- The Circular Flow Diagram
The circular flow diagram captures the relationship of money and resources between households and firms in the economy. The inner loop represents the flows of inputs for production and goods and services: households sell their labor to firms, and the firms sell the goods and services they produce to households. The outer loop in the diagram represents the corresponding flows of money: households pay the firms for the goods and services, and the firms pay wages and profit to the households.
Households increase savings. The presence of increase in household saving implies that there is a leakage in the economy. Household savings leak out of the economy and is channeled in the capital markets; households deposit their savings in banks. To maintain equilibrium in the system, there have to be an equal amount of investment injected in the economy; thus, the borrowing activities of firms from the capital market. Assuming that the increase in savings is due to an increase in household income, ceteris paribus, this results to increase in aggregate demand due to increase in the level of investment spending by the firms. In effect, higher demand leads to higher production and therefore higher level of income in the economy.
Drastic Spending Cuts by the Government. The government affects the economy through its fiscal policies (spending and/or tax). A drastic cut in the spending of the government lowers aggregate demand in the economy, resulting in decrease in the level of equilibrium output. Government spending is considered as an injection in the circular flow hence, a cut in spending implies reduction in the injection, thereby reducing economic activity.
- US Economic System
The three types of economic systems are the free market economy, the command economy, and the mixed economy. The free market economy is described as an economic system without the government intervening and regulating economic activities. The only role that the government has is the enforcement of contracts and ownership or properties. The second type is the command economy, which is an economic system that is managed by the state. The economic decisions (e.g. production and consumption of goods and services) are highly centralized and done by the government. The government has the control over all of the sectors of the economy and makes all the decisions regarding the use and distribution of output. Also, the economic planners decide what goods to be produced based on the national and social objectives of the state. The third type of economic system is the mixed economy which is characterized by both private and government control over economic activities; it is a mixture of socialism and capitalism. Relevant aspects of mixed economy include a degree of private economic freedom combined with centralized economic planning and government regulation.
The economic system that closely resembles that of the US economy is the mixed economy. Though many have considered the United States economy to resemble that of the capitalist system (free market system) as evident in the high degree of private ownership and individual freedom, a significant component of the US economy is controlled by the Federal government. Hence, the US economic system is a mixed economy.
- Keynes versus Hayek: How the Government Should Manage the Economy?
John Maynard Keynes and Friedrich von Hayek have opposing ideas as to how the government should manage the economy.
J.M. Keynes. Keynes called for a significant role for the government in the economy. Keynes argument focused on the government’s use of fiscal policy (spending, tax, deficits) to affect the aggregate demand to maintain full employment. He believed that balancing the government budget during periods of low output would only worsen the situation. The government, according to him, could borrow money to spend on public works and the spending deficit that is created eventually creates jobs and increases the purchasing power, thereby relieving the economy from a slump. Meanwhile, during periods of recovery and expansion, Keynes posited that the government could reduce spending.
The government could also make use of monetary policy (money supply, interest rate) to stimulate the economy.
F.A. Hayek. Like Keynes, Hayek recognized the complexity and unpredictability of markets; however, unlike Keynes, he thought that policymakers could not master such complexities in order to manage the economy. Hayek favored more economic freedom and less government intervention in the economy. He believed that the economy will run smoothly and efficiently if the people have more freedom to choose. Hayek associated government intervention to central economic planning of which he maintained that under central planning, there is no way that a rational decision will be arrived at because of the absence of economic calculation for the use of resources, that is there is the absence of a price system that will aid in weighing economic alternatives. Moreover, since the decision-makers in the government do not possess the economic knowledge necessary to plan the economy rationally, they have the tendency to rely on the readily available information; and their decisions are influenced by their incentives to exercise political power.
Hayek argued that the government should not control the interest rate (the price of money). He said that efforts to stimulate the economy, like more government borrowing to encourage spending during slump, would only make things worse. More interestingly, Hayek distrusted both monetary and fiscal policies of the government in managing the economy.
The Major Differences. The most obvious difference between Keynes’ and Hayek’s ideas lies on the role that they gave to the government in managing the economy. As mentioned in the discussion above, Keynes favored significant role for the government to stimulate the economy through its use of fiscal and monetary policies; Hayek, however, distrust the government in handling the economy especially the use of the policy instruments as he thought that the decision-makers are not economically equipped to come up with rational decisions in guiding the economy. For Keynes, intervention by the policymakers could make the economy better; for Hayek, policymakers would only make the economy worse.
- Keynes or Hayek? My Side
Answering this question “which of the two economists would you agree with more?” is like dealing with the Keynes vs. Hayek economic debate over and over; of who is correct and who is not. My answer is this: both economists are correct and I agree to both of them.
Reading on the history of economic thought, made me realized that both of their arguments have weights; only that their ideas were shaped by differing economic conditions that have prevailed in their respective countries. Keynes was a British economist while Hayek was an Austrian economist. Though both of them came of intellectual age in the aftermath of WW1 and have witnessed the boom of the 1920s and the Great Depression of the 1930s, their different views on the extent of government intervention in the economy were mainly influenced by the events that happened in their respective economies. Keynes have witnessed how Britain have endured the persistent high level of unemployment despite and the economic crisis with the government doing nothing to stimulate the economy. Meanwhile Hayek had witnessed the large scale spending programs of the government and how hyperinflation had devastated the Austrian economy.
In sum, the applicability of their ideas depends on the economic situation that an economy is currently facing. With this, I cannot take my side as to whom to agree because again, they are both correct.
References
Council for Economic Education (n.d.). “Keynes vs. Hayek: the rise of the Chicago School of Economics”. Accessed from http://www.econedlink.org/lessons/index.php
Koehn, Nancy (2011). “The tale of the dueling economists”. The New York Times, October 22, 2011. Accessed from http://www.nytimes.com/2011/10/23/business/keynes-hayek-views-origins-of-an-economics-debate-review.html
Nasar, Sylvia (2011). “Hayek, Keynes and how to prevent economic crisis”. Bloomberg. Accessed from http://www.bloomberg.com/news/print/2011-09-13/hayek-keynes-and-preventing-economic-crises-commentary-by-sylvia-nasar.html
Phelps, Edmund (2011). “Keynes vs. Hayek: stumbling blocks to spending our way to prosperity”. Statement in the Keyenes vs. Hayek Debate produced by Reuters, November 8, 2011. Accessed from http://capitalism.columbia.edu/files/ccs/Keynes%20Vs.%20Hayek%202011-11-17.pdf
