Raghunathan T & Pratik Kumar
Great Lakes Institute of Management
Keynesian Economics
In this article, we intend to brief about the Keynesian economics and its practical implications in day to day life. Keynesian economics refers to a school of economic thought proposed by Lord John Maynard Keynes in his book, “The General Theory of Employment, Interest and Money”. This theory was introduced during the times of “The Great Depression”. Keynes stated that “Government must not be silent spectator, but should actively take part in spending money during times of crisis”. During times of crisis, Keynes observed that private sector usually led to inefficient macroeconomic outcomes which needs active fiscal/monetary policy from the government to stabilize output over the economic cycle. This was majorly because, many macroeconomic decisions when taken by a large group of people, results in excess supply; whereas the demand for the products are not felt to that specific extent. Classical theory of economics stated that, the market has a self-adjusting mechanism which brings back the economy to the real level of GDP. However, Keynes observed that, excessive saving, i.e. saving beyond a point led to serious issues which often resulted in recession or depression. He stated that the market doesn’t behave in a Laissez-faire way. His argument was four fold. During the time period of 1929 to 1932, Federal Reserve had cut its interest rate by 25 basis points about 20 times; hoping economy will stabilize the classical way. Keynes said that savings doesn’t follow interest rate cuts because the income effect and the substitution effect goes in the opposite ways. That is, as the rate of interest of loans decreases, commodities with greater demand in the market get sold at a greater rate. In addition, investments in plant assets or equipment were done with a longer time scale in focus. During times of paranoia, people were scared if the business will be profitable. Hence, the investments are not easily done by private parties. He also argued that savings and investments were not the primary determinants of the interest rates specifically in short run. Instead, the supply and demand for the money was a bigger concern in the shorter run. That is, even if there are huge savings, when there is a greater demand for the money, the interest rates will have to be cut. Finally, he felt that classical theory might not work in terms of adversities, because people may continue to hoard money expecting deflation. This might result in less trade there by creating a liquidity trap. This results in piling up of goods which results in unproductive inventory and in unemployment of large group of people. Keynesian economics has been used extensively by the government across the world, especially during the 50s
February 2013
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