Limitations to the applicability of Keynesian economic policies

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Limitations of the Applicability of the Keynesian Economic Policies

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The Keynesian principles of economics are a school of macroeconomic theory that basis its arguments on the principles and ideologies of John Keynes, a twentieth century economist. The principles point out that the decisions of the private sector at times result to inefficient macroeconomic results and, thus, campaigns for responses by the public sector through such actions as monetary policy and fiscal policy by the central bank and the government respectively to stabilize the output in the cycle. The principles by this economist argue for a mixed economy, one that is mainly composed of the private sector, but also has a considerable role of the public sector and the government. This particular economy model was seen and practiced during the Second World War, the great depression and during the economic expansion of after the war (Chapter 12. Keynesian economics and the Great Depression).

This paper, therefore, will look at and try to solve the issue of what the economists of the Keynesian principle suggest is the best solution for the problem of insufficient aggregate demand if it were to exist in an economy. Furthermore, the article will also attempt to find out whether there are any limitations or shortcomings of the applicability of the principles proposed in the Keynesian economic theory.

After the great depression, the socialist cause became extremely popular and especially in the 1930s. While the capitalist world at this time was experiencing one of the most challenging depressions, the Soviet economy was experiencing a booming growth. The depression hit, and most Americans were caught by surprise, as they had to come to believe in the notion that their nation was destined to attain immense success. The economic system based on capitalist ideas seemed inadequate to address these challenges and was actually on the verge of collapse. To revive it, a number of countermeasures had to be developed, nut to develop such measures, an understanding of what had happened was also crucial. One English economist named Keynes, who in his book tried to explain what had happened to the capitalist economy, made this task easier (Chapter 12. Keynesian economics and the Great Depression).

Keynes began his task by attempting to look at and understand the production process. In a certain period, a company produces a certain amount of products worth a certain value. From the revenues generate from the sale of these products, the company pays and compensates for the production cost, which in many cases includes wages, rent, salaries, raw materials, supplier and interest on loans. What remains after all this has been paid off is the company’s profit. According to the economist, one thing never to forget here is that the production cost to the business organization represents income to another firm or individuals. The profit is also the income the owners of the firm gain. Because the production value is exhausted, the value of the products has to be equal to the generated incomes resulting from its production (Chapter 12. Keynesian economics and the Great Depression).

In terms of the whole national economy, the aggregate picture is similar to that for an individual company. The value of all products in the economy during a certain stage is equivalent to the overall profits established during the matching stage. As it follows, for a company to sell all its products, customers have to spend in the aggregate all of their incomes. If any amount equal to the society’s total income is spent on services and goods of a certain company, then the production value is realized in the realized sales. As a result, profits remain high, and business owners are willing to manufacture or produce similar amounts or more amounts of the product (Chapter 12. Keynesian economics and the Great Depression).

Keynes referred to such a trend as a circular flow because money flows from businesses to the society in the form of salaries, wages, rent, profits and interests, and the money then flows back to the companies when the society procures the merchandise and services created by the companies. However, this flow is never complete. When money moves from the companies to the society, some of it never goes back to the companies. Therefore, this circle has leakages. This is because not all people spend all of their money. They save certain percentage and, therefore, they withdraw it from the spending stream. Another group of people who take loans from banks because they spend more money than their income also offsets this saving. Keynes, however, argued that at the peak of success savings are usually more than what customers borrow; therefore, there is usually a net leakage or a net saving from the circulating flow of expenditure and income (Chapter 12. Keynesian economics and the Great Depression).

Keynes also pointed out other kinds of leakages. Firstly, individuals buy services and goods from foreign businesses, but the capital they spent on importing these goods and services cannot be spent on products that are produced domestically. Secondly, the taxes individuals pay are also not included in the income, expenditure flow. Leakages that result from imports, saving and taxes can be offset by exports. This happens when foreigners purchase goods produced in the US in levels or amounts similar to the imports bought by US citizens. The government makes use of taxes to finance the buying of services and goods. If it makes use of all taxes for the same reason and balances the budget, then the expenditures of the state will offset taxes in the spending flow. On the other hand, if business people want to expand their capital, they have the option to finance investment on capital goods through taking loans from funds saved at the bank. Investment, thus, may in a way offset the leakage in savings (Chapter 12. Keynesian economics and the Great Depression).

If these three are injected into the flow of income and expenditure then they are just as significant as the three leakages in the savings, and spending becomes equal to the production value. Everything that businesses produce has the potential to be sold and success reigns.

The economist, however, held the belief that it was unlikely that the process could go on without interruptions for a long period. Investment, which is needed to absorb savings enlarges the stock of capital and, therefore, increases the productive capacity of an economy. Income and production must, therefore, increase in the following period to make use of the new capacity of production fully. However, with increase income increases in savings occurs, which calls for increases in investment, and according to Keynes, this investment is never forthcoming. He saw that people with higher incomes saved more percentages of their income as compared to those individuals with lower incomes. He held that this pattern is true for the whole society, as the society’s aggregate income increase, total society’s savings increase (Chapter 12. Keynesian economics and the Great Depression).

This is to mean that, at each new higher income level, an even larger level of income is kept away as savings. Therefore, investment would have to increase at a higher rate than income if it would successfully offset savings constantly. Only such a quick increase would allow businesses to sell all of their products, but as investments grows quicker, the quicker is the increase in the capacity to produce. As a result, the economy has to invest in even larger amounts in each successive time if it is to maintain the balance. Keynes, however, pointed out that in any mature economy generated by the private enterprise the number of investments profitable enough are limited, thus, as the process of growth of the economy continues, so does the difficulty of finding enough outlets of investment. If it becomes difficult to find sufficient outlets for investment, then investment falls short of total and saving expenditures of products fall short of the product value of the produced goods. If a business is unable to sell all of its produced goods then it reduces the level of production for the next period. This in turn results to decline in income, decrease in employment and reduction, in production (Chapter 12. Keynesian economics and the Great Depression).

With the decline in incomes, however, more consumers spend less on products in the following period. This leads to further cuts in the levels of production and the downward trend continues. Under such circumstances, incentives to expand a business’s capital are low, and investment reduces. All types of expenditures decrease. Savings, as well, decline with decreases in income. This process goes on until the time when income reduces so much such that there is no longer surpasses the decreased investment level. Equilibrium is realized at such low levels of income. Leakages from the flow of expenditure and income are equal once more to the injections into the flow. The economy becomes stable but at a level where significant unused capacity of production and unemployment exists (Chapter 12. Keynesian economics and the Great Depression).

The application of the Keynesian economic policies has a number of limitations according to several of his critics. One such criticism that pointed out the limitations of the Keynesian policies is the neoclassical macroeconomists who in the 1950s started to disagree with the policies and methodologies Keynesian employed. Keynesian and his successors focused on the dependence of consumption of income that is disposable, and of investment on current cash flows and current profits. Furthermore, the Keynesians posited a curve that connected the nominal inflation of wages to rates of unemployment. To support his theories, Keynesians and his successors traced to the logical basis of their model and supported their theories with statistical data for evidence. Neoclassical macroeconomists demanded that macroeconomics be based on similar foundations as theories of microeconomic theories, rational, profit- maximizing companies and utility- maximizing customers (Akerlof, 2007).

An Australian economist who pointed out that the Keynesian economic policies exhibited and made use of a collectivist approach pointed out another limitation of the applicability of the economic policies of Keynes. The economist argued that such theories or approaches encourage planning that is centralized which in turn leads to capital malinvestment, which is the predominant cause of cycles in business. The critic also argued that the studies by Keynes of aggregate relations in an economy are not applicable, as recessions are, as a result, of micro- economic factors. He pointed out that what begins as a temporary fix by the government usually grows to become expanding and permanent programs of the government, which limits or eliminates the civil society and the private sector all together (Hayek, 1989).

References

Akerlof, G. A. (2007). The Missing Motivation in Macroeconomics. American Economic Review 97, 5–36. 

Chapter 12. Keynesian economics and the Great Depression. Retrieved from http://www.public.coe.edu/~eichhorn/Pmac/HuntCh12.pdf

Hayek, F. (1989). The Collected Works of F.A. Hayek. University of Chicago Press.

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