Question

What macroeconomic policies would Keynes prescribe either to avoid or to ameliorate the boom and bust cycle? Explain.

Answer 1

Keynes considered savings to have an adverse economic effect, especially if the savings rate is high or excessive. Since consumption is a major factor in the aggregate demand model, when people put money into the bank instead of purchasing goods or services, GDP would decline. Therefore, a reduction in demand causes companies to produce less and require fewer employees, which raises unemployment. There is also less desire for businesses to invest in new factories.

In both real and nominal terms, salaries can be expressed. Real wages take the impact of inflation into account, but not nominal wages. Industries would have a hard time convincing workers to cut their nominal wage rates for Keynes, and it was only after other wages dropped across the economy, or the price of goods fell (deflation) that workers would be willing to accept lower wages. The actual inflation-adjusted wage rate would have to drop in order to increase employment levels. Nevertheless, this could lead to worsening recession, weakening consumer sentiment, and increasing aggregate demand.

It is important to understand that the government's role in the economy is not just to dampen the recessionary impact or bring a country out of depression; it must also keep the economy from heating up too quickly. Keynesian economics indicates that the relationship between the state and the economy as a whole is moving in the opposite direction to that of the business cycle: more upward investment, less upward spending. If an economic boom causes high inflation rates, the government could cut spending or raise taxes. This is called fiscal policy.

Keynes argued that insufficient overall demand would result in prolonged periods of high unemployment. The production of goods and services from an economy is the sum of four components: consumption, investment, government purchases, and net exports (the difference between what a country sells and buys from abroad). Any demand rise must come from one of these four components. Yet strong forces also dampen demand during a recession as spending drops. Uncertainty also erodes consumer confidence during economic downturns, for example, causing them to reduce their spending, especially on discretionary purchases such as a house or a car.

When companies respond to decreased demand for their products, this decline in consumer spending can result in lower investment spending by businesses. It positions the responsibility of growing the government's efficiency on the shoulders. State intervention is needed to stabilize the booms and bust in economic activity, also known as the business cycle, according to Keynesian economics.

Keynes believed that policymakers must address short-term issues instead of waiting for market forces to fix things in the long run because, as he said, "In the long run, we're all dead." That doesn't mean it Keynesians support changing strategies every few months to keep the economy at full employment. We strongly believe that governments are unable to learn enough to effectively fine-tune.