AS and A2 Macro Revision: Keynesian Economics

Keynesian thought has been given renewed prominence in recent years with the Global Financial Crisis, deep recessions in many countries and a remarkable monetary and fiscal policy response across continents. An understanding of some key Keynesian themes can be helpful in evaluating macro policies and the search for macro stability and better economic outcomes. Crucially Keynesian economics focuses on psychology, uncertainty and expectations in driving macroeconomic decisions and behaviour. Animal spirits are vital.

1. Free market volatility:
a. The free-market system is naturally prone to periods of recession & depression.
b. The volatility of aggregate demand (AD) can be explained by big and important changes in consumer and business sentiment – also known as animal spirits.
c. In a world of depression, the standard rules of economics may no longer apply.

2. Free markets are not always self-correcting:
a. When a recession or a depression occurs, the free market economic system is not necessarily self-correcting – indeed individuals collectively can become trapped in a deflationary depression which is in no one’s interest but which, as individuals, few can counter-act.
b. Persistent deflation can be as costly as high inflation – it can be damaging especially in economies where there is huge private & public sector debt driving wages, profits and jobs downwards
c. You cannot always rely on new inventions / innovations and other natural economic stabilisers to drag an economy out of a recession (they do happen though!)

3. Saving and demand:
a. The paradox of thrift helps to explain why a rise in precautionary saving (i.e. people rationally looking for security during a time of uncertainty) can lead to a fall in aggregate demand and incomes and a reduction in national output, income and wealth.
b. In other words – negative multiplier and accelerator effects can drag an economy to a low level where it can remain unless tere is some external stumulus to lift demand and output again
c. On an international level, when the global desire to save exceeds the global willingness to invest the result is a contraction in world demand and production, a fall in incomes and employment, which eventually brings savings back into balance with investment

4. Deflationary depression:
a. Prolonged recession (and perhaps worse – a deep depression) represents a pure waste of scarce economic resources.
b. Unemployed workers want to work, and businesses want to use their productive capacity to supply goods and services.
c. If they did, then the things they produced would be available for all to buy, and the incomes they received would enable them to purchase the products of others. Incomes – in the form of higher wages and stronger profits would be made feeding through the circular flow in the standard macro model

5. Fiscal stimulus can be self financing:
a. When private demand (consumption and investment and exports) is weak (as it is in a recession) then extra borrowing by the Government, if it encourages more output, can be self-financing and propel an economy out of a slump.
b. The larger the value of the fiscal multplier, the greater the impact of a deliberate stimulus to demand on the final value of GDP.

6. Lift aggregate demand to create jobs:
a. The key is to lift aggregate demand and bring about an expansion along the short-run aggregate supply curve
b. Demand drives output both in the short run and the long run - indeed demand matters in the long run as well as the short (often ignored in explanations of the multiplier etc)
c. Businesses create jobs because they foresee a profitable demand, not because they see a queue of unemployed workers at their door
d. Supply does not necessarily create its own demand - a refutation of Say’s Law

7. The Liquidity Trap:
a. In normal circumstances it is possible to move from recession to recovery by reductions in interest rates (i.e. an expansionary monetary policy)
b. But there is a level below which nominal interest rates cannot go (0.5% in the UK?) and at that point conventional monetary policy is powerless. Moreover, even if interest rates can be lowered this may have no effect if people cannot or will not borrow. This is known as the liquidity trap. Some central banks have turned to quantitative easing on a huge scale (£200bn in the UK, 14% of GDP)
c. Monetary policy may cease to be effective as a means of responding to unexpectedly large demand-side shocks such as a collapse in confidence or a steep fall in the supply of credit / willingness to lend - the interest elasticity of demand will be low

8. Role for government in re-balancing demand and output:
a. At this point, aggregate demand can only be boosted by the Government borrowing more, either to spend directly or to give to others to spend via tax cuts or the like. In other words – a targeted Keynesian fiscal stimulus.
b. Most Keynesians believe that the fiscal multiplier is higher for extra government spending than it is for tax cuts.
c. The aim is simple – when private sector demand is low, the government needs to find a compensating source of demand to rebalance the economy – and the solution comes from the government in the form of higher borrowing or dis-saving. In an economic depression, fiscal deficits crowd-in rather than crowd-out private sector investment

Key terms

Recession
Deflation
Effective demand
Cyclical unemployment
Aggregate demand
Employment
Government intervention
Fiscal stimulus
Fiscal multiplier
Multplier effect
Accelerator effect
Confidence
Animal spirits
Crowding in
Output gap

University of Cambridge Video
John Maynard Keynes - Life - ideas - Legacy