Situation of Economic Instability:
Investment is always equal to savings if total expenditure (C + I) = total income (Y). This is the condition of economic stability or full employment. In such a situation total income (Y) is spent either on the purchase of consumption goods (C) or on the purchase of investment goods (I) which are used for further production.
But, if a part of the income received by an individual is not spent, and if this deficiency of expenditure is not made up by investment expenditure, the reduced expenditure of one will lead to a fall in the income of others, with a lower income they would be able to spend less and then the income of others will also thereby be reduced. The circumference of the circle of income and expenditure will be shortened and this lead to unemployment.
However, the propensity to consume tends to diminish as capital income increases. In other words, the propensity to save increases as capital income increases, and a larger proportion of the additional income is saved and is not spent. This saved income creates instability in the economy. Hence, to maintain economic stability, i.e., income and employment at the previous level, it is necessary to offset the effects of the decrease in demand for output due to a decrease in consumption by a corresponding increase in investment expenditure on public works. It is, here the role of public expenditure is emphasized. Here the objective of public expenditure is to maintain a balance as between savings and investments or income and expenditure or aggregate demand and aggregate supply. Thus, public expenditure which is undertaken to offer any deficiency is private spending i.e. effective demand. So as to bring a balance between aggregate demand and aggregate supply (i.e., total expenditure = total income) is called compensatory expenditure.
Keyness pointed out that the aggregate demand function of employment does not automatically adjust itself to the aggregate supply function of employment. This adjustment can be achieved only by a positive and dynamic operation of fiscal policy, i.e., direct government expenditures as well as measures for guiding and influencing private investment decisions.
Thus, Keyness regarded fiscal policy “as a balancing factor” which would “bring about an adjustment between the propensity to consume and the inducement to invest”. He looked at public finance as one of the instruments of a policy designed to bridge the deficiency in aggregate demand function resulting from the deficient behavior of the consumption and investment functions. In this way, the instrument of fiscal policy could raise the economy to a higher level of employment and output.
Keyness advocated the use of fiscal policy as a balancing factor not only in the form of a progressive tax structure to raise the propensity to consume but also in the form of a national investment programme so broad that it may include direct government expenditures as well as measures for guiding and influencing private investment decisions.