- Keynesian economics believes that free markets are volatile and not always self-correcting, leading to lengthy periods of recession and depression without intervention. Keynes argued for state intervention through fiscal and monetary policy to boost aggregate demand and lift the economy out of stagnation.
- The fiscal multiplier measures the impact of changes in government spending or taxes on GDP. According to the IMF, spending multipliers tend to be larger than tax multipliers. The size of the multiplier also depends on the state of the economy and spare capacity.
- Infrastructure spending can have large multiplier effects by boosting aggregate demand and jobs. Well-targeted government investment in areas like transportation and utilities increases the capital stock and productive potential of the economy
2. Keynesian Ideas
An understanding of Keynesian ideas can be helpful in evaluating
macroeconomic stability in terms of prices, jobs and incomes
⢠Keynesians believe that free markets are
volatile and not always self-correcting in
the event of an external shock
⢠The free-market system is prone to
lengthy periods of recession & depression
⢠Economies can remain stuck in an
âunderemploymentâ equilibrium
⢠In a world of stagnation or depression,
direct state intervention may be essential
to restore confidence and lift demand.
⢠Keynes was one of the first economists to
criticise the profession for adhering to
unrealistic assumptions
John Maynard Keynes
was born in 1883.
Educated at Eton College
and Cambridge University
- where he later taught.
He died aged 63 in 1946
4. âKeynes made a key distinction between risk and
uncertainty. Risk is when probabilities can be known
(measured); uncertainty exists when they cannot be
known (or measured), i.e. when the future is
unknowable.â
Lord Robert Skidelsky
5. Importance of (Keynesian) Animal Spirits
John Maynard Keynes coined the notion of animal spirits which
refers to the driving force that gets people going in the economy
⢠Animal spirits refers to a mix of confidence, trust, mood and
expectations among economic agents
⢠Animal spirits can fluctuate quickly as populations of people and
the business community change their thinking
⢠When confidence is low, individuals save more, businesses save
more too and, because demand and profits are lower than
expected, they cut back on production and perhaps postpone or
cancel capital investment projects. Real economic activity suffers.
⢠Higher saving and reduced investment both have the effect of
reducing aggregate demand and incomes in the circular flow
causing an economic contraction
7. Keynesian Ideas â Modern Day Relevance
Animal spirits
⢠Deflation and
saving
⢠Planned
investment
⢠Expected tax
burdens
Effective
demand
⢠Targeted tax
cuts
⢠Housing
affordability
⢠Minimum
wage
Paradox of
thrift
⢠Share buy-
backs
⢠Cash
hoarding
⢠Deflation and
saving
8. Paradox of Thrift - micro-rationality to macro-perversity
Rational to
save more
Increase
in savings
ratio
Fall in
consumpt
ion
Drop in
aggregate
demand
Risk of
deeper
recession
Decline in
real
incomes
per capita
Less money to
save
In a world of uncertainty, the tendency to save is often stronger than the incentive
to invest.
9. âIn terms of economic policy Keynesian economics has
only one proposition: that governments should make
sure that aggregate demand is sufficient to maintain a
full-employment level of activity.â
âThe purpose of the General Theory (Keynes, 1973A)
was to explain how an economy could get stuck in a
low employment trap. This explanation was provided
by the theory of effective demand .â
Lord Robert Skidelsky
11. The Keynesian Liquidity Trap
A liquidity trap occurs when low nominal interest rates and a high
amount of cash balances fails to stimulate aggregate demand
Two Sides of a
Liquidity Trap
Risk averse
commercial
banks
Required to
hold more
capital
Risk premium
on new loans
Private sector
businesses and
consumers
Low on
confidence
Focused on
cutting debt
12. Low Interest Elasticity of Demand
Interest rate
Planned
investment (I)
Marginal efficiency of
capital (MEC)
R1
R2
I2I1
A fall in interest rates in theory makes some
capital investment projects profitable âat the
marginâ but interest rates are not the only
factor affecting the willingness and ability of
businesses to go ahead with planned
investment projects
MEC: The expected rate of return over
costâas compared to the rate of interest.
13. Low Interest Elasticity of Demand
Interest rate
Planned
investment (I)
Marginal efficiency of
capital (MEC)
R1
I3 I1
Changes in business confidence (animal spirits)
can have a powerful effect on planned
investment â for example, a deterioration of
sentiment causes an inward shift in the
investment demand curve
14. Does QE Work? A Keynesian Perspective
The Bank of England, through its
Asset Purchase Facility now holds
30 per cent of the stock of
outstanding UK government debt
âQuantitative easing has had a positive effect on stock market
prices. But most of it has not yet filtered into the real economy.
It has bid up prices of existing assets, but not stimulated new
investment, because lenders are still asking more from
borrowers than borrowers can expect to earn.â (Skidelsky)
15. Keynesian Approaches to Managing Demand
Keynesian economists tend to favour the active use of fiscal policy
as the may way of managing demand and economic activity
Counter
cyclical
policies
Targeted tax
changes
Government
capital
spending
Government
borrowing
can pay for
itself
Active measures
to inject extra
demand can drag
an economy out
of a recession
Tax cuts for lower
income groups
with higher
propensity to
spend boosts AD
Depending on the
size of the fiscal
multiplier â
borrowing will
create more tax
revenues
Keynesians favour
labour-intensive
projects such as
new transport
infrastructure
projects and
house-building
16. Austerity â Is Cutting Government Spending Right?
Is the Conservative Government right to use fiscal austerity to reduce
the size of the budget deficit?
⢠Arguments In Favour:
1. Reducing debt is in long run
interests of the economy â
helps to keep UK taxes lower
2. Shrinking state encourages
private sector growth
3. High opportunity cost from
ÂŁbillions on debt interest
4. Cutting deficit increases
investor confidence â attracts
FDI into UK
5. Upturn of cycle is time for
government to borrow less â
ahead of another downturn
⢠Arguments Against:
1. Austerity is self-defeating e.g.
if it leads to price deflation
2. Government bond yields are
low â a time to invest more
3. Infrastructure investment will
increase AD and LRAS
4. Wrong to cut spending when
economy is in a liquidity trap
5. Economic growth is ultimately
needed to pay back the debt;
fiscal austerity makes this
harder to achieve
17. Austerity â Risks of Price Deflation
Deflation is a persistent fall in the general price level of goods and
services. The rate of inflation becomes negative.
Demand-side causes of deflation
⢠Deep fall in AD causing a
persistent recession /
depression
⢠Large negative output gap â i.e.
high level of spare capacity
Supply-side causes of deflation
⢠Improved productivity
⢠Technological advances
⢠Significant fall in wage rates
⢠High exchange rate causing
import prices to fall
Real GDP
GPL1
AS1
Y1
AD1
AS2
Y3
AD2
GPL3
GPL
18. Crowding Out â Analysis Diagram
Quantity of
Loanable Funds
Real Interest
Rate Supply of
loanable funds
Demand for
loanable funds
R1
D2 (with government
borrowing)
R2
Q1 Q2Increased government borrowing may
lead to higher demand for loanable funds
and a rise in market interest rates e.g. on
bonds. This might increase borrowing
costs for private sector businesses.
19. Evaluating the Crowding Out Theory
⢠Probability of 100% crowding-out is remote, especially if
the economy is operating below its capacity and if there is
a plentiful supply of saving available to purchase newly
issued state debt
⢠Keynesian economists argue that fiscal deficits crowd-in
private sector investment.
⢠Well-targeted, timely and temporary increases in
government spending can absorb under-utilized capacity
and provide a strong fiscal multiplier effect that generates
extra tax revenue.
20. Keynesian v Austrian Perspectives on Policy Response
⢠Provide strong monetary & fiscal stimulus â public sector spending
is badly needed when private sector demand is weak
⢠Focus in particular on labour-intensive infrastructure projects
⢠Bailout the private sector to prevent catastrophic job losses
⢠Key is to support animal spirits and prevent a collapse in demand
Keynesian approach
⢠Avoid bail-outs as they lead to moral hazard and the survival of
zombie businesses which ultimately constrains long run growth
⢠Fast-forward structural economic / market reforms to promote
competition and raise productivity
⢠Against counter-cyclical macro stimulus - especially ultra-low
interest rates as this "distorts" the allocation of capital
Austrian approach
21. What is the Fiscal Multiplier?
⢠Fiscal multiplier measures effect of a £1 change in
spending or ÂŁ1 change in tax revenue on the level of GDP
⢠According to an IMF research report published in 2014,
âthe literature finds that (government) spending
multipliers tend to be larger than revenue multipliers.â
⢠This would be supported by Keynesian theory, which
argues that tax cuts are less effective than spending
increases in stimulating the economy since households
may save a large portion of additional after-tax income.
⢠The IMF also found that fiscal multipliers are generally
larger in downturns than in expansions â this supports the
Keynesian view of using fiscal stimulus when conventional
monetary policy is shown to be ineffective
22. Summary of Factors Affecting Value of the Multiplier
High Multiplier
Value when
Economy has plenty
of spare capacity (i.e.
a negative output
gap) to meet higher
aggregate demand
Marginal propensity
to import and tax is
low â 2 important
leakages)
High propensity to
consume any extra
income (i.e. a low
propensity to save)
Low Multiplier
Value when
Economy is close to
itâs capacity limits e.g.
during a boom phase
of the economic cycle
Propensity to import
goods & services is
high â this means
extra demand leaks
from circular flow
Higher inflation
causes rising interest
rates which then
dampens the other
components of AD
What Determines the
Size of the Fiscal
Multiplier?
Government capital
investmentâsuch as
new infrastructure
projectsâoften results in
higher multiplier effects.
Economists at the IMF
have calculated the long-
run multiplier value at
+1.5 for developed
countries and +1.6 for
developing countries.
Source: The Economist
23. The Multiplier and Aggregate Supply Elasticity
GPL
RNO
GPL1
AS
Y1
AD1
GPL
RNO
GPL1
AS
Y1
AD1AD2
Y2 Y1
AD2
When AS is highly elastic, the
multiplier effect is likely to be high
When AS in inelastic, it is harder for
AS to expand to meet rising AD
24. Importance of Infrastructure Spending
Spending on new sewers, roads, wind farms, telecommunications networks
and ports by both the private and the public sector
Examples of UK infrastructure projects
⢠2nd Forth Road Bridge in Scotland
⢠CrossRail, CrossRail2 & HS3 (Leeds â Manchester)
⢠London Gateway Port & new London super sewer
⢠Nuclear power plants including Hinkley Point
Economic significance of infrastructure
⢠Potentially high multiplier effects from multi-billion
investment projects â boosts AD and jobs
⢠Lack of infrastructure may discourage Foreign direct
investment e.g. due to rising costs of logistics
⢠Increases the capital stock / productive potential
25. What determines the size of the Fiscal Multiplier?
1. Design: A key decision is whether to focus a fiscal stimulus on
higher government spending, or perhaps a targeted tax reduction
2. Financial stress: Uncertainty about job prospects, future income
and inflation levels might make people save tax cuts
3. Temporary or permanent fiscal raise: Expectations of the future
drive behaviour today - most of us now expect taxes to rise in the
coming years. Will this prompt a higher household saving and a
paring back of spending and private sector borrowing?
4. The availability of credit: If fiscal policy works in injecting fresh
demand, we still need the banking system to supply sufficient
credit to businesses who need to borrow to fund an increase in
production
5. Openness of the economy: The more open an economy is (i.e.
the higher is the ratio of imports and exports to GDP) the greater
the extent to which higher government spending or tax cuts will
feed into rising demand for imports, lowering the impact on
domestic GDP.
Confidence surveys, with information generally released ahead of official statistical data, can indicate changes to the economic outlook as well as turning points in the economic cycle.