Keynesian economics is the view that in the short run,
especially during recessions, economic output is strongly influenced by
aggregate demand. In the Keynesian view, aggregate demand does not necessarily
equal the productive capacity of the economy; instead, it is influenced by a
host of factors and sometimes behaves erratically, affecting production,
employment, and inflation.
The theories forming the basis of Keynesian economics were
first presented by the British economist John Maynard Keynes in his book, The
General Theory of Employment, Interest and Money, published in 1936, during the
Great Depression. Keynes contrasted his approach to the aggregate
supply-focused 'classical' economics that preceded his book. The
interpretations of Keynes that followed are contentious and several schools of
economic thought claim his legacy.
Keynesian economists often argue that private sector
decisions sometimes lead to inefficient macroeconomic outcomes which require
active policy responses by the public sector, in particular, monetary policy
actions by the central bank and fiscal policy actions by the government, in
order to stabilize output over the business cycle. Keynesian economics
advocates a mixed economy – predominantly private sector, but with a role for
government intervention during recessions.
Keynesian economics served as the standard economic model in
the developed nations during the later part of the Great Depression, World War
II, and the post-war economic expansion, though it lost some influence
following the oil shock and resulting stagflation of the 1970s.
Theory
Keynes argued that the solution to the Great Depression was
to stimulate the economy through some
combination of two approaches:
# A reduction in interest rates, and
# Government investment in infrastructure .
By reducing the interest rate at which the central bank
lends money to commercial banks, the government sends a signal to commercial
banks that they should do the same for their customers.
Investment by government in infrastructure injects income
into the economy by creating business opportunity, employment and demand and
reversing the effects of the aforementioned imbalance.
Concept
Wages and spending
During the Great Depression, the classical theory attributed
mass unemployment to high and rigid real wages.
To Keynes, the determination of wages is more complicated.
First, he argued that it is not real but nominal wages that are set in
negotiations between employers and workers, as opposed to a barter
relationship. Second, nominal wage cuts would be difficult to put into effect
because of laws and wage contracts. Even classical economists admitted that
these exist; unlike Keynes, they advocated abolishing minimum wages, unions,
and long-term contracts, increasing labour market flexibility. However, to
Keynes, people will resist nominal wage reductions, even without unions, until
they see other wages falling and a general fall of prices.
Active fiscal policy
Classical economists have traditionally yearned for balanced
government budgets. Keynesians, on the other hand, believe this would
exacerbate the underlying problem: following either the expansionary policy or
the contractionary policy would raise saving
and thus lower the demand for both products and labour. For example,
Keynesians would advise tax cuts instead.
"Multiplier effect" and interest rates
Two aspects of Keynes's model has implications for policy:
First, there is the "Keynesian multiplier", first
developed by Richard F. Kahn in 1931. Exogenous increases in spending, such as an
increase in government outlays, increases total spending by a multiple of that
increase. A government could stimulate a great deal of new production with a
modest outlay if:
# The people who receive this money then spend most on
consumption goods and save the rest.
# This extra spending allows businesses to hire more people
and pay them, which in turn allows a further increase in consumer spending.
This process continues. At each step, the increase in
spending is smaller than in the previous step, so that the multiplier process
tapers off and allows the attainment of an equilibrium. This story is modified
and moderated if we move beyond a "closed economy" and bring in the
role of taxation: The rise in imports and tax payments at each step reduces the
amount of induced consumer spending and the size of the multiplier effect.
Second, Keynes re-analyzed the effect of the interest rate
on investment. In the classical model, the supply of funds determines the amount of fixed business
investment. That is, under the classical model, since all savings are placed in
banks, and all business investors in need of borrowed funds go to banks, the
amount of savings determines the amount that is available to invest. Under
Keynes's model, the amount of investment is determined independently by
long-term profit expectations and, to a lesser extent, the interest rate. The
latter opens the possibility of regulating the economy through money supply
changes, via monetary policy.
New Classical Macroeconomics criticisms
Another influential school of thought was based on the Lucas
critique of Keynesian economics. This called for greater consistency with
microeconomic theory and rationality, and in particular emphasized the idea of
rational expectations. Lucas and others argued that Keynesian economics
required remarkably foolish and short-sighted behavior from people, which
totally contradicted the economic understanding of their behavior at a micro
level. New classical economics introduced a set of macroeconomic theories that
were based on optimising microeconomic behavior. These models have been
developed into the Real Business Cycle Theory, which argues that business cycle
fluctuations can to a large extent be accounted for by real shocks.
New classical theorists demanded that macroeconomics be
grounded on the same foundations as microeconomic theory, profit-maximizing
firms and rational, utility-maximizing consumers.
The result of this shift in methodology produced several
important divergences from Keynesian Macroeconomics:
# Independence of Consumption and current Income
# Irrelevance of Current Profits to Investment
# Long run independence of inflation and unemployment
# The inability of monetary policy to stabilize output
# Irrelevance of Taxes and Budget Deficits to Consumption
