10 Chapter Outline What is Keynesianism?

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1 PART III MODERN ECONOMIC SCHOOLS OF THOUGHT Modern Schools in Economy Part II 10 Chapter Outline What is Keynesianism? Historical review The Great Depression Keynes solution Components of Macroeconomy The labor market The market for loanable funds (money market) The Multiplier Keynesian inflation theory 1 of 36 Defining Keynesianism Keynesianism is named after John Maynard Keynes, a British economist who lived from 1883 to Even Keynes' critics call him the greatest and most influential economist of the 20 th century. Much of Keynes work took place at the time of the Great Depression in the 1930s, and perhaps his best known work was: the 'General Theory of Employment, Interest & Money' which was published in Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 2 Keynesian Economics in brief Keynes stated that if Investment exceeds Saving, there will be inflation. If Saving exceeds Investment there will be recession. One implication of this is that, in the midst of an economic depression, the correct course of action should be to encourage spending and discourage saving. This runs contrary to the prevailing wisdom, which says that thrift is required in hard times. In Keynes's words, "For the engine which drives Enterprises is not Thrift, but Profit. Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 3

2 Investment Saving inflation Saving > Investment recession The right course of action in an economic depression is to encourage spending and discourage saving Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 4 _ Keynesian Economics in brief Say's Law states that supply creates demand Keynes believed the opposite to be true: Output (supply) is determined by demand _ Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 5 _ Keynesian Economics in brief _ In recessions, the aggregate demand of economies falls. In other words, businesses and people tighten their belts and spend less money. Lower spending results in demand falling further and a vicious circle results in job losses and further falls in spending. Keynes's solution to the problem was that governments should borrow money and boost demand by pushing the money into the economy. Once the economy recovered, and was expanding again, governments should pay back the loans. Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 6

3 _ Vicious cycle of depression _ KEYNESIAN SOLUTION: Job losses Less spending Aggregate demand falls Government should borrow money to boost demand $ Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 7 Keynesian Economics in brief Keynes's view that governments should play a major role in economic management are upheld in economically and socially successful economies that have significant contributions from both the government and the private sectors. A break with the laissez-faire economics of Adam Smith, which held that economies function best when markets are left free of state intervention. Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 8 Historical review The Great Depression The tragedy of the Great Depression began in October 1929, when the stock market in the United States dropped rapidly. The longest and worst period of high unemployment and low business activity in modern times. Banks, stores, and factories were closed and left millions of Americans jobless, homeless, and penniless. Many people came to depend on the government or charity to provide them with food. Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 9

4 The Great Depression The Depression affected almost all nations in the 1930's: World trade decreased sharply as each country raised tariffs on imports to protect their own industries. Some nations changed their leader and their type of government. In Germany, poor economic conditions led to the rise to power of the dictator Adolf Hitler. The Japanese invaded China to control their mines and develop their own industries. Japan claimed this economic growth would relieve the depression. This militarism of the Germans and Japanese eventually led to World War II ( ). Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 10 The Great Depression Keynes, however, came up with an explanation of economic slumps that was surprisingly simple. In fact, when he shared his theory and proposed solution with Franklin Roosevelt, the President is said to have dismissed them with the words: "Too easy." Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 11 _ Video: the great depression _ Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 12

5 _ Keynes explanation of the slump In a normal economy, there is a circular flow of money in the economy, as my spending becomes part of your earnings, and your spending becomes part of my earnings. _ Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 13 _ Components of the Macroeconomy The Circular Flow Diagram: A diagram showing the income received and payments made by each sector of the economy. _ 14 of 24 Keynes explanation of the slump In a crisis, worried consumers may try to weather the coming economic hardship by saving their money. My decision to hoard money makes things worse for you. And you, responding to your own difficult times, will start hoarding money too, making things even worse for me. So there's a vicious circle at work here: people hoard money in difficult times, but times become more difficult when people hoard money. Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 15

6 Keynes explanation of the slump The cure for this, Keynes said, was for the central bank to expand the money supply. By putting more bills in people's hands, consumer confidence would return, people would spend, and the circular flow of money would be reestablished. Just that simple! In these dire circumstances, Keynes believed that the government should do what individuals were not, namely, spend: a final government effort to reestablish the circular flow of money. Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 16 _ If the savings are greater then the economy will suffer _ Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 17 Keynesianism in the Postwar Era As mentioned above, Keynes' advice on ending the Great Depression was rejected. President Roosevelt tried countless other approaches, all of which failed. Almost all economists agree that World War II cured the Great Depression; Keynesians believe this was so because the U.S. finally began massive public spending on defense. This is a large part of the reason why "wars are good for the economy." After the war, economists found Keynesianism a useful tool in controlling unemployment and inflation. Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 18

7 _ The labor market The market for loanable funds (money market) The Multiplier Keynesian inflation theory _ Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 19 The labor market Households supply labor and firms and the government demand labor. Keynes concluded that the economy was not always at, or tending toward a full employment equilibrium Keynes believed three possible equilibriums existed Below full employment At full employment Above full employment Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 20 The labor market Keynes stood Say s law on its head Keynesian theory can be summarized with the statement, Demand creates its own supply Keynes maintained that aggregate demand is the prime mover of the economy Aggregate demand determines the level of output and employment Business firms produce only the quantity of goods and services they believe consumers, investors, governments, and foreigners will plan to buy Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 21

8 The labor market In the classical model, the unemployment caused by the Great Depression should have been solved by wage reductions that would rapidly clear the labor market. However, this did not seem to be happening. Keynes argued that market forces are not an adequate adjustment mechanism ; The government alone has the capacity and the responsibility to stabilize the economy. Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 22 The labor market Policy makers should manipulate government expenditures to achieve a desirable level of aggregate demand. In times of economic downturn, this can be achieved either through lowering tax rates or increasing government expenditures. According to Keynes, governments should incur deficits and borrow money in times of downturn; these debts can be repaid through higher taxation in times of economic growth. Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 23 The market for loanable funds (money market) Classical economists were of the view that savings would need to be increased to provide more funds for investment. Keynes had less faith in markets as the economics 'miracle cure'. He argued that any increase in savings would mean that people spent less. More savings decrease in aggregate demand less demand for products less investments for firms He felt that investment depended much more on business expectations. Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 24

9 The Multiplier Any increase in demand results, according to Keynes, in an even bigger increase in National Income. More demand more jobs more spending more employment more income more spending more more The length of time this process went on for would depend on how much of the extra income was spent each time. If the initial recipients of the extra income saved it all, then the process would stop very quickly as no-one else would get their hands on the extra income. However, if they spent it all the knock-on effects of the extra spending would carry on for some time. Therefore the higher the level of leakages, the lower the Multiplier would be. Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 25 _ The Multiplier _ Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 26 _ Keynesian inflation theory Keynesian economic theory proposes that changes in money supply do not directly affect prices, and that visible inflation is the result of pressures in the economy expressing themselves in prices. _ Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 27

10 Keynesian inflation theory Reflationary policies Reflationary policies to boost the level of economic activity might include: Increasing the level of government expenditure Cutting taxation (either direct or indirect) to encourage spending Cutting interest rates to discourage saving and encourage spending Allowing some money supply growth Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 28 Keynesian inflation theory Deflationary policies Deflationary policies to dampen down the level of economic activity might include: Reducing the level of government expenditure Increasing taxation (either direct or indirect) to discourage spending Increasing interest rates to encourage saving and discourage spending Reducing money supply growth Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 29 Modern Schools in Macroeconomics In a speech during a celebration of Milton Friedman s 90th birthday in late 2002, then-fed governor Ben S. Bernanke, who would become chairman four years later, said, I would like to say to Milton and Anna [Schwartz]: Regarding the Great Depression, you re right. We [the Fed] did it. We re very sorry. But thanks to you, we won t do it again. Read thoroughly and discuss Article No 9: THE GREAT DEPRESSION ACCORDING TO MILTON FRIEDMAN