KEYNESIAN ANALYSIS AND THE DETERMINATION OF AGGREGATIVE EQUILIBRIUM

Though so fundamentally different in many important respects, Keynes and the neo­classical writers spoke in unison in their definitions of aggregative equilibrium. In both traditions the necessary condition was an equilibrium between intended saving and intended investment.

Stated in its simplest form, Keynes's alternative solution linked the mechanism of adjustment to variations in the level of income. Neo-classical writers, of course, had largely neglected this relationship as, within the framework of their thought, national income was subject to fluctuation only within rather narrow limits. For Keynes, on the other hand, a wide spectrum of equilibrium income positions was possible. The pertinent question was: at what level would equilibrium in the national income be established?

Keynes's development of this problem drew upon the concept of the multiplier first formulated by his Cambridge colleague, R. F. Kahn. The essentials of this ingenious argument can be set out in a simple example. Let it be assumed that an initial equilibrium between intended saving and intended investment is disturbed by the decision of investors to

spend more on plant and equipment. What adjustments would then follow? Clearly an increase in investment expenditure would add to total income. But the achievement of a new equilibrium would require saving to rise by as much as investment had increased. This condition could be satisfied when income had risen enough to generate the required increment in saving. How much would income have to grow before equilibrium was restored? The multiplier concept permitted a theoretically precise answer to be given.

The mechanics of this process can also be illustrated in more everyday terms. An increase in investment expenditure will generate higher total demand and call for more workers and more raw materials in the industries producing capital goods. A substantial part of the additional income paid out to workers and suppliers of raw materials is likely to be spent. Additional rounds of spending and re-spending are thus likely to follow. In this manner the stimulus of increased investment radiates throughout the economy, raising income and employment.

The magnitude and timing of the increase in national income touched off by a rise in investment expenditure would, of course, be affected by a number of factors - among them, the lags between the receipt of income and its expenditure. Obviously a considerable time period would be required before the total process of expansion had worked itself out. The pace and magnitude of the rise in income might also be dampened by leakages from the expenditure stream. Part of the additional spending, for example, might be directed to imported rather than to home-produced goods. To that extent, the stimulus to domestic income and employment would be weakened. Though the multiplier does not operate quite as tidily in practice as it appears in theory, it highlights relationships that are vital to an understanding of economic fluctuations.

Keynes used the multiplier concept to explain the manner in which the level of income was determined and to emphasize the crucial importance of investment expenditure to recovery from depression. The same analytical argument, however, can be applied to a fully employed economy. In such circumstances, an increase in investment would still have multiplier effects but only an increase in money income would then be produced.

Later theoretical writing has integrated the Keynesian multiplier scheme with a concept known as the 'acceleration principle'. Whereas the multiplier is concerned with the connexion between changes in investment and subsequent spending on consumption, the acceleration principle refers to the manner in which increases in income and consumption may also stimulate investment and give rise to further rounds of income expansion. This line of analysis is perfectly compatible with the argument of the General Theory, though Keynes did not make use of it. J. B. Clark, writing in 1916, had spelled out the basic structure of the accelerator mechanism. Keynes may perhaps be excused for his failure to draw upon this insight in the 1930s. His concern was then with the problems of a depression economy. In such

circumstances, the accelerator is unlikely to have a forceful impact until income has risen enough to wipe out idle plant capacity. So long as excess capacity exists the growth in demand generated by rising income can be satisfied without additional investment to augment productive capacity.

Keynes's analysis of the determination of aggregative equilibrium opened an entirely new vista for economic investigation and inquiry. For the first time, income was recognized as a primary variable and one, moreover, that was subject to extreme fluctuations. The prominence assigned to changes in national income in the Keynesian theoretical system gave quite a different orientation to a number of familiar analytical building blocks. The treatment of the rate of interest in the Keynesian model provides a significant case in point. Keynes denied that it had much influence on decisions to save and consume, but it did not follow from this conclusion that the rate of interest bore no connexion with saving. He maintained that:

... the influence of moderate changes in the rate of interest on the propensity to consume is usually small.

The resolution of this apparent paradox can be seen when one considers the nature of the Keynesian argument on the determination of aggregative equilibrium. Investment can be influenced by changes in interest rates. Thus, should a fall in rates of interest stimulate activity, national income would grow via the multiplier process. Higher levels of income, in turn, would produce a larger volume of saving. This result would follow from the establishment of a new equilibrium at increased levels of investment and income. A connexion between interest rates and saving was thus retained, but in a manner far removed from the one neo-classical economists had in mind. In the Keynesian formulation the causal linkage was indirect, running from interest rates to investment, from investment to aggregate income, and from aggregate income to actual saving.

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