Keynesian Economics: Rational Policies for an Irrational World

“When the facts change, I change my mind. What do you do, sir?”

John Maynard Keynes

Keynesian economics is one of the most hotly debated political and economics in our time. Without the allure of total equality like Marxist economics or the magnetism that small-government ideologies like Austrian or Monetarist economics provide, Keynesian economics aren’t always at the forefront of political topics. Keynesian economics has basic tenets that are key to helping understand the economy or learn more about it, whether you agree with them or not. Obviously the follow topics are very general, but they are beliefs of Keynes.

Sticky Wages

A key belief in Keynesian economics is that wages are sticky– that is, the price of labor, or pay of employees, has a slow response to changes in the firm or overall economy. Wages are sticky for multiple reasons, such as workers being more willing to accept pay raises rather than pay cuts, some workers and their wages are protected by unions, contracts, and companies’ wants to not get ostracized for cutting employee wages. Even if some wages aren’t sticky, aggregate wage levels will become sticky because of the fact that some wages actually are. The entry of wage stickiness in one area can bring wage stickiness in another one, as companies try to keep wages competitive in competitive job markets.

“under any conceivable institutional arrangements, and certainly under those that now prevail in the United States, there is only a limited amount of flexibility in prices and wages”

Milton Friedman

Now why is it important that sticky wages exist? Well, if they didn’t, wages would always adjust in tune with the market and equilibrium would be achieved, no problem. Wage reductions would happen sometimes, but little job loss, and the economy would recover nicely. However, due to sticky wages, wages are likely to stay where they are in the event of a disruption in the market. Instead of reducing wages, firms would reduce employment, which starts this own cycle. Reductions in employment leads to less consumer spending, which leads to less aggregate demand, which leads to less firms producing goods and services, which leads to less firms hiring, which is a reduction in employment. Thus, the cycle continues. The market won’t clear, and the economy will spiral, unless someone, or something, intervenes. For example, in 2008, nominal wages did not decrease, and instead companies laid off more and more employees.

Sticky Prices

Wages are just the price of labor, and just as wages are sticky, so are prices. This is caused by a multitude of reasons. A reason prices don’t immediately adjust is because it’s costly to adjust them- something commonly called “menu costs.” Changes in prices sometimes require new catalogs, price lists, and menus. While critics are right in calling menu costs tiny, they aren’t inconsequential and have an effect on the economy. When you take into account aggregate demand externalities (one firm lowering price level, rise in real wages, demand rise in all products), the “tiny” menu costs turn prices sticky.

This is important because it hurts society and the economy. If a car-selling firm has just announced its prices, and the money supply falls, the firm has the option to cut prices. Doing this would give car buyers a higher real income, but this will benefit all companies because of an increase in demand—even the ones that didn’t cut prices. Thus, this car-selling firm would keep the price despite its social desire, showing how prices can be sticky in a bad way. Price staggering and coordination failure also makes price sticky, but the overall lesson is how prices and wages being sticky means prices don’t “clear” markets by acting quickly.

The Multiplier Effect

Another key part of Keynesian theory is the multiplier effect. Some critics of Keynesianism might say “OK, the government increased the GDP a little more, but how does that get the economy on track?” These people ignore the multiplier effect.

When the government increases expenditure, it has a huge effect. For example, when a government increases spending by $100,000, the total effect added to the economy isn’t “$100,000.” If the government hires a firm to make roads, they will in turn hire and pay workers, and these workers will go spend money on something else. There is a constant exchange of money being spent because in many cases one person’s spending is another’s income.

This goes along with the basics of Keynesian theory— when the government hires workers for infrastructure projects, the workers get more expendable income, demand will increase, firms will start producing more because of this demand (putting idle resources to use), and they’ll hire workers to do this, and the cycle continues, making the economy get back on track.

Misallocation of Resources

A common criticism of Keynesian economics is from their ideological rivals, the Austrians. The Austrian Business Cycle Theory (ABCT) explains that the government lowers interest rates below the “natural rate” that lets businesses take on normally unprofitable loans, which causes misallocation that inevitably cause a crash. The ABCT is much more complex, and has many problems that come with it, like the abscence of a natural market rate for interest rates and the way it deals with consumption markets. However, the basis of this theory is malinvestment, and while Keynesianism admits it can happen, it doesn’t necessarily.

“Going back to the beginning of the theory I mentioned inflationary pressures. Inflationary pressures are a product of expanding the demand in the capital goods industry. Resources get used by companies competing and expanding on finite resources. An upward pressure on prices results from the competition and scarcity of capital resources. Inflationary pressures are a key part of the ABCT, but what happens to the theory when a significant amount of idle resources exists? An economy (The U.S. One in Particular) is rarely at full capacity during a recession. In a recession, a country has empty factories, unused workers, and resources not being used up. When full capacity and efficiency does exist; a company will be forced to take resources being used somewhere else. First world countries such as the U.S. have significant amounts of idle resources. Using capital resources will not necessarily cause inflationary pressures as the resources were not being used anyway. So, without inflation how does the malinvestment present itself and businesses fail? If rates continue to be low after it is clear we are at full capacity and employment then malinvestment would indeed present itself. However, Keynesian monetary policy would be to increase rates even if a small amount of overexpansion were to occur. Slight overexpansion would be much preferable to the alternative faced.”

The Centre Right Review by @_keynesian

Marginal Propensity to Consume

The marginal propensity to consume sounds complex, but in reality it is a very simple topic. It is closely related to the previously mentioned multiplier effect, and it is the measure of how much consumption changes when income changes. Lower income consumers have a tendency to have larger MPCs than higher income ones, showing how allowing lower income consumers to have more money can lead to the economy getting better. Knowing the MPC helps economists predict the effect of governmental fiscal initiatives. An increase in production increases consumer income, and they will spend more. Knowing the MPC, we can calculate how this production increase will affect spending (which will generate additional production and the cycle continues). The MPC can help governments not overspend on fiscal stimulus to prevent the inflationary pressures and mal-investment that Austrians talk about.

Unemployment vs Inflation

At least in the short run, there’s no denying that unemployment and inflation have a trade off. As more workers are hired, unemployment decreases. However, the price level increases, leading to inflation.

There’s even evidence this happens, or at least a version of it, nowadays relatively long-term.

While it doesn’t form the L-shape the model predicts, it still shows an increase in unemployment coinciding with a decrease in inflation over a long period of time. A common criticsm of this concept is the 1970s “stagflation” that was the hallmark of Jimmy Carter’s presidency. Stagflation is what blew open the economic game, as it was high unemployment and high inflation. This caused many economists to abandon Keynesianism, but in reality there are reasons that this happened. These models were very stable before the 1970s— showing how the real problem was that common economic models didn’t take into account supply shocks, which can easily be fixed. The “Lucas Critique” that claimed otherwise, and caused people to think Keynesianism was outdated, has its own numerous flaws. 

Demand-Side Solutions

During a recession, a decrease in output and increase in unemployment leads to decreased consumer spending and decreased demand, which leads to decreased production, which then causes the cycle to start all over again. The economy does not stabilize quickly, and before this cycle is exacerbated, government intervention is needed to boost short term demand to get the economy back on track. Wages and unemployment are slow to respond to needs of the market, and government intervention is needed. Monetary policy interventions can also be made because of price rigidity, making it possible to use money supply and interest rate changes to boost aggregate demand, to a point. The three solutions Keynesians talk about using are changes in interest rates, government-sponsored projects, and cutting taxes. Running a deficit during recessions and surpluses during “booms” allows the government to help the economy while also not falling into a fiscal crisis.

The State of Keynesianism Now

Keynesianism now has a stigma, one that conflates the ideology to requiring extreme government intervention and regulation the market. Keynesianism, at its core, is about government intervention during recessions to get it back on track. This doesn’t mean that Keynesians want “Medicare-for-all” or subsidies for all industries. However, Keynesians nowadays have broken off into different branches, each with differing viewpoints from each other and John Maynard, like New Keynesianism and Post Keynesianism. And while some might deride Keynes for his beliefs and solutions, his ideology still pervades our government and policies.

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