Question

As I lectured in class, J.M Keynes is credited with three major changes to the Classical model which among other things made the determination of real output and employment dependent on fiscal policy (G*,T*): (1) He introduced an liquidity motive for holding money; (2) he introduced wage/price stickiness; (3) he employed the consumption function in a new way. A. Explain how (1)-(3) led to the conclusion that fiscal policy could have an impact on real output and employment (which the Classical theory had said could not happen). B. In your opinion (that means there is not necessarily a “correct” answer), which would you argue is the most important “Keynesian” feature—i.e., (1), (2), or (3)—making real output and employment to depend on fiscal policies? Note: It is your reasoning, not your choice, that matters in part B.

Answer 1

A. Keynes argued that government intervention is important and that they should work for the stabilization of the economy in short run rather than wait for the market forces to fix the issue in the long run. Due to the Great Depression of the 1930s, Keynes argued that free economies are not able to stabilize or increase demand and employment in the economy. It is because of this reason he concluded that government intervention is important to stabilize the economy. Keynes model also includes multiplier effect which means output responds in a multiple way to the changes in spending. He said because wages and prices are sticky downwards and hence when recession takes place, unemployment can occur in the economy. When liquidity trap situation arises due to decline in economic activity and low investment by the public even when the interest rate is 0 or extremely low, monetary policy becomes ineffective in boosting demand in the economy. It is with the fiscal policy and government intervention of borrowing from surplus private sectors and investing in the economy which gives boost tot he demand and employment in the economy. This policy of government intervention also creates some inflation in the economy. Keynes consumption fiction was not based on an individual rather for the whole economy which depends on real income, past savings and rate of interest. Keynes believed in influencing aggregate demand in the economy and consumption function is one of the most important component of that.

B. The most important Keynesian feature which led output and employment to depend on fiscal policy is liquidity preference theory which states that consumers hold money for three purpose: transactional, precautionary and speculative. During economic downturn when interest rate is almost 0 or very low, people don't feel like spending or buying assets in the economy. This further reduces activities in the economy. The saving held by the public or the private players can only be utilised by increased government borrowing which makes monetary policy ineffective and fiscal policy taking control to maintain outpt and employment in the economy.