Keynesian economics | Aggregate demand and aggregate supply | Macroeconomics | Khan Academy

Summary

This video explores Keynesian economics, contrasting it with classical models. It highlights John Maynard Keynes' view that classical models failed during the Great Depression. The video compares aggregate supply and demand in both models, emphasizing Keynes' belief in the short-term efficacy of government intervention to stimulate demand and boost economic output. It also touches on the potential for inflation with increased government spending and the need for a balanced approach combining classical and Keynesian economics.

Takeaways

• 👤 John Maynard Keynes was an influential economist whose work was particularly significant during the Great Depression.
• 🔄 Keynesian economics is a departure from classical economics, focusing on aggregate demand and its role in economic stability.
• 📉 During the Great Depression, Keynes observed that classical models were inadequate and proposed that aggregate demand needed to be managed.
• 🆚 Classical economics posits that long-term economic output is independent of price and is determined by productivity and capacity.
• 💰 In classical models, increasing the money supply without a corresponding increase in productivity leads to inflation, not increased output.
• 📉 Keynes argued that in the short run, prices are sticky and can lead to underutilization of economic capacity if aggregate demand is low.
• 🔄 Keynesian models suggest that increasing aggregate demand through monetary or fiscal policy can stimulate the economy and increase output.
• 🌐 Keynesian economics does not reject classical economics outright but suggests it is more applicable in the long run.
• 🔄 A balanced view might involve an aggregate supply curve that starts flat and becomes steeper as output approaches full capacity, combining elements of both classical and Keynesian thought.
• ⚠️ There are risks associated with government intervention in the economy, such as difficulty in reducing spending once it has been increased.

Q & A

Who is John Maynard Keynes and why is he significant?

John Maynard Keynes was an influential economist known for his work during the Great Depression. He is significant because his economic theories, known as Keynesian economics, challenged the classical models and proposed that government intervention through fiscal and monetary policy could stimulate demand and pull an economy out of recession.

What is the main difference between classical economics and Keynesian economics?

Classical economics assumes that economies naturally reach full employment and output is determined by supply-side factors like productivity and technology. Keynesian economics, on the other hand, emphasizes the importance of aggregate demand and suggests that insufficient demand can lead to prolonged periods of high unemployment and underutilization of resources.

What does the statement 'In the long run we are all dead' imply in the context of Keynesian economics?

This statement by Keynes suggests that while classical economics may predict that economies will eventually self-correct in the long run, Keynesian economics focuses on immediate solutions to economic problems. It implies that the long-term solutions may not be helpful for addressing current economic crises.

What is the role of aggregate demand and aggregate supply in classical economic models?

In classical economic models, aggregate demand is seen as a function of price levels, with a downward sloping curve indicating that as prices fall, the quantity demanded increases. Aggregate supply in the long run is considered to be vertical, implying that the economy's output is determined by its productive capacity and not by price levels.

How does Keynesian economics view the short-term aggregate supply curve?

Keynesian economics views the short-term aggregate supply curve as being upward sloping, indicating that as the economy moves towards full capacity, producers will start to raise prices due to increased demand, leading to inflation.

What is the 'helicopter drop' of money mentioned in the script?

The 'helicopter drop' of money is a metaphor for the government increasing the money supply by distributing money directly to the public. In classical economics, this would only lead to inflation without increasing output, as the long-term aggregate supply curve is vertical.

What is the significance of the 'very short run' in Keynesian economics?

In Keynesian economics, the 'very short run' refers to a period where prices are sticky and do not adjust quickly to changes in demand. This implies that increases in aggregate demand can lead to increased output without immediate inflationary pressures.

How does Keynesian economics propose to increase GDP during a recession?

Keynesian economics suggests that during a recession, increasing GDP can be achieved through fiscal policy, such as government spending, or monetary policy, such as lowering interest rates or increasing the money supply, to stimulate aggregate demand.

What is a self-fulfilling prophecy in the context of the script?

A self-fulfilling prophecy in this context refers to a situation where pessimistic expectations about the economy lead to reduced spending and investment, which then causes the economy to perform worse, confirming the initial pessimistic expectations.

What are the dangers of government intervention in the economy according to the script?

The script suggests that while government intervention can stimulate demand and pull an economy out of recession, there are dangers such as creating inflation, over-reliance on government spending, and the difficulty of reducing government spending once it has been increased.

What is the 'medium run supply curve' mentioned in the script?

The 'medium run supply curve' is a concept that suggests the aggregate supply curve may be flat at low levels of output, indicating price stickiness, but becomes more vertical as output approaches potential, indicating that increases in demand lead to higher prices rather than increased output.

Outlines

00:00

📚 Introduction to Keynesian Economics

The paragraph introduces Keynesian economics, focusing on John Maynard Keynes' work during the Great Depression. Keynes questioned the effectiveness of classical economic models in times of crisis. The narrator aims to contrast classical aggregate supply and demand models with Keynesian ones. The video will explore the differences without advocating for either, acknowledging the long-term validity of classical models according to Keynes, but also his famous quote about the long-term being irrelevant when considering immediate economic needs. The paragraph sets the stage for a deeper dive into Keynesian thought and its divergence from classical economics.

05:02

📈 Keynesian vs Classical Economic Models

This section delves into the differences between Keynesian and classical economic models. Classical economics posits that in the long run, an economy's output is independent of price levels, assuming a vertical long-run aggregate supply curve. Keynes, however, argued that during times like the Great Depression, aggregate demand was insufficient, leading to underutilization of resources and unemployment. The Keynesian model suggests that short-term economic output can be increased by stimulating aggregate demand through monetary or fiscal policy, rather than focusing solely on supply-side improvements. The narrator illustrates this with a simple transactional example, showing how reduced demand can lead to a self-fulfilling prophecy of economic downturn.

10:06

🌟 The Role of Government in Economic Stabilization

The final paragraph discusses the role of government in economic stabilization according to Keynesian theory. It suggests that during times of economic downturn, government intervention through fiscal or monetary policy can stimulate demand and bring the economy back to its potential output. The narrator illustrates this with a scenario where a government's temporary purchase can restore confidence and demand, allowing the economy to operate at a higher level. The paragraph also acknowledges the risks of such policies, including the difficulty of reducing government spending once initiated. It concludes by suggesting that a balanced approach, considering both classical and Keynesian perspectives, is likely the most accurate economic model.

Keywords

💡Keynesian thinking

Keynesian thinking refers to the economic theories of John Maynard Keynes, which emphasize the role of aggregate demand in the business cycle and how economic output can be influenced by government policy. In the video, this concept is central to understanding how Keynes believed that government intervention could stimulate the economy during periods of low demand, such as during the Great Depression.

💡John Maynard Keynes

John Maynard Keynes was a British economist whose ideas, particularly regarding state intervention in the economy, have had a profound impact on modern economic policy. The video discusses his work during the Great Depression and how his theories were a departure from classical economic models, which he believed were insufficient to address the issues of his time.

💡Great Depression

The Great Depression was a severe worldwide economic depression that lasted from 1929 to the late 1930s. In the context of the video, it is the period during which Keynes developed his theories, as he observed that classical economic models did not adequately explain or address the economic conditions of the time.

💡Classical economics

Classical economics is an economic theory that emphasizes the role of supply and demand in determining prices and the belief in the self-regulating nature of markets. The video contrasts this with Keynesian thinking, showing how classical models did not account for the need for government intervention during economic downturns.

💡Aggregate supply and demand

Aggregate supply and demand are economic concepts that refer to the total quantity of goods and services produced (supply) and the total quantity that consumers wish to purchase (demand) in an economy. The video uses these concepts to illustrate the differences between classical and Keynesian economic models.

💡Inflation

Inflation is the rate at which the general price level of goods and services in an economy is increasing over time. In the video, it is mentioned as a potential consequence of increasing aggregate demand without a corresponding increase in aggregate supply, leading to higher prices but not necessarily higher output.

💡Fiscal policy

Fiscal policy refers to government actions, such as taxation and spending, that influence the economy. The video discusses how fiscal policy can be used to stimulate demand, such as by increasing government spending or lowering taxes, which can shift the aggregate demand curve to the right.

💡Monetary policy

Monetary policy is the process by which a government or central bank influences the economy by adjusting the money supply and interest rates. The video mentions it as a tool that can be used to increase aggregate demand, for example, by printing more money.

💡Productive capacity

Productive capacity refers to the maximum output that an economy can produce with its available resources and technology. The video contrasts the classical view that an economy's output is determined by its productive capacity with the Keynesian view that demand can influence output.

💡Self-fulfilling prophecy

A self-fulfilling prophecy is a prediction that causes itself to come true due to the simple fact that one or more people believe in it. In the video, this concept is used to illustrate how a decrease in demand can lead to a decrease in production, which in turn confirms the initial pessimistic expectations.

💡Deficit spending

Deficit spending occurs when a government's expenditures exceed its revenue, resulting in a budget deficit. The video discusses how deficit spending can be a form of fiscal policy to stimulate the economy by increasing aggregate demand.

Highlights

Introduction to Keynesian economics and its contrast with classical economics.

John Maynard Keynes' work during the Great Depression, challenging classical economic models.

Comparison between classical aggregate supply and Keynesian economics.

Keynesian view that classical models are insufficient during economic crises like the Great Depression.

Explanation of the aggregate demand and supply model in classical economics.

Keynesian critique of classical economics' long-term productivity focus.

Keynes' famous quote, 'In the long run we are all dead', emphasizing the importance of short-term economic policies.

Differentiation between Keynesian and classical views on the role of aggregate demand.

Classical economics' stance on money as a facilitator of transactions rather than a driver of output.

Keynesian argument for the importance of aggregate demand in influencing economic output.

Illustration of how fiscal policy can shift aggregate demand in a classical model.

Keynesian perspective on the short-term stickiness of prices and its impact on aggregate supply.

Keynes' assertion that increasing GDP can be achieved through demand-side policies like monetary or fiscal interventions.

The concept of a self-fulfilling prophecy in economic downturns and the potential role of government intervention.

Keynesian model's implication for government stimulus during economic depressions.

The nuanced view that economic policy should balance both classical and Keynesian approaches.

Discussion on the potential dangers and challenges of government intervention in the economy.

A proposed aggregate supply and demand model that incorporates both classical and Keynesian ideas.

Transcripts

Voiceover: What I want to do in this video

is start introducing and we've already talked about him

a little bit.

So actually they've already been introduced,

but maybe flesh out a little bit more Keynesian thinking.

This right here is a picture of John Maynard Keynes

and I often mispronounce him as Keynes,

because that's how it's spelled,

but it's John Maynard Keynes.

He was an economist who did a lot

of his most famous work during the Great Depression,

because in his view, classical models did not seem

to be of much use during the Great Depression.

To understand this a little bit better,

let's compare purely classical aggregate supply

aggregate demand models to maybe one

that's more Keynesian.

Some of what we've talked about -

Keynesian, I should say.

I already did my first mispronunciation.

One that's a little bit more Keynesian.

Keynesian right over here.

In some of the conversations, we've already begun

to introduce a little bit of Keynesian thinking,

but in this video we're going to try

to show the difference between the two

and it's not to say that one is right or one is wrong.

In fact, Keynesian felt that in the long run,

the classical model actually made sense,

but he also famously said,

"In the long run we are all dead."

I also want to emphasize that this isn't a defense

of Keynesian economics.

There are some points to what he has to say,

but there are other schools of thought.

Unfortunately, they often get very dogmatic,

but they also have some reasons to be wary

of Keynesian economics and we hope to go over

some of that in future videos.

In this one, we just want to understand

what Keynesian economics is all about

and how it really was a fundamental departure

from classical economics.

In classical economics, I'm going to use

aggregate demand and aggregate supply in both.

This is classical, this is price, this right over here

is real GDP and I'm going to do it

for the Keynesian case, as well.

This is price and this right over here is real GDP.

In both views of reality, or both models,

you have a downward sloping aggregate demand curve

for all the reasons that we've talked about

in multiple videos.

That's aggregate demand right over there.

We've already seen it, the classical view is that

in the long run, an economy's productivity,

or productive capacity, or its output shouldn't

be dependent on prices.

We've seen the long run aggregate supply curve

something like this.

This is the aggregate supply in the long run,

or sometimes you'll have long run aggregate supply.

Sometimes it'll be referred to that.

Saying, look, all prices are, they're a way to signal

what people want and demand and things like that,

but at the end of the day, prices and money,

they're just facilitating transactions.

You go to work and you get paid and all that,

but then you go and use that money to go and buy

other things that the economy produces,

like food and shelter and transportation.

All money is is a way of facilitating the transactions,

but the economy, in theory, based on how many people

it has, what kind of technology it has,

what kind of factories it has,

what kind of natural resources it has, it's just going

to produce what it's going to produce.

If you were to just change aggregate demand,

if the government were to print money

and aggregate demand were to -

and just distribute it from helicopters,

in this classical model, you would just have

aggregate demand shift to the right, but you have

this vertical long run aggregate supply curve

so the net effect is it didn't change the output

in this classical model.

All that happens is that the price goes

from this equilibrium price to this equilibrium price

over here.

You have the price would go up

and you would just experience inflation

with no increased output and there's multiple ways

you could've shifted that aggregate demand curve

to the right.

You could have a fiscal policy where the government,

maybe it holds its tax revenue constant,

but it increases spending, or it goes

the other way around.

It does not decrease, it doesn't change its spending,

but it lowers tax revenue.

Either of those, it tries to pump money into the economy

and pushes that aggregate demand curve to the right.

In this purely classical view, it says in the long run,

that's not going to be any good, just will lead to inflation.

The only way that you can increase the output

of economy is by making it more productive.

Maybe making some investments in technology,

make the economy more efficient,

maybe your population grows.

The only way is to really shift this curve to the right

on the supply side right over here.

Keynes did not disagree with that, but he sitting here

in the middle of the Great Depression, saying,

"Look, all of a sudden people are poor in the 1930s.

"Factories did not get blown up, people didn't disappear.

"In fact, there are factories that want to run,

but they are being shut down, because no one

"is demanding goods from them.

"There are people who want to work, but no one

"is asking them to work.

"They could work and produce wealth that could then

"be distributed to -

"But no one's demanding for them to do it."

He suspected something weird was happening

with aggregate demand, especially in the short run.

In a very pure, very, very short run model,

I know we have talked about a short run

aggregate supply curve that is upward sloping.

Something that might look something like that.

That is actually starting to put some

of the Keynesian ideas into practice.

What I like to think of is something in between,

but if you think in the very, very, very short term,

Keynes would say prices are going to be very sticky.

Especially in the short run, and I'll call it

the very short run, you have,

especially if the economy's producing well below

its capacity, like it seemed to be doing

during the Great Depression, prices are sticky.

That makes intuitive sense.

If the economy's trying to get overheated,

people are being overworked, you want them

to work more, hey, I want overtime.

You want factories to operate faster, people are going

to start -

The utilization is high, people are going to start charging

more and more, but if I'm unemployed and I'm desperate

to work, I'm not going to ask for a pay raise.

If my factory is at 30% utilization and someone wants

to buy a little bit more, that's not the time that I'm going

to say, "Hey, I'm going to raise prices on you."

I'll say, "Yeah, exact same price.

"You want another 5% of my factory to be utilized?

"Sure, that sounds great."

In the very short run, it has the opposite view

of the aggregate supply curve than the classical model.

It says at any level of GDP in the short run,

prices won't be affected.

It won't be affected.

So in this model right over here, this is aggregate supply

I'll call it, in the very short run.

You can debate what short run or very short run means,

whether we're talking about days, weeks, months,

or even a few years here, but once you start looking

at the world this way,

then something interesting happens.

In this model right over here, the only way to increase

GDP was on the supply side.

In this model right over here, the only way to increase

GDP is on the demand side, to actually either

through monetary policy, print more money,

or through fiscal policy, lower taxes

while holding spending constant or maybe do both,

essentially deficit spending.

Someway, without holding taxes constant,

but the government's spending more, whatever.

Shift the curve to the right and that might be a way

to increase the overall output.

Keynes' real realization was that, look,

the classical economist would tell you if you have

a free and unfettered market, the economy will just get

to its natural, very efficient state.

Keynes says, "Yes, that is sometimes true,

"but that's sometimes not true."

We'll talk about different cases.

By no means do I think the Keynesian model

is the ideal and I don't think even Keynes

would have thought the Keynesian model

describes everything.

Depends on the circumstance.

Keynes would say, "Look, let's think

"of a very simple idea."

You have person A, person B, person C, and person D.

Let's say person A sells to person B, person B sells

to person C, person C sells to person D,

and person D sells to person A.

Let's say that they're all selling two units

of whatever good and service that they offer.

For whatever reason, let's say C, all of a sudden,

just got a little bit pessimistic, had a bad dream,

woke up on the wrong side of the bed and says,

"You know what?

"I'm not feeling so good about the economy.

"I'm going to hold off from my purchase from B.

Instead of two units, I'm going to purchase one unit.

Well, B says, "Well, gee, my business is bad.

"Now I'm only going to purchase one unit."

A does the same thing for the same reason,

D does the same thing.

Now it all came back to C and now C says,

"Wow, I was right, that dream was predictive."

It was a self-fulfilling prophecy.

Now they're going to operate in this state

and there might not be any natural way to get them

bumped up to that state where they're all buying

two units from each other without maybe some outside,

especially some government act

or maybe all of a sudden saying,

"Hey B, if C doesn't want to buy two, I'm going

"to buy two temporarily."

There are dangers to this, huge dangers,

and we'll talk about that in future videos,

but then someone else, let's say the government,

tries to shift the aggregate demand curve

through fiscal policy and they say,

"Hey, I'll buy one from you, B."

Then B says, "Okay, now I can buy two again,"

and A can buy two again and then D can buy two again

and then C can buy two again.

Then in an ideal world, and this is the danger

of the government, the government would step back

and say, "Okay, everything is fine again.

"I don't have to buy this."

As we know, it's very hard once the government

starts spending money in some way, to actually cut

this spending right over here.

This was the general idea behind the Keynesian

versus the classical.

He says, "Look, there are circumstances,

"like the Great Depression, where the economy

"is operating well below its potential

"and in those circumstances, you need to have

"a stimulus on the demand side, not just a supply side."

The correct answer, as with all things,

is probably something in between.

A probably more accurate model is something like this.

Let's draw ...

This is price, this is real GDP right over here

and we'll still draw our downward sloping

aggregate demand curve and the more accurate thing

might look something like this.

Let's say that this is the absolute

theoretical maximum output, if everyone in the country

isn't sleeping, the factories are just being run

to the ground, that's the absolute theoretical output.

Let's say that this is its potential.

Just a healthy state where the economy

might be operating.

The real medium run supply curve or short run

aggregate supply curve.

This is aggregate supply in the very long run.

This is the long run aggregate supply.

The best model would be something that's in between

and might look something like this.

Our aggregate supply curve might look something like -

I want to do it in a different color.

Let me do it in magenta.

It might look something like this.

For whatever reason, maybe someone has a bad dream

or a bunch of people have a bad dream

or something scary happens, aggregate demand -

The stock market crashes, something happens,

aggregate demand shifts over there.

When we're out here, now all of a sudden

our output is well below potential, we have a lot

of excess capacity and now the Keynesian ideas seem

maybe they'll make sense.

Maybe there should be

some outside stimulus happening.

On the other side, if we're performing well at potential,

then all of a sudden the government wants to do

Keynesian policies and we'll see in future videos,

the government will always want

to do Keynesian policies, even if they're not justified.

It will push aggregate demand out here

and then the net effect is,

especially the more vertical this is, the more

this net effect will be true, that you really just get

more inflation and you don't really get a lot

of increase in output.

It really depends on the circumstance,

but an aggregate supply curve that starts flat

at low levels of output and then gets higher

and higher slope and becomes almost vertical

in your high levels of output, this is probably

a better model that takes into consideration

both the classical and the Keynesian ideas.