Keynesian Economic theory suggests

December 14, 2015
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keynesJohn M Keynes

The essential element of Keynesian economics is the idea the macro economy can be in disequilibrium (recession) for a considerable time. Keynesian economics advocates government intervention to help overcome the lack of aggregate demand to reduce unemployment and increase growth.

Theory behind Keynesian Economics

1. If saving exceeds investment we get a recession

Classical theory suggested any fall in investment would led to lower interest rates; this fall in interest rates would reduce saving, increase investment and cause the economy to return to a new equilibrium of full employment. However, Keynes’ analysis suggests this is unlikely to occur, due to a number of factors, such as a liquidity trap and the general glut of savings.

Why Keynes felt Recessions could last a long time

  • Liquidity trap. When interest rates fail to boost demand. Interest rates can’t fall below a lower bound rate of zero, and lower interest rates are ineffective in boosting demand anyway.
  • General Glut. If saving is high and consumer spending low, firms will have a lot of unsold goods. In this climate, they will cut back on investment.
  • Animal Spirits If there is an initial fall in investment, businessmen may have negative confidence. Their ‘animal spirit’s’ fear recession and lower profits, so they cut back on investment. Consumer confidence may be adversely affected and they spend less too. Thus Keynes emphasised the importance of expectations and confidence.
  • Negative Multiplier effect. Keynes popularised the idea of a multiplier effect. The idea that a fall in injections into the economy has a knock on effect and the final impact may be greater than the initial. If a firm reduces investment, people lose their jobs, and this higher unemployment leads to lower spending and effects everyone in the economy.
  • Paradox of Thrift. In a recession, people take a rational approach to be risk averse – fearing possible recession, they increase savings and spend less. When this lower spending is aggregated, it leads to lower overall demand in the economy.

2. Sticky Wages

Another classical economic theory was that the idea that labour markets should clear. According to classical theory, any unemployment was due to wages being artificially kept above the equilibrium through minimum wages e.t.c. (real wage unemployment) According to classical theory, the solution to unemployment is to cut wages and allow wages to clear. However, Keynes argued this was unsatisfactory.

  • Firstly, even in the absence of unions and minimum wages, workers would resist nominal wage cuts.
  • Secondly a cut in wages wouldn’t necessarily solve disequilibrium. Lower wages would further depress income and spending, leading to lower aggregate demand, and therefore lower demand for labour.

Keynes’ contribution was to show the interaction between labour markets and the national economy, and not treat the labour market in isolation (e.g. from micro perspective). It is this macro perspective on savings and labour markets that led to creation of macro economics.

Keynes theory on impact of falling wages was to a large extend supported by Irving Fisher in his Debt-Deflation Theory of Great Depressions (1933)

3. Importance of Aggregate Demand.

An important classical assumption of the day was Say’s law. This stated that supply creates demand. However, Keynes believed the opposite was true. Keynes argued – demand determines the level of national output.

Policy Implications of Keynesianism

1. Governments should provide counter-cyclical demand management.

Keynes was critical of the UK 1931 budget, which cut wages for hospital workers, and cut back spending on roads and new houses. He argued this would depress demand further and make the recession worse. Instead he advocated higher government spending financed by higher borrowing.

In a A Treatise on Money (1930) Keynes wrote:

“For the engine which drives enterprise is not thrift, but profit.”

Keynes’ policy recommendations went against classical orthodoxy. Classical orthodoxy argued higher government spending would crowd out private sector investment. Higher government borrowing would push in interest rates on bonds and reduce the quantity of private sector investment. The Treasury view was to try and balance the budget, but Keynes’ criticism was this only reduced overall aggregate demand.

The Great Depression only ended in the UK and US, when government spending on military caused sufficient demand. Though, there is evidence partial stimulus (e.g. in 1936, helped stimulate demand) The problem with Keynesianism is that governments are often too timid – unless there is a war.

  1. Accelerator effect. This stated that investment was highly volatile. If the rate of GDP growth fell, private sector investment fell. However, if government spending increased the growth rate – this would encourage the private sector to also invest. Thus government investment could complement private sector investment – not crowd it out.
  2. Multiplier effect. Government spending could have a bigger final impact on real GDP. the Multiplier is likely to be higher in a recession because there are unused resources.
  3. Ending the glut. Keynes’ strongest argument is that in a recession, private sector saving rises sharply leading to unused saving. Therefore, the government spending is merely making use of unemployed resources. Bond yields on government borrowing won’t rise because the private sector want to buy government bonds.
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