Keynesian Theory

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Economics Assignment

The Great Depression in the early 1920s hits Britain and left economists to plan for a solution. According to John Maynard Keynes, a British economist whose life was experienced in this long and deep recession, an economy in recession when there is an insufficient level of aggregate demand, in other word, lack of spending. At this level, full employment cannot be maintain because there is no point for business to keep investing on employees and other factor of production to maximise production if goods cannot all be sold due to lack of demand. Because of low production, sales will be low and therefore wages will be low. Lower wages means lower income. There will be a multiply downward effect on national income. As a result, households will then spend less on domestic goods ands services that the economy is capable of producing. The economy will slide into a lower position at a lower level of activity and will just stay there. Unless something turns up, which Keynes suggested that it should be the government intervene actively to move the whole economy back into the position where it has started.

The idea of a normal economy is where it achieves full employment. At this level, national output is maximised to its capacity. So it is when the rate growth in actual output exceeds the rate of growth in the economy’s capacity to produce; in other words, actual growth has to exceed potential growth. This is not always the case, as actual growth will tend to fluctuate in the short run. The output gap between actual output and potential output must be closed because the wider the gap, the more spare capacity and employments are available. Economy does not use all of it resources and therefore, inefficiency.

It is believed that mass unemployment cause the problem in the economy and solving this problem will bring the whole economy out of recession. “The classical school’s view was that mass unemployment was a sign that wages in labour market were too high” (Atkinson. J, slide.4). A rational solution is a fall in real wages rate and all these employees available will go. However, according to Keynes, wages were rigid. Usually wages rate is set for the whole year or two. It won’t change immediately when there is a change in aggregate demand. In facts, a fall in wages rate will lower workers morale if they willing to accept wage cuts. Productivity will fall as a result. On the other hand, workers would likely to resist accepting wage cuts and possibly unions might involve. In the end of the day, firm would likely to sack workers (or cut jobs) so they don’t waste the payroll. This even leads to further unemployment. As a result, “ wages would not fall and the labour market would not clear quickly” (Atkinson. J, slide.5).

In a recession, households usually start to lose confidence and feel uncertain about the future of the economy so they tend to put most of their incomes into savings and try to get some security from it rather than spend it. This effect will create a disequilibrium state in the economy as withdrawals (W) are higher than injection (J). Classical economists encourage this because of savings’ effect on loanable funds. More saving means rate of interest will fall and there will be a greater fund of money for business to borrow for investment. This would get the economy growing again. However, Keynes rejected this idea. He regards saving as just non-consumptions. If households start saving more money (mostly incomes), the less money they can save later on as it just drag down aggregate spending. A decrease in aggregate spending will have a multiplied effect onto national income. With less to invest, firms would sell fewer goods and so less wages would be paid. Less income means fewer saving. In other words, the more people save, the less aggregate savings will be because national income fall. Saving really do more harm than good as it just makes the economy worse....
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