April 23, 2018 

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GROSS DOMESTIC PRODUCT AND NATIONAL INCOME: Gross domestic product (GDP) is the total market value of all final goods and services produced within the political boundaries of an economy during a given period of time, usually a year. National income (NI) is the total income earned by the citizens of the national economy resulting from their ownership of resources used in the production of final goods and services during a given period of time, usually one year. While the vast majority of domestic production is undertaken by domestic factors of production (national income is about 80% of gross domestic product) key differences do exist. The six main differences between gross domestic product and national income are (1) capital consumption adjustment, (2) indirect business taxes, (3) business transfer payments, (4) net foreign factor income, (5) government subsidies, and (6) statistical discrepancy.

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The macroeconomic study of Keynesian economics relies on three key assumptions--rigid prices, effective demand, and savings-investment determinants. First, rigid or inflexible prices prevent some markets from achieving equilibrium in the short run. Second, effective demand means that consumption expenditures are based on actual income, not full employment or equilibrium income. Lastly, important savings and investment determinants include income, expectations, and other influences beyond the interest rate. These three assumptions imply that the economy can achieve a short-run equilibrium at less than full-employment production.
Like any economic theory, Keynesian economics relies on a set of fundamental assumptions. The three most noted assumptions are rigid or flexible prices',500,400)">inflexible prices, effective demand, and important savings and investment determinants other than the interest rate. These three assumptions are in direct contrast, and in response, to three assumptions underlying classical economics--flexible prices, Say's law, and savings-investment equality.

Whereas classical economics assumes that prices are flexible and quickly adjust to equilibrium, Keynesian economics assumes that prices are inflexible and do not quickly adjust to equilibrium. Whereas classical economics assumes that supply creates its own demand, termed Say's law, Keynesian economics assumes that demand, especially consumption expenditures, depends on actual income received by the household sector. Whereas classical economics assumes that saving and investment achieve equality through flexible adjustment of the interest rate, Keynesian economics assumes that saving and investment depend on factors other than the interest rate and might not achieve equilibrium.

A Keynesian Overview

Keynesian economics can be traced to the pioneering work of John Maynard Keynes (often referred to as the father of macroeconomics). The specific event launching the modern study of macroeconomics and Keynesian economics was the publication by John Maynard Keynes of The General Theory of Employment, Interest and Money in 1936.

Keynesian economics dominated the study of economics for 40 years after it was introduced. It fell out of favor in the 1980s largely because it did not adequately explain the simultaneous occurrence of high rates of unemployment and inflation that came to be known as stagflation.

Highlights of Keynesian economics include:

  • One, Keynesian economics offers a theoretical explanation of, and a remedy for, persistent unemployment problems, especially those occurring during the Great Depression.

  • Two, the theoretical structure of Keynesian economics is based on a view that the macroeconomy is a distinct entity operating accord a set of principles distinct from those governing microeconomic phenomena. The macroeconomy is more than just a collection of markets.

  • Three, these macroeconomic principles of Keynesian economics indicate that aggregated markets, especially resource markets, do not automatically achieve equilibrium, meaning full employment is not guaranteed.

  • Four, Keynesian economics indicates that the recommended way to achieve full employment is through government intervention, especially fiscal policy.

Rigid Prices

The first of three key assumptions underlying Keynesian economics is the presumption that prices are inflexible or rigid, especially in the downward direction. This price rigidity is fundamental to the Keynesian implication of sustained unemployment. If prices, especially wages, do not decline, then the resulting labor market surplus means unemployment.

Rigid prices can exist for a number of reasons. First, producers often have long-term, multi-year contracts with resource suppliers that specify resource prices. These agreements prevent prices for changing. Second, workers tend to view wages as an indication of intrinsic self-worth and thus resist attempts to lower wages. Workers might opt for temporary unemployment, rather than working at lower wages.

Third, the employment and payment system is guided by inertia. Employers are often reluctant to change wages because doing so can be costly. Fourth, firms often reduce employment rather than wages to "clean house" and get rid of the least productive workers. Fifth, many firms, especially small ones, are price takers in resource markets. They have NO control over the resource prices set by the market.

Effective Demand

The second key Keynesian assumption is the notion of effective demand, that consumption expenditures are based on the disposable income actually available to the household sector rather than income that would be available at full employment. Effective demand means that people spend the income that they actually have not the income that they could have under other circumstances.

This assumption means that changes in income, especially disposable income, are the prime influence on consumption expenditures. If the household sector has more income because the economy is expanding, then they increase consumption expenditures. If the household sector has less income because the economy is contracting and a large group of workers is unemployed, then they decrease consumption expenditures.

This effective demand proposition is embodied in a key Keynesian principle, termed the consumption function, which is the relation between household consumption expenditures and household income. More specially, as specified by the so-called psychological law, the consumption function indicates that people use only a fraction of any extra income for consumption.

Saving and Investment Determinants

The third important Keynesian assumption is that saving and investment are influenced by factors other than the interest rate. These other factors can prevent the equality between saving and investment, or perhaps allow equilibrium ONLY at a negative interest rate. The lack of equality between saving and investment can lead to a cumulatively reinforcing downward spiral of declining production and income.

The most important non-interest-rate determinant of household saving is disposable income. As the disposable income changes, not only does the household sector change consumption expenditures, it also changes saving. Keynesian economics assumes that the relation between saving and income is a great deal more important than that between saving and the interest rate. Another key non-interest-rate determinant of saving is expectations. That is, the household is motivated to save in anticipation of future spending (saving for college, saving for retirement, saving to buy a house, etc.), regardless of the interest rate.

The most important non-interest-rate determinant of business investment is expectations, especially expectations of future production and profitability. That is, the business sector is primarily motivated to undertake investment expenditures on capital goods if they anticipate a profitable return. A booming economy can ensure profitable returns even with a high interest rate. Moreover, a stagnant economy can prevent profitable returns even with a low interest rate. In fact, the economy might be in such a dismal state that a negative interest rate is needed to entire enough business investment to achieve equality with saving.


Recommended Citation:

ASSUMPTIONS, KEYNESIAN ECONOMICS, AmosWEB Encyclonomic WEB*pedia,, AmosWEB LLC, 2000-2018. [Accessed: April 23, 2018].

Check Out These Related Terms...

     | Keynesian economics | Keynesian cross | Keynesian model | Keynesian equilibrium | classical economics | assumptions, classical economics | aggregate expenditures | inflexible prices | psychological law |

Or For A Little Background...

     | assumptions | macroeconomics | business cycles | macroeconomic problems | unemployment | inflation | gross domestic product | macroeconomic goals | macroeconomic theories | macroeconomic sectors | macroeconomic markets | product markets | government functions | full employment |

And For Further Study...

     | aggregate market analysis | scientific method | fallacy of composition | monetary policy | marginal propensity to consume | paradox of thrift | injections-leakages model | consumer confidence | fiscal policy | multiplier | autonomous expenditures | induced expenditures | aggregate expenditures determinants |

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