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Chapter Outline

10Modern Schools in Economy –

Part II

PART III MODERN ECONOMIC SCHOOLS OF THOUGHT

What is Keynesianism?

Historical review

The Great Depression

Keynes solution

Components of Macroeconomy

Basic theories

The labor market

The market for loanable

funds (money market)

The Multiplier

Keynesian inflation theory

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Thursday, October 15, 2015 Chapter 4 - NeoClassical economic theories 2

Defining Keynesianism

Keynesianism is named after John Maynard Keynes, a British economist who lived from 1883 to

1946.

Even Keynes' critics call him the greatest and most influential economist of the 20th 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 1936.

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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.”

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• Investment Saving inflation

•Saving > Investment recession

The right course of action in an economic depression is to encourage spending and discourage saving


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Say's Law states that supply creates demand

Keynes believed the opposite to be true:

Output (supply) is determined by demand

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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.

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Vicious cycle of depression

Less spending

Aggregate demand

fallsJob losses


Government should borrow money to boost demand

$

KEYNESIAN SOLUTION:

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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.

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Historical review


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.

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Historical overview


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 (1939-1945).

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Historical overview


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."

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Video: the great depression


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Historical overview

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.

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Components of the Macroeconomy

The Circular Flow Diagram:A diagram showing the income received and payments made by each sector of the economy.

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Historical overview


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.

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Historical overview


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.

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If the savings are greater then the economy will suffer


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Historical overview

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.

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Basic theories

•The labor market

•The market for loanable funds (money market)

•The Multiplier

•Keynesian inflation theory


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Basic theories

• 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 equilibriumKeynes believed three possible equilibriums existed

•Below full employment•At full employment•Above full employment

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Basic theories



Keynes stood Say’s law on its headKeynesian 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

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Basic theories



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.

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Basic theories



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 ratesor 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.

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Basic theories

• 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.

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Basic theories

• 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.

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Basic theories

•The Multiplier


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Basic theories

• 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.


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Basic theories

• 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


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Basic theories

• 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


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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 MILTON FRIEDMANTO

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Documents

Components of Macroeconomy The labor market Keynes ...drpaulineayoub.weebly.com/.../1/0/2/6/10265963/ch10... · The Great Depression The tragedy of the Great Depression began in October