140 THE MARKET AND BUSINESS

for goods may not be high enough to absorb the supply. The result is unemployment and a slide into economic
depression.
Keynes argued that the total demand for goods and services is the sum of the demand of three sectors of the
economy: households, businesses, and government.45 The aggregate demand of these three sectors may be
less than the aggregate amounts of goods and services supplied by the economy at the full employment level. This
mismatch between aggregate demand and aggregate supply will occur when households prefer to save some of
their income in liquid securities instead of spending it on goods and services. When, as a consequence, aggregate
demand is less than aggregate supply, the result is a contraction of supply. Businesses realize they are not selling all
their goods, so they cut back on production and thereby cut back on employment. As production falls, the incomes of
households also fall, but the amounts households are willing to save fall even faster. Eventually, the economy reaches
a stable point of equilibrium at which demand once again equals supply, but at which there is widespread
unemployment of labor and other resources.
Government, according to Keynes, can influence the propensity to save, which lowers aggregate demand and
creates unemployment. Government can prevent excess savings through its influence on interest rates, and it can
influence interest rates by regulating the money supply: The higher the supply of money, the lower the rates at
which it is lent. Second, government can directly affect the amount of money households have available to them by
raising or lowering taxes. Third, government spending can close any gap between aggregate demand and
aggregate supply by taking up the slack in demand from households and businesses (and, incidentally, creating
inflation).
Thus, contrary to Smith's claims, government intervention in the economy is a necessary instrument for
maximizing society's utility. Free markets alone are not necessarily the most efficient means for coordinating the use of
society's resources. Government spending and fiscal policies can serve to create the demand needed to stave off
unemployment. These views were the kernels of Keynesian economics.
Keynes's views, however, have fallen on hard times. During the 1970s, the United States (and other Western
economies) were confronted with the simultaneous occurrence of inflation and unemployment, termed stagflation.
The standard Keynesian analysis would have led us to believe that these two should not have occurred together:
Increased government spending, although inflationary, should have enlarged demand and thereby alleviated
unemployment. However, during the 1970s, the standard Keynesian remedy for unemployment (increased
government spending) had the expected effect of creating increasing inflation but did not cure unemployment.
Various diagnoses have been offered for the apparent failure of Keynesian economics to deal with the twin
problems of inflation and stubborn unemployment particularly during the 1970s.46 Notable among these are the new
Keynesian approaches being pioneered by the so-called post Keynesian school.`? John Hicks, a long-time Keynesian
-

enthusiast and a "post-Keynesian," has suggested, for )erxcaominpplee,tithtiavte in m an )

m arke;
forcesasKeynesasauned.Instead,theyaresetbyconventionalindustriestodaypricesandwagesarenolongerdeterminednb
a agreements among
'
producers and unions." The ultimate effect of these price-setting convenetieonfonbsvlehisme continuing oenrf
tinuing inflation in the face of continued unemployment. Regardlesespor
Hicks's analysis is correct, a flourishing post-Keynesian school has lately
claimofKeynesdevelop-
ing new approaches to Keynes that can more adequately account for,
thowever, Hicks stagflation. Post-Keynesian
theories, like those of Hicks, retain the key
that unemployment can be cured by increasing aggregate demand (the "principle of effective demand") through
government expenditures. Unlike Keynes h
ans take more seriously the oligopolistic nature of most modern
and other post-Keynesi