ECO 368M - Keynes

two assumptions behind classical view: economics return to full employment without government intervention

1. flexible wages and prices would automatically bring economics back to equilibrium in the long run

2. assuming savings would automatically become investment, supporting demand for output and employment

two reasons Keynes rejected reliance on the “automatic” adjustment process during the Great Depression

1. adjustment was slow, so waiting for long-run recovery left people unemployed for long periods of time

2. weak consumption and investment with cash hoarding could leave the economy below full employment

two components of private demand and how each affects output and employment

1. household consumption: weaker spending reduces demand, so firms reduce output and employment

2. firm investment: lower spending on equipment and other assets reduces demand and can trigger a decline in output and employment

two ways consumption and investment affect the maintenance of full employment

1. as income rises, consumption rises by less because some additional income is saved

2. investment needs to fill gap between consumption and production if demand is to sustain full employment as savings don’t automatically become invested

two reasons Keynes supported gov. borrowing during downturns

1. spending can replace deficient private demand and move output and employment towards their potential

2. when the economy is below potential, borrowing to spend isn’t inflationary because there is room to increase output

two policies Keynes recommended to boost demand

1. public works to create jobs and deficit spending to raise demand

2. tax cuts to increase disposable income and encourage consumption

1) define animal spirits and 2) explain how they influence investment

1. the spontaneous impulses and confidence that prompt action under uncertainty, rather than on calculations and probabilities

2. greater optimism can encourage investment, loss of confidence can discourage investment

define a gov. budget deficit and a gov. debt and explain how they differ

deficit: gov. spending exceeds revenue in a given year

debt: reflects accumulated deficits over time

differ: deficit is in a year and debt is accumulation over many years

1) define automatic stabilizer and 2) use unemployment benefits to explain how one works

1. changes gov. spending as economic conditions change without a new policy decision

2. during a downturn, people become eligible for unemployment benefits, increasing gov. spending and helping support incomes/demand

two ways Keynes’ ideas influenced thought/policy after the Second World War

1. Keynesian economics became a dominant framework for demand and employment until the 1970s

2. Paul Samuelson helped incorporate Keynesian ideas into neoclassical economics

1) define stagflation and 2) explain a reason the 1970s weakened confidence in Keynesian ideas

1. combines slow economic growth, high inflation, and high unemployment

2. oil price shocks drove up prices and attempts to spend were criticized for adding inflation

two developments after the GFC that renewed interest in Keynes’ ideas

1. slow recovery and weak demand revived debate on if govs. should spend rather than impose austerity

2. low borrowing costs and weak investment strengthened the case for govs. to borrow for infrastructure projects

two objections to gov. borrowing/fiscal stimulus

1. critics feared persistent deficits and rising debt would cause investors to demand higher returns, increasing gov. borrowing costs

2. crowding out of private investment: gov. borrowing may raise interest rates, making borrowing more expensive for private firms

two reasons why Keynes thought low interest rates alone might fail to restore investment during weak recovery

1. weak expected sales: firms have little incentive to expand when household and gov. spending remain weak

2. uncertainty about recovery: long recession makes firms hesitant to commit money to long-term projects

1) define paradox of thrift and 2) explain its effect on savings in two linked steps

1. when people try to save more, consumption falls, reducing demand and output

2. lower output/demand reduces incomes and the funds available to save, so aggregate saving can fall despite people trying to increase it

two responses to weak consumption/investment and how each could support demand

1. public investment: gov. borrowing for investment raises output and incomes, supporting consumption when private investment is insufficient

2. automatic stabilizers: payments rise during downturns without new policy decisions, helping support household incomes/spending

1) define austerity and 2) one reason European governments adopted it after the GFC

1. fiscal restraint aimed at reducing budget deficits and containing gov. debt

2. European govs. argued that fiscal discipline was needed to restore investor confidence and preserve access to borrowing

when should governments borrow to spend and when should they repay debt?

borrow: to spend during downturns when deficient demand leaves output and employment below their potential

repay: debt during good times or a boom, when the economy is stronger

define crowding out and crowding in

crowding out: gov. borrowing can raise interest rates and make private investment more expensive

crowding in: public investment, like better telecommunications, can increase the returns to private investment