Can Keynesian economics reduce the boom-bust cycle?

For years, economists have struggled with the root causes of depression, recession, unemployment, liquidity crisis, and many other problems. Then in the early twentieth century, the idea of ​​a British economist provided a possible solution. Read on to learn how John Maynard Keynes changed the course of modern economics.

Fundamentals of Keynesian Economics

John Maynard Keynes (1883-1946) was a British economist and graduated from Cambridge University. He was fascinated by mathematics and history, but eventually became interested in economics under the impetus of one of his professors and the famous economist Alfred Marshall (1842-1924). After leaving Cambridge University, he held various government positions, focusing on the application of economics to real-world problems. Keynes rose in importance during the First World War and served as a consultant at the conference that led to the Treaty of Versailles, but this will be his 1936 book, General Theory of Unemployment, Interest and Money, Which will lay the foundation for his legacy: Keynesian economics.

Keynes’s Cambridge course focused on classical economics, and its founders included Adam Smith.Classical economics relies on laissez-faire market adjustment methodsIn some respects, this is a relatively primitive method. Immediately before the advent of classical economics, most parts of the world were still in the feudal economic system, and industrialization had not yet fully established a foothold. Keynes’s book fundamentally pioneered the field of modern macroeconomics by examining the role played by aggregate demand.

Keynesian theory attributed the emergence of economic depression to the following factors:

  • Circular relationship between expenditure and income (aggregate demand)
  • Savings
  • unemployment

Aggregate Demand Keynes

Aggregate demand is the total demand for goods and services of an economy, and is usually considered to be the gross domestic product (GDP) of an economy at a specific point in time. It has four key components:

Aggregate demand = C + I + G + NX where: C = consumption (consumers buying goods I = investment (enterprise, in order to produce G = government expenditure S = net exports (export value minus import value)begin{align} &textit{Aggregate Demand}=C+I+G+NX \ &textbf{where:} \ &begin{aligned} C = &text{ consumption (consumers who purchase goods)\ & text{ and services)}end{aligned}\ &begin{aligned} I = &text{ Investment (through the enterprise, in order to produce}\ &text{ more goods and services)} end{ aligned}\ &G = text{ government expenditures}\ &S = text{ net exports (export value minus imports)}\ end{aligned}

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Total Require=C+A generation+G+NXWhere:C= Consumption (by consumers who purchase goodsA generation= Investment (through the enterprise, for productionG= Government spendingsecond= Net exports (export value minus import value)

If one component falls, the other component will have to increase to keep GDP at the same level.

Keynes on Savings

Keynes believed that saving would have an adverse effect on the economy, especially when the saving rate was too high or too high. Because one of the main factors in the aggregate demand model is consumption, if individuals deposit money in banks instead of buying goods or services, GDP will fall. In addition, the decline in consumption has led to a reduction in enterprise production, and fewer workers are needed, thereby increasing the unemployment rate. Companies are also reluctant to invest in new factories.

Keynes on Unemployment

One of the pioneering aspects of Keynesian theory is its treatment of the topic of employment. Classical economics is rooted in the premise that the market satisfies full employment. However, Keynes’s theory is that wages and prices are flexible, and full employment is not necessarily achievable or optimal. This means that the economy seeks to find a balance between the wages workers demand and the wages companies can provide. If the unemployment rate drops, there will be fewer workers available to companies seeking to expand, which means that workers can demand higher wages. There are points where companies will stop hiring.

Wages can be expressed in two forms, actual and nominal. Real wages take into account the effects of inflation, while nominal wages do not. For Keynes, it is difficult for companies to force workers to lower their nominal wage rate. Workers will only be willing to accept lower wages after other wages in the entire economy fall or commodity prices fall (deflation).

In order to increase employment levels, the inflation-adjusted real wage rate must fall. However, this could lead to a worsening economic recession, worsening consumer confidence, and a decline in aggregate demand. In addition, Keynes believed that wages and prices were slow to respond to changes in supply and demand (ie, “sticky” or inelastic). One possible solution is direct government intervention.

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The role of the government

One of the main players in the economy is the central government.It can influence the direction of the economy by controlling the money supplyWhether through the ability to change interest rates, or through the repurchase or sale of government-issued bonds. In Keynesian economics, the government takes an interventionist approach; it does not wait for market forces to improve GDP and employment. This leads to the use of deficit spending.

As one of the components of the aforementioned aggregate demand function, if individuals are reluctant to consume and companies are reluctant to build more factories, government spending can create demand for goods and services. Government spending will consume additional production capacity. Keynes also proposed that if companies hire more people and employees spend money through consumption, the overall impact of government spending will be magnified.

It is important to understand that the role of the government in the economy is not only to suppress the effects of the recession or to pull a country out of the recession; it must also prevent the economy from heating up too quickly. Keynesian economics shows that the interaction between the government and the overall economy develops in the opposite direction of the business cycle: increase spending when the economy is down, and decrease spending when the economy grows. If economic prosperity causes high inflation, the government may cut spending or increase taxes. This is called fiscal policy.

Application of Keynesian Theory

The Great Depression was the catalyst that put John Maynard Keynes into the spotlight, but it should be noted that he wrote this book a few years after the Great Depression. In the early days of the Great Depression, many key figures, including then President Franklin D. Roosevelt, believed that the government’s concept of “using the economy for health” seemed an oversimplified solution. It is by visualizing the economy as a demand for goods and services that allows this theory to persist.

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In his New Deal, Roosevelt hired workers in public projects, which not only provided employment opportunities, but also created demand for goods and services provided by enterprises. During World War II, government spending also increased rapidly because the government invested billions of dollars in companies that manufacture military equipment.

Keynesian theory was used to test the Phillips curve of unemployment and the development of ISLM models.

Critique of Keynesian Theory

The economist Milton Friedman is one of the most outspoken critics of Keynes and his methods. Friedman helped develop the monetarist school (monetarism), which shifted its focus to the role of money supply on inflation rather than the role of aggregate demand. Government spending can drive the spending of private companies because there is less money available for private borrowing in the market. Monetarists suggest that monetary policy should be adopted to alleviate this situation: the government can raise interest rates (make borrowing more costly) or can sell national debt ( Reduce the amount of U.S. dollar funds that can be loaned out) to combat inflation.

Another criticism of Keynesian theory is that it favors a centrally planned economy. If the government is expected to spend money to stop the depression, it means that the government knows what is best for the economy as a whole. This eliminates the influence of market forces on decision-making. The economist Friedrich Hayek promoted this criticism in his 1944 book, The road to slavery. The foreword to the German version of Keynes’s book shows that his method may be most effective in totalitarian countries.

Bottom line

Although Keynesian theory in its original form is rarely used today, its radical approach to the business cycle and its solution to depressions have had a profound impact on the field of economics. Today, many governments use partial theories to smooth their economic boom and bust cycles. Economists combine Keynesian principles with macroeconomics and monetary policy to determine which course of action to take.


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