The second major breakthrough of the 1930s, the theory of income determination, stemmed primarily from the work of John Maynard Keynes, who asked questions that in some sense had never been posed before. Keynes was interested in the level of national income and the volume of employment rather than in the equilibrium of the firm or the allocation of resources. He was still concerned with the problem of demand and supply, but “demand” in the Keynesian model means the total level of effective demand in the economy, while “supply” means the country’s capacity to produce. When effective demand falls short of productive capacity, the result is unemployment and depression; conversely, when demand exceeds the capacity to produce, the result is inflation.
Central to Keynesian economics is an analysis of the determinants of effective demand. The Keynesian model of effective demand consists essentially of three spending streams: consumption expenditures, investment expenditures, and government expenditures, each of which is independently determined. (Foreign trade is ignored.) Keynes attempted to show that the level of effective demand, as determined in this model, may well exceed or fall short of the physical capacity to produce goods and services. He also proved that there is no automatic tendency to produce at a level that results in the full employment of all available human capital and equipment. His findings reversed the assumption that economic systems would automatically tend toward full employment.
While some economists argue that full employment can be restored if wages are allowed to fall to lower levels, Keynesians maintain that businesses will not employ workers to produce goods that cannot be sold. Because they believe unemployment results from an insufficient demand for goods and services, Keynesianism is considered a “demand-side” theory that focuses on short-run economic fluctuations.
Keynes argued that investment, which responds to variations in the interest rate and to expectations about the future, is the dynamic factor determining the level of economic activity. He also maintained that deliberate government action could foster full employment. Keynesian economists claim that the government can directly influence the demand for goods and services by altering tax policies and public expenditures.