Overview
Purpose:
To show how successive schools of economic thought struggled unsuccessfully to give a satisfactory explanation of business cycles until John Maynard Keynes showed that shifts in aggregate demand were the primary cause of these fluctuations.
Objectives:
1. Classical economists did not have a satisfactory explanation for business cycles. Instead, they viewed them as temporary phenomena brought on by financial panics. They believed that the natural forces in the economy would always bring about an equilibrium between total supply and demand for goods in the economy.
2. There were two other more satisfactory explanations of business cycles which provided partial explanations of why the economy could find itself with high levels of unemployment and large inventories of unsold goods.
a) Karl Marx provided a theory of mass unemployment in the context of his view of the capitalist system as the exploiter of the working classes.
b) Joseph Schumpeter explained business cycles as a natural by-product of growth and innovation. Economic growth, he maintained, resulted in periodic overproduction and subsequent retrenchments.
3. It was not until the mid-1930s that John Maynard Keynes developed the concepts necessary to understand how the economy could move toward and remain at a less-than-full-employment equilibrium. One of the key concepts developed by Keynes was aggregate or total demand.
4. In very simple terms, aggregate demand is the sum of all the goods and services that buyers are willing to purchase at a given price level.
a) Shifts in aggregate demand are affected by the circular flow. The circular flow of income has leakages (savings, taxes, and imports) and injections (investment, government spending and exports).
b) If the amount of leakages equals the amount of injections, then the circular flow (i.e., aggregate demand for GNP) will remain constant-it will be in equilibrium.
c) If the injections are larger than the leakages, aggregate demand for GNP will grow, and vice versa.
| Key Economic Concepts circular flow, investment, imports, leakages, taxes, aggregate supply, injections, government spending, aggregate demand, savings, exports, classical economics, Keynesian economics. |
| Contemporary Issues In early 2003 there was a gap of about 3% between actual GDP and potential GDP – what the economy could produce if it were at full employment. This "output gap" was the key reason behind the rise in the unemployment rate from 3.9% in 2000 to around 6% in 2003. What are the costs to the economy associated with operating below potential? Is this because of a shortfall in aggregate demand or aggregate supply? What can the government do to close the output gap? |
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