Quiz 11: Fiscal Policy: the Keynesian View and the Historical Development of Macroeconomics

Business

The great depression of 1930s give rise to the most important school of thought is economics, the Keynesian school of thought. The Keynesian school of thought opposed the age long classical notion that supply creates its own demand and because wages and prices are inflexible downward, they fail to adjust to direct back the economy towards stable long run equilibrium. According to Keynes the amount of spending determines the equilibrium rate of output in the economy. The equilibrium in the economy will be achieved when total spending in the economy equals to the total supply of goods and services in the economy. In this case, the inventories of the business firms will be constant and they will have no incentive to change their level of output. When the expectation of the people about the future state of the economy is pessimistic, they will cut back their spending and producers will cut back their level of production. The great depression of 1930 is the most severe economic downturn ever experienced by the US economy. This era is marked by decade long high employment, falling GDP and difficult living conditions. Even lower wage and near zero interest rate failed to generate enough demand to push the economy towards its potential state. According to the Keynesian belief the pessimism about the state of the economy prompted the consumer to cut back the level of spending. Keynesian argued that the downward inflexible wages and interest rate will make cost to the producers constant and they will cut back their production. Even when the wages fell, it decreases the income of the consumer and decreases total spending. The lower interest rate could not motivate the producers' to take new investment project because of abundant excess capacity in the economy. Hence, The economy dipped into the further recession and GDP fell well below its potential rate while unemployment soared high.

The great depression of 1930s give rise to the most important school of thought is economics, the Keynesian school of thought. The Keynesian school of thought opposed the age long classical notion that supply creates its own demand and because wages and prices are inflexible downward, they fail to adjust to direct back the economy towards stable long run equilibrium. According to Keynes the amount of spending determines the equilibrium rate of output in the economy. The equilibrium in the economy will be achieved when total spending in the economy equals to the total supply of goods and services in the economy. In this case, the inventories of the business firms will be constant and they will have no incentive to change their level of output. When the expectation of the people about the future state of the economy is pessimistic, they will cut back their spending and producers will cut back their level of production. The opposite will happen when people will be optimistic about the state of the economy and will increase their spending accordingly. Thus, in Keynesian view, it is the amount of total spending that causes the fluctuations in the amount of output produced in the economy. As the amount of spending determines the equilibrium rate of output in the economy; the equilibrium in the economy will be achieved when total spending in the economy equals to the total supply of goods and services in the economy. In this case, the inventories of the business firms will be constant and they will have no incentive to change their level of output. Therefore, to maintain the output at full capacity level there should be enough spending demand that should match the full capacity level of output.

According to Keynes the amount of spending determines the equilibrium rate of output in the economy. The equilibrium in the economy will be achieved when total spending in the economy equals to the total supply of goods and services in the economy. In this case, the inventories of the business firms will be constant and they will have no incentive to change their level of output. When the expectation of the people about the future state of the economy is pessimistic, they will cut back their spending and producers will cut back their level of production. According to Keynes the market will fail to generate the optimum solutions as any small amount of deviation will be amplified to generate even larger amount of changes in the economy. This is called the multiplier effect of change in the economy. The multiplier effect is based on the principle that spending of one economic agent generates the income of another. As increase in income increases spending, each spending generates even more income. Thus, a small amount of spending increases the income and spending in the economy at an even larger amount. The catch is, the converse is also true. The multiplier is the number by which the initial changes in spending in the economy gets multiplied to generate total amount of changes in the income in the economy. The multiplier is given as img ….. (1)Here MPC is marginal propensity to consume. The MPC gives the changes in consumption due each addition unit changes in income. In other words, this is the fraction of income that the consumer spends from each addition units of increased income. Therefore, we see that the MPC determines the size of multiplier. The multiplier changes the income of the income at a multiple of total initial spending and makes it less difficult to stabilize the economy. The

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