KEYNESIAN THEORY AND POLICY AT A GLANCE

Keynes believed that the price system doesn't work--or doesn't work well or works too slowly or works perversely. If not augmented by wisely chosen fiscal policies, the economy, he believed, could linger for months, years, or even decades below its full-employment potential. For simplicity, let's assume that the price system doesn't work at all, i.e., that prices and wages don't change. Then let's ask two questions:
        (1) How does the economy perform on its own?
        (2) How can the economy's performance be enhanced by fiscal policies?
It is important to keep these two questions separate. We can answer the first one in terms of a market process through which income is adjusted--from some postulated disequilibrium level to its equilibrium level. We can answer the second one in terms of fiscal policies (DG and DT) that change the equilibrium level of income so as to achieve a full-employment equilibrium.
 
(1) Suppose the macroeconomy is currently in (Keynesian) disequilibrium; i.e., Y does not equal E.

If total spending (C + I + G) is less than total income (Y), then income must be above its equilibrium level. More goods are being produced (as measured by the income paid to have them produced) than are being bought. The difference shows up as excess inventories. Firms reduce the rate of production; they lay off workers; total income declines; unemployed workers reduce their consumption expenditures; hence total spending declines, but not as fast as income--because the marginal propensity to consume (b) is less than one. The process continues until the excess inventories are eliminated, at which time income and expenditures will just be equal: Y = C + I + G. Through income adjustments, the economy has now settled into a macroeconomic equilibrium.

If total spending (C + I + G) is greater than total income (Y), then income must be below its equilibrium level. Fewer goods are being produced (as measured by the income paid to have them produced) than are being bought. The difference shows up as an inventory deficiency. Firms increase the rate of production; they hire more workers; total income rises; newly employed workers increase their consumption expenditures; hence total spending increases, but not as fast as income--because the marginal propensity to consume (b) is less than one. The process continues until the inventory deficiency is eliminated, at which time income and expenditures will just be equal: Y = C + I + G. Through income adjustments, the economy has now settled into a macroeconomic equilibrium.

(2) Suppose this equilibrium (i.e., Y=E) is not a full-employment equilibirum (i.e., Y is not equal to Yfe)
The Keynesian equilibrium brought about by income adjustments may not be--and probably won't be--consistent with full employment without inflation. Total spending in equilibrium is probably either less than or greater than the total spending consistent with full employment without inflation. In the first case the economy is beset by recession, which means unemployment; in the second case, the economy is beset by inflation, which means rising wages and prices. Recessionary and inflationary gaps can be closed through wisely chosen fiscal policies:
 
 
Applicable Multiplier
For a recessionary gap
For an inflationary gap
i.
DY = [1/(1 - b)] DG
Increase G
Decrease G
ii. 
DY = [-b/(1 - b)] DT
Decrease T
Increase T
iii.
DY = DG = DT
Increase both G and T 
Decrease both G and T
 
Of course, if prices, wages, and the interest rate adjust so as to clear their respective markets, none of these fiscal policies are called for. The market process, rather than government policy, will give us full employment.