Keynesian Economics- Macro Economics IGCSE

Keynesian Economics

Introduction

An understanding of Keynesian themes can be helpful in evaluating macro policies and the search for macroeconomic stability in terms of prices, jobs, incomes and profits for both developed and developing countries.

• Keynesian economics focuses on psychology, uncertainty and expectations in driving macroeconomic decisions and behaviour. As we shall see, in Keynesian economics, the state of animal spirits is vital.

Keynesian economists and free markets

• Keynesian economists believe that free markets are volatile and not always self correcting.
• The free-market system is naturally prone to periods of recession & depression
• The volatility of aggregate demand (AD = C+I+G+X-M) can be explained by important changes in consumer and business sentiment – also known as animal spirits.
• In a world of economic stagnation and/or depression, the standard rules of economics may no longer apply and direct intervention in the economic may be essential
• Free markets are not always self-correcting:
• When a recession or a depression occurs, the free market economic system is not necessarily self-correcting – indeed en-masse, individuals can become trapped in a deflationary depression which is in no one’s interest but which, left on our own, no one can counter-act.
• Persistent deflation can be as costly as high inflation – it can be damaging especially in economies where there are huge levels of private & public sector debt
• You cannot always rely on new inventions / innovations and other natural economic stabilisers to drag an economy out of a recession (they do happen though – as the Austrian school believes)

Keynes on under-employment equilibrium
One of Keynes’s revolutionary propositions was that following a big economic shock - usually a collapse in investment - there were no automatic recovery forces in a market economy. The economy would go on shrinking until it reached some sort of stability at a low level. Keynes called this position "under-employment equilibrium"

Professor Robert Skidelsky, Biographer of Keynes

Savings and aggregate demand

• The paradox of thrift helps to explain why a rise in precautionary saving (i.e. people looking for security) can lead to a fall in demand and incomes and a reduction in output, income and wealth.
• In other words – negative multiplier and accelerator effects can drag production and employment in the economy to a low level where it can remain for some time unless there is some external stimulusto lift demand and output again
• On an international level, when the global desire to save exceeds the global willingness to invest the result is a contraction in world demand and production, a fall in incomes and employment, which eventually brings savings back into balance with investment

The risks of a deflationary depression

Recession (and worse – a deep depression) represents a pure waste of scarce economic resources. Unemployed workers want to work, and businesses want to use their productive capacity to supply goods and services. If they did, then the things they produced would be available for all to buy, and the incomes they received would enable them to purchase the products of others. Incomes from higher wages and stronger profits would be made feeding through the circular flow in the standard macro model.
But in a recession a country can experience a persistent state where output is well below a country’s capacity to produce. The key is to take measures to lift AD and bring about an expansion along the short-run aggregate supply curve.

The Liquidity Trap

• In normal circumstances it is possible to boost demand by cutting interest rates. But there is a level below which interest rates cannot go (they have been at 0.5% in the UK since the spring of 2009 and at low levels in other countries) and at that point monetary policy may become powerless.
• Moreover, even if interest rates can be lowered this may have no effect if people cannot or will not borrow. This is known as the liquidity trap.
• At this point, aggregate demand can only be boosted by the Government borrowing more, either to spend directly or to give to others via tax cuts or the like.
• In other words, we need a targeted Keynesian fiscal stimulus. Keynesians believe that the size of thefiscal multiplier effect is higher for government spending than for tax cuts.
• The aim is simple – when private sector demand for goods and services is low, the government needs to find a compensating source of demand to rebalance the economy – and the solution comes from the government in the form of higher borrowing or less saving.

Animal spirits

• John Maynard Keynes coined the notion of animal spirits which refers to the driving force that gets people going in the economy
• Animal spirits helps to explain why countries fall into a recession but also what eventually brings about a recovery. It refers to a broad mix of confidence, trust, mood and expectations and animal spirits can fluctuate very quickly as populations of people change their thinking. This focus on animal spirits helps to explain why psychology can be so important in macroeconomics.
• When animal spirits are poor then there is a risk of a slowdown or a recession. Individuals save more, businesses save more too and, because demand and profits are lower than expected, they may opt to cut back on production and perhaps postpone or cancel capital investment projects.
• Higher saving and reduced investment both have the effect of reducing demand and incomes in the circular flow causing an economic contraction.

Keynesian economics and fiscal deficits

Keynesian economists are usually supportive of the state borrowing more money during times of weakness.

1. Government borrowing can benefit growth: A budget deficit can have positive effects if it is used to finance capital spending that leads to an increase in the stock of national assets. For example, spending on transport infrastructure improves the supply-side capacity of the economy. And increased investment in health and education can boost productivity and employment.
2. Demand management: Keynesian economists support the use of changing the level of government borrowing as a legitimate instrument of managing aggregate demand. An increase in borrowing can be a useful stimulus to demand when other sectors of the economy are suffering from weak or falling spending. If crowding out is not a major problem - fiscal policy can play an important counter-cyclical role “leaning against the wind” of the economic cycle
3. Low interest rates – it makes sense for the state to borrow when interest rates are low and inject extra demand into the economy, especially when private sector demand (C+I+X) is low

Naturally there are counter-arguments to this:

1. Financing a deficit: A budget deficit has to be financed through the issue of debt. If the budget deficit rises to a high level, in the medium term the government may have to offer higher interest rates to attract sufficient buyers of debt. This raises the possibility of the government falling into adebt trap where it must borrow more simply to repay the interest on accumulated borrowing.
2. A government debt mountain: As state debt rises, there is an opportunity cost involved because interest payments on bonds might be used in more productive ways, for example on health services or extra investment in education. Higher public sector debt also represents a transfer of income from people and businesses that pay taxes to those who hold government debt and cause a redistribution of income and wealth in the economy.
3. Crowding-out - the need for higher interest rates and higher taxes. If a larger budget deficit leads to higher interest rates and taxation in the medium term and thereby has a negative effect on growth in consumption and investment spending, then ‘fiscal crowding-out’ is said to be occurring.
4. Risk of capital flight: High levels of state borrowing and debt risk causing a ‘run on a currency’. This is because the government may find it difficult to find sufficient buyers of debt and the credit-rating agencies may decide to reduce the rating on sovereign debt. Foreign investors may choose to send their money overseas perhaps causing a currency crisis

Government Macro Economic policies

Macroeconomic Policy - Overview

Introduction

Targets, instruments and goals of macroeconomic policy

The policy goals of macroeconomic policy vary from country to country and according to the political priorities of different governments

In the UK in recent years the main focus of macro policy has been maintaining price stability and also in improving competitiveness and promoting sustained and sustainable economic growth.

The degree of freedom (or autonomy) that policy makers have depends on the economic circumstances of the time and also the extent to which a country is locked into a set of institutions. For example the UK remains outside of the single European currency (the euro).

Macroeconomic performance covers a wide range of indicators – summarised as:

• Economic growth (short term and long term)
• Jobs (unemployment and employment)
• Prices
• Trade
• Productivity
• Average standard of living
• The distribution of income and wealth
• Quality of and financing of public services

The macroeconomic performance of any one nation is affected by events, policies and shocks in othercountries. No economy is immune to what is happening in the global financial and economic system.

Conflicts between Macro Objectives

Managing the Economy – Conflicts between Macro Objectives

Introduction

The current macroeconomic policy framework

Here is a brief overview of the current framework for macroeconomic policy in the UK:

• Monetary policy: The Bank of England retains control over monetary policy and sets policy interest rates on a monthly basis. Since the spring of 2009 the Bank has also used ‘unconventional’ monetary policy in the form of quantitative easing (QE).
• Fiscal policy: The government is in charge of fiscal policy. During the recession the government opted to use changes in spending and taxation to cushion the economy from the effects of the downturn. But the Coalition Government which took power in May 2010 have opted to tighten fiscal policy through cuts in government spending and higher taxes and have an aim of halving the size of the budget deficit over the next four years
• Exchange rates: The UK operates with a floating exchange rate and the Bank of England has not intervened in the currency markets to manipulate the value of sterling against other currencies. This means that the exchange rate is determined by the market forces of supply and demand.

Possible conflicts between macro objectives

• It is rare for a country to achieve all of its main objectives at the same time
• Frequently conflicts appear between the different aims and as a result, choices might have to be made about which objectives are to be given greatest priority.
• This will vary from one country to another since the needs of different nations will differ according to their stage of economic development.

Here are some possible policy conflicts:

• Inflation and unemployment: Falling unemployment might create demand-pull and cost-push inflationary pressures leading to a fall in the value of money
• Economic growth and environmental sustainability: Rapid economic growth and development frequently puts extra pressure on scarce environmental resources threatening the sustainability of living standards in the future
• Economic growth and inflation – an overheating economy may suffer accelerating inflation which then has negative effects on trade performance, business profits and jobs
• Economic growth and the balance of payments: Strong GDP growth fuelled by high levels of consumer demand for goods and services might lead to a worsening of the trade balance. This is particularly true when an economy has a high marginal propensity to import.

Unemployment and inflation – the Phillips Curve concept

Unemployment and inflation rates for the UK – inflation measured by the CPI

In 1958 AW Phillips plotted 95 years of data of UK wage inflation against unemployment

It suggested a short-run trade-off between unemployment and inflation

Falling unemployment might cause rising inflation and a fall in inflation might only be possible by allowing unemployment to rise

If a Government wanted to reduce the unemployment rate, it could increase aggregate demand but, although this might temporarily increase employment, it could also have inflationary implications in labour and the product markets.

The key to understanding this trade-off is to consider the possible inflationary effects in both labour and product markets from an increase in national income, output and employment.

• The labour market: As unemployment falls, labour shortages may occur where skilled labour is in short supply. This puts pressure on wages to increase and prices may rise as businesses pass on these costs to their customers.
• Other factor markets: Cost-push inflation can also come from rising demand for commodities such as oil, copper and processed manufactured goods such as steel, concrete and glass. When an economy is booming, so does the derived demand for components and raw materials.

Product markets: Rising demand can lead to suppliers raising prices to increase their profit margins. The risk of rising prices is greatest when demand is out-stripping supply-capacity leading to excess demand (i.e. a positive output gap.)

In the late 1980s the UK overheated and suffered a rise in inflation. Unemployment was falling (the economy was moving up a short run Phillips Curve) but the loss of control over inflation caused 15% interest rates and led to a painful recession that caused unemployment to rise to nearly 10 per cent. Higher unemployment helped to bring inflation down once more but the cost was heavy.

The period from 1993 through to 2005 was a remarkable one for the UK. We saw a sustained decrease in the unemployment rate, yet consumer price inflation remained low and fairly stable. Indeed in the mid 1990s both unemployment and inflation were on a falling trend and this was evidence of an improvement in the inflation-unemployment trade-off.

From 2006 onwards the picture began to change once more. Inflation edged higher from below the 2% target to 3% in the spring of 2007. Unemployment leveled off with the claimant count measure flat lining at 3% of the labour force. But in 2008 there was a sharp pick-up in inflation with prices driven higher by a combination of higher fuel and food costs. The rate of inflation peaked at 5.2% in October 2008 just at the time when unemployment started rising again with the economy slowing down and then entering recession.

In 2008 the big danger was thought to be a return to stagflation – a combination of weak growth, high inflation and rising unemployment. In the event the inflationary dangers ebbed away in 2009 as recession started to bite and global commodity prices fell back down. Indeed with unemployment rising sharply and inflation falling, the policy risk has switched to the dangers of a deflationary recession – a combination of high unemployment and a falling price level.

In 2010-11 fears of deflation has ebbed away, indeed consumer price inflation has climbed once more above target. It was only during 2012 that the rate of inflation has fallen back towards the 2% CPI inflation target.

The possible conflict between unemployment and inflation can be moderated if:

• The economy achieves higher labour productivity – this raises efficiency, reduces the unit costs of production and also leads to higher real wages which boosts consumer demand
• Innovation allows businesses to produce new products at cheaper costs
• Expectations of inflation remain stable – a credible inflation target can help here
• The economy is sufficiently flexible to weather external demand and supply-side shocks such as unexpectedly volatility in the prices of raw materials and components.

Economic growth and the balance of payments

A period of fast growth may come into conflict with the balance of payments. Much depends on the income elasticity of demand for traded goods and services. In the case the UK, the evidence is that consumers have a high propensity to consume imports; the income elasticity of demand is strongly positive. Say for example, real disposable incomes grow by 3% and that the income elasticity for imports = +2.5. That would lead to a 7% rise in the volume of imports. Unless there is a corresponding rise in exports, we expect to see a worsening of the balance of trade (i.e. a widening trade deficit).

In a recession, this effect works in reverse as demand for imported products including raw materials, components and ready to consume goods and services declines. The trade balance will improve although the root cause is a drop in economic activity.

Economic Growth and Inflation

Most governments hope that they can achieve steady economic growth without it causing acceleration in demand-pull and / or cost-push inflationary pressures. The dangers of a booming economy is that inflationary pressures build and that the economy must slow down or fall into recession for these inflation risks to be controlled.

Economic growth and inflation for the UK economy

• During the early part of the last decade, the British economy enjoyed a period of steady growth and relatively low and stable inflation
• In 2007-08 the trade-off between growth and inflation worsened
• Inflation surged higher – mainly because of external factors such as high food and oil prices
• The economy suffered a steep descent into recession following the global financial crisis
• In early 2009 the economy experienced recession and higher inflation – some economists warned of a lengthy phase of “stagflation” conditions
• Inflation fell back largely because of the recession. But in 2010 and into 2011, inflation has been rising again whilst GDP growth has been weak with the risk of a second downturn (a “double-dip”)

Stagflation

Stagflation is a period of economic stagnation accompanied by rising inflation. In other words, both of these key macro objectives are worsening. It can happen when an economy goes into a downturn or a recession but when other external forces are bringing out higher inflation. The obvious example of this is when recession is afflicting a country but the prices of imported products are surging causing prices to rise and real incomes and profits to fall.  The rise in the cost of imports can be shown by an inward shift in the short run aggregate supply curve leading to a contraction in real national output and an increase in prices.

One of the dangers of stagflation is that the fall in real incomes causes consumer and investment spending to fall and thus the rate of economic growth suffers too (a deterioration in a third objective of policy). Wage demand may also pick up as people experience rising prices. The central bank needs to consider appropriate policy responses to this. Too severe a tightening of monetary policy for example will help to curb inflation but risk causing a deep recession.  The combination of deflation and a sustained drop in economic output is termed an economic depression

An improvement in aggregate supply can help to resolve the growth – inflation trade off. We see in the diagram how aggregate supply has moved outwards and this allows aggregate demand (C+I+G+X-M) to operate at a higher level without threatening a persistent increase in the general price level (inflation).

Overcoming a conflict between economic growth and inflation – increases in AD and AS

Conflicts between objectives – the economics of deflation

Deflation is a sustained fall in the prices of goods and services, and thus the opposite of inflation. Increased attention has focused on the impact of price deflation in several countries in recent years – notably in Japan (inflation -0.3% in 2010) and in some Euro Area countries such as Ireland Greece where prices have been falling, national output has dropped and unemployment has been rising.

It is normally associated with falling level of AD leading to a negative output gap where actual GDP < potential GDP. But deflation can be caused by rising productive potential, which leads to an excess of aggregate supply over demand.

Greece has suffered from a severe rise in unemployment (right hand scale) and is now seeing her relative living standards fall. A deflationary depression is a risk for Greece

Possible damaging consequences of persistent price deflation

• Holding back on spending: Consumers may postpone demand if they expect prices to fall further in the future.
• Debts increase: The real value of debt rises when the general price level is falling and a higher real debt mountain can be a drag on consumer confidence and people’s willingness to spend. This is especially the case with mortgage debts and other big loans.
• The real cost of borrowing increases: Real interest rates will rise if nominal rates of interest do not fall in line with prices. If inflation is negative, the real cost of borrowing increases and this can have a negative effect on investment spending by businesses
• Lower profit margins: Lower prices hit revenues and profits for businesses - this can lead to higher unemployment as firms seek to reduce their costs by shedding labour.
• Confidence and saving: Falling asset prices including a drop in property values hits wealth and confidence – leading to declines in AD and the threat of a deeper recession.

Resolving the threat of price deflation

• Using expansionary Monetary Policy
• Interest rates: Deep cuts in interest rates can be made to stimulate the demand for money and thereby boost consumption
• Quantitative Easing – printing money in the hope that, by injecting it into the economy, people and companies will be more likely to spend.
• Using expansionary Fiscal policy
• Keynesian economists believe that fiscal policy is a more effective instrument of policy when an economy is stuck in a deflationary recession and a liquidity trap
• The key Keynesian insight is that a market system does not have powerful self-adjustments back to full-employment after there has been a negative economic shock. Keynes talked of persistent under-employment equilibrium – an economy operating in semi-permanent recession leading a persistent gap between actual demand and the potential level of GDP.

Keynes argued that this justified an exogenous injection of aggregate demand as a stimulus to get an economy on the path back to full(er) employment and to prevent deflation

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Factor Immobility

Introduction

One cause of market failure is the immobility of factors of production. There are two main types of factor immobility, occupational and geographical immobility.

Occupational Immobility

Occupational immobility occurs when there are barriers to the mobility of factors of production between different sectors of the economy which leads to these factors remaining unemployed, or being used in ways that are not efficient.

Some capital inputs are occupationally mobile – a computer can be put to use in many different industries. And commercial buildings such as shops and offices can be altered to provide a base for many businesses. However some units of capital are specific to the industry they have been designed for – a printing press or a nuclear power station for example!

People often experience occupational immobility. For example, workers made redundant in the steel industry or in heavy engineering may find it difficult to find a new job. They may have specific skills that are not necessarily needed in growing industries which causes a mismatch between the skills on offer from the unemployed and those required by employers looking for workers. This problem is called structural unemployment. Clearly this leads to a waste of scarce resources and represents market failure.

Geographical Immobility

Geographical immobility refers to barriers people moving from one area to another to find work. There are good reasons why geographical immobility might exist:

• Family and social ties.
• The financial costs involved in moving home including the costs of selling a house and removal expenses.
• Huge regional variations in house prices leading to a shortage of affordable housing in many areas
• Differences in the general cost of living between regions and also between countries.

Policies to Improve the Mobility of Labour

To reduce occupational immobility:

• Invest in training schemes for the unemployed to boost their human capital to equip them with new skills and skills that can be transferred from one occupation to another.
• Subsidise the provision of vocational training by private sector firms to raise the skills level

To reduce geographical immobility:

• Reforms to the housing market designed to improve the supply and reduce the cost of rented properties and to increase the supply of affordable properties.
• Encourage part-ownership / part-rented housing
• Specific subsidies for people moving into areas where there are shortages of labour – for example teachers and workers in the National Health Services.

Kerala tourist spots

Drinking Beer and Playing Billiards Helps in Healthy Aging, Say Researchers

• nkedin  

If you think drinking beer is not a healthy habit, think again. Researchers have come up with some conclusions, which may change your mind.

Researchers Reveals that beer along with billiards helps for healthy aging [Representational Image]Reuters/ Lucas Barth

A recent study conducted by Aske Juul Lassen from the University of Copenhagen's Centre of Healthy Aging reveals that drinking beer and playing Billiards helps in aging well and is something that keeps people above the age of 70 active.

Lassen conducted field work on activity centres for the elderly in Copenhagen, Denmark, and found that one in 15 men between the ages of 70 and 95 meet to play billiards four times a week.

"Playing billiards often comes with a certain life style – drinking beer and drams for instance – and I am quite sure this was not what WHO and EU meant when they formulated their active ageing policies. But billiards does constitute active ageing. Billiards is, first of all, an activity that these men thoroughly enjoy and that enhances their quality of life while immersing them in their local community and keeping them socially active," said Lassen

Billiards is suited for active ageing, Aske Juul Lassen's reseaerch shows.Reuters/Kim Kyung Hoon

He also added that Billiards is a very suitable exercise for old people as the game varies naturally between the periods of activity and passivity, which in turn makes the men play the game for hours.

Lassen, who studied the European Union's and WHO's perceptions on aging, also said that there are lot of things which are not categorised as "healthy" by health authorities, but in fact helps the elderly enhance the quality of life.

"We therefore need a broader, more inclusive concept of healthy and active ageing that allows for the communities the elderly already take part in and that positively impact their everyday lives, quality of life, and general health. It must also allow for the fact that the elderly do not constitute a homogenous group of people: activities that for some seem insurmountable will be completely natural for others", added Lassen

He also said that senior citizens do not continuously focus on their ailments when they are engaged in something else

Maharashtra Assembly polls

Maharashtra Assembly Polls: Bookies Predict BJP's Victory by 110-115 Seats

By Neha Singh October 8, 2014 15:49 IST
•      

Ahead of the assembly elections, Maharashtra bookies, who rightly predicted a single-party majority for BJP in the Lok Sabha elections in May, believe the 15 October poll results in the state will favour the Saffron party once again.

A supporter of Bharatiya Janata Party (BJP) holds a cut-out of louts, the election symbol of BJP. [Representational Image] Reuters File

If the prediction is anything to go by, Prime Minister Narendra Modi's convincing speeches at campaign rallies in several districts of Maharashtra and his magnificent fan-following that has only increased over time, will reward him with a massive victory of 110-115 seats out of total 228 assembly seats, The Economic Times reported.

This will be a major blow to the Congress that has ruled the land of one of the greatest warriors, Chatrapati Shivaji, for long. It won 10 out of 12 assembly elections that took place since 1960. This time, however, Congress may have to bow out with only 40 to 50 seats, predictions claim.

While others—NCP and Shiv Sena that recently severed its 25-year long alliance with BJP—too will not get more than 40-45 seats in Maharashtra assembly. However, the bookies believe Shiv Sena may go back with BJP post elections, which the latter is likely to deny if it wins majority seats, i.e. over 145.

The bookies, however, do not feel BJP will bag more than 145 seats this assembly elections as the campaigning began late.

But since Modi has now taken task of campaigning in his own hands and has been conducting rallies across the state, there are chances that BJP may get lucky after the debacle in Bihar, Rajasthan and Uttar Pradesh bypolls last month.

With just one day at campaign rallies in Maharashtra and 15 more rallies to come, it is not clear now whether PM will be successful in retaining the slowly vanishing "Modi wave". That we will know on 19 October, when the votes are counted.