Keynesian Theory
In an attempt to understand the great depression economist John Maynard Keynes developed the Keynesian economics. It is an economic theory of total spending in the economy and its effect on output and inflation. The theory was critical to the classical economic arguments that natural forces and incentives would be sufficient in recovering the economy. The theory advocated for the government to increase expenditure and lower taxes to stimulate demand. Keynes believed that consumer demand is the primary driving force in an economy. Through activist stabilization and economic intervention policies, the aggregate demand would be influenced, and the optimal economic performance could be achieved and prevent the economy from slumps.
The fundamental principle, in theory, is that if the investments in an economy exceed its saving, it will lead to inflation and vice versa will cause a recession. Keynes believed that recession could last long due to the liquidity trap as low- interest rates will make banks unprofitable and reduce lending. He also argued that if the saving were high, there would be low demand, which will make firms cut back on investment. If a firm reduces investment, there will be an increase in the rate of unemployment, leading to low spending. In a recession, people will be risk-averse, and this will lead to low demand. Keynes criticized the classical economic theory on cutting wages as it wouldn’t solve the disequilibrium, lower wages would depress income and spending and therefore affecting demand for labour. Keynes stated that demand creates supply contrary to Say’s law. He argued that demand determined the level of national output. He believed that spending would decrease unemployment and help economic recovery.
Keynes advocated for government intervention in a way to curb unemployment. He argued that the government jobs program would increase government spending and an increase in the budget deficit. He suggested that the best way to pull the economy out of recession, the government should borrow money and increase demand by infusing the economy with capital to spend. This went against the classical orthodoxy that argued government spending would crowd out the private sector. This is because higher government borrowing will increase interest rates on bonds. Crowding out does not always occur as it depends on the state of the economy. Keynes argued that spending cuts and tax rises would lead to reduced aggregate demand. The private sector will improve if the government spending increase, and so will increase the GDP.
The multiplier effect is likely to be higher during the recession because of the unused resources. This means increased government spending does not increase interest rates. The magnitude of the multiplier is related to the marginal propensity to consume. A consumer becomes an income for a business; the cycle shows that when the government spends the private sector improves. Keynes did not encourage big government spending and borrowing but argued for counter-cyclical demand management. The government should undertake deficit spending to make up for the decline in investments. In times of prolonged recession, the theory holds well and has little scruple.
References
Baddeley, M. (2018). Financial Instability and Speculative Bubbles: Behavioural Insights and Policy Implications. Alternative Approaches in Macroeconomics (pp. 209-234). Palgrave Macmillan, Cham.
Marglin, S. A. (2020). History vs. equilibrium one more time: how Keynes’s General Theory foundered on the rocks of comparative statics. Review of Social Economy, 78(1), 35-52.