Keynes was a British economist (1883-1946), son of the economist and methodologist John Neville Keynes. J. M. Keynes first gained notoriety with his work during the Versailles Peace Conference, when he cleverly proposed in his book “The Economic Consequences of the Peace”, 1919, not to punish Germany to avoid future retaliation. Later, during the Great Depression, he fought the conservative views advocating for a restoration of the gold standard in the famous pamphlet “The Economic Consequences of Mr. Churchill”. After a series of papers on monetary issues, he published in 1936 the most important of his works, the “General Theory of Employment, Interest and Money”, which was the foundation of the then called New Economic Science, or Keynesianism. Keynes’ main thesis was that unemployment during the Great Depression was the result of the decrease in effective demand. Therefore, to achieve full employment, it was necessary to revive the economic system through public investment. In the last years of his life, J. M. Keynes participated in the negotiations of Bretton Woods, in 1944, leading to the creation of the International Monetary Fund.

At the Bretton Woods conference, where he was part of the British delegation, he raised the idea that the IMF should be constituted as a true worldwide central bank, capable of issuing paper currency for international payments, for which he proposed the name “bancor”. Most of the ideas mentioned in the “Keynes Plan” were not followed through, since they competed with the U.S. proposals specified in the “White Plan”.

Great disciples of Keynes, part of the Cambridge School, were Joan Robinson, Nicholas Kaldor and John R. Hicks, to name a few.

Cobweb models explain irregular fluctuations in prices and quantities that may appear in some markets. The key issue in these models is time, since the way in which expectations of prices adapt determines the fluctuations in prices and quantities. Cobweb models have been analysed by economists such as Ronald H. Coase, Wassily Leontief or Nicholas Kaldor. It was in Kaldor’s paper on the subject, “A Classificatory Note on the Determinateness of Equilibrium”, 1934, where the analysis of these models became of great interest, and where the phenomenon took the name of Cobweb theorem. Four years later, in 1938, economist Mordecai Ezekiel wrote the paper “The Cobweb Theorem”, which gave the phenomenon and its particular diagrams popularity.

Cobweb models are easily explained using the example used by Kaldor in 1934: agricultural markets. Let’s say weather conditions aren’t optimal during a year, which causes the quantity supplied of a certain crop to be quite small (Q_t, see figure below, first diagram). This excessive demand, or shortage, causes prices to be unusually high (P_t). When farmers realise how high prices are, they’ll plant more in order to supply more the following year. However, supply is so high the following year (Q_t+1) that prices decrease to meet consumers’ demand (P_t+1). Since prices are low, farmers decide to lower their supply the following year (Q_t+2), resulting in high prices again (P_t+2). This process will go on until an equilibrium is reached after a few fluctuations. This unique equilibrium is reached because in this first scenario, the elasticity of the demand curve, in absolute terms, is higher than the elasticity of the supply curve, which implies a convergent fluctuation.

The second diagram shows that a continuous fluctuation between two equilibriums will take place when both elasticities are equal to each other. The third diagram shows a divergent fluctuation, given by the fact that the demand curve is steeper than the supply curve. Even though these three diagrams show very different results, the example explained above can result in any of these scenarios, depending on each curve’s elasticity. 

There is another possible scenario, which is given by changes in the steepness of curves: if near the point where the supply and demand curves cross demand is steeper than supply, but when we move far away from this point the supply curve gets steeper than the demand curve, we get a cobweb as the one in the figure below. At first, prices and quantities act as in a divergent fluctuation. However, as supply gets steeper than demand, a limit cycle may be reached, turning this divergent fluctuation into a continuous fluctuation.

Market clearing occurs in those market situations in which the amount demanded by consumers equals the amount supplied by firms. In market clearing the equilibrium point has its corresponding equilibrium quantity and an equilibrium price. Economic science has developed several adjustment models to reach this stable point. Léon Walras’ and Alfred Marshall’s models are those mostly studied.

Léon Walras’ model is based on price as the force that motivates the adjustment process towards equilibrium. In moments of an excessive demand, prices will rise and against an insufficient demand a decrease in price will take place. The process of tâtonnement or “groping” will happen until the equilibrium price is reached and then transactions will begin to take place.

On the contrary, Alfred Marshall’s model considers that adjustment occurs via quantity. If the demand price is lower than that of supply, the quantity will decrease. The available quantity will be sold at the different prices that consumers are willing to pay for, until the actual equilibrium is reached.

The walrasian approach makes sense when prices are easily observed (a market with perfect information) and modified, being auctions of almost any kind a good example. When prices can hardly be modified (let’s say, because of adjustment costs such as menu costs), and when it’s easier to modify quantities (when there are excessive inventories), the marshallian approach is more reliable.

Demand and supply are possibly the two most fundamental concepts used in economics. The concept of market is usually defined as a number of buyers and sellers of a given good or service that are willing to negotiate in order to exchange those goods. We will first explain them separately and then jointly to show their interaction.

Demand:

Demand is the global market value that expresses the purchasing intentions of consumers. The demand curve shows the quantity of a specific product that individuals or society are willing to buy according to its price and their income. This curve shows an inverse relationship between price and quantity demanded giving it a downward slope. The reason why this happens is known as the law of demand: ceteris paribus, and considering ordinary goods, the higher the price the lower the quantity demanded, and vice versa.

We can start by analysing demand from a purely microeconomic point of view: a single individual, let’s say her name is Joan. Joan’s demand for, let’s say, books, is such as shown in the adjacent graph. If the price of a book is $35 or more, Joan won’t demand any (point a), given her preferences (basically, she would rather spend her money on something else). However, if the price of books goes down to $30, she will want to buy one (point b). If it decreases to $20, Joan will buy two books (point c), and so on. By joining all the points (a-h), we’ll get Joan’s demand curve. It’s worth mentioning that, for simplicity’s sake (though violating monotonicity), we consider that the demand curve ends at the axes.

From a macroeconomic point of view, the demand curve is just the aggregation of all demand curves from all buyers in a particular market. Let’s say the market for books has only two buyers: Joan and her classmate Edward. The horizontal sum of Joan and Edward’s demand curves will give us the market demand: 

Supply:

On the other side, supply is the set of offers made in the market for the sale of goods and services. The supply curve records the location of the points corresponding to the amount offered for a particular good or service at the different prices. This curve shows a direct relationship between price and quantity supplied, giving it an upward slope. The reason why this happens is known as the law of supply: ceteris paribus, and considering ordinary goods, the higher the price the higher the quantity supplied, and vice versa.

Let’s see how the supply curve can be built, starting with an individual’s offer, let’s say his name is Robert. Robert is willing to supply books for $10 or more, this is, Robert won’t supply any books for $5 (point a). However, if the price of books goes up to $10, he will be willing to sell one book (point b). If it increases to $15, Robert will sell two books (point c), and so on. By joining all the points (a-g), we’ll get Robert’s supply curve. Notice that the supply curve goes up and seems not to have limits, an assumption made for simplicity’s sake. Of course Robert will have troubles to supply more than a certain amount of books, but let’s keep it simple and not think about the upper end of the supply curve.

Again, the market’s supply curve is just the aggregation of all supply curves from all sellers in a particular market. Let’s say the market for books has only two sellers: Robert and the librarian next door, Gregory. The horizontal sum of Robert and Gregory’s supply curves will give us the market supply:

Equilibrium and market clearing:

The demand and supply curves define the market clearing, that is, where the demand of the products meets its supply. At this point we have what is known as, an equilibrium point, with its corresponding price and quantity of equilibrium.

It is possible for disequilibrium to occur when the amount demanded does not equal the amount supplied. There are a series of scenarios in which this can happen. In situations in which the quantity demanded is higher than the quantity supplied, the market is suffering from an excess demand. When the opposite occurs we will be talking about an excess supply. Prices will have to gradually adjust through different market mechanisms until the equilibrium price is met.

Movements vs. shifts:

When analysing demand and supply and their respective curves, it is important to distinguish between two aspects: movements along curves and shifts in curves.

A movement refers to a change in either the demand or supply curve, which occurs when a change in the quantity is caused by a change in price and vice versa. An increase in the price of a good or service would cause a movement along its demand curve, decreasing the amount demanded. In the case of supply curves, as we previously saw, an increase in price would also increase quantity. It’s important to understand that movement along the curves does never actually change the equilibrium point, as movements along the curves do not affect it. In the adjacent figure we can see a price increase (let’s say, because an increase of VAT), which causes a movement along the demand curve.

Sometimes the market suffers from changes due to a displacement (shift) of the demand and/or the supply curve. This shift in curves will always result in a new market equilibrium. When a shift occurs, the curve moves, meaning that for each price there will be a new different quantity being demanded or offered. This curve shifts can occur in two directions, upwards and downwards, or if preferred, rightwards and leftwards. Depending in what curve we are considering one is equal to another one.

Demand curves may shift for multiple reasons, for example, an increase in the consumers’ level of income would increase the aggregate demand of a normal good for each price, and hence shift the demand curve to the right (left figure). Other examples would include changes in the price of competitors (substitute goods), changes in complementary goods, tastes, expectations, number of buyers, seasonality, etc.  Supply curve shifts may be also motivated by a variety of different reasons, such as input prices: an increase on the price of paper would shift the supply curve to the left, since the same quantity would be sold at a higher price (right figure). Other variables that can shift the supply curve include technological progress, expectations, number of sellers, etc.

Net exports (also known as balance of trade or commercial balance), are one of the components of the gross domestic product. Net exports of a country are the difference between that country’s exports and imports of goods and services. Exports are defined as the merchandise produced domestically and sold in the rest of the world, whereas imports is merchandise produced overseas and sold domestically:

Net exports = exports – imports

An equivalent denomination for net exports is the trade balance, a term that allows us to determine situations of surplus, deficit or equilibrium in a country’s relations with the rest of the world. When exports are greater than imports, there is an excess of exports and we talk about a trade surplus. In contrast, when imports are greater than exports, the country is said to run a trade deficit. In the case that the country’s exports and imports are identical, net exports are zero, and the country has a balanced trade.

Some of the factors that influence the trade balance are: the tastes and incomes of domestic and foreign consumers, the prices of the products in the country and abroad, the exchange rates, the associated costs to trade (e.g. transport costs), government policies, or international agreements.

Government spending, or government expenditure, is one of the components of a country’s gross domestic product. It includes all the spending on goods and services made by the government at all levels: local, regional, federal, national, etc. This component corresponds to the sum of government consumption and government gross investment.

Government consumption corresponds to the amount the government spends, subtracting the government’s revenue. On the one hand, government spending includes transfer payments made to households, such as unemployment benefits. On the other hand, government revenue includes taxes, which account for most of it.

As for investment, government spending has a multiplier effect. The reason is that government spending includes government investment. The multiplier effect makes that any amount spent in the present generates more than that amount in the future.

The level of government spending is one of the tools used in fiscal policy. An increase of public spending can be used to boost the economy, because the GDP increases as public spending does. On the other hand, a reduction of the public spending slows down the pace of GDP growing. The weight of government spending as a percentage of the GDP is considered as a measure of the importance of the public sector in a country.

Investment is one of the four components of a country’s gross domestic product. It is the use of money in order to accumulate capital, which will be used by other entities. For this reason, it is called productive investment, because it is an expense made with the aim of producing new goods. Investment can be made by households or by firms, always by private entities, since public investment is considered when analysing government spending. In the case of households, usually, their main investment is in the form of buying a new house, whereas in the case of firms investment is very diverse: capital equipment, machinery, vehicles, or inventories. Gross private spending can be divided into three categories: residential investment, which basically consists of buildings and houses; non-residential investment, such as machinery or tools; and change in inventories of firms.

Investment has an outcome called multiplier effect. This effect consists on the fact that any amount of money spent today in investment result in more than that amount in the future. Consequently, an increase of investment results in a higher increase of future rent, leading to higher economic growth and living standards. Countries with an elevated degree of investment have a better development projection in the long run. John Maynard Keynes made this concept popular in his “The General Theory of Employment, Interest and Money”, 1936, even though the idea came from one of his students, Richard Kahn, who developed it in his paper “The Relation of Home Investment to Unemployment”, 1931.

When analysing business cycles, we must note that investment is highly procyclical: during expansion, investment usually increases, firms have more funds and reinvest them or they have easier access to borrowing. By contrast, during recessions, investment is one of GDP’s components that more quickly decline, which makes more difficult the recovery.