Keynesian economic theory and its applications

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 workers are unlikely to be more or less productive as a result of wage changes. 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.