Indeed, Keynes developed the Aggregate Demand (AD) function, which in words, states that aggregate demand (or total output) in an economy is directly proportional to people’s consumption for goods and services, government spending (e.g., in public services, subsidies etc.), investment (e.g., R&D, foreign direct investment) and net exports (i.e., the difference between the value of exports and imports in an economy). In Keynesian Economics, effective demand is the equilibrium level of aggregate demand; where aggregate demand equals aggregate supply. For more information on Aggregate Demand-Aggregate Supply, see our study guide on the AD-AS Model. Recall that Keynes argued that demand induces supply and that government intervention is needed to incentivise people to spend and help economies stabilise. Therefore, this demand function was an important foundation throughout The General Theory to explain what components governments could play with in order to intervene in economies and aid them in reaching stability.
The Marginal Propensity to Consume (MPC)
Keynes was not a big advocate of savings. From the AD function, excessive saving in an economy meant that output was likely to plummet and limit recovery and output growth. In other words, when people save and put their money in banks, their consumption (C) decreases and aggregate demand falls. It was here that Keynes introduced a novel concept in economics which is vital to understand how economies behave: the marginal propensity to consume (MPC). This is the proportion of income that people are willing to spend, assuming that the remaining will be saved. For example, an MPC of 0.6 means that one will spend 60% of their income, and save the remaining 40%. This simple ratio became one of the building blocks for complex models and theories that were developed during the Keynesian Economics era including the Multiplier Effect or the IS-LM model.
Keynes on Unemployment
Most of Keynes’ contributions stemmed from his stand on the chicken-and-egg problem. Indeed, because Keynes argued that demand came first and supply followed, this had a domino effect on the dynamics of other working elements in an economy such as unemployment. Unlike Classical economists, Keynes argued that full employment was not the optimal level of employment. Instead, he proposed that there was an optimal level of employment which was aligned to the level of demand and supply in a market. If demand for a product increases, supply responds, and the product becomes increasingly available. More workers are needed to produce in that market and wages will adjust to attract the required number of workers. However, he theorised that this process was slow - prices and wages are “sticky” because they respond slowly to changes in supply and demand in a market. This inefficiency led to what he coined to be “involuntary unemployment”. The book Involuntary Unemployment (Vroey, 2004) explains that over time, economists have interpreted and defined involuntary unemployment in different ways but all definitions go back to Keynes’ General Theory.