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“The General Theory” also includes a number of assertions that have not proven influential.<br />

1. Keynes found an “element of scientific truth in mercantilist doctrine”. Mercantilist doctrine,<br />

which calls for trade restrictions to maintain a “favorable” balance of trade, has been generally<br />

rejected by broadly accepted economic theory.<br />

2. Keynes proposed that usury laws to maintain low interest rates might be good policy. Price<br />

controls have been generally rejected by broadly accepted economic theory.<br />

3. Keynes proposed a type of tax to be imposed on money holders as a way to discourage the<br />

holding of money and thus achieve lower interest rates.<br />

4. Keynes proposed that “a somewhat comprehensive socialisation of investment will prove the<br />

only means of securing an approximation to full employment…If the State is able to determine<br />

the aggregate amount of resources devoted to augmenting the instruments and the basic rate<br />

of reward to those who own them, it will have accomplished all that is necessary”.<br />

5. Keynes asserted that the adoption of his theory, by providing full employment, would reduce<br />

the competitive struggle for international markets and would thus be favorable to maintaining<br />

peace. However, earlier in the book Keynes had spoken favorably of mercantilist doctrine<br />

which calls for trade restrictions to maintain a “favorable” balance of trade. Free international<br />

trade is generally believed to be more favorable to maintaining peace than is a policy of trade<br />

restrictions.<br />

Study Guide for Chapter 8<br />

Chapter Summary for Chapter 8<br />

Keynesian theory argues that factors other than the interest rate affect savings and investment. If<br />

investors become pessimistic about future rates of return, they may not invest more in response<br />

to lower interest rates. Thus, excessive savings could lead to inadequate Total Expenditures.<br />

Keynesian theory argues that wages and prices are not flexible downward. Therefore, the<br />

economy can get stuck in a recessionary gap for an extended period. The solution to a<br />

recessionary gap would be an increase in Total Expenditures to shift the AD curve right.<br />

Consumption is determined primarily by disposable income. The curve showing the relationship<br />

between disposable income and consumption is the consumption function. The slope of the<br />

consumption function is the marginal propensity to consume (MPC), which is equal to the change<br />

in consumption divided by the change in income.<br />

According to Keynesian theory, the level of Total Expenditures determines the level of Real GDP.<br />

TE consists of consumption, investment, government purchases, and net exports. Consumption<br />

is directly related to Real GDP. The levels of investment, government purchases, and net exports<br />

are all unrelated to the current level of Real GDP.<br />

In Keynesian theory, equilibrium Real GDP occurs where Total Expenditures equals Real GDP<br />

(total production). If TE were greater than Real GDP, inventories would decrease, signaling<br />

producers to increase production. If TE were less than Real GDP, inventories would increase,<br />

signaling producer to decrease production.<br />

Graphically, Real GDP occurs where the TE curve intersects the 45° angle line. Ideally,<br />

equilibrium Real GDP will occur at Natural Real GDP. According to Keynesian theory, the level of<br />

Total Expenditures may not be the level that will cause the economy to achieve Natural Real<br />

GDP.<br />

A change in one of the components of TE (consumption, investment, government purchases, or<br />

net exports) will lead to a multiplied change in Real GDP. The multiplier effect occurs because the<br />

initial change in TE triggers a chain reaction. The eventual change in Real GDP will be equal to<br />

the initial change multiplied by a factor called the multiplier. The multiplier is equal to one divided<br />

by one minus MPC. The greater the MPC, the larger the multiplier, and the larger the eventual<br />

change in Real GDP.<br />

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8 - 11 Keynesian Economic Theory

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