Tutorial Notes

CHAPTER 13

• The Great Depression of the 1930s was the most traumatic economic event of
the twentieth century. Falling industrial output, staggering unemployment, food
shortage and poverty became the story of the time and people everywhere
suffered.
• The length and severity of the Great Depression caused most of the Anglo-
American economics profession to question classical laissez-faire
economics and the ability of a free-market capitalist system to correct
itself.
• The capitalist system of natural liberty was under siege and the house that
Adam Smith had built faced its greatest threat yet. The assault was on two
levels—the competitive nature of capitalism (micro) and the stability of
the general economy (macro).

1. KEYNES TURNS CLASSICAL ECONOMICS UPSIDE DOWN

• The General Theory was a book written by Keynes that served as a sustained
attack on the classical economics doctrine of its time. Before the book had
come into being, Adam Smith’s classical model had been embraced by the
economics profession along with all its virtues of thrift, balanced budgets, free
trade, low taxes, Says laws and the gold standard.
• The General Theory aimed to replace all of this with its unconventional
concepts. Keynes was of the mindset that Smiths only applied to a “special
case” where the economy is in full employment.
• His theory on the other hand was applicable during times of underemployed
labour and resources, which he believed could last indefinitely. Under such
circumstances, Keynes offered the following principles:

• Consumption is more important than production in encouraging

investment, thus reversing Say’s law: “Demand creates its own supply”.
• The federal government’s budget should be kept deliberately in a state of
imbalance during a recession. Fiscal and monetary policy should be
highly expansionary until prosperity is restored, and interest rates should
be kept permanently low.

• Government should turn to active fiscal and monetary approach, leaving

behind laissez-faire policy and increasing state involvement in
market/economy when it is called for.

• The inelasticity of the gold standard made it unadaptable to the ever-

changing business environment and its needs. A managed fiat money is
preferable. gold standard severely limited credit expansion and preserved
the status quo of scarcity.

• By progressively expanding credit to promote full employment, Keynes believed

that the universal economic problem of scarcity would finally be overcome.
• Interest rates would fall to zero, and mankind would re-enter the Garden of
Eden. It was Keynes’ belief that economists would live and work most of the
time in Keynes’s house, while using Smith’s house occasionally, perhaps as a
vacation home.

• Keynes rejected the classical notion that the capitalist system is self-adjusting
over the long run.

• The General Theory was written specifically to create a model based on the
view that the market system is inherently and inescapably flawed. Capitalism is
unstable and therefore can be stuck indefinitely at varying degrees of
“unemployed equilibrium,” depending on the level of uncertainty in a fragile
financial system.
2. THE CULPRIT: UNINVESTED SAVINGS
• In Keynes’s model, the key factor in causing an indefinite slump is the
delinking of savings and investment. If savings failed to be invested, total
spending in the economy would fall to a point below full employment.
• If savings were hoarded or left in excessive reserves in the banks, as was
the case in the 1930s, the fetish for liquidity would make national investment
and output fall.
• If Investments exceeds Savings – boom, if savings aren’t invested, the
boom will turn into a burst.
• If Savings exceeds Investments – slump

• In his book, Keynes argued that as income and wealth accumulate under
capitalism, the threat grows that savings will not be invested; the marginal
propensity to save increased as people earned more money.
• This theory essentially stated that people who experienced increases in
wealth over time were more likely to save more money rather than spend it,
and so savings would tend to rise out of proportion as national income rose
too.
•
In a modern society, saving and investing are done by two separate groups:

• Saving = negative act of refraining from spending

• Investment = positive act of starting or maintaining some process of
production.
3. SPENDING AS A KEY INGREDIENT
• Savings is an unreliable form of spending and only effective if they are
invested by businesses.
• Saving that is hoarded or put in a bank is a drain on the economy. He
supported investment of money instead by businesses. He used a
formula to define his effective demand:
Y=C+I
Where…
Y = aggregate output/GDP
C = consumption
I = investment

• Keynes effectively demonstrated that if savings aren’t invested by

business, GDP does not reach its potential because factories produce
less goods/services. Recession or depression therefor indicates a
lack of effective demand.
• Keynes solution to bring about an end to recession was to bring about an
increase in effective demand, mainly through stimulating additional
spending on goods/services.
• More purchases would mean factories would have to produce more goods,
potentially hire more workers and this repeating cycle would eventually
result in economic recovery.
• The only way to increase spending in a recession would be to get the
government to start spending more, as investors would be more
sceptical and cautious during this time. This led to the adding of
government expenditure [G] to the aggregate output equation:

Y=C+I+G

• Government - Keynes saw government as an independent agent capable

of stimulating the economy through the printing presses and public works.
An expansionary government policy could raise “effective demand” if
resources were underutilized without hurting consumption or investment.
 4. HOW THE MULTIPLIER GENERATES FULL EMPLOYMENT
• The multiplier effect refers to the increase in final income arising from
any new injection of spending.
• The size of the multiplier would depend on the nations marginal
propensity to consume. The multiplier is a powerful tool used to illustrate
how increment increases in investment could result in full employment.
Keynes formula for the multiplier was:

K = multiplier
MPC = marginal propensity to consume

1. Example
South Africa is in a recession and battling COVID-19. The government decides to
employ a catering company to cook meals for the less fortunate during this time and
pays the R500 000.
• Round One – in the first round of spending, the R500 000 paid by
government is added into the economy
• Round Two – the caterers have a marginal propensity to consume of 60%.
This means that they spend R300 000 of the money they got from
government, and this amount is added to the economy in this round.
• Round Three – the money spent buy caterers in round two finds its way to
the other businesses where they spent it at. These businesses experienced
increased demand and may opt to hire more employees to handle the
additional demand. These new workers get paid and may have a marginal
propensity to consumer of 80%. This would mean that of the R300 000 they
are paid in total, they spend R240 000.
• Ultimately, the public investment has a multiplier effect that generates round
after round of gradually declining spending. By the time the new spending
has run its course, the aggregate spending has increased tenfold.
 2. Extra example
Given that the economy is in a recession due to covid 19 that resulted to hard lockdown
as a result many people lost their jobs. Furthermore, this resulted to fall in aggregate
demand in the economy. SA government decided to increase spending in the public
sector by R20 000. Given that MPC = 0.2. Calculate the multiplier effect to the
national income?

• Step1: calculate the value of the multiplier.

𝟏
𝒌 = 𝟏−𝟎,𝟐 = 𝟏, 𝟐𝟓

Step2: Multiply the value of the multiple by spending.

𝟏, 𝟐𝟓 × 𝟐𝟎𝟎𝟎𝟎 = 𝟐𝟓𝟎𝟎𝟎

➢ Summary: according to the definition of the multiplier which states that a

smaller change in expenditure result to a larger income.
➢ As seen in our example the R20 000 that government which the effect of
multiplier it resulted to larger change in the national income.
➢ Its national ‘income’ because every rand spend by the buyer is the income
to the seller.
➢ Ultimately, the government spending has a multiplier effect that generates
round after round of gradually declining spending.
➢ By the time the new spending has run its course, the aggregate spending
has increased tenfold.