The most fundamental concept is that of gross national product, or GNP, which is made up of all the goods and services, shoes, ships, sealing wax and so on, that constitute the total product of economic activity. This begins as a set of outputs, or quantities of products, in physical terms.
Each physical quantity is reduced to a value quantity, for example, dollars, by multiplying it by a valuation coefficient generally derived from a market price. Thus, 500 million pairs of shoes at 20 dollars a pair represent 10 billion dollars in shoes. The total sum in dollars can then be added up to obtain a total dollar value of gross national product.
If this process is carried out year after year using constant prices, we obtain a measure of “real” gross national product. This is subject to the difficulty that, over a period of time, relative prices vary, and there is no rule indicating which set of relative prices should be used to calculate real product.
There are many criticisms of gross national product into which we need not enter here. In fact, it does not include all products, and it may include products that are harmful to welfare. Thus, it does not adequately take into account negative products, such as pollution. Some concepts of net national product constitute a better measure of economic welfare. However, once its limitations are recognized, gross national product remains a very useful concept.
The basic idea of national income theory is very simple. Total gross product must be absorbed or disposed of in ways that do not involve undesired accumulations or decumulations. Four main channels of disposal are generally identified.
It may be taken by households as family purchases, which Keynes, perhaps mistakenly, called “consumption”; it may be taken by the state; it may be taken, in the case of national product going abroad, in the form of net exports; or it may be left in the hands of firms as investment, that is, an increase in the total stock of products forming part of the economy.
A basic condition is that the sum of these four items must equal gross national product itself. This has sometimes been called the “principle of additivity.”
Investment, that is, the increase in stocks of economic goods such as buildings, machines and inventories held by firms, is generally considered the critical factor in this model. It is usually assumed that there is a “desired” level of total investment, determined by a complex combination of factors including expected returns, the interest rate, conditions in financial markets and so on.
If actual investment, that is, the actual rate of accumulation of goods by firms, is greater than desired investment, there will be excess investment, which will produce some kind of response. In the simple Keynesian model, the response is a reduction in production and, consequently, unemployment.
This, however, has secondary effects by reducing consumption, or household purchases, so that the reduction in investment is smaller than the decrease in total production. If investment is still above the desired level, there will be further reductions in production.
This process will continue until production is low enough to bring investment down to the desired level. Meanwhile, rising unemployment and declining production may result in a further decline in profit expectations, which in turn may reduce the desired level of investment, thus producing a repetitive spiral that ends in large-scale unemployment and depression, as in 1932.
The great virtue of Keynesian analysis is that it provided a key to understanding a phenomenon that had been so puzzling to economists that they frequently denied its existence.
On the other side of equilibrium, if the actual rate of investment is lower than desired investment, and if unused resources exist, they will be absorbed into new production as firms attempt to increase their rate of accumulation.
However, the increase in income that this generates will raise household purchases, so that firms will find that they are accumulating less than they expected. If this is still below the desired rate of accumulation, there will be further increases in employment and production, and so on.
But if, once some critical level of employment is reached, the rate of accumulation is still lower than desired, the attempt to increase production will result in higher wages and prices, producing inflation.
Because of the increase in money prices and wages, gross national product will rise in monetary terms, but not in real terms.
This analysis, presented here in the simplest possible form, has been a major contribution to economic policy, as we can see through even the most casual study of, say, the two “pre-Keynesian” decades that followed the First World War.
There was widespread unemployment even in the 1920s, and the Great Depression of the 1930s led directly to Hitler’s rise to power and to the Second World War.
By contrast, the two and a half decades following the end of the Second World War have been much more fortunate, at least from the standpoint of economic policy, because there has been no great depression.
