Keynesian Economics

By | on October 24, 2016 | 0 Comment

classixKeynesian economics gets its name, theories, and principles from British economist John Maynard Keynes (1883–1946), who not only introduced new concepts in Economic theory but also converted economics into a study of the flow of incomes and expenditures and opened up new vistas for economic analysis.

He rose to the prominence during the Great Depression of the 1930s, when the prevalent economic theory, now known as Classical Economics, failed to explain the causes of this global recession which saw falling prices and increasing unemployment with consequential widespread poverty. Worse, it could not provide an adequate public policy solution to come out of this recession and jump-start production and employment.

Main reason for this failure on conceptual and practical level of the classical economists was their exclusive emphasis on supply side of the economy. They believed that in a flexible wage-price environment supply created its own demand because of increased incomes generated during the process. As such, there was no fear of any over production. If there is some unemployment, they contended, just increase the dose-produce more and make the wages flexible i.e. reduce them

However, before condemning them in their failure to properly assess the situation we must keep in mind the peculiar economic conditions in which they were living prior to the Great Depression. It was a period of all over economic expansion due to rapid development of science and technology, increasing population and the availability of vast markets in the colonies. Naturally, they inferred wrong signals from the conditions obtaining on the ground and concluded that there was no fear of any overproduction-supply will create its own demand

John Maynard Keynes came with a different explanation of the underlying causes of the global recession and hence a different solution. He did not believe in the idea that free markets would automatically provide full employment—that is, that everyone who wanted a job would have one as long as workers were flexible in their wage demands. He asserted that aggregate demand is the most important driving force in an economy. During a recession, uncertainty often erodes consumer confidence; hence reduction in spending by consumers which can result in less investment spending by businesses, as firms respond to weakened demand for their products.

Secondly, he maintained, free markets had no self-balancing mechanisms that could lead to full employment because wages are not flexible in real life. Even if we reduce the wages, it would reduce the aggregate demand because of less buying power of those who spend more and save less

Consequently, government intervention through increased spending is the main policy tool to achieve full employment and price stability. If government spending increases, then output will increase directly as well as through a multiplier effect. He therefore strongly advocated unbalanced government budgets during recessions. For example, deficit spending on labor-intensive infrastructure projects to stimulate employment and stabilize wages during economic downturns and raising taxes to cool the economy and prevent inflation when there is abundant demand-side growth.

No doubt,he also advocated aggressive use of monetary policy to stimulate the economy—for example, by reducing interest rates to encourage investment. He however cautioned its ineffectiveness during a liquidity trap, when increases in the money stock fail to lower interest rates and, therefore, do not boost output and employment.

Paul Krugman is one of the most prominent economists of our age and a strong advocate of Keynesian Economics. He has recently given a very cogent explanation of Keynesian economics and its all-time relevance

“I would summarize the Keynesian view in terms of four points:

  1. Economies sometimes produce much less than they could, and employ many fewer workers than they should, because there just isn’t enough spending. Such episodes can happen for a variety of reasons; the question is how to respond.
  2. There are normally forces that tend to push the economy back toward full employment. But they work slowly; a hands-off policy toward depressed economies means accepting a long, unnecessary period of pain.
  3. It is often possible to drastically shorten this period of pain and greatly reduce the human and financial losses by “printing money”, using the central bank’s power of currency creation to push interest rates down.
  4. Sometimes, however, monetary policy loses its effectiveness, especially when rates are close to zero. In that case temporary deficit spending can provide a useful boost. And conversely, fiscal austerity in a depressed economy imposes large economic losses.

Is this a complicated, convoluted doctrine? It doesn’t sound that way to me, and the implications for the world we’ve been living in since 2008 seem very clear: aggressive monetary expansion, plus fiscal stimulus as long as the zero lower bound constrains monetary policy.

But strange things happen in the minds of critics. Again and again we see the following bogus claims about what Keynesians believe:

  • Any economic recovery, no matter how slow and how delayed, proves Keynesian economics wrong. See [2] above for why that’s illiterate.
  • Keynesians believe that printing money solves all problems. See [3]: printing money can solve one specific problem, an economy operating far below capacity. Nobody said that it can conjure up higher productivity, or cure the common cold.
  • Keynesians always favour deficit spending, under all conditions. See [4]: The case for fiscal stimulus is quite restrictive, requiring both a depressed economy and severe limits to monetary policy. That just happens to be the world we’ve been living in lately.

I have no illusions that saying this obvious stuff will stop the usual suspects from engaging in the usual bigotry. But maybe this will help others respond when they do.”


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