Background
Economics is a branch of social science that focuses on studying how individual, households, and organizations work. These individuals are collectively coined as economic actors, agents, or players, as their collectively movements influence how the overall economy works. The study of economics also deal with how these economic players manage resource—especially natural resources which are considered to be scarce or limited; how they use, buy, and sell alternative commodities, all in an effort to arrive at their desired ends. An individual, one of the economic factors we have mentioned, may, for example, go to a supermarket to buy goods for him and his family. This process—buying goods from the supermarket, is an economic process in itself wherein the person who bought the goods and the person who sold them acting as the economic agents, and the process of buying and selling goods as the ends. Classical economic theories are based on the notion that all economic agents act in a rational way, and more often than not, based on their needs; that they have multiple goals or ends in sight; that they know there is only a limited amount of resources for them to meet those ends, that these economic agents have a stable set of preferences, that may change from time to time; that they have the capability to make a choice; and that they have a definite overall objective behind every end . The purpose of economics is to enable man to understand why economic problems occur, and to arrive at the best possible outcome while at the same time being bounded by the conditions and the general innate characteristics of economic agents we have recently mentioned, among other rational conditions. It can also be argued that the fundamental goal of economics is to enable the economic agents successfully control the inflow and outflow of limited resources and maximize their values under a finite amount of time. Now, the conditions we have mentioned were mostly derived from the classical theories of economics. Just like in any other field, there are numerous laws and theories in the field of economics. However, this paper will only focus on one of the many theories in economics and that theory would be the Keynesian Theory of Economics.
The Keynesian Theory of Economics may also be referred to as Keynesian Economics or Keynesianism, as in the case of other economic textbooks. In general, this economic theory suggests that aggregate demand (or the total amount or worth of spending in the economy) strongly influences economic activity and economic output during period of economic slumps and especially during economic recessions . What it important to take note of about this economic theory is the fact that the strategies it suggests, such as the stimulation of the economy by increasing the level of aggregate demand, only works best over the short run. This means that if the government or whatever organization or department that manages the state’s fiscal matters’ timing is off and made the mistake of relying on this economy theory for the long term, economic problems may give birth to more problems and become counterproductive . It is also worth mentioning that under the principles of Keynesian Economics, aggregate demand does not necessarily equate to the productive capacity of the economy because it merely influences it in a directly proportional way because economic output may also be directly influenced by other economic factors such as employment, inflation, and production capacities and performances, which is why there are cases wherein even when aggregate demand is pushed upwards, the value of the economic output still tends to behave erratically .
Applied Example
There are numerous applied examples that may show how Keynesian Economics work. In order for the readers to understand how this economic theory works in a real-world setting, we are going to use a modern and active example and focus on every detail of that example and try to relate it to Keynesian Economics. When thinking about the best applied example to be used in this case, the best one that came into mind is the current economic situation in the United States that came as a result of the recent Great Financial Crisis of 2008. It is worth mentioning that the Keynesian Theory of Economics actually started when the world was hit with the consequences of the Great Depression, during which many economists started to doubt the validity and reliability of classical economic theories . At this modern a time, it can be argued that the government has once again, chose to rely on Keynesianism, at least based on what their actions and new economic policies would tell us. The United States government suffered a direct hit when its real estate market collapsed. It suffered from a large number of defaulted loans that severely limited the amount of liquidity in its financial markets. With a limited amount of liquidity, there were not enough cash that businesses could borrow to stimulate economic growth as those cash were forcefully stored in real estate properties . What the United States government did was they stepped in and bailed the big financial institutions and corporations that were on the brink of bankruptcy for they know that if a large number of those institutions and corporations fall, the economy would suffer even further mainly due to the sharp decline in aggregate demand. One of the main consequences of a limited amount of liquidity is a lower level of purchasing power (because people and enterprises basically do not have the cash to buy anything at all). And one of the main consequences of a low level of purchasing power is a lower level of aggregate demand. It works like a chain. The fact that investors and individual people lost their confidence on the American economy because of the events that happened in the crisis may also be added to the reasons why aggregate demand may have plummeted. People were basically afraid to spend that time because most of them were either unsure of what would happen to their money if they spend it or they know that the market is relatively unstable and that the best decision for them at the time was to withdraw their money from the banks and keep it themselves and not start spending until economic conditions become normal again. The problem with that, however, is that it brings us back to the main problem that caused the decline in aggregate demand, which was the limited amount of liquidity. Another strategy that the United States government did was they introduced the a stimulus package—something which we can directly correlate to their belief in the effectiveness of the Keynesian Theory of Economics over the short run, in the form of Quantitative Easing. Under the Quantitative Easing, the United States would print new currency valued at 85 Billion USD per month, in the form of government bonds. This was allegedly done to encourage the investors to invest more and the market to spend more, thereby increasing the aggregate demand and economic output. This scenario perfectly describes how Keynesian Economics work. Over the past years, the United States’ central bank, the Federal Reserve System, has been slowly winding down its Quantitative Easing program following reports that the United States has been slowly recovering from the Great Financial Crisis of 2008.
Prescriptive or Positive
The Keynesian Theory of Economics is more prescriptive than positive. Based on the Peter van der Hoek (2011),”prescriptive theories include those that have been descried as normative or those that provide recommended methods to achieve the intended results”; positive theories on the other hand can either be descriptive and explanatory. “Descriptive theories merely note what is observed; explanatory theories also show how or why some budgetary behavior occurs” . The example given in the resource was the greedy bureaucrat theory of Niskanen that described how greedy bureaucrats who seek to increase their level of spending by appealing for an increased amount of discretionary budget (which would result to higher levels of utility, through larger staffs and increased pays, among others), rather than increasing the spending levels for the public. So, given these two concrete definitions and example of prescriptive and positive theories, it is somewhat clear that the Keynesian Theory of Economics lies more on the prescriptive. In classifying whether this economic theory is either prescriptive or positive, it would be important to remember how this theory was invented. This theory was invented amidst the Great Depression, at a time when economists believed that even though market behavior may seem erratic—characterized by a series of ups and downs, devastating market movements would unlikely occur because that was just how the market works. People who believed in this groundless assumption were proven all wrong, and it was John Maynard Keynes who revolutionized classic economic thoughts. He suggested in his works that markets have the tendency to behave violently and wildly. Unfortunately, they learned this lesson the hard way. One of the prescribed actions according to Keynesianism to counter the effects of a plunging economy secondary to a recession or worse, a depression, is to increase aggregate spending in the economy. In the recent financial crisis, this is, in fact, what the government did. The Keynesian Theory of Economics does not try to explain a phenomenon—although it does in some cases, but its fundamental goal is to teach economists and at this point, policymakers what to do in case another event that is similar to the Great Depression happens again .
Level of Rationality
John Maynard Keynes created the principles behind his economic theory after the great depression has devastated the world economy. In relation to that, rationality, or rational expectations, refers to hypotheses made in the field of economics that suggest that the predictions that economic agents make about the future value of economically relevant variables are systematically correct and that all errors are random. In the past, rational hypotheses have been made to support or refute economic policies. During the economically troublesome years of the 1970s, for example, the United States Federal Reserve attempted to solve the high level of unemployment by increasing the monetary supply in the economy. It can be argued that this strategy is based on the principles of Keynesianism because increased monetary supply makes the economic agents think that the economy is in good condition and so they tend to consume and pay for goods and services that they normally consume, keeping the levels of aggregate demand stable and in some cases, even higher. Rational hypotheses during that time, however, suggested that the Keynesian economic theory-backed strategy of increasing monetary supply may only lead to higher levels of inflation and may not even contribute to the creation of more jobs. So, in this case, it can be argued that the Keynesian theory of economics has an unsatisfactory level of rationality .
Theories it may be similar to or compatible with
The most compatible or similar theory with the original Keynesian Theory of Economics would be the New Keynesian Theory of Economics. The only thing that makes these two theories different from each other is the fact that the original Keynesian Theory of Economics was made to deal with macroeconomic factors as evidenced by its focus on aggregate demand or the total level of spending in an economy while the New Keynesian Theory of Economics focuses on the microeconomic foundations of the original Keynesian Economic Theory. Additionally, more assumptions about different possibilities of market failures have been presented in the New Keynesian Theory of Economics.
Theories it may be incompatible with
Two economic theories have been identified as incompatible with the Keynesian Theory of Economics. The first one is the Crowding out Theory; the second one is the Theory of Money and Economic Fluctuations by Friedrich Hayek. The Crowding out Theory explains that economic strategies that aim to increase monetary supply by means of increasing levels of government borrowing—in an effort to stimulate the economy and stabilize or even increase levels of aggregate demand may, in fact, lead to reduced investment spending which is the opposite of what the government would want to happen during recessive and depressive economic phases. Friedrich Hayek’s Theory of Money and Economic Fluctuations, on the other hand, is, in fact, a direct rebuttal of Keynes’ work in Keynesian Economics. Hayek argued that increasing levels of government spending is one of the poorest strategies to increase aggregate demand in the economy. He suggested that increasing the levels of investments in public markets would be a better road to wealth and economic freedom. Even though Keynes and Hayek agreed on many theoretical matters about the economy, Hayek’s fiscal and monetary policy often contradicted that of Keynes’, as evidenced by their contrasting claims about the best way to revive an ailing economy .
Reasons why policymakers should endorse the Keynesian Theory
There are many reasons why a lot of economic analysts and policy makers prefer to follow the macroeconomic foundations suggested by the Keynesian Theory of Economics. Firstly, during the periods of recession and depression, the United States Federal Government has repetitively used strategies such as increasing the level of liquidity, increasing the level of monetary supply in the economy to stabilize and increase economic spending and aggregate demand. So far, the economy has been able to recover from such periods of low economic activity . This means that the government, particularly the central bank, has made a good decision in choosing a strategy backed by the Keynesian Theory of economics because otherwise, the United States economy would still be in a period of recession or depression.
In the most recent economic crisis, the central bank, in fact, used the same strategy—increasing monetary supply, and liquidity, with the addition of lower interest rates. All of which are actually aimed at increasing government spending and aggregate demand. So far, the United States’ economy has been on the path towards recovery, at least based on the economic reports released by the government. If at least half of what these reports suggest is true, then the past and most recent outcomes of the government’s reliance on a basically Keynesian Theory-based economic and fiscal policy should already be an enough reason for us to recommend and or endorse the Keynesian Theory of Economics to the current and future policy makers.
References
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