Beyond Keynesian Economics - Example

Table of Contents 1.0.Introduction 1 2.0.Policy Analysis 3 2.1.The Event 3 2.2.Analysis using Keynesian Framework 3 2.2.1.Changes in government spending 4 2.2.2.Changes in the global interest rate 5 3.0.Limitations of the analysis 7 4.0. Beyond Keynesian Economics 8 5.0.Conclusions 10 6.0.References 12 1.0. Introduction The development of macroeconomics was purely based on ideologies and economics; a methodological revolution that was meant to find impeccable solutions to the Great depression (Plosser, 1989). According to Bose (1989), “From the 1950s onwards, Keynesian macroeconomics established itself as a new sub-discipline of economics and the predominant use of the IS-LM model became a baseline analytical tool”. Cooper and John (2012), in his book Theory and Applications of Macroeconomics(pp 123) explains IS-LM model as an analysis tool gives a deeper overview of the aggregate demand (AD) that represents the equilibrium balance in output and interest rates resulting from the equilibrium in the money market and the goods. In IS-LM, equilibrium in investment and saving (IS) represents the goods market while liquidity preference and money supply (LM) represents the money market. As an economic analysis tool, the Mundell–Fleming model is an extension of the IS-LM model. With this model, the economy can be analysed from an open perspective unlike the traditional IS-LM model which is closed and provided rigid analysis. The short run relationship that occurs between an economy’s nominal exchange rate, the output and the interest rate is best portrayed in the Mundell-Flemings model. On the contrary, Mankiw and Taylor (2008) in his studies provide that the IS-LM model focuses on how the output relates to the interest rate which makes it a weak analysis tool. The overriding issue therefore has revealed how macroeconomics analysis can be done by Mundell-Fleming model in maintaining an independent monetary policy, fixed exchange rates and free capital movement. Phillips curve is an economic analysis tool that gives a relationship between the unemployment rates and the economic inflation. It is as historical as the IS-LM model compared to the Mundell-Fleming model. With Phillips curve, an inverse relationship where an increase levels of employment results to a decrease in inflation in an economy. However, according to Keynes (1936), analysis of the Phillips curve does not provide a precise relationship between unemployment and inflation since it is only realized in a short run. Accordingly, the Phillips curve proves not to be strong enough based on the fact that unemployment basically is predictably on a short run by the money supply measures. 2.0. Policy Analysis 2.1. The Event One of the most severe economic events was noted in the case of the Great Depression of 1929 which directly emanated from Hooverliers effect in the stock market crash. Hooverliers effect surmounted another great failure in the banking sector that starved Americans of their savings. In addition, with reduction in the stock market, arose the decrease in the purchasing and trade with other economies. As was reported by BBC (2014), as a result of the economic depression, United States government was compelled to put barriers on imports and loans which translated into widespread unemployment and economic stagnation across all the revenue generating industries and banking sector. As a result, the Keynesian analytical tools were used in the analysis of the fiscal and monetary policies. 2.2. Analysis using Keynesian Framework The many problems in the economic sector that were realized sprung as a result of the Great depression. As a consequence, many economists made efforts to avert the crisis by making a deeper analysis of the monetary policies. During this time most the theories that were advanced could be used to solve a variety of the problems that emerged in the money market as others provided conflicting solutions and far reaching implications particularly in the money supply (Mankiw and Taylor, 2008). Since macroeconomics is concerned with the aggregated indicators including the price indices, unemployment and gross domestic product to understand the decision making and behaviour in the economy. During flexible exchange rates, banks become flexible and allow the market forces to dictate the exchange rates. In an instance where the LM curve is moved to the right by an increase in money supply, the local interest rates are reduced in comparison to the international rates. Contrariwise, a decrease in the supply of money causes an increase in the local rates and a reduction in the global rates. 2.2.1. Changes in government spending The government expenditure can be analysed on the context of the Keynesian theory on the basis in which it affects the money market (Byrne, 2006). A subsequent increase in the government expenditure is captured in the IS-LM curve in terms the position in which it is moved towards. A shift in the IS curve to the right, portrays an increase in the government spending and a shift to the left a decrease in the spending. As a consequence, the interest rates therefore rise as well as the Gross Domestic Product (GDP). In equal measure, if the IS curve shifts to the left, the GDP falls substantially and there is an incipient increase in interest rates (Mankiw and Taylor, 2008). In addition, the shift causes an incipient increase in the rates thereby causing an upward pressure on the exchange rates. The local currency and foreign currency will increase as a result of the increase in the interest rates. However, an increase in the government spending compels the supply of the local currency by the supply market to stabilize the exchange rates. According to the curve, in the case where capital mobility is perfect, the balance of payments (BoP) is likely to remain unaltered in the position represented by FE. 2.2.2. Changes in the global interest rate For any upward increase in the international interest rate, changes occur on the curve of balance of payments upwards that compels the capital flows outside local economy. The value of the local exchange currency decreases hence increase in net value of exports, leading to a shift in the IS curve to the right (Cooper and John, 2012). The banks in such cases are compelled to sell the foreign currency reserves to sustain the outflows. If the capital mobility is imperfect then the decreased exchange rates shift the curve of alliance of payments back. In instances where the capital mobility is not perfect, the curve is ever at par with the international exchange rates. Hence any increase in the international rates, shifts the balance of payments curve upwards with a significantly equal amount. The net effect creates a scenario that equates the domestic exchange rates to the international rates with shift in the IS curve where it crosses the intersection of LM and balance of payment curves. For a decrease in the international interest rate, there is a corresponding downward change in the balance of payments. The graph shows that if the IS curve shifts inwardly, then there is a corresponding decrease in the interest rates and consequently the gross domestic product. Bose (1989), in his analysis suggests how the interaction of the IS-BoP dictates the analytical role taken by the LM curve. This comes as a result of the shift of the BoP upwards which creates a scenario of capital outflow, making taking the state of the opportunity towards the shift. In addition, Attfield et al (1991) posit that using the Mundell-Fleming model in an economy whose capital mobility is perfect and the local interest rates pre-determined by the international rates, there is a difference generated by a closed economy model. Under fixed exchange rates, this model provides different implications unlike the closed and rigid IS-LM model. Notably, in a closed economy, expanding the supply of money, the LM shifts out decreasing the interest rate and increasing the income. In imperfect open capital mobility, monetarism is inefficient shifting the LM curve stationary. An expanded monetary policy, the LM curve shifts outwards and compels the capital flow out of proportion. 3.0. Limitations of the analysis The Keynesian models provided an analytical process that tried to explain unemployment that resulted from the Great depression. However, the Keynesian could not explain that the involuntary unemployment of both capital and labour. However, Byrne (2006) provides a different perspective-the fact those firms contributed to the unemployment by reducing their employment and output in order to sell their products with a substantive profit was beyond the analysis of the old Keynesian models. The failure to make clear a good business environment made economists abandon the use of the Keynesian models to the new Keynesian models. Since the technical advances have take place after a long period of time, it could not be easy to use the model for a long period of time in explaining the advances in terms of the economic levels since technology can never be regressed. This was an attempt to kill the Keynesian theory with an aim of converting it to a theoretical oddity. As Cooper and John (2012) suggested that the Keynesian theory could not explain dual economy as could be by the dependency theorists. As a result of the unbalanced growth continued to create unemployment. In addition the Keynesian theory could not rationally use the optimization strategies to find a solution to the great depression. The models relied on the theories in explaining the data unlike other areas of the macroeconomics field that analysed the money market in terms of the optimization strategies which somewhat provided realistic conclusions. After the seventies, a variety of topics came into existence explaining the expanse in the economies of the third world countries. According to Byrne (2006), the structural rigidities that the Keynesian model could not remove continued causing inelasticity of the money market. Inflation therefore continued in most parts of the world as a result of the depression. The rigidity in the manner in which the model analysed the market failures prompted the development of new business cycle theories. The new advanced theories had a lot to do with the conveniences of the analytical adaptive expectations (Attfield et al, 1991) 4.0. Beyond Keynesian Economics As noted by the Snowdown and Vane (1997) “The New Classical revolution was in part a response to that tension”. This suggests that even though the Keynesian model could help in solving an array of problems that arose as a result of the depression. A simple Keynesian model was not perfect to solving the crisis of the Great depression proposed an idea did never seem inclusive to solving the imperfect market forces. It provided a model that believed that an economy was only able to attain equilibrium level output sluggishly below the employment level of output. Keynesian model never placed interest in explaining the real issues of the depression but the simply the movements of aggregate output and how the government policies could be used to decrease unemployment in the same economic situation. The post Keynesian model primary tended to be flexible enough in addressing the monetary issues. With the real business cycle (RBC) theory, the monetarism logic was never flawed with deregulation and financial innovation solved the flaws. Real business theory, explains the conduct of a business through the classical models. With the real business theories, the ideology behind the equilibrium theory in understanding the economy bases in the context of demand and supply in the market. The real business theory as a neo- classical economic analyser unlike the Keynesian theory came as a response to address the fundamental changes of the economic factors. The economic factors are the ideal reasons behind the relative price changes and equilibrium quantities. As a result, the allocation of resources on the basis of the relative prices is controlled. Using real business cycle theory, it can be determined that if the resources endowments are reduced then a corresponding contraction in output would be realized. The post Keynesian theories including the real business approach ascended and dominated as institutional based theories with a proof that the Keynesian model was not the only solution to the market failure issues and unemployment. However, the post Keynesian models seemed to replace the earlier models though to these end it was not still sufficient. In addition, the real business theory explains the changes in consumer preferences relative to employment and the output of contraction (Byrne, 2006). The idea of working less is detrimental to the bearing of gross domestic product. However, this has structurally appeared to be a long term change. As a tool that analyses the money market, the fluctuations in the technical change rates would not be explained by the old Keynesian principles as would the real business cycle theory. In addition the real business cycle theory advanced an explanation to the causes of the boom and the recession that resulted from the Great depression. With a rapid technical change, the boom that resulted could be solved by the real business analysis. Recession that resulted from the slow technical change could not be explained by the old analytical tools including the IS-LM and Mundell-Fleming models. With positive technical change, labour and capital marginal product would also rise in correspondence to the extent of the technical change. The neutrality nature of money has not posited any real effects in the money market (Plosser, 1989). This theory which arises as a post-Keynesian could explain the market conditions in terms of the neutrality of money. If the money market is expanded, this theory explains a scenario where the products would rise and the price level fall substantially. As a result of the Great depression most governments tried control their gross domestic products using the fiscal and monetary policies. However, this could not be done by the Keynesian models but the real business cycle models. According to Cooper and John (2012), RBC theory provides an explanation to unemployment and recession using the explicit changes in technology advancements rather than the changes in the market money. However, RBC is not sufficient to providing a lasting solution to the depression since the role of money in economic improvement cannot be underpinned to the technological advancements. Nevertheless, the questions raised on the RBC models do not render its influence in the economic methodology influential. 5.0. Conclusions Money market problems seemed complex to an extent that only the Keynesian models could not be used to find solutions to address the depression. Majority of the financial institutions shifted to inflation targeting and interest rates operating procedures that could respond to the money market problems. As a solution to the rigid model, Attfield et al (1991) posited an influential critique to the Keynesian theory by presenting an empirical argument that changing the data would forecast on the relationship that would yield similar products. In addition to the empirical results, he advocated for a model that pushes the values of fundamental economic theory that would adapt to the changes in the economies. An economic logic put forward by Bose (1989), is that targeting the interest rate envisages a policy that provides insulation against the financial sector fluctuations as would otherwise by the money supply. The post Keynesian theories advanced analytical explanations to the money market that would not be solved during the recession period. By 1990, most economists had agreed on a solution to help solve the rigidities in the market by adopting the using a combination of the real business cycle theories and the dynamic stochastic general equilibrium (DSGE) models. Such a combination of provided a continuum to the new neoclassical synthesis which have been recently utilized by a core of contemporary macroeconomics. 6.0. References Mankiw, N and Taylor, M (2008), Macroeconomics European Edition, New York: Worth Publishers BBC (2014), The Depression of 1930s, available at http://www.bbc.co.uk/schools/gcsebitesize/history/mwh/britain/depressionrev1.shtml (accessed on 20th April 2014) Byrne, D. (2006), The Great Depression A Monetarist View, available at http://www.csus.edu/indiv/v/vangaasbeckk/courses/145/sup/Byrne.pdf (accessed on 20th April 2014) Cooper, R. and John, A. (2012), Theory and Applications of Macroeconomics, available at http://2012books.lardbucket.org/books/theory-and-applications-of-macroeconomics/s20-macroeconomics-toolkit.html (accessed on 20th April 2014) Keynes, J (1936). The general theory of Employment, Interest and Money. London: Macmillan. Snowdown, B and Vane, H (1997). A modern Guide to Macroeconomics .Cheltenham: Edward Elger. Attfield, L, Demery, D and Duck, W (1991). Rational Expectations in Macroeconomics. Oxford: Blackwell. Plosser, C (1989). Understanding Real Business Cycles. Journal of Economic Perspectives 51-77 Bose, A (1989). Short Period Equilibrium in Less Developed Economy. Studies in the Macroeconomics of Developing Countries pp 26-41.Delhi: Oxford University. Read More