatically redirected to demand (consumption and investment) but is saved or even hoarded.

Thus, by refuting Say’s law, Keynes shows that there can be an imbalance between supply and demand for goods and services. The crisis of the 1930s characterized by overproduction (supply greater than demand) is a perfect illustration of this. So, unlike the classics, he considers that supply does not create demand but rather that it is demand which conditions supply. It is effective demand that explains the level of production and employment.

Effective demand -Effective demand represents the overall demand anticipated by businesses. It determines the investment and hiring levels of companies. If companies anticipate weak demand, they reduce production and investments, thus slowing the growth of the economy or worsening its recession. If they anticipate an increase in demand, they will increase their production and their investments.

For the classics and neoclassics, there is no involuntary unemployment in a market (capitalist) economy regulated by supply and demand. They believe that, if people are unemployed, it is because they refuse to work at the equilibrium wage. In other words, they prefer to remain unemployed rather than accept a lower wage.

Keynes believes the wage is not downward flexible, that is, workers always refuse a reduction in wages. Given the weakness of effective demand and the non-flexibility of wages, an economy can remain stuck in an equilibrium of underemployment. This means a situation where supply and demand for goods and services are equal but where unemployment exists.

To remedy this, he advocates state intervention to stimulate overall demand, in particular through expansionary budgetary policies. This includes massive public investments, redistribution policies and targeted tax cuts.

The Keynesian Multiplier

According to JM Keynes, in a context of involuntary unemployment (different from frictional or voluntary unemployment among the neoclassicals), the State triggers cumulative increases in consumption and income which will reduce unemployment, thanks to the multiplier effect of the initial increase in public spending.

Three hypotheses are the basis of the Keynesian multiplier:

1) Short-term reasoning: in this case, production capacities are fixed, and they are partly unused.

2) Prices are fixed and there is unemployment caused by insufficient demand.

3) The interest rate is constant to avoid a crowding out effect.

Let’s take the case where the State increases its spending by 20 billion Euros to build roads. The marginal propensity to consume (pmc) designates the part of the increase in income intended for consumption. Here, if income increases by 20 Euros, consumption increases by 16 Euros so pmc = (16/20 = 0.8). In other words, savings increase by 4 Euros. So the marginal propensity to save (SME) is equal to (4/20 = 0.2).

These 20 billion become income for construction companies, their employees, their suppliers, etc. This additional income will be partly spent (consumption) and partly saved, but the part consumed constitutes new demand, which in turn generates new production. This new production will in turn generate new income which in turn will generate new consumption, so on until the end of the process.

The table below describes the iterative propagation of the increase in income (ΔY) and consumption (ΔC), following an initial increase in investment (ΔI) out of 20.

For step 1 for example:

– ΔS (increase in savings) = pms x ΔY (increase in income) =

0,20 x 20 = 4

– ΔC (increase in consumption) = pmc x ΔY (increase in income) =

0,8 x 20 = 16

Iterative plan for increasing public investments by 20 billion

We observe that each iteration generates an increasingly small increase in income and consumption. The final stage is reached theoretically, when the sum of successive variations converges towards the total value of 100. This happens when the terms become extremely small, close to 0. At the end of the process, the increase in public investments of 20 billion led to an increase in national income of 100 billion.

This result could be obtained directly by applying the multiplier formula:

The multiplier = k = = . Which gives 100 = 5 x 20.

Interpretation of the multiplier: in this economy, from the behavior of the population which consumes 80% of its additional income (pmc = 0.8), we can say that any increase in investment of 1 Euro results in a increase in national income by 5 Euros.

Keynes’ contribution to economic policy is based on the idea that the state has a crucial role to play in stabilizing the economy and avoiding crises. His thinking emphasizes the need to stimulate aggregate demand, use sustainable budget deficits and regulate markets. His approach remains at the heart of contemporary economic debates, particularly in the face of the offensive of the new classical economics.

A propos

Prof. Amath Ndiaye is an eminent Senegalese economist, holding a State Doctorate in Economic Sciences from the Cheikh Anta Diop University of Dakar (2001) and a 3rd cycle Doctorate in Development Economics from the University of Grenoble, France (1987). Since 1987, he has taught at the Faculty of Economics and Management at Cheikh Anta Diop University in Dakar. A recognized expert, he has collaborated with prestigious institutions such as the African Development Bank, the World Bank, and the IMF, specializing in particular in the areas of exchange rates, economic growth, and institutional development. He was an expert member of the steering committee of the African Union Commission for the Creation of the African Central Bank. Prof. Ndiaye is the author of numerous influential publications, notably on exchange rate regimes and economic growth in West Africa. Trilingual, he is fluent in Wolof, French and English.