Keynesian school of economics

 This school is one of the more recent schools of economics as it surfaced in the 1930s. The theory was developed in the aftermath of the great depression. John Maynard Keynes, an economist from Cambridge University, neither supported the free market or the communist ideals. Instead of this, he took ideas from both and made a new idea of thinking. Keynesian economics. This branch of economics suggests that the government has the power to protect the economy from the harsh peaks and troughs in the business cycle using monetary and fiscal policy. This would be done by government spending in recessionary troughs and taxes in economic booms. There were more theories such as the multiplier effect.

Fiscal policy

Fiscal policy is a method of controlling the economy as a macroeconomist such as Jerome Powell in my last blog. Fiscal policy is all about taxes and government spending. There are two methods of using fiscal policy, expansionary and contractionary fiscal policy. The definitions are quite self-explanatory. Expansionary fiscal policy is used to increase the size of the economy. And contractionary fiscal policy is used to reduce the size of the economy. Expansionary fiscal policy is a combination of a reduced taxes and increased government spending, contractionary fiscal policy is the combination of increased taxes and decreased government spending.

Monetary policy

Monetary policy is the main method of controlling the circulation of money. This is done by the use of interest rates and results in the appreciation or depreciation of money depending on whether the policy is expansionary or contractionary. Contractionary monetary policy is when the central bank raises interest rates. This makes borrowing money more difficult and thus reducing the aggregate demand (AD) of the economy, a side effect of this is the deflation of the currency. Expansionary monetary policy is the raising of interest rates, making borrowing easier, increasing AD. A side effect is an increased inflation rate.

How monetary and fiscal policy relate to Keynes?

The business cycle shown above has large and sudden changes in real GDP, Keynes saw this as an issue as he believed that “in the long run we are all dead.” And sought to flatten the curves to allow for a steady economy so that depressions do not last for years. His theory suggests that the government can reduce the volatility of the business cycle by using expansionary policy in recessions. To counter the government deficit by doing this, during the booms and peaks, the government should use contractionary policy to reduce/negate the deficit caused by the expansionary policy.

The multiplier effect

The multiplier effect is what happens when there is a change in inputs of the economy such as government spending, this change results in a larger change in the economy. This happens due to the marginal propensity to consume (MPC) this is because if people spend more, a higher percentage of their money is kept in the economy. And as “the spending of one man is another man’s income,” the money keeps circulating, increasing the benefit an injection into the economy causes. However, a portion of that money is saved each time after it changes hands.

The graph of the multiplier effect is shown above. There are some differences between this graph and a normal AD/AS graph. The differences being the curve of the AS and the absence of the LRAS curve. The AS is curved to show the changes in Real GDP with the changes of AD as a result of an injection. It is curved to show that the continuous changes in AD will not lead to infinite growth, but an increase in the Price Level (PL). there is no LRAS curve as this graph is designed to show how the change in AD affects the short-run equilibrium. And since AD doesn’t impact the LRAS, the LRAS curve here is not useful.

Is the Keynesian school of economics correct? (Note: this is my opinion. Economic theory is subjective so feel free to form your own opinions based on your own research/evaluations)

I believe that in theory, the Keynesian school of economics seems the most obvious as it would make sense to implicate in the present day. However, in practice it is not the most viable. This is because the government may not be able to allocate the money in the most efficient manner, resulting in a type of market failure called “government failure”. Government failure occurs when there is a misallocation of resources resulting in some companies being overly subsidised and not making much profit for the economy or government backed monopolies forming or unintended consequences occurring

When economics is mixed with politics, the best economic decisions are seldom made. This is usually because of political parties abusing their control of fiscal policy to increase their popularity. And therefore, there is usually an urge for political parties to increase government spending even during times of economic growth. This leads to an ever-increasing deficit which causes even more economic issues.

However its multiplier effect theory is undoubtedly correct. And thus, the Keynesian school of economics has resulted in a fantastic and different way of thinking about allocation of resources. Overall, the school has a lot of teachings and is revolutionary in the field of economics.