Essay on "Keynesian Theory"

Essay 10 pages (2910 words) Sources: 2 Style: MLA

[EXCERPT] . . . .

Keynesian Theory

The response of the Obama administration to the current economic crisis has been described by some observers as Keynesian. The use of government spending to stimulate the economy is rooted in theories about aggregate demand, to which is applied the doctrine that the government can make up for shortfalls in other aggregate demand components. This paper will examine the definition and nature of Keynesian economics. Then, the evolution of that concept known as New Keynesian economics will be examined. These theories will then be applied to the current economic crisis to better understand both the problem and the government's proposed solutions.

Keynesian Theory -- History and Definition.

John Maynard Keynes was the son of an economist and trained at Cambridge. A prolific writer, he made his most significant impact with his 1936 book The General Theory of Employment, Interest and Money. This book would go on to be the basis for what became known as the Keynesian school of economics. This school remains one of the most vital in the world today, for its ability to explain the state of national economies and the way they react to government stimulus. Keynes' views have held strong influence on economic policy since the publication of the book, which profoundly changed the way that the role of government in the economy is viewed.

Keynes was active in public policy throughout his career, and by the 1920s had developed disdain for the laissez-faire policies of that era. He wrote a series of articles critical of that philosophy. Ultimately, a lively rivalry developed between Keynes and other Cambridge economists and the neoclassicists at the London School of Economics. This rivalry dominated economic thought until the publication of the General Theory, which all but buried neoclassical theory for the next several decades.

Keynes' theories diffused throughout economic and political circles rapidly, because they resonated with a world caught in the depths of the Great Depression. The world economic under the laissez-faire system had collapsed, highlighting deficiencies in that philosophy. The New Deal had begun to turn the U.S. economy around -- if not unemployment. While there is considerable debate as to the role the New Deal played in the turnaround, if the role was positive at all, observers at the time certainly felt that the government spending contributed to stabilizing and restoring the American economy. Thus, Keynesian economics fit well with the perception of economic events at the time. In periods of economic downturn, government spending could improve aggregate demand.

There are six ideas essential to Keynesian economics. The first is that aggregate demand is influenced by a host of economic decisions both public and private. The public decisions are mainly fiscal and monetary policy; private decisions refer to consumer spending and business investment. Thus, aggregate demand is the sum of government spending (fiscal policy) and private decisions, which are impacted by monetary policy. Extending this view, government can influence aggregate demand both by spending and/or by influencing the money supply (Blinder, 2008).

The second theory is that changes in aggregate demand have their greatest impact in the short run, affecting output and employment. Keynes argued that even though the long-run impacts of changes in demand would eventually occur all else being equal, decisions are made in the short-term. Prices, he suggested, would not change as much (Ibid).

The third theory is that because prices respond slowly to changes in supply and demand there will be periodic shortages and surpluses. This can be applied especially to wages, such that there will inevitably be surpluses and shortages in labor. These first three theories are underlying principles, and are not unique to Keynesian theorists. Keynes' other role, in public policy, led him to apply these there underlying beliefs to policy prescriptions.

Flowing from the third theory is the fourth -- that because wages only adjust gradually, the rate of unemployment at any given time is unlikely to be ideal. In general, unemployment is viewed by Keynesians as too high. When unemployment spikes, it is not the result of market response but an economic malady (Ibid).

The fifth theory is that government should actively fine-tune policy in order to keep the economy at full employment. This is intended to address the amplitude of the business cycle. The laissez-faire years and the Great Depression illustrated to Keynes that the business cycle, if left largely unregulated by government, will have a high level of amplitude. In the long-run, policies should be set to facilitate growth. In the short-run, however, government can make adjustments. This theory has limitations, being that government cannot know enough soon enough to exercise full control over employment through any combination of policy levers (Ibid).

The sixth theory is that unemployment is of more concern than inflation. Inflation can contribute to unemployment by reducing business investment. However, if inflation does not result in unemployment then it is not inherently the most important problem. Flowing from this and the other theories is that economic fluctuation reduces economic well-being. The inability of the labor market to respond rapidly to stimulus means that when stimulus changes, the economy is moved out of equilibrium. The government therefore can and should be active in the market in order to limit these fluctuations and therefore their impacts.

The way that government is presently structured, it will inevitably play a role in the economy. Most Keynesians view monetary policy as the best means for this to happen. The lever of the money supply is typically applied. This lever is focused more on managing inflation, but can be used for other purposes. At the outset of the current economic process, the Federal Reserve responded with rate cuts. It is only when that failed that the Obama government was compelled to take further action.

New Keynesian Thought

Keynesian thought was subject to considerable criticism during a stretch of time in the 1970s and 1980s from a revived new classical school. The thrust off the criticism was a disparity of opinion with respect to how quickly wages and prices adjust. The Keynesian view was that while the adjustments would occur in the long run, those adjustments would take time to manifest. Prices are fixed in many cases by contracts, as are wages. Thus, they are not perfectly flexible (Mankiw, 2008).

The New Keynesian school emerged in response to this criticism. The new classical school had faced adversity when the prolonged, deep recession in the early 1908s could not be explained by their model. The Keynesian view was that the slow response time of prices and wages was the reason why these recessions occurred. It is not that they feel that market cannot respond, just that the market does not respond quickly. Thus there is an imbalance in the economy, such as involuntary unemployment, and that imbalance can be prolonged (Ibid).

Keynesian thought was essentially observant of phenomena, but the theory was weak at explaining certain phenomena. The pace of wage and price changes, for example, could not be explained. Thus, while in Keynesian economics worked in the field, it could not be rationally explained. The goal of the New Keynesian school is to close the theoretical gaps in the original theory. The observed phenomena could be explained, and this is what New Keynesians are attempting to do.

The sluggishness of price adjustments is explained as a function of menu costs. In classic economic models there are no menu costs. But in the real world, prices cannot always be changed quickly. In some cases, prices are set by contract. In other cases, the firm's ability to communicate price changes slows the pace down. Because there are menu costs for most firms, prices are adjusted intermittently rather than immediately. Moreover, prices are not adjusted by all firms at the same time. Moreover, in many industries prices at a given firm depend on prices at the competing firm. All of this supports the New Keynesian view that prices are not continually adjusted.

The same can be said with labor costs, especially wages. Employment contracts dictate wage levels, so they are adjusted intermittently. For most firms, there are substantial menu costs involved in adjusting the wages paid by adjusting worker number levels.

Another tenet of New Keynesian thought is the concept of coordination failure. Firms do not adjust wages and prices immediately because they are not universally coordinated with one another. Union leaders negotiation a contract, for example are concerned with their negotiations, with the negotiations of others not being as much a factor. But without this coordination, we have failure, resulting in delays in re-setting wages and prices.

New Keynesian thought also considers unemployment to be a central problem. Unemployment should theoretically be a self-correcting problem. The forces of supply and demand should push unemployment towards equilibrium. The New Keynesian school explains this in terms of efficiency wages. That is, workers become more efficient as their wages increase. As a result, firms do not lower their wages because they fear that productivity will decline in equivalent numbers (Ibid). Individual… READ MORE

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