Evolution of the Keynesian Theory of Macroeconomics in the UK - Essay Example

?Evolution of the Keynesian Theory of Macroeconomics in the UK I. Introduction The fundamental point at issue between the Keynesian and ical macroeconomic theory lies on the participation of the government on the market activity. Classical economists argue that the market will always eventually reach equilibrium even without government intervention while Keynesian economists believe that only through government intervention can the market ensure employment at full level. Market booms and busts are evidences to how markets work. According to Charles Kindleberger, a self-proclaimed ‘literary economist,’ concludes that “markets generally work well but will need a little help on an occasional basis” (The Economist 2003: 2). In this sense, it can be implied that only in times of market failures are governments are justified to intervene. This paper will explore the different viewpoints of classical and Keynesian economic principles and concludes how prevailing economic policies are only transient and evolutionary. II. Fundamental Policy Issues A. Classical Economics The classical economic thought resides on the simple concept that the market can work effectively even without any form of human intervention. The market, as Adam Smith puts it, possesses an invisible hand that automatically puts the economy back into plump shape when otherwise with the guiding advocacy to let the government leave market activity into the interests of individuals (2009z: 400). Smith states that the “governments that intervene in the market activity only represent the wealthy and the powerful” rather than a mass (as cited in Sowell 1994: 23). Even to classical liberals such as Frederic Bastiat, state interference on any activity which goes beyond its functions (i.e. maintaining order and justice) is a “usurpation upon conscience, upon intelligence, upon industry; in a word upon human liberty” (as cited in Haney 1911: 257). That is to say that the state should serve “minimal functions in its participation to trade and commerce” (Medema & Samuels 2001: 96). Generally, classical economics held that there is no such thing as public interest during market activity but only private or self-interest which is promoted will also promote public interest inevitably. From this standpoint stemmed the principle of laissez-faire which would eventually resolve deficiencies in employment and output levels. B. Keynesian Economics According to the brainchild of Keynesian economics, John Maynard Keynes, the government is the only fundamental societal structure that can manage the aggregate demand from households, businesses, and the government itself to ensure price stability (Korten 2010). Keynesian economics assume the opposite of what classical economists theorise -- that a free market is not self-correcting so that it would result in unemployment in the process (the Great Depression, being the proof). Furthermore, market forces will consume a long period to bring back full employment because in the real -time market, demand is not sufficient to maintain full employment (Cowling & Sugden 1990: 108). Keynesian economists say that in order to efficiently sustain employment at full level, the government must push through monetary and fiscal policies (i.e. increase government spending and decrease taxation) in order to stimulate the aggregate demand for commodities, hence creating additional employment opportunities (Cowling & Sugden 1990: 108). When there is a right level of demand, the supply-side would look after itself (Cowling & Sugden 1990: 108). This would result in an increase of budget deficit (Cowling & Sugden 1990). However, Keynesian economists sustain that this is only justifiable. III. Theory A. Market Equilibrium: On Fluctuating Prices a.1. Classical Perspective Market clearing in both the labor and commodities markets is entirely possible because of equilibrium forces (Free 2010: 73). For instance, when the supply exceeds demand, the market reaches equilibrium if prices decrease which is only an inevitable reaction. In another instance, when demand exceeds supply, increasing the price will clear the market (Tool & Bush 2003: 253). Furthermore, because individuals are perceived to be indifferent about price, prices are flexible in such markets such that market equilibrium is instantaneously possible. Classical economists rely on the real balances effect wherein if the price decreases, the purchasing power of money increases; because consumers purchase more, the real demand for GDP (gross domestic products) will increase eventually (Tucker 2008a: 244). Classical economists also argue that market failures are only temporary occasions due to the capitalist price system which would gradually allow for a full- employment level (Tucker 2008a: 283). a. 2. Keynesian Perspective In contrast to the classical standpoint on market clearing, Keynesian macroeconomics hold that some markets do not clear since the price is rigid downward (Carlton 1987: 1). The labor market, in particular is believed to have an intrinsic disequilibrium which would explain why unemployment exists (Thurow 1983: 182). Keynesian economists assume that labor markets apply a fixed-price model and that labor markets only clear through worker qualifications -- not based on wages (Thurow 1983: 213). Keynes argues that the existence of minimum wage levels or contract-based employment implies that wages do not immediately change, that wage prices are inflexible. Therefore, in order to restore economic equilibrium in labor markets, the government must intervene (Thurow 1983: 182). Similar to the labor market, the commodities market does not clear immediately because of the rigidity of prices. The market is in equilibrium if the aggregate expenditures are equal to the aggregate production (Arnold 2008: 227). Inventories will rise and impede production if the total expenditures are lesser than the total production; while the opposite occurs if the total expenditures are greater than the total production (Arnorld 2008: 227). Keynesian economics assume that the real GDP is always at a lower level than the natural GDP. With this recessionary gap, governments are justified to intervene (Arnorld 2008: 227). B. Say’s Law The Say’s Law states that supply will create its own demand. In plain terms, Say’s Law declares that any manufactured product will have to be consumed; therefore, there can’t be any insufficient or ineffective demand (Tucker 2008a: 197). Additionally, economic turmoil will not last long due to the same factors. While the classical economic thought uses the principle of Say’s Law, Keynesian economics rejects the law, stressing that ‘demand creates its own supply’ rather than the other way around (Tucker 2008a: 198). More exactly, Keynesian principle holds that the aggregate demand will equate to the aggregate consumption, investment, government spending, and net exports (Tucker 2008a: 198). C. Quantity Theory of Money The quantity theory of money assumes that the price level is directly proportional on the money supply (Tucker 2008b: 407). For example, if the money supply is doubled, the price level will also increase through the same proportion. However, this relation does not affect the real economic output. What the quantity theory of money suggests is that by stimulating demand such as in increasing government spending, inflation will occur without affecting the real economic standing. When the money supply increases, demand will increase so that firms are left with two options which are to either increase the prices or increase production. Either way, however, will result in inflation. IV. Course of the Debates With the two clashing assumptions on macroeconomic thought presented above, it may be inferred that only during major economic phenomena will a prevailing economic policy become vulnerable to repudiation. That is to say, that both the Keynesian and classical economic perspectives are best applicable according to the economic conditions where they prevailed in the mainstream economic thought. A. Keynesian versus Classical Economics When the government increases its spending in pursuit of clearing markets, it can only resort to the private sectors. However, as classical economists stressed out, borrowing for public benefit will only force out private investment without even allowing for a longer-lasting stable employment curve (Peden 2004: 57). The phenomenon is called crowding out’ where without increasing the taxes, interest rates will instead increase, thereby decreasing private investment (Middleton 2006: 149). Keynes, together with other critics refuted this assumption which would later be laid in detail in his book The General Theory of Employment, Interest, and Money. He argued that if such were the case, resources would have to be diverted from other uses because of additional expenditures (Middleton 2006: 148). In addition, he said that such case should be impossible with the assumption that there is always less than full employment (Middleton 2006: 148). B. Keynesian Demand Management and the Post-War Boom Decades after the Second World War, the succeeding Labour and Conservative governments in the UK adopted Keynesian demand management policies that manage an effective level of employment and output (Middleton 1987: 5). Indeed there were “full employment, stability of prices, a surplus on the current account of the balance of payments, and economic progress” which were coincidentally disrupted at the inception of Thatcherism (Middleton 1987: 5). But while a managed economy provides a theoretical framework for the supply-side, inflation, economic progress, and income distribution (Karagiannis 2002: 176), demand management policies caused large fluctuations in the employment and output levels due to ‘volatile expectations’ (Nativel 2004: 11). Furthermore, it only pronounced the negative impacts of deficits. High marginal tax rates were dispersed throughout all economic classes and private investment diminished (crowding out) (Harrop 2000: 233). The UK experienced stagflation in the 1970s. C. The classical / monetarist counter-attack against Keynesianism. The entry of a decade of Thatcherism in the UK proved how Keynesian economic policies became largely ineffective in the long term. Monetarism and the new classical economic thoughts repudiated Keynesianism, criticizing that the latter ignores the importance of the money supply and the ability of the educated economic agents (Bateman et al. 2010: 3). The biggest argument thus far was stressed in the effect of repressing the interest rates which could lead to the intensification of destabilizing forces in the economy (IMF 1983: 13). Keynesian macroeconomic policies only focused on the short-term objectives but lead to long-term negative impacts. Milton Friedman, credited for the monetarist revolution, endorsed a strict control of the money supply and emphasized the importance of free market economies (Bateman et al. 2010: 156). D. Conclusion It is notable to infer that policy debates only occurred at the onset of the Great Depression. These arguments were directed to highlighting the macroeconomic stability where the two traditional thoughts came clashing at the issue of government intervention. On another point, it is highly difficult to reconcile both economic perspectives since what the other promotes is what the other deters. One cannot discount the evolutionary tendencies of these economic theories. Recall that the new classical economics and/or the monetarists’ ideologists are mere improved structures of the classical thought. Therefore, without a clash, no one will exert the effort of mining the real cause of the problem. V. General Conclusion Both the classical and Keynesian standpoints of economics present anomalies existent in each other in practice. Before the Great Depression, Smith’s school of economic thought prevailed upon market activities. Keynesian economics was more of a reactive mechanism to the economic turmoil and that promoted fiscal initiatives. It is essential to highlight the historical and economic backgrounds of both. Apparently, market conditions were the compelling forces that lead to the development of both principles. Therefore, both theories are not yet fully applicable in all market phenomenon. In the first place, pure free and/or interventionists markets do not exist in the world. There is only a mixed market. 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