The purpose of this chapter is to examine the role played by aggregate demand for goods and services in determining the economy's level of national income, and thus explain the heart of the Keynesian approach to macroeconomics. Although this approach has been greatly modified over time, it remains the intellectual foundation of modern views of the macroeconomy, and its implication that government expenditure increases (or tax decreases) can pull the economy out of a recession offered policy activists a rationale for government intervention in the operation of the economy to achieve goals such as full employment.
With the publication of The General Theory of Employment, Interest, and Money in the midst of the Great Depression, John Maynard Keynes revolutionized macroeconomic thinking in many ways. He introduced a model he thought capable of explaining the existence of prolonged unemployment, something that previous macroeconomic models did not do. He stimulated research on fundamental economic relationships, such as the consumption function (how consumption demand responds to income changes), that had been overlooked. He argued persuasively for the need for government intervention in the operation of the economy, an issue that is still contentious, and he placed the level of aggregate demand for goods and services at center stage of macroeconomic analysis, a position it has maintained to this day, although now in tandem with other macroeconomic variables. Appendix 4.1 at the end of this chapter offers some perspective on Keynes's contribution by describing the classical approach to macroeconomics the school of macroeconomic thought dominant prior to publication of Keynes's theory.
Milton Friedman, the leader of a school of thought opposing the Keynesian view of the world, in 1965 said, ''We are all Keynesians now, and nobody is any longer a Keynesian." What he meant was that Keynes had so clearly described the working parts of the modern macroeconomy that whether you agreed with his assessment or not, you had to use his basic ideas even to disagree, which most economists were then and still are doing. The purpose of this chapter is to prepare for later macroeconomic analysis by learning these basic ideas, the foundation of macroeconomic thinking.