ECON 272 Notes on Keynesian Economics

ECON 272 - Notes on Fiscal Policy and Keynesian Economics

Most of these ideas come from John Maynard Keynes, The General Theory of Employment, Interest and Money, 1936.

The basic point of Keynesian economics is that recessions and depressions can occur because of inadequate aggregate demand for goods and services.

Overall basic ideas:

The economy is demand (spending) driven. Say’s Law not correct – economy is demand driven. Keynes said that Say's law did not hold up in the "general case" - hence the title of his book;
The short run is the relevant time period to judge outcomes of markets and also to judge the outcomes of government policies;
Markets are chaotic if left on their own. They are not able to "self-correct" because of "sticky" wages and prices (it is costly to adjust wages and prices so they do not always move with market changes).
The focus is to bring down unemployment through counter-cyclical government policies.
Planners have the knowledge and know-how necessary to “smooth out” the cycles of the economy by the use of monetary and/or fiscal policy.

Keynesian Macro Policy

Keynesians want to stimulate aggregate demand - since they believe that with more spending there will be more income - and more hiring and less unemployment.

So, which policy is best: monetary or fiscal?

Keynesians like both -- however, one might be more effective than another depending upon circumstances.

Remember, fiscal policy is usually recommended over monetary policy if interest rates are low - this is because of a "liquidity" trap.

The Simple Keynesian Model (Income-Expenditures Model or 45 degree Model)

Remember - to a Keynesian, the economy is driven by aggregate demand -- or aggregate expenditures or consumption in the economy.

The most important variables that determine the level of aggregate consumption are:

Current disposable income:
Household wealth:
Expected future income:
The price level:
The interest rate:

Notice how income (current and expected) is very important. In the simple Keynesian model, a certain level of national income (Y) in the economy will correspond to a certain level of expenditures in the economy -- which in turn corresponds to a certain level of unemployment. Higher levels of AD and Y will decrease unemployment.

All of the above will impact one or all of the four components of aggregate demand.

AD = C + I + G + Net Exports. If income is higher, for example, consumption will be higher, etc.

Graphically, the Keynesian model adds up the components of expenditures (AD) in the economy. Equilibrium is where AD = AS (GDP).

C = Consumption function:

Autonomous expenditure or consumption:

What about savings - also a function of income. More later.

GRAPH:

I = Investment:

This is the most volatile component of aggregate demand. It is what can create the deep cycles - a big drop in aggregate demand, for example.

Keynes explanation then of a business cycle was what he called "animal spirits" (basically a psychological explanation for economic problems) -

Keynes used this term to talk about the importance of confidence and the ‘gut instincts’ of investors (and consumers too) regarding future business ventures and investing generally. He said:

"Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities." The General Theory of Employment, Interest and Money.

So, for example, economic data such as rates of return today may be inadequate in terms of how business decisions are made. For example, rates of return may be high, but, if businessmen fear a recession then investment is likely to go down.

If people expect a recession, then confidence in the future (or expectations of future returns) will be low and saving will increase.

What does 'Animal Spirits' mean

A term used by John Maynard Keynes used in one of his economics books. In his 1936 publication, "The General Theory of Employment, Interest and Money," the term "animal spirits" is used to describe human emotion that drives consumer confidence. According to Keynes, animal spirits also generate human trust.

BREAKING DOWN 'Animal Spirits'

There has been a resurgence of interest in the idea of animal spirits in recent years. Several books and articles have been published on this topic. Keynes believed that animal spirits were necessary to motivate people to take positive action

What does 'Animal Spirits' mean

BREAKING DOWN 'Animal Spirits'

What does 'Animal Spirits' mean

BREAKING DOWN 'Animal Spirits'

G = Government spending:

NX = Net Exports (the simple model does not include net exports - but we could easily add them in):

Adding C + I + G + NX gives us AD (aggregate demand) GRAPH:

Let's add a 45% line. What does that mean?

Let's show a recession on the 45 degree model (let's say animal spirits are alive and well and people are expecting bad times - so they stop investing and consuming and start saving):

GRAPH:

In this situation, Keynes argued for fiscal policy to boost demand and therefore, in the Keynesian model, economic growth.

So let's be Keynesian economic planners. What knowledge do we have to know in order to hit our target (YF) - the income level that will lead to full employment.

First we have to know the model - which includes these concepts:

The Keynesian Multiplier Effect: an increase in expenditure leads to a larger increase in income (Y) and real GDP. Remember, Y = GDP in equilibrium.

A change in C or I or G or NX will cause a multiple change in National Income (Y) and real GDP. This is the Keynesian multiplier effect. Example: when C increases, Y increases, which in turn will increase C & S, and then Y again, then C & S again, and so on.

Depends upon the Marginal Propensity to Consume (MPC) and Marginal Propensity to Save (MPS).

Marginal Propensity to Consume (MPC):

Marginal Propensity to Save (MPS):

MPC + MPS = 1. The higher the MPC, the higher the multiplier effect.

So if G increases - income (Y) will increase even more than G did! It's a miracle! GRAPH:

Remember - Keynesian Goal is full employment. And to reach that, aggregate demand must increase. Remember what the problem is: lack of aggregate demand.

So let's return to saving. Saving is not good for the economy. Saving means less spending.

Furthermore, when someone puts their saving in the bank - it doesn't necessarily get back out in the economy through loans or investments.

Savers and investors are two different groups and are not linked.

S = f (Y)

I is a function of animal spirits. So there's no reason that even when people put their money in the bank, people will borrow and spend/invest it.

Furthermore, Keynesians talk about what they call The Paradox of Thrift (or Savings):

As individuals save, aggregate demand goes down - thereby causing income and employment to drop.

Therefore, as the economy becomes worse, individuals are not able to save as much - since many of them have lost their jobs!!

The paradox is that total savings may fall even when individual savers attempt to save more. So basically, this theory says that while individual savings might be good to the economy if it leads to future investment in capital goods, etc., this paradox says that "collective" savings may be bad for the economy.

So the Keynesian planners must stimulate aggregate demand with fiscal policy. But what fiscal policy in particular? What will lead to the greatest increase in aggregate demand and economic growth?

What are the planners options?

1. Increase G but keep a balanced budget. So increase in G must = increase in T.

2. Just cut taxes (don't increase or decrease G) - the deficit gets larger.

3. Most powerful fiscal policy is to increase G but do not increase T (i.e. deficit spend) in order to stimulate demand and therefore income and employment.

Why?

So Keynes recommended deficit spending as a fiscal policy tool. He did not foresee the large deficits (and therefore debt) that many countries have today. He thought - in good times when tax revenue is high - pay down the debt. But in bad times -- stimulate the economy through deficit spending in the short run.

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The Critics of Government Deficit Spending

Total federal spending as a share of the total economy (measured by GDP) - growing from 3% of the economic pie prior to the New Deal, to over 20% of today's GDP. https://fred.stlouisfed.org/series/FYONGDA188S

Let's look deeper into government deficit spending and the government's debt. Remember - the U.S. federal government goes into debt by issuing bonds.

The Debt Clock

As with any debt - we need to look at the debt compared to the pie: so if we use GDP as our pie measure, how big is the debt compared to GDP?

Debt as % of GDP

https://research.stlouisfed.org/fred2/series/GFDEGDQ188S

Who holds the U.S. government debt?

There are two basic categories of debt owners:

1) the public, which includes foreign investors and domestic investors and,

2) federal accounts, also known as "intragovernmental holdings."

1. Debt Held by the Public: Domestic Investors

Public debt is also held domestically. Domestic private investors - which includes regular American citizens as well as institutions like private banks. Finally, U.S. state and local governments have also lent money to the federal government. About 26.5%.

The U.S. Federal Reserve Bank buys and sells Treasury bonds as part of its work to control the money supply and set interest rates in the U.S. economy. About 13%.

Debt Held by the Public: Foreign Investors

The U.S. debt is also held internationally by foreign investors (i.e. foreign governments, foreign institutions, and individual people in foreign countries) who buy U.S. Treasury bonds as investments. About 32.5%.

2. Debt Held by Federal Accounts

Debt held by federal accounts is not considered public debt - it is the amount of money that the Treasury has borrowed from itself. That may sound funny, but it means that the Treasury borrows surplus money from one trust fund and gives it to another trust fund. For example, the Treasury might borrow money from Social Security to finance current government spending in another area. At a later date, the government must pay that borrowed money back. About 28%.

americas debt

My source: http://money.cnn.com/2016/05/10/news/economy/us-debt-ownership/

The Criticisms

There are many critics of the idea that deficit spending should be used to "stimulate" the economy. Obviously, those who follow Say's Law do not believe that stimulating demand (in any way) is the answer. But there are more specific criticisms. Here are a couple.

1. Keynes was and Keynesians still are naive to believe that deficit spending doesn't lead to more and more debt over time - a political argument - James Buchanan.

a. First of all - is it moral?

Passing the debt burden to future generations (is this moral?)

Future Taxes: deficit spending today and interest payments mean that future generations will pay more of their tax dollars to the government's creditors and less for other things. Remember, when the government spends - the private sector can't.

b. He said that what Keynesian economics did (by making deficit spending acceptable as a policy tool for the government) was change the "cultural norm" of the government (which was to keep a balanced budget except in perhaps war time). This change in the norm has lead to very large deficits and a very large debt. It "opened the door" for politicians to use deficits for political reasons. Remember, it was not that Keynes himself said we should run large deficits all of the time -- but what Buchanan said was that Keynes was naive of the political consequences of this policy. Politicians like deficits and therefore many governments end up with very large debts. Why?

How might the government debt be paid? "Public Choice argument" -

2. Opportunity cost -- when someone lends money to the government (buys a treasury bond), they are moving resources from the private sector to the government sector.

When people buy a government bond instead of a corporate bond, for example -- there's less private investment. So there is an opportunity cost as to the use of those resources (Bastiat's unseen again).

Will the government be as "productive" with the resources as the private sector would be? That is the question. This is often the political debate we see in Washington, D. C.

3. Crowding out -- government borrowing reduces private spending by raising interest rates (theory regarding why a large government debt, or prolonged deficit spending, is anti-productive).

Those who believe that productivity drives the economy criticize deficit spending for potentially decreasing productivity through crowding out.

CROWDING OUT

As with any model - we must first look at the assumptions being made. The model is of the loanable funds market.

Savings = f (interest rate)

Investment = f (interest rate)

There are savers - who supply loanable funds.

There are investors - who demand loanable funds (they want to borrow).

So the loanable funds market:

Savings = supply of loanable funds.

Investment = demand for loanable funds.

GRAPH

When G > T (the government deficit spends and goes into debt). It enters the loanable funds market and bids for investment funds. This increase in the demand for loanable funds drives interest rates up and this “crowds out” some private investment (demand for funds by private investment goes down because of the higher cost of borrowing). So why anti productive? Private investment is productive investment (in capital goods). Government spending is mainly on "consumer goods" (non productive spending). The government has moved resources from the productive to the unproductive sector of the economy.

Keynesian Counter: Infrastructure argument.

Counter to this Counter: Private firms can produce infrastructure and there's no guarantee that the government will spend money on infrastructure.

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