Keynesian Economics

References

• Keynesian Economics Wikipedia Article]

Notes

Keynesian economics are the various macroeconomic theories and models of how aggregate demand (total spending in the economy) strongly influences economic output and inflation. In the Keynesian view, aggregate demand does not necessarily equal the productive capacity of the economy. It is influenced by a host of factors that sometimes behave erratically and impact production, employment, and inflation.

Keynesian economists generally argue that aggregate demand is volatile and unstable and that, consequently, a market economy often experiences inefficient macroeconomic outcomes, including recessions when demand is too low and inflation when demand is too high.

• A recession is a business cycle contraction that occurs when there is a period of broad decline in economic activity. Recessions generally occur when there is a widespread drop in spending.

They argue that these economic fluctuations can be mitigated by economic policy responses coordinated between government and central bank. The government's physical policy and the monetary policy taken by the bank can stabilize economic output, inflation, and unemployment over the business cycle.

• A central bank is an institution that manages the currency and monetary policy of a country or monetary union.
• Fiscal policy is the use of government revenue collection and expenditure to influence a country's economy.
• Monetary policy is the policy adopted by the monetary authority of a nation to affect monetary and other financial conditions to accomplish broader objectives like high employment and price stability.

Keynesian economics developed during and after the Great Depression from the ideas presented by Keynes in his 1936 book, The General Theory of Employment, Interest, and Money. Keynesian economics, as part of the new classical synthesis, served as the standard macroeconomic model in developed nations during the later part of the Great Depression, WWII, and post-war expansion. It lost some influence following the oil shock and resulting stagflation. Keynesian economics was later redeveloped as New Keynesian economics, becoming part of the contemporary new neoclassical synthesis, that forms mainstream economics.

Historical Context

Macroeconomics is the study of factors applying to an economy as a whole. Important macroeconomic variables include the overall price level, the interest rate, the level of employment, and income measured in real terms.

• In economics, nominal value refers to value measured in terms of absolute money amounts, whereas real value is considered and measured against the actual goods or services for which it can be exchanged at a given time.

Precursors to Keynesianism

Although Keynes work was crystallized and given impetus by the advent of the Great Depression, it was part of a long running debate within economics over the existence and nature of general gluts. A number of policies Keynes advocated to address the great depression - government deficit spending at times of low private investment or consumption - and many of the theoretical ideas he proposed - effective demand, the multiplier, the paradox of thrift - has been proposed by economists in the 20th and 19th centuries.

A precursor of Keynesian economics was underconsumption theories developed with John Law, Thomas Malthus, the Birmingham School of Thomas Attwood. These people were more concerned with the lack of consumer spending than overproduction by companies.

Early Writings

In the 20s, Keynes studied the hyperinflation of the European economies. He drew attention to the opportunity cost of holding money (identified with inflation rather than interest) and its influence on the velocity of circulation.

• The velocity of money measures the number of times that one unit of currency is used to purchase goods and services within a given time period.

Development of The General Theory

Given the backdrop of high and persistent unemployment during the Great Depression, Keynes argued that there was no guarantee that the goods that individuals produce would be met with adequate effective demand, and period of high unemployment could be expected, especially when the economy was contracting in size.

He saw the economy as unable to maintain itself at full employment automatically, and believed that it was necessary for the government to step in and put purchasing power into the hands of the working population through government spending.

Prior to Keynes, a situation in which aggregate demand for goods and services did not meet supply was referred to by classical economists as a general glut, although there was disagreement among them as to whether a general glut was possible. Keynes argued that when a glut occurred, it was the over-reaction of producers and the laying off of workers that led to a fall in demand and perpetuated the problem.

Keynes argued that government spending can be used to increase aggregate demand, thus increasing economic activity, reducing unemployment and deflation.

Origins of the Multiplier

The Liberal Party in the UK fought the 1929 General Election on a promise to "reduce levels of unemployment to normal within one year by utilizing the stagnant labor force in vast schemes of national development".

Example of the Multiplier:

Let's suppose that I hire unemployed resources to build a $1000 woodshed. My carpenters and lumber producers will get an extra $1000 of income... If they all have a marginal propensity to consume of 2/3, they will now spend $666.67 on new consumption goods. The producers of these goods will now have extra incomes... they in turn will spend $444.44 ... Thus an endless chain of secondary consumption respending is set in motion by my primary investment of $1000.

The General Theory

Keynes set forward the ideas that became the basis for Keynesian economics in his main work The General Theory of Employment, Interest and Money (1936). It was written during the Great Depression, when unemployment rose to 25% in the United States and as high as 33% in some countries. It is almost wholly theoretical, enlivened by occasional passages of satire and social commentary.

Keynes objects to the classical theory's assumption that wage bargains determine the real wage by noting that if money wages change, one would have expected, according to the classical school, that prices change in the same proportion, leaving the real wage and level of unemployment practically the same as before.

In Keynes' view, unemployment arises whenever entrepreneurs' incentive to invest fails to keep pace with society's propensity to save (propensity is one of Keyes's synonyms for "demand").

• Saving is that part of income not devoted to consumption, and consumption is that part of expenditure not allocated to investment.

The incentive to invest arises from the interplay between the physical circumstances of production and psychological anticipations of future profitability; but once these things are given the incentive is independent of income and depends solely on the rate of interest .

Keynes viewed the money supply as one of the main determinants of the state of the real economy. The significance he attributed to it is one of the innovative features of his work, and was influential on the politically hostile monetarist school.

• money supply refers to the total volume of money held by the public at a particular point in time.

Money supply comes into play through the liquidity preference function, which is the demand function that corresponds to money supply. It specifies the amount of money people will seek to hold according to the state of the economy.

• liquidity preference is the demand for money

An increase in the money supply. according to Keynes's theory, leads to a drop in the interest rate and an increase in the amount of investment that can be undertaken profitably, bringing with it an increase in total income.

He mentions increased public works as an example of something that brings employment through the multiplier.

Keynesian Models and Concepts

Keynes' view of saving and investment was his most important departure from the classical outlook.

The liquidity trap is a phenomenon that may impede the effectiveness of monetary policies in reducing unemployment.

• A liquidity trap is a situation, described in Keynesian economics, in which "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rather than holding a debt which yields such a low rate of interest".

Paul Krugman said the following related to the liquidity trap, discussing the Japanese economy at the turn of the millennium:

Short-term interest rates were close to zero, long-term rates were at historical lows, yet private investment spending remained insufficient to bring the economy out of deflation. In that environment, monetary policy was just as ineffective as Keynes described. Attempts by the Bank of Japan to increase the money supply simply added to already ample bank reserves and public holdings of cash

Keynesian Economic Policies

Keynes argued that the solution to the Great Depression was to stimulate the country (incentive to invest) through some combination of two approaches:

1. a reduction in interest rate (monetary policy) and
2. Government investment in infrastructure (fiscal policy)

If the interest rate at which businesses and consumers can borrow decreases, investments that were previously uneconomic become profitable, and large consumer sales normally financed through debt (such as houses, automobiles, and, historically, even appliances like refrigerators) become more affordable. A primary function of central banks in countries that have them is to influence this interest through a variety of mechanisms collectively called monetary policy. This is how monetary policy that reduces interest rates is thought to stimulate economic activity, "grow the economy", and why it is called expansionary monetary policy.

Keynesianism does not consist solely of deficit spending, since it recommends adjusting fiscal policies according to cyclical circumstances.

Keynes' views influenced FDR. During his presidency, Roosevelt adopted some aspects of Keynesian economics, especially after 1937, when, in the depths of the Depression, the United States suffered from recession yet again following fiscal contraction.

Keynes believed in eliminating trade imbalances. His view was that creditor nations may be just as responsible as debtor nations for disequilibrium in exchanges and that both should be under an obligation to trade back into a state of balance.

Keynes on free trade:

I sympathize, therefore, with those who would minimize, rather than with those who would maximize, economic entanglement among nations. Ideas, knowledge, science, hospitality, travel—these are the things which should of their nature be international. But let goods be homespun whenever it is reasonably and conveniently possible, and, above all, let finance be primarily national.