Question

4. How did John Maynard Keynes criticize the free market economy? What does he claim is necessary to maximize the social utility of the economic system? Why does stagflation present an obstacle to his theory?

Answer 1

According to Keynes Government intervention in the economy is necessary instrument for maximizing society's utility.Keynesian Economics is a form of demand-side economics that encourages government action to increase and decrease demand and output. It is based on the idea that government spending and tax cuts help an economy by raising demand.

Keynes was critical of laissez-faire with regard to boom and bust cycles.Keynes advocated that the best way to pull an economy out of a recession is for the government to borrow money and increase demand by infusing the economy with capital to spend. This means that Keynesian economics is a sharp contrast to laissez-faire in that it believes in government intervention

Government can influence the society by:

i.Influencing interest rates by regulating the money supply

When the Fed decreases the money supply, households and firms will initially hold less money than they want, relative to other financial assets. Households and firms will sell Treasury bills and other financial assets and withdraw money from interest-paying bank accounts. These actions will increase interest rates.

When the Fed increases the money supply, households and firms will initially hold more money than they want, relative to other financial assets. Households and firms use the money they don't want to hold to buy Treasury bills and make deposits in interest-paying bank accounts. This increase in demand allows banks and sellers of Treasury bills and similar securities to offer lower interest rates. Eventually, interest rates will fall enough that households and firms will be willing to hold the additional money the Fed has created.

Fiscal Policy is the federal government efforts to keep the economy stable by increasing or decreasing taxes or government spending.

ii Expansionary Fiscal Policy

It involves an increase in government purchases of goods and services, a decrease in net taxes, or some combination of the two for the purpose of increasing aggregate demand and expanding real output.

iii.Contractionary Fiscal Policy

This Fiscal policy used to decrease aggregate demand or supply. Deliberate measures to decrease government expenditures, increase taxes, or both. Appropriate during periods of inflation.

Stagflation represent an obstacle to this theory because not only does increasing government spending not cure unemployment, it also causes inflation. During stagflation economic stagnation and high inflation occur together; prices increase and output decreases; renders most policy tools impotent since policies used to fight inflation may cause stagnation or decline and vice versa.Increased government spending is likely to cause a rise in aggregate demand. This can lead to higher growth in the short-term. It can also potentially lead to inflation.