Economic Principles and Theories of John M Keynes - Essay Example

A Focus on the Different Economic Principles and Theories of John M. Keynes Introduction Keynesian economics refers to a theory of economics that is based on the principles of John Maynard Keynes, a popular English economist of the 20th century. His ideas were aimed at responding to the Great Economic Depression of the 1930s (Blinder, 2006). Keynesian economic principles promote mixed economies in which both the state as well as the private sector will play significant roles. The emergence of Keynesian economics closed the curtain on laissez-faire economics that were based on the idea that markets as well as the private sectors could be able to operate independently without government intervention (Keynes, 1936). Keynesian economists believe in the governments role to level the business environment. State intervention may take the form of tax breaks and government spending with a view of stimulating the economy. In good economic times, government expenditure cuts as well as tax hikes would help curb inflation (Blinder, 2006). This paper advances Keynes’s theory that the best way to ensure economic stability and growth is by active government intervention in the marketplace and monetary policy. Keynesian Principles Keynes differed with the Classical economic theories posing various arguments to disapprove them. Basically, Keynes believed that markets could not automatically attain full-employment equilibrium, but rather, the economy would settle in equilibrium at any given level of unemployment (Blinder, 2006). This implies that the classical principles of non-intervention by government would not apply. For the economy to grow in the correct direction, it would require prodding and this means active government intervention in order to manage the demand level. The Keynesian principles are illustrated on the basis of circular income flow. In case of disequilibrium between income injections and leakages, then, according to classical economists, prices would move to appropriately restore the equilibrium. However, Keynes principles that the output level (National Income) will adjust appropriately in attempt to restore equilibrium (Keynes, 1936). For instance, if, for some reason, there is a rise in income injections, say due to increased government expenditure, an imbalance would result between injections and leakages. Following the resulting extra aggregate demand, firms will tend to employ more persons and this would result in more income within the economy. Some of this income could be spent while some would be saved or remitted in tax. The extra expenditure is likely to prompt most of the firms in that economy to increase their production further creating even more employment opportunities and in turn increasing income within the economy. This process will continue until it finally comes to a stop. It would finally stop since with every increase in income, leakages’ levels also increase (tax, savings and imports). When income injections finally equal the leakages, equilibrium will be restored. This process, according to Keynes is referred to as the Multiplier effect (Blinder, 2006). Keynesian Theories Keynes suggested that it was not a perfect idea to rely on markets in order to attain full employment in the economy. He believed strongly in his view that economies can settle at any given equilibrium. As a result, there couldn’t be automatic changes that could correct equilibrium in the markets. The main theories used to justify the Keynesian view are: The labor market theory (the monetarist theory), the money market theory (market for loan-able fund theory), the Multiplier effect theory and the Keynesian Inflation Theory (Keynes, 1936). Monetarist Theory: The Labor Market To Keynes, wage determination is more complex. First, he pointed out that it nominal wages but not real wages that are often subjected to negotiations between workers and their employers such as in barter relationship. In the first place, it is very difficult to effect nominal wage cuts due to wage contracts and laws (Keynes, 1936). Even classical economic theories admitted that this situation exists; unlike Keynes, classical economists advocated for the abolishing of minimum wages, worker’s unions as well as long-term contracts and increasing flexibility of the labor-market. However, as stated earlier, nominal wage reductions are bound to be restricted by the people even in the absence of unions until the workers see other wages decreasing an a general fall in prices. Other economists later admitted to the fact that” Keynes’s forecast that mass unemployment would be necessary to deflate sterling wages back to pre-war gold values had been proven right in the 1920s” (Donald, 2009, 1121). The Money Market Theory (Market for loan-able funds) Before the advent of Keynesianism, classical economic theories suggested that savings ought to be raised to provide more investment funds. However, Keynes disapproved this assumption. He view was based on the fact that an increase in savings implies that that the people are spending less. This would result in decreased aggregate demand. This would only worsen the situation as investors would be less inclined to investing due to a low demand for their products. Keynes was of the feeling that business expectations influenced investment much more (Blinder, 2006). To Keynes, saving beyond targeted investment (excessive saving) was a notable problem that encouraged economic recession and depression. Excessive savings result from investment falls, probably due to a fall in consumer demand, pessimistic/negative business expectations, over-investment in prior years and in cases where saving fails to immediately fall in place (Keynes, 1936). The Multiplier Effect Theory According to Keynes, an increase in aggregate demand would lead to an even greater increase in national income in the economy. This process is so since any significant increase in demand results in more people getting employed in the economy. When more people are employed, they will gain extra earning and spend them. This led to even greater spending, which in turn created more employment opportunities, which again resulted in even more income, then spending again and the cycle would continue (Blinder, 2006). The amount of extra income spent each time would determine the length of this process. In case the initial recipients of that extra income opted to save the whole of it, then this process would halt quite quickly since none else would get hold of any extra income. However, should they spend it all; the knock-on impact of the extra expenditure will persist for some time. Thus, the multiplier effect decreases with increase in leakages. Keynesian Theory of Inflation The classical theory of inflation was based on the Quantity Theory of Money which made use of the Fisher Equation of Exchange: MV = PT Where: M denotes the amount of money in circulation; V is the velocity of circulation of that money; P is the average price level and T is the number of transactions taking place. Once again, Keynes disputed this theory. His argument was based on the reasoning that an increase in the supply of money will not unavoidably increase inflation. Instead, increasing M may cause a decrease in V. This implies that the average circulation rate of money will fall due to a rise in its supply (Keynes, 1936). Increasing M may alternatively increase T to ascertain Keynes rejection of the notion that the economy can automatically restore equilibrium. Keynesians believe that inflation is most likely cost-pushed or results from excess demand hence the term, demand-pull inflation (Mankiw, 1993). Contribution of Keynes and His Theories to World Economy John M. Keynes died in 1946. However, his ideas live to flourish in the world with most of the modern economic and political thinkers who now control the world’s money as well as economy. Many economists such as Paul Krugman, Robert Reich, Martin Wolf, Tim Geithner, Paul Volcher and Ben Bernanke as well as a host of many others still espouse the principles of Keynes and Keynesian theory as the best cure for the world’s economic problems. All the modern-day Central Banks of the various countries in the world formulate their modern policies on the basis of Keynesian philosophy and principles. Keynesian principles have ruled the world economy from 1944 even to date (Donald, 2009). Most of the countries today also still formulate their economic and fiscal policies based on Keynes’s theories despite modern criticisms from opponents (Mankiw, 1993). Keynes recognized the fact that it was impossible for the common man to create global prosperity, depressions or recessions. This could only be achieved through large public expenditures. He also lobbied for a stable currency which enhanced price stability over time though his main ideas were based on probability and mathematical theory (Donald, 2009). His greatest idea was a world currency (called the Bancor) would serve as a worldwide clearing currency for balancing trade imbalances (Keynes, 1936). For Western democracies, Keynes pushed for western style government management and freedom as the best way for progress and growth. Keynes never agreed to Marxian socialism. However, many of his critics have suggested that Keynesian philosophy might, in time, lead towards socialism. John M. Keynes, as an individual, has prevailed in minds of many world political leaders. Even Richard Nixon, his former critic, eventually adopted Keynesian philosophy after closing down the gold window (Donald, 2009). John M. Keynes also played a key role in engineering the Bretton Woods Agreement of 1944. This agreement created a monetary system in which the USA came to dictate most monetary and economic policies of the world (Donald, 2009). Despite his many stressful health challenges while negotiating terms of the agreement, Keynes still gave immense contributions towards the same. His principles and theories played a significant role on the final product of this agreement. Finally, however, the then US Secretary of Treasury, Harry Dexter White, dominated most of the key economic issues like the use of the US dollar as the global reserve currency. Keynes agreed to the eventual outcome of ideas. As a result of this agreement, the monetary system that the world still uses was formulated. Both Harry and Keynes were in agreement that the Word Bank and the International Monetary Fund (IMF) should be the world’s financial institutions. Based on Keynesian philosophy, the World Bank and the IMF were thus created (Blinder, 2006). Most of the world’s heads of governments gradually came to adopt Keynesian principles and theories and applied them in their individual countries. Schools as well as colleges also taught these philosophy and principles as the world’s best economic ideas of the time. Most of the schools’ economic curriculum centered about formulae, graphs and mathematical probabilities of Keynes. Little mention, or not at all, was ever made of the establishment of money by the founding fathers or about the money principles included in the US’s constitution. Mathematics became the thought of all modern day and Keynesian mathematical models were key concepts for those studying economics as well as advanced business studies. Numbers and math, as suggested by Keynes, were adopted in the thinking and understanding of economic reality in the schools (Donald, 2009). Thus, it is true that Keynes and Keynesian philosophy played a significant role in creating the modern day economy. Benefits of Keynesian Philosophy Many people have argued whether Keynes has helped or hurt our economy. Keynesian economics have had vast economic benefits not only in the developed world, but al in developing countries. First, Keynes’s philosophy resulted in increased overall material wealth in the world with the US being the chief beneficiary, consuming 25% of the global wealth between 1971 -2009 despite being home to only 6% of the world’s population. It allowed the US to become the world’s economic superpower that promoted economic prosperity around the globe. Thus, Keynesian economics majorly benefited the US and other Western countries. Another key benefit of the system was its flexibility as well as hopes of widening the democratic economic space (Blinder, 2006). From the foregoing, despite its weaknesses and eventual expected collapse, no one can deny the fact that Keynesian philosophy has played a key role in building the modern economy. Its major drawback was the temporary nature as a feasible economic system. Today, Keynesian philosophy is in the verge of collapsing as the world shifts focus to correcting the economic imbalances witnessed between developed and the developing countries. This is because Keynesian philosophy was based on using debts to wealth for nations. He emphasized short-run strategies of rapidly growing wealth through financial capitalism. The system also led to the growth and expansion of the services sector at the expense of the industrial sector. However, global debts have now reached levels that are unsustainable and investors now seek save havens of protecting their wealth. It is projected that this trend is likely to continue into the future till all the fluff is removed from the global economy, a situation that may prompt great revolution among those who have invested on the basis of this philosophy (Mankiw, 1993). What the World Now Needs In light of the current economic situation in the world, what is now needed is educating and explaining to the public the causes of the inherent economic breakdown. Education may be a perfect way to prevent chaotic revolutions and a complete erosion of the trust and confidence in the system and in our past great leaders. Perhaps if Keynes would be alive today, he could have agreed to the current economic policies that aim to correct economic imbalances between nations, probably with such seriousness as he disputed classical economics in his time in order to correct market imbalances of the time through state interventions (Keynes, 1936). In fact, Keynes himself alluded to the possibility that his philosophy was of a short-term focus when he said that at one time we are all dead. Thus, with the death of his system, Keynes could have easily accepted the coming to life of modern economic principles such as world trade liberalization that is now enhancing economic growth in developing countries by giving them the largest share of global welfare gains (Mankiw, 1993). Conclusion Keynesian theory of employment, prices and determination real equilibrium GDP, are based on the relationship between expenditure and aggregate income. Keynes, using his income-expenditure model, argued that the output equilibrium level of an economy’s of output (real GDP) may not necessarily correspond with the natural real GDP level. Thus, state interventions would be necessary to restore equilibrium other than automatic market forces as proposed by classical economic theories. Though Keynes died, his economic principles still rule the world economy as well as education. Keynes played a key role in the Britton agreement that established the World Bank and the IMF and the subsequent rapid growth of global wealth. However, developed countries, especially the US and the West reaped much of the benefit at the expense of the developing world. All in all, Keynesian Philosophy will still stand out as having been the best way of ensuring economic stability by promoting government involvement at the time. References Blinder, A.S. (2006). Keynes after Lucas. Eastern Economic Journal, 12(3):209–216. Donald, B.S. (2009). John Maynard Keynes is now dead… but his ideas still live. Journal of Economic Litereature, 28(3):1115-1171. Keynes, J.M. (1936). The General Theory of Employment, Interest, and Money. London: Macmillan. Mankiw, N.G. et al (1993). A Symposium on Keynesian Economics Today. Journal of Economic Perspectives 7(12): 3–82. Read More