Economics: Taxation, Welfare, and International - Coursework Example

5 Keynesian Solutions to Aggregate Demand and Limitations of Keynesian Economic Policies Keynes was not an opponent of capitalism. In fact, Keyneswas an opponent of socialism, and Keynesian economic theory offered solutions that could help capitalist economies stabilize their economies and recover from depression conditions. In terms of Keynesian economics, a depression is a state where there is not enough spending by businesses and individuals on newly produced goods and services, meaning that there is a deficiency is aggregate demand. Keynes asserted that depression conditions could be corrected by third party spending, such as government spending of tax or borrowed money (Yates, 2003, p. 135-136). Because the theory was developed and became well known during the Great Depression, Keynesian economic policy is a strong framework; however, Keynes himself as well as the subsequent economists that built upon his theories limited themselves by not stressing factors such as inflation, future globalization, public deficit, and long-term results of economic policy. These are several of the factors that ultimately limit the application of Keynesian economic policies to contemporary economies, through recessions in recent years have resulted in a resurgence of interest in application of Keynesian theory. Keynesian economic theory suggests that depression occurs in all economies periodically, and that depression is not necessarily self-correcting (Bootle, 2008). If no action is taken, depression can grow exponentially as individuals and businesses hoard their money. While this may be beneficial to the individual, to an economy this can drastically reduce overall spending, or aggregate demand, resulting in decline of economic conditions. Keynes asserted that this effect could be counteracted by the government, who during recession or depression could induce increase in aggregate demand by spending tax or borrowed money. This money could be acquired through borrowing, such as the sale of safe-investment government bonds to investors, or taxation of corporate profits (Yates, 2003, p. 135-136). In order for the acquisition of funds to make a positive economic impact the money must originate from hoarded funds possessed by high-income individuals and high-profit businesses—funds that would otherwise have stagnated, failing to stimulate the economy. After the third party, normally a government body, has acquired funds, Keynesian economics insisted that those funds must be inserted into the economy immediately in order increase spending and thus increase aggregate demand. This can be accomplished through giving funds to the poor, who will immediately spend the money, stimulating the economy. Another option is investment in public projects, such as healthcare, public housing, and improved infrastructure. These and similar public projects create immediate jobs as well as improving public perception of the state of the economy (Yates, 2003, p.136). The government could spend the money in a variety of ways, but the end result, from the Keynesian viewpoint, is the immediate investment of funds into the economy, which stimulates employment, and ultimately stimulates individuals and businesses to spend their money instead of hoarding it. Throughout the Second World War Keynesian theories were validated in many capitalist economies, and up to the mid 1960s many these theories were widely applied. During the Second World War, in what many referred to as “Military Keynesianism”, governments set up entire factories, employing thousands, as part of the war effort (Yates, 2003, p.136). This stimulated the economy and resulted in the opposite of depression conditions: a labour shortage. The results of these programs seemed to widely validate Keynesian economic theory. As the twentieth century progressed beyond the Second World War, one of the most obvious real-world effects of Keynesian economic policy was the increase in macroeconomic policy activism up to the middle of the 1960s (Krugmand and Wellis, 2009, p.474). Macroeconomic policy activism refers to the widespread use of monetary and fiscal policy to smooth out the business cycle in order to avoid recession and depression (Krugmand and Wellis, 2009, p.474). During the mid-twentieth century many government bodies became more actively involved in making policy to regulate the economy, policies in which Keynesian economic theory often played a large role. In the 1970s, many economists began to assess the limitations of Keynesian theory in the changing global economy. In his groundbreaking work that would eventually result in an award of the Nobel Prize in economics in 1995, Dr. Robert Lucas of the University of Chicago released a series of papers that proved that changes in monetary policy have a dramatically reduced effect if the changes are not a surprise to the public, demonstrating that the effects that Keynes observed could not be duplicated by arbitrary changes in policy alone (Krugmand and Wellis, 2009, p.482). This proved that public opinion played a large role in the natural economic cycle, which is stated in the “rational expectation hypothesis”. This and other influential economic ideas led to the development of the “New Keynesianism” developed in the 1990s, which argues that imperfections in the market interact, resulting in temporarily sticky prices, or prices that resist change (Krugmand and Wellis, 2009, p.482). Keynesianism has been influential in the development of modern fiscal policy. Despite its past successes and its integration into more modern theories, Keynesian economic policy suffers from a number of limitations that prevent economists from using this theory to manipulate contemporary economies with total success. Libertarianism dominates modern economics, with the idea that the increase in economic globalization and improvements in electronic communications have largely made the Keynesian theory obsolete (Yates, 2003, p.137). Modern economies do not exist in isolation, or near isolation, as they once did. This may limit the impact that government programs have in effecting the economy. Additionally, modern businesses and individuals have much higher mobility, and may leave areas when they do not agree with fiscal policy. Keynesian theory does not account for the globalization that has occurred in recent years, providing major weakness in the theory’s application to contemporary economic policy. Another primary flaw in the application to Keynesian economic theory to contemporary policy is the lack of emphasis placed on inflation as an economic factor. Owing to the fact that the theory was developed during the Great Depression, inflation is treated in a vague manner. Many Keynesian economists have suggested that inflation is unimportant, that it either does not matter at all or will be automatically checked by application of policy. In reality however, Keynesian policy that increases aggregate demand for prolonged periods, as such to avoid recession or depression, additionally has the result of allowing inflation to grown unchecked (Bootle, 2008). Keynesian theory is vague in is treatment of how policy should cope with inflation. Despite a large portion of Keynes’ work focusing on monetary factors, the emphasis on borrowing in order to prevent depression was largely misconstrued by economists in the mid twentieth century, producing a generally relaxed attitude towards public deficits as a whole (Bootle, 2008). This has resulted in public deficits for many countries escalating rapidly and unchecked over the twentieth century, in the amounts of millions and even trillions of dollars. Keynesian economic theory discussed the importance of public deficits; however, many Keynesian based policies have largely disregarded much of the discussion of the original author. While Keynesian economic theory deals well with economies in depression or recession conditions, the theory provides poor long-term solutions for economic policy makers. Because of this, some economists argue that Keynesian economic theory is not applicable to all economic situations, but that during a recession or depression, many of Keynesian ideas are relevant and should be widely applied to fiscal and monetary policy in order to ensure economic recovery (Bootle, 2008). Keynesian economics, as some economists argue, may be applied as a temporary solution for distressed economies, but makes a poor lasting economic plan. Despite its wide acceptance as a method applicable during depression conditions, other economic theories argue that aggregate demand, as suggested by Keynesian economic theory, is not the sole cause for economic depression. Instead, these theories suggest that economic depression in reality is caused not by over-investment and subsequent Keynesian-style hoarding. These theories suggest that depression is instead caused by mal-investment, often caused by government intervention in the credit market in modern economies (Ritenour, 2000, p.80). If these theories are held to be true, then Keynesian theory is limited by its simplistic definition of depression, one that does not take into account the diversity of factors that influence the spending levels within an economy. In order to better understand the above argument, it is essential to point out the difference between micro- and macro- economic theories. In macroeconomics, unlike microeconomics in which only a single product is discussed, aggregate demand is used. Aggregate demand represents the total of spending on all products of an economy, not only spending that occurs on a single good or service. Keynesian theory generally assumes that a level of spending is roughly equal between products within an economy, or that spending levels are homogenous. Because of the heterogeneous nature of production in real economies, it is possible that spending is occurring at an adequate level to avoid Keynesian depression, but that spending is occurring in a misbalanced manner that favors some products over others within an economy (Ritenour, 2000, p.80). This uneven distribution results in depression. Because Keynesian economic theory does not fully address the heterogeneous nature of spending, its application to contemporary policy is limited. Keynesian economic theory suggests fund acquisition through borrowing, often through bonds, and taxation of high-profit individuals and organizations and subsequent reinvestment of funds into an economy can increase aggregate demand, allowing recovery from recession or depression conditions. Because this theory provides limited solutions for inflation, public deficit, increasing economic globalization, and long-term economic goals, Keynesian theory is of limited use in developing contemporary monetary and fiscal policy. Despite its limitations, Keynesian economic theory still provides a framework for many of the successful policies currently utilized in many major world economies, as well as playing a critical role in monetary and fiscal policies that impact economic recovery following recession and depression conditions. References Bootle, Robert. (Oct 2008). “We Now Face Keynesian Conditions and Need Truly Keynesian Solutions”. Telegraph Magazine. Retrieved from http://www.telegraph.co.uk/finance/comment/rogerbootle/3264845/We-now-face-Keynesian-conditions-and-need-truly-Keynesian-solutions.html Krugman, Paul; and Wells, Robin. (2009). Macroeconomics. Second Edition. New York: Worth Publishers. Ritenour, Shawn. (2000). “Review Article: Post-Modern Economics: The Return of the Depression Economics, Krugman, Paul: 1999”. The Quarterly Journal of Austrian Economics. 3(1): 79-83. Yates, M. D. (2003). Naming the System: Inequality and work in the global economy. New York: Monthly Review Press. Read More