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Essay: Keynesian Economics and its Importance in Times of Crisis

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Before Keynesian economics came out, the classical economic believes that free markets will regulate themselves if they are left alone, and markets will eventually find their level of equilibrium without government intervention. In a classical economy where everyone pursuits their self-interest, through the freedom of production and consumption, the economy can be fulfilled.

In 1929, The Great Depression strikes the world, causing the world economy to contract 26.7% and the unemployment rate peaked at 24.9%. It was the worst and longest depression ever. According to the classical theory, output and prices will eventually return to equilibrium, however, the Great Depression countered this theory because the output was low, yet unemployment remained high throughout the decade. Hence, Keynes argued that the cause of this tragedy was due to the free market without government intervention.

As Keynes did not believe that classical economic was able to end depression, he argued that market uncertainty will cause individuals and businesses to stop spending. Hence, he strongly believed that government intervention was crucial to get the economy back on track, especially during recessions. Keynes proposed countercyclical fiscal policy, in which the government undertakes deficit spending to cover for the decline in private investment and to increase consumption in the market. Once government spending increase, aggregate demand will increase as well, thus shifting the demand curve right. Therefore, this will lead to higher growth in the short-term to save the economy from depression.

Moreover, the classical view suggests that Long-Run Aggregate Supply (LRAS) is inelastic as it insists that an increase in aggregate demand will cause inflation and will not increase real GDP in the long term. On the other hand, the Keynesian view argues that the economy will be below full capacity in the long term. One of the reasons is a negative multiplier effect, it refers to a drop in aggregate demand will cause people to have less income, thus further reducing their consumption. (Pettinger et al., 2019) Keynes believes that an increase in aggregate demand can help the country overcome recessions, contrasting the theory of classical view.

The coronavirus disease 2019 which was first identified among an outbreak of virus cases in Wuhan City, Hubei Province, China, has infected a lot of people in 185 countries. Therefore, China is affected heavily by the coronavirus disease (David J Cennimo, 2020). In the first three months of 2020, the virus forces China to implement quarantines and large scale shutdowns to fight with the virus. It causes the second largest economy in the world which is China to reduce its GDP in its economy.

Since the number of confirmed cases of the Covid-19 pandemic continues to rise, it has emerged huge damage to the China economy. Due to the coronavirus pandemic, there are a lot of factories temporarily closed and travel restrictions in China. This situation leads to the demand for products to increase, and the inflation rate increases at the same time. According to the Phillips curve in the Keynesian perspective, inflation and unemployment have maintained an inverse relationship. Therefore, when the inflation rate decreased to 1% during the pandemic, the unemployment rate increased to 4.3%, which lower inflation is associated with higher unemployment.

The coronavirus has brought huge damage to China’s economy which decreases the GDP and unemployment. Therefore, the government should intervene and step out to minimize the negative impact to improve economic growth.

Due to Covid-19, most of people are having a hard life. According to the data above, China is having an unemployment problem. To solve this case, expansionary fiscal policy by the government can be applied. China’s government should reduce the tax and utility payment, and also spend more money as an aid. By applying this way, China can reduce the unemployment rate, and increase consumer demand. This is to boost growth to a healthy economic level (Amadeo, 2020).

We can calculate the tax cut or government spending in China through the formula Multiplier= (∆ in Real GDP)/(∆ in Initial Spending) (Multiplier Effect, 2020).
We can get the multiplier by using the formula Multiplier= 1/(1-MPC) or Multiplier= 1/MPS (Khan Academy, 2020). The marginal propensity to consume (MPC) in China is low since the inflation rate is low. Therefore, we can assume that MPC in China is 0.2, MPS is 0.8. Then, we will get 1.25 for multiplier. The real GDP in China is USD$ 13,608,151.86 million and we assume that the potential GDP is $20,000,000 million.

According to the table above, China’s government should increase the spending by $5,113,478.51 million or cut tax by $25,567,392.55 million to increase the GDP to $20,000,000 million.

In conclusion, the aggregate expenditure curve will shift upward when reducing taxes or increasing government spending. This shows productivity increases and reduces the unemployment rate. Besides, the aggregate demand curve will shift to the right when the job opportunities increase to allow people to get more income to spend in life.

I have no faith that this intervention will be effective. The first reason is there is a problem of time lag. It includes recognition lag, law-making lag, and impact lag. For instance, recognition lag happens because the government, central bank, and economists need time to assess the current state of the economy and realize the occurrence of recession or inflation when there is a sudden shock in the market. Decision making lag is the time delay of the occurrence of an economic problem and the policy passed by the Parliament to make changes on taxes and spending. Impact lag is the time delay from the implementation of the policy to impact real GDP.

Besides, state and local fiscal policies are often counter-cyclical to balance their budgets. They are dependent on the funds allocated by the central government. During the recession, the local government would have a smaller allocation. They would cut their spending further and worsen the recession.

Crowding out effect makes me have no faith in this intervention as well. When a government borrows a huge sum of money to finance their projects, the domestic real interest rate will be pushed up. Private firms are discouraged to borrow money, offsetting the stimulus of the fiscal policy.

Last but not least, expectation complications can be hard to calculate in magnitude. We cannot foresee what will happen in the future. For instance, when the consumers expect the price of the goods in the future will be cheaper, they are more likely to delay their purchases such as big-ticket items like television and refrigerator. This causes the a decrease of consumption and investment exceeds the stimulus the government introduced. There is a negative multiplier effect, where a leakage further causes the aggregate demand to fall. Referring to the graph below, when the government increases its spending, the AD curve shifts to the right, causing AD1 shifts to AD2. However, the decrease in consumption and investments shifts the AD curve leftwards, AD2 shifts to AD3. With a negative multiplier effect, the AD curves further shifts left from AD3 to AD4. The final effect is real GDP falls more than proportional.

Keynesian economics was popular after the Great Depression.

Friedman disagreed with Keynes’s theory. In Friedman’s view, Keynesian theory neglected the influence of money supply and the importance of monetary policy to the economic cycle and inflation. When Friedman put forward his thoughts on monetarism, he began to oppose many policy suggestions made by post-war Keynesian economists. He advocated deregulation in most areas of the economy and called for a return to the free market of classic economists such as Adam Smith. Keynes’s money demand function is based on the liquidity preference of interest rate, which is an important factor determining money demand. Friedman, on the other hand, believes that the interest rate elasticity of money demand is relatively low, that is, it is not sensitive to the interest rate. Friedman believes that the theory of monetary quantity is not a theory about output, monetary income, or price level, but a theory of monetary demand, that is, the theory of what factors determine monetary demand. Keynesian economics holds that the function of money circulation speed and money demand is unstable. Friedman, on the other hand, believed that the velocity of money circulation and the function of money demand were highly stable. According to monetarist economics, the money supply is the most important determinant of economic growth rate.

Friedrich Hayek opposes Keynesian economics. His theory of the role of price signals in assisting individuals in the economy to coordinate economic activities is considered a breakthrough in economics. Hayek once proposed the currency’s excessive investment theory. He believed that the root of the economic cycle lies in changes in investment caused by changes in credit. The expansion of bank credit has stimulated investment. Once banks stop credit expansion, the economy will erupt into crisis due to a lack of capital. He believes that the capitalist economy itself has a function of stabilizing itself and opposes state intervention in economic life. He thinks Keynesians emphasize full employment, which requires more money supply in the market. If the government does not know when to stop printing money, it will lead to high inflation. He blamed Keynesian theories and policies for the stagflation of capitalism in the 1970s.

Robert Emerson Lucas, Jr disagreed with Keynes’s theory. He proposed that macroeconomics should have a micro foundation. This is different from Keynes’s conclusion on macroeconomics. Lucas found that individuals would make private economic decisions based on experience and expected results, thus offsetting the expected results of national fiscal and monetary policies. So he questioned Keynes’s government intervention. He thinks Keynesianism pays too much attention to government intervention.

No, Keynesian economics is not dead today. Keynesian economics is still existing and practice today. Economics is not the same as other subjects, there are no clear effects or formulas, it’s based on assumptions. Although there are many different views on Keynesian economics, many countries still applied Keynesian theory to stabilize the national economy and survive during recession and inflation. Another reason Keynesian economics is not dead today because most of the universities still teach about Keynesian economics as a foundation to learn future theories. Besides, numerous countries do apply Keynesian theory to stabilize their economy currently.

The President of China, Xi Jin Ping, had applied the Keynesian economics in 2010, as the economic growth plan is about to increase public spending and cut taxes. He said that the growth of the economy in China was slowed to a six-year low of 7%. Therefore, the economic growth plan is applied to increase economic growth. We too can see in domestic demand and China-U.S. trade war, the Chinese economy grew at the weakest rate in the past 30 years, promoting Beijing to apply a series of measures to increase growth to avoid the risk of a sharp slowdown. Expenditure policy in 2019 includes will invest 85 billion yuan ($12.5 billion) in aviation infrastructure, china’s ministry of communications expects the country to invest 1.8 trillion yuan in reading and waterway infrastructure construction. Tax cuts by approximately 1.3 trillion yuan in 2018 and the amount of tax cut was 1.02 trillion yuan in 2017. Major tax cut contains but not limited to cancellation of import and exports on a range of goods, enterprises with annual sales below 100,000 yuan will be exempt from VAT tax reduction policy (Reuters, 2019).
In America, in 2008, President Obama proposed an economic stimulus plan. Congress approved the American Recovery and Reinvestment Act (ARRA) in February 2009 and will increase the budget deficit of $787 billion. The stimulus plan ended the Great Depression by stimulating consumer spending. ARRA divided into three expenditure categories, extended unemployment benefits, education, and health care. It spent $34 billion in health services, $21 billion on education, also spent $28 billion in unemployment compensation, and $13 billion in extra social security and veterans’ checks. Meanwhile, it cut tax by $288 billion. This plan increased GDP by 1.4% to 3.8%, increase employment by 7 million full-time jobs at the end of 2012.

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