Abstract
Financial depression is not a new thing to the economy. The economy around the world has faced it previously and on many occasions. Depression brings the whole market to a standstill, increasing unemployment, money value comes crashing down, business becomes dull, business contracts takes a set back and in the household the money that is saved regularly decreases, as prices increases. Keynes a British economist came up with a theory called the Keynes income expenditure theory. In this theory the economist says that the government should involve itself in and begin to spend money in the market so that this spending can cause demand to rise. Keynes theory was not looked upon at that time, but later on after the II world war things changed and Keynes theory became the centerpiece of all economic theories.
Introduction
Keynes income expenditure can fine tune the macroeconomics like the engine of a car; this is a statement, regarding Keynesian views on economics, is this possible or not. We will make a study on this statement in this research. Schumpeter (1939) points out that financial crisis are not a new happening for the economy, such crisis happens now and then. John Maynard Keynes a British economist had influenced the world of economy just as Isaac Newton did in science. Keynes stated that it is demand that determines the GDP; he states that the great depression was prolonged, because demand dropped short of productive capacity. Hence the remedy is that demand should be stimulated. Today every economist believes in this view point. According to Keynes government spending would help the economy during depression, because taxation and spending by the government would help demand increase. Romer (2006, P.174) States that as the employment and aggregate keep falling and unemployment rises and at times it is the opposite understanding these aggregated fluctuation is the main macroeconomic goal.
Great Depression
During the 1930s the economy was in deep crisis, which had been a prolonged crisis is what is called the Great Depression. John Maynard Keynes stated that the government should get involved in such situations by cutting down taxes and increasing spending so that the economies can be boosted. This view of his was counted to be heretical as the prevailing view of that those days was that market economy recovers by itself, automatically, and the government's involvement was not acceptable. Keynes pointed out that the economy and employment would struggle with the lack of adequate demand. Keynes pointed out that the monetary policy lacked the power to help the economy since the monetary policy considered reducing interest rates, whereas during depression the interest rates are already near the zero mark. But if the government increases its spending then the demand would be boosted directly and a set of chain reaction would take place with demand from suppliers and workers increasing as their income would be increased with the government's spending. And likewise a cut in the taxes would save some income of the consumers boosting the demand further. Keynes further supported the fiscal policy of running budget deficits when unemployment was high, such views were hard for the conventional wisdom as budget deficits were counted to be bad at all times. The ideas of Keynes were ignored by both the U.S and Britain who tried to put their budgets right until World War II broke out. After the war ended, Keynes views were highly regarded. Keynes fiscal policy turned to be the prime policy of macroeconomics in national policy, public debate and in academic research. Keynes concentrated most on the causes of the great depression. Even today the 1920s breakdown is debated. Many economist states that there was surely not one reason for the great depression, there were many combined worldwide domestic factor that caused the economic dip leading to depression. That's why the causes cannot be exactly defined (1997).
THE KEYNESIAN THEORY OF INCOME AND EMPLOYMENT
The "General theory of Employment" a book published by John Maynard Keynes in the year of 1936, in this book Keynes criticized Say's law as he puts forth his argument that employment and national output is determined by aggregate demand, he states that supply is created by demand. According to Keynes wages and prices are rigid; especially when the economy is downward. This is contrary to the classical economists. Keynes states that economy is not a mechanism that can be self-corrected. According to him since wages and prices are rigid, it is possible that the economy remains at below-full-employment equilibrium. For example if the economy is full-employment equilibrium and the aggregate demand dips, then the national output should come down below the level of full employment leading to unemployment as the downward pressure on wages will increase. And in Keynes view wages will not fall because they are rigid. Hence output from firms will be stopped and so the national output will remain at the level of below-full-employment. Keynes states that during the Great Depression the high and prolonged unemployment was due to downwards rigidity of wages and aggregate demand deficiency (Edmund Quek, 2011).
Behavior of components of GDP during recession
Components of GDP
Average Share of GDP (%)
Average share in fall in GDP in recession relative to normal growth (%)
Consumption
durables
8,5
15.1
Non durables
25,4
10,3
Services
30,4
9,5
INVESTMENT
Residential
4,8
10,7
Non residential
10,6
20,3
inventories
0,6
41,8
NET EXPORT
-0,6
-11,4
GOVERNMENT
PURCHASES
20,3
3,8
Source: D. Romer, Advanced Macroeconomics, 2006, p. 176.
Variable
Average change during recession
REAL GDP (%)
-3,9
EMPLOYMENT (%)
-2,8
UNEMPLOYMENT (percentage points)
1,6
INFLAMATION (GDP deflator; percentage points)
-0,1
NOMINAL INTEREST RATE ON 3-MONTH TREASURY BILLS (percentage points)
-1,5
Source: D. Romer, Advanced Macroeconomics, 2006, p. 176.
Tax Multipliers
Keynes followers were in support of the fiscal policy that it could be instrumental in moving the economy. According to them additional demand for consumption goods would be multiplied due to tax cuts and increase in spending. Let us consider that during a recession a $100 million is sanctioned by the government for building a bridge. Workers and machinery that have been idle will be pulled back into work, by which the GDP will increase to $100 million through construction, further the firm owners and workers income increases by a $100 million. A chain reaction is set off, as these firm owners and workers will spend part of that $100 million on services and goods, and some part of it will be saved as well, and the amount spend on services and goods will spend more on other goods and services.
Consumption spending is what sets off the multiplier effect with an initial amount of expenditure; a simple model is given below.
[DELTA]Y = k[DELTA]Z = (1/s) [DELTA]Z,
Here the nominal income is Y (GDP), while the multiplier is k, s is the saving prosperity marginal propensity, and Z is some expenses like government expenses or investments, which is not domestic savings. Richard Kahn's (1931) argument elaborated by Keynes (1933, 1936) terms consumption spending to be a significance of magic in the analysis of macroeconomics, contradicting the classical emphasis on savings and productions in investments to uplift and promote employment and output. The current economic expansion in the U.S is consumer spending driven, which is a reflection of the multiplier view of keynesian's theory (Akhiaphor 2001).
How About a Tax Cut?
Taxes being cut down can help as well. A rebate or a cut in $1 tax will set a chain reaction off, increasing consumption and income in a household, but the government spending is not to be counted in this $1. This cut in taxes would equal to (mpc + mpc2 + mpc3 + ...) this is similar to the expected spending multiplier lacking the first term "1+". It's a fact that a cut in the taxes is negative, it is [1/(1-mpc)]-1. A tax cut multiplier is one less compared to the spending multiplier of the government. It is also written as follows [mpc/ (1-mpc)] this signifies equivalent. Comparing the multipliers, the spending multiplier is always bigger than the tax cut multiplier, during recession tax cuts are not considered to be potent enough to boost an economy like the spending increase. If there is a 1 $ billion spending increase by the congress, what will be the outcome? Since the added expenditure is exactly offset by the new tax on the disposable income, hence a multiplier effect will not be available. If tax multiplier is subtracted from spending multiplier the result will be exact 1regardless of the mpc value.
Fiscal Policy
The theory by Keynes suggests that depression can be solved by expansion in fiscal policy, like investing in infrastructure (Romer, 2006) Fiscal policy attempts to stir the economic by moderating government taxation and spending fiscal policy mainly aims to increase demand by stimulating production through this. It depends upon the circumstances that economic faces, for employment to be raised than effective demands is necessary to be raised, aid for consumption to be increased, income should be redistributed ,investment can be increased by dropping interest rates or by increasing the expectation of profit (chick,1983,1318).
Keynesian Economic
Keynesian theory is an idea based on actions it states that it is not always the public sector that leads to effective macroeconomic situation and that's why the government need to enter the market the message from Keynesian theory is the same even today as it was at the time of Keynes. Bruce and Oser (1988, pp.412-414) point out certain principal and characteristics of Keynesian economic.
1 Demand Stimulation; His argument was mainly based on aggregate demand and how it effects output. Economic equilibrium is established by effective demand and by investment, consumption, net export expenditure and the government.
2 Fiscal policy; government entry is needed so that price stability, full employment and economic growth promoted.
The Marginal Propensity to Consume and the Multiplier
We shall develop a model to help us understand the means of marginal propensity determining the effect of change when government spends on GDP. We consider an increase of $ 1 of government purchases of services and goods consisting of households with similar marginal propensity for consumption then we will abbreviate mpc. To make the model simple, the households provides the government with services directly, so we put it as the government is paying each household $1, we put the household as *1. Household *1 fraction spend is equal to mpc of the added income for purchasing consumption products, and we take it as this purchase is bought from house *2 directly. Household *2 when there is a 1$ rise of its mpc, will make purchases likewise from household *3. Hence we see that the additional income setting off a chain reaction according to mpc amount.
Government spending impact on GDP (in Dollars)
gov't purchasing _ 1_ $ income for_ HH #1 spending to_ mpc •
1_ $ income for_ HH #2 spending for_ mpc • mpc •
1_ $ income for_ HH #3 spending for_ mpc • mpc • mpc •
1_ $ income for HH #4 spending for_ mpc4 •
1_ $ income for_... and so on..... and so on .. .. and so on ..
After adding these: _ 1 + mpc + mpc2 + etc._ dollars _ equals 1/ (1-mpc) dollars in total 7
This clearly displays a chain reaction taking place with spending, continuing indefinitely producing small GDP increments. For all the increments to be added the fact we use is that any fraction like the mpc ( ) (1 mpc) 1 mpc mpc2 ... 1− + + + =
The quantity 1/ (1-mpc) is the spending multiplier of the government. The algebraic result shows it clearly, as well as our intuition, that as large as the mpc that large will the influence of added government spending will be on the GDP.
Keynes theory in today's market
The financial crisis of 2007 has made many to question the current economy policy. The CEO of Deutche Bank Josef Ackerman stated that he has no faith in the regulations of the free market anymore. Many economists are of the same opinion, James K. Galbraith, Robert Reich, Robert Shiler, Greg Mankiw, Josheph Stiglitz, believe that the Keynesian theory is more for today than ever before. The U.S. president Barack Obama administration consists economists from Keynesian School (ex. Timothy E, Lawrence Simmers, Christina Rower and Geither) it is not only U.S. that is trying the Keynesian approach, but China as well. China has been one of the first nations worldwide who tried the excessive fiscal stimulus for solving the crisis in their country. February 2009 was when the first recovery signs began to show (report, Financial Times).
Conclusion
The Keynes theory believes that demand is the chief method to reduce financial crisis. The study clearly shows that if tax prices are cut and if government involves in the spending expenditure a chain reaction takes place and the demand increases. The concept of Keynes had got recognition after a very long period. The study shows that Keynes fiscal policy has an answer to every situation during the recession depending upon the circumstances that economic faces, for employment to be raised than effective demands is necessary to be raised, aid for consumption to be increased, income should be redistributed, investment can be increased by dropping interest rates or by increasing the expectation of profit. Thus one can say that Keynes theory can tune the macroeconomics like a car engine.
