Keynesian Prescription To Fix Insufficient Aggregate Demand
Why Keynesians Believe That The Economy Is Demand-Driven
The most important plank in all of Keynes´s economic theories is the belief that
aggregate demand is the primary determinant of the health of an economy (Jahan, Mahmud,
& Papageorgiou, 2014). Keynes disagreed with Say´s Law – which was largely considered
demand.¨ Keynes on the other hand believed the exact opposite to be true. Namely that
demand drives production. He believed that economies are composed of aggregate demand
which are caused by an aggregate amount of spending. Therefore when people spend an
insufficient amount of money unemployment will occur (Keynesian Economics in a
Nutshell, 2016). Aggregate demand determines the output of an economy which consists
of four parts: consumption, investment, expenditures by the government, and net exports
(Jahan, et al., 2014).
Keynesians Belief In The Rigidity Of Prices In The Short-Run
Keynes believed that prices are rigid in the short-run, i.e. prices (particularly wages) are
slow to react to adjustments in demand and supply. This effectively causes temporary
surpluses and shortages, particularly of labor. He therefore believed that modifications in
aggregate demand in the short-run have a more drastic impact on employment and
production than they do on prices. Due to Keynesians´ belief in prices being inflexible
in the short-run, alterations in any of the parts of spending that comprise aggregate demand
will cause a change in the level of output. Hence an increase in government expenditures
will result in an increase in output (Jahan, et al., 2014).
Keynes espoused his belief that the goal of full employment will not always be achieved
via reducing wages to a low enough level (Keynesian Economics in a Nutshell, 2016).
Therefore he did not prescribe a reduction in nominal prices and/or wages as a means of
addressing the issue of insufficient aggregate demand. To the contrary he asserted that
such a reduction would in all probability amplify the predicament of underutilized capital.
This is why he advised that measures should usually be taken to prevent deflation (Fazzari,
Ferri, Greenberg, & Variato, 2012).
Causes Of Insufficient Aggregate Demand
Keynes asserted that when the total level of investment is greater than the total level
level of savings in an economy, the result will be an increase in the inflation rate. On the
other hand when aggregate savings is greater than the total level of investment in an
economy a recession will occur (Keynesian Economics in a Nutshell, 2016). During
recessions consumer confidence is often times significantly hampered by uncertainty,
which induces consumers to reduce their spending (Jahan, et al, 2014) This, in turn,
will propel a reduction in the total level of spending in the economy and concomitantly
reduces the proclivity of businesses to maximize their output and hire additional employees
(Cable, 2011). Therefore when there is a recession or a depression the correct
prescription is to implement governmental policies that stimulate spending and suppress
saving. This belief runs counter to the belief held by most right-wing economists that
prescribes thrift during economic downturns. Keynes countered this belief by asserting
¨For the engine which drives enterprise is not thrift, but profit (Keynesian Economics in a
Nutshell, 2016, para. 1).
Lack Of Aggregate Demand Results In Recessions And Vice Versa
Not only does a lack of aggregate demand result in recessions, but the inverse is true
according to Keynes. There is kind of a snowball effect as recessions result in a reduction
in aggregate demand. This is the natural result of the propensity of both individuals and
businesses to spend less money during recessions due to reduced confidence. Hence
reduced spending spirals into aggregate demand being even further diminished which
results in a loss of jobs and snowballs into even lower spending throughout the economy
(Keynesian Economics in a Nutshell, 2016).
Why The Government Must Intervene During Recessions
Keynes explicitly denied that there are self-correcting mechanisms inherent in a free
market economy that will induce full employment. Therefore Keynesians believe that
government intervention in the economy that is designed to achieve full employment is
justified. Keynes asserted that insufficient aggregate demand could result in high
unemployment persisting over long periods of time. This sentiment is echoed by
contemporary Keynesians. According to the dogma of contemporary Keynesians, it is
necessary for the government to intervene in the economy in order to temper the highs
and lows of the business cycle (Jahan, et al., 2014). Keynes´s fiscal prescription to solve
the problem of insufficient aggregate demand and the concomitant recessions that it induces
is for the federal government to run budget deficits. This will effectively increase
aggregate demand via injecting the economy with more money. After the economy has
reached recovery mode and a sufficient economic growth rate has been attained the federal
government should then run budget surpluses. Keynes´s belief in the government playing a
significant role in the macro-economy served as a sharp contrast to the laissez-faire beliefs
of classical economist Adam Smith. Smith believed that the economy performs at its
optimal level when the state does not intervene in markets (Keynesian Economics in a
Nutshell, 2016). Likewise adherents of the Austrian school of economics believe that the
business cycle consisting of booms and busts is natural and that intervention by the
government only slows the recovery process (Jahan, et al., 2014).
Keynesian Belief In Using Monetary Policy To Fine-Tune Economy
In addition to fiscal policy, Keynesian economists have traditionally prescribed utilizing
monetary policy in order to combat the problem of insufficient aggregate demand in an
economy and its concomitant recessions. Specifically, Keynesians have traditionally
prescribed decreasing interest rates until the point has been reached where the increased
level of total investment brought about by this is on par with the total level of savings in the
economy (which will naturally decrease as interest rates fall). Nevertheless, Keynes
asserted that utilizing monetary policy to increase aggregate demand would sometimes be
insufficient to combat the problem during stints of low expected aggregate demand (Cable,
2011). Therefore sometimes only fiscal policy can be utilized in order to combat
recessions.
Keynesian Belief In Enacting Tax Cuts To Spur Aggregate Demand
Keynesians believe in the existence of a component of aggregate demand that functions
in a manner that is autonomous from the conditions of the economy. This element of
aggregate demand encompasses not only government expenditures but also contains
autonomous parts of private sector investment and consumption (Fazzari, et al., 2012).
Hence an increase in government spending can increase aggregate demand but so can tax
cuts. Specifically a tax cut that spurs an increase in private sector investment (such as a
reduction in tax rates on interest income or capital gains) will increase aggregate demand.
Likewise a reduction in income tax rates on ordinary income (e.g. income from salaries,
wages, commission, e.t.c.) will result in a concomitant increase in aggregate demand via
increased consumption,.
Why Higher Government Spending Is Sometimes The Only Solution
However, many Keynesians believe that cutting taxes can sometimes be an ineffective
means of increasing aggregate demand and lifting the economy out of a recession. Since
consumer confidence and business confidence tend to be low during a recession if a
recession is severe enough tax cuts will only have a minimal impact on inducing an
increase in private sector consumption and/or investment. Hence, according to most
Keynesians sometimes the sole effective cure for a severe recession is an increase in
government spending. Furthermore, most Keynesians believe that such an increase in
government spending would be the most effective if it happened in an area of the budget
in which there is pent-up demand. Many Keynesian economists would argue that the
current area of the budget that most fits this bill (in both the U.S. and the U.K.) is
infrastructure investment (Cable, 2011).
Reduced Regulation On Businesses Can Boost Aggregate Demand
Many Keynesian economists (as well as many non-Keynesian economists) assert that a
reduction in business regulation decreases the price of capital which will in turn increase
investment and therefore aggregate demand (Cable, 2011). It should be noted that while
contemporary Keynesian economists still focus primarily on the demand side of the
economy, they also have increasingly acknowledged the importance of the supply side of
the economy. They believe that although an increase in aggregate demand is undeniably
essential for long-term growth, it is most assuredly not sufficient (Fazzari, et al., 2012).
Limits To The Applicability Of Keynesian Economic Policies
Supply-Side Factors Can Limit Efficacy Of Keynesian Solutions
There are several limitations to the applicability and effectiveness of Keynesian economic
policies, and I will touch on a few of them. First of all, the whole basis of Keynesian
theory is based on the belief that there are not any impediments to supply in the
economy.. However, the validity of Keynesian theory has its limitations in the real world
when a specific sector of the economy has a significant impediment which effectually
hinders an increase in production, e.g. the agricultural sector (Ghosh, 1999). On top of this,
unanticipated events can also cause supply shocks to occur in one or more sectors of the
economy
Deflation Is Not Always A Bad Thing
Another shortcoming to Keynesian theory is the belief that when deflation occurs in the
economy it is necessarily a bad thing. The mountain of historical evidence unveils that
deflation is not necessarily bad for the economy. During the 1890s, 1920s, and 1950s a
modest level of deflation and a significant increase in real output occurred simultaneously.
Ultimately no logical reason exists in regards to why deflation and an increase in the real
level of production in an economy cannot occur simultaneously. This is because it is profit
margin that determines the real level of production in an economy rather than solely price.
A Straight Aggregate Supply Curve Renders Keynesianism Futile
Such theoretical underpinnings and the historical empirical evidence indicates that it is
unlikely that the aggregate supply curve is positively sloped beyond a certain point. If the
aggregate supply curve is completely straight after the total output in the economy exceeds
a certain point (as many right-wing economists believe) then an increase in government
spending at that point will not increase real national output but will rather only spur an
increase in prices. The straight, upward aggregate supply curve (beyond a certain point of
national output, called the classical range) is also rooted in the belief held by most right-
wing economists that prices are flexible even in the short-run (Skousen, 1991).
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REFERENCES
Cable, V. (2011). Keynes would be on our side. NewStatesman.
Retrieved from http://www.newstatesman.com/economy/2011/01/investment-keynes-essay
Fazzari, S.M., Ferri, M., Greenberg, E.G., & Variato, A.M. (2012). Aggregate Demand,
Instability, & Growth. Retrieved from http://www.santannapisa.it
Ghosh, J. (1999). A note on the relevance and limitations of Keynesian economics.
Retrieved from http://www.old.nasledie.ru/politvne/18_31/article.php?art
Jahan, S., Mahmud, A.S., Papageorgiou, C. (2014). What is Keynesian Economics?
International Monetary Fund, Finance and Development, Vol. 51, No. 3. Retrieved from
http://www.imf.org/external/pubs/ft/fandd/2014/09/basics.htm
Keynesian Economics in a Nutshell. (2016). Retrieved from
http://www.maynardkeynes.org/maynard-keynes-economics.html
Skousen, M. (1991). Economics on Trial. Burr Ridge, Illinois; New York, New York.
