Keynesian Theory the Response of Essay

  • Length: 10 pages
  • Sources: 2
  • Subject: Economics
  • Type: Essay
  • Paper: #97833077

Excerpt from Essay :

This means that the impact will be the result of natural attrition. So the theoretical firm's wages are resent every once in a while. Productivity will not respond right away to wage changes, but will happen as the natural course of turnover occurs.

There are several policy implications for the New Keynesian school. One is that government intervention is required. While new classical economists view recessions as a natural component of the business cycle, New Keynesians believe recessions to be the result of market failure. Thus, intervention is required in order to correct the failure and put the economy back on course.

The Economic Crisis

The New Keynesian school would view the current economic crisis as a market failure. The failure would likely be identified as the real estate bubble, which can be attributed to a number of externalities. The Fed reduced rates sharply to stimulate growth in the wake of the bursting of the dot-com bubble. The Bush Administration had made home ownership a priority and set out policies to support that activity. These externalities and others had brought about this market failure. The prescription, then, is to intervene to restore the market.

With respect to the escalating unemployment rate, the Keynesian view holds that this is economic malady, rather than a natural, rational function of the economic cycle. Thus, it is not a response to labor prices that has resulted in the growing unemployment, but a response to the decrease in aggregate demand. This concept appears sound during the current downturn, simply because aggregate demand has fallen so significantly. In boom times, however, we see that there are other factors more strongly associated with employment levels. These include changes in the technological environment and shifts of labor overseas. Keynesian economics is slightly dated in the respect that it strictly considered national accounts. With the free flow of investment capital resulting in substantially greater global economic integration, employment cannot be analyzed in strictly national terms.

The response of the Obama administration, in particular with respect to the stimulus plan, is to increase spending to help create jobs. In Keynesian fashion, the plan assumes a multiplier effect. What we have seen thus far is that the government's response did not come quickly enough, which is consistent with a key limitation of the activist policy. The Federal Reserve, unencumbered by the need to go through Congress, hold elections or any other such delaying constraints, was able to act first, in early 2008. Their moves were not sufficient to avoid the economic downturn. However, by the time the lack of effectiveness became apparent, two things had happened. One was that the Fed had used its most powerful levers, having brought interest rates to a minimum almost immediately after the warning signs of recession manifested. The other thing that happened was the impending recession had gained strength, in particular as crude oil prices skyrocketed. Even though those prices later declined, the momentum towards recession had been built. The crude price increase had essentially neutralized the Fed's moves. At this point, the government still had to organize a response.

There has been considerable criticism with respect to the use of government spending to stimulate the economy. The problem is that the monetary policy levers were ineffective. In general, those levers have functioned well, guiding the market economy towards steady growth. However, in lieu of those levers, other action needed to be taken. Hence the move towards the old school Keynesian approach. The stimulus spending is simply intended to prop up the aggregate demand function, on the understanding that supply will be increased to meet demand. The traditional Keynesian view of unemployment as the most economic concern is at play here as well. This fits well with the current economic situation. Inflation rates are low -- deflation is more a risk. Even if the government spending stimulated some inflation, it would take time for that inflation to get out of control. The Fed would be able to raise rates quickly in the interim to stem the inflation before it was out of control. Moreover, growing unemployment is going to have a multiplier effect on demand.

The major issue with respect to the stimulus package is not whether it will stimulate demand, but whether it will stimulate enough demand. Keynesians believe that government has the ability to impact the market. For this to be true, however, the government would need to increase spending enough to offset declines in other components of aggregate demand. In this case, that is unlikely. The credit crunch environment and threat of job loss has reduced consumer spending. Consumer spending has only now begun to show signs of stabilization (Trumbull, 2009). Business investment, however, has continued to decline (NY Fed, 2009). We saw that the Fed rates cuts in 2008 were ineffective because the impact of the increase in the money supply was insufficient to offset the declines in business investment and, later, consumer spending. The same situation may apply here with the Keynesian fiscal policy.

The assumptions of the New Keynesians are based on observable action in the real world. By clarifying the issues that surround the classical view, the New Keynesians are able to explain the observable phenomena in the current economic crisis. Unemployment -- always a lagging indicator, trailed the actual start of the recession because firms were unable to make adjustments to their labor costs immediately. They waited until signals from the market and their competitors showed that the economy really was in the tank. The classical view would have held that employment would have adjusted quickly, and refound equilibrium. That it did not is a strong indicator that the New Keynesian explanation for the current crisis holds.

As for the prescribed antidote, the response is probably not strong enough. The best outcome is likely to simply stall the decline in the nation's economy long enough for some of the multiplier effect to kick in, and employment to begin to be restored. It is not the fault of the Keynesian theory that the government is constrained in terms of spending. The stimulus would work in theory if it were applied to a high enough level.


Keynesian economics receives its share of criticism, and President Obama shares in that criticism as an apparent proponent of Keynesian philosophy. In some ways, holding Keynesian views is simple political expediency. The appeal to government of running deficit budgets to prop up the unemployment picture is strong -- saving voters' jobs tends to play well on election day. The pre-Keynesian New Deal had populist appeal, and Keynes' idea proved popular with politicians for the same reason. Part of the problem today, however, is that the government did not run a surplus in the good years (as it theoretically should have). Another problem is that the usual monetary policy levers have proven ineffective. This leaves little option, if unemployment is the biggest concern, except to increase aggregate demand through extensive spending projects. The problem facing the administration is that it has not staunched the job losses. Keynesian economics understands that the market will reach equilibrium in the long run, therefore government should intervene in the short run. The results have not been favorable, primarily because it appears as though one of the conditions required for Keynesian theory to hold true -- that of government actually being able to exert influence -- is not holding this time. Monetary stimulus failed; fiscal stimulus now seems inadequate. It does not invalid Keynesian or New Keynesian theory, but it calls into question the universality of its application to solve our domestic economic issues.

Works Cited:

John Maynard Keynes biography retrieved May 4, 2009 from

Becker, Jo; Stolberg, Sheryl Gay & Labaton, Stephen. (2008). White House Philosophy Stocked Mortgage Bonfire. New York Times. Retrieved May 4, 2009 from

Blinder, Alan S. (2008). Keynesian Economics. The Concise Encyclopedia of Economics. Retrieved May 4, 2009 from

Trumbull, Mark. (2009). Silver lining of shrinking economy: consumer spending up. Christian Science Monitor. Retrieved May 4, 2009 from

No author. (2009). Industrial Production. Federal Reserve Bank of New York. Retrieved May 4, 2009 from

Mankiw, N. Gregory. (2008). New Keynesian Economics. Concise Encyclopedia of Economics. Retrieved May 4, 2009 from

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