III.

Keynes's Theory

Keynes argued that the economy did not automatically tend to a state of full employment, and that market forces could not be relied on to pull it out of recession. Suppose, for example, that there is initially full employment, and that for some reason businesses decide to cut their investment in new machinery. Those who make machinery will lose their jobs and have less to spend on consumer goods, so that some of those who make consumer goods will lose their jobs as well. Thus a “multiplier” effect gets under way, leaving the economy at a lower level of employment, incomes, and output than before. There are, Keynes maintained, no automatic forces at work in the economy which will put an end to this. Wage cuts will not help, because although they will reduce business costs, they will also reduce what workers can buy, so that business cannot sell any more than before. Thus, there is high unemployment because there is too little demand (that is, expenditure) in the economy. Only government action to cut taxes or increase its own expenditure (even though this means a budget deficit for a while) can bring the economy back to full employment. In short, the government must ensure that there is enough demand in the economy to create and maintain full employment, but not so much as to lead to inflation.