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Economic Policies and International Relations

5.1  What do Keynesian economists suggest would fix the problem of insufficient aggregate demand in the economy? Do you see any limitations to the applicability of Keynesian economic policies?

Keynesian economics focuses on the notion of aggregate demand and its impact on output and inflation. In fact, Keynes believed that aggregate demand is the most significant driving force in the economy (Jahan, Mahmud, & Papageorgiou, 2014). Capitalist economies often face insufficient aggregate demand due to an unequal income distribution. As a result, the lack of aggregate demand leads to inefficient use of resources, since during such unproductive time resources are idle and wasteful due to the lack of sales. The most important factor for maintaining the balance between aggregate demand and supply and full employment is to use the additional capacity effectively and prevent idle capacity. If the rate of demand growth is not consistent with capacity growth, it would lead to recession and unemployment.

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The key problem that Keynesian economics aims at is the insufficient demand that does not let the economy to reduce the gap between available resources and the needs of people. In the 1930s, when economists were not able to explain the causes of the Great Depression or offer any policies to increase production and employment, many of them adopted the Keynesian ideas. The ideas suggested that states should not be only a safeguard of private property in capitalism economy. The protection of private property is important as private property rights are essential feature of capitalist economies. Keynes believed that government’s role should not be limited to only one function, but instead he advocated for active state intervention into economies through public policies that aim at regulating unemployment and prices. Such belief was based on the assumption that free markets do not have any self-balancing ability that could help from growing unemployment and insufficient aggregate demand. 

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States use various economic policies and mechanisms to decrease the effects of economic collapse. According to Keynesian views, aggregate demand depends on a number of economic decisions, both public and private. Therefore, an adequate response of the state should include either monetary or fiscal policy or both (Blinder, 2008). Monetary policy deals with a decrease of interest rates, at which the central bank gives money to other banks, which, in turn, decreases their interest rates for their clients. Although Keynes claimed that monetary policy did not have significant influence on demand, most economists now agree that it plays a big role. Fiscal policies involve state investing in infrastructure, which is achieved by increasing income in the economy.

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One of the most important factors that affect aggregate demand is the savings of private households. As liberal theory claims, if households do not spend all of their total income on consumption, the portion that remains is considered savings. Savings can be used for investment purposes, which would prevent the economy from recession. However, Keynesians argue that there is no guarantee that all of the savings of all households are really used. Such argument is true since a significantly bigger share of total income and wealth is distributed among the rich. Anyway, even the most wasteful lifestyles cannot consume all income of all the rich households. As for investment, it is also argued that there cannot be ideal conditions that would absorb all extra savings for investments (Yates, 2003). In some cases, investment finance may become too expensive due to high interest rates. The lack of investment would lead to decline in production, which would affect consumption as unemployed people would have even less income than others. Subsequently, there is a significant amount of savings not used in either consumption or investment. Thus, excessive savings that are not used in investing into economy can lead to recessions.

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According to Keynesian economic policies, the excessive savings should be returned back into the economy. However, while it is not possible to make all households and private companies to utilize all of the savings, a state should compensate for lack of such investments through public spending. Thus, new monetary policies should aim at reducing interest rates by the central banks. In Keynesian economy, such actions is believed to have several positive effects on aggregate demand. First, it would lower the cost of investment financing as low rates increase private demand. Secondly, the state itself would also benefit from low interest rates as it uses the same credit funds to finance public spending, and it is much more effective when credits are cheaper. Additionally, a state can use one more approach to reduce excessive savings. It involves imposing higher-rate taxes on the rich. In such way, the government could receive additional financing for public spending.

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Keynesians argue that the government spending includes a multiplier effect, which is “output increases by a multiple of the original change in spending that caused it” (Blinder, 2008). The government may spend funds on various sectors, and it is not significant where exactly the money goes as long as private companies are involved in the process. By increasing public spending the state issues government contracts that private companies have to fulfill by delivering demanded goods and services. What is important, for such purpose, the companies would have to hire workers. Therefore, government spending creates a “win-win situation” (Yates, 2003). The government increases demand so that companies can sell more of their products and services, receive more income and hire more workers, which decreases unemployment. Subsequently, more employed workers means that they would have higher consumer power, which, in turn, would additionally increase aggregate demand. As workers spend most of their earnings on consumer goods, the output would be higher than the initial public spending. Such situation constitutes of the multiplier effect of government spending.

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Although the injection of government funds is potentially beneficial for both companies’ profits and reducing unemployment, the applicability of Keynesian economic policies has some limitations. One of such limitations is the possibility of undermining tone of the basic condition of capitalist mode of production, creating a reserve army of labor. Reserve army refers to the unemployed and under-employed people in the capitalist society and it performs the function of regulating wages. If the reserve army is big, the wages decrease as it is implied that more workers are available on the labor market that are willing to take vacant positions on less beneficial terms. Subsequently, the bargaining power of workers decreases. However, in case government spending stimulates economy to the point when full employment is achieved, the reserve army would be zero. It means that workers, who would now have no competition on the labor market would demand higher wages, more public services and more favorable work conditions. Employees would not worry about being fired as there is almost no one to substitute them. As a result, such situation would lead to the increase of both their marketplace bargaining power and their workplace bargaining power. They may even demand less work hours, longer breaks and vacations and so on. All these factors would decrease the effectiveness of their work and, as a result, decrease the surplus value of business. Therefore, the opponents of Keynesian economy argue that such policies must be avoided.

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Another important limitation of Keynesianism is a policy lag. According to Keynesian economics, changes in the aggregate demand require government to take appropriate actions on the regular basis. When the economic situation in the country is healthy, it should reduce public spending. When the economy becomes weaker, it should accordingly increase spending. However, implementation of policies requires much time. Usually, there is a substantial lag between the time when government recognizes the need to change public spending and the actual realization of such change. In such case, the situation may occur where the process of creating a policy is responsible for it. Furthermore, there is an additional delay between the time when policy is implemented and the time when it produces some significant results. It may occur that such delay would last months, and when it eventually comes into effect, the situation in the economy may already be different and require another policy (Hall, n.d). Additionally, Keynesian economic policies may also have negative political implications. Some critics argue that they may lead to inefficient, corrupt spending. Although Keynesian theory argues that it is not important where the government spending money go, it may often turn out to be spent on “projects which creates vested interests” (Pettinger, 2013). Therefore, Keynesian policies can potentially lead to the growth of state, which many specialists view as a serious disadvantage.

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Lastly, inflation is considered the major disadvantage of Keynesian economics. As stated above, the main assumption of the Keynesian theory is that free markets do not have any self-balancing ability that could prevent from growing unemployment and insufficient aggregate demand. Therefore, in order to fix the problem of insufficient aggregate demand in the economy, Keynesians suggest that the government should implement fiscal policies. Theoretically, such process stimulates the multiplier effect and is limited only by the size of the reserve army of labor and the pace of creating extra production capacity through investments. However, on practice, as opponents of the Keynesian theory argue, the growth of public spending creates an additional incentive to the economy, increasing prices for private households and companies. Therefore, the increase of the aggregate demand may not only result in higher employment and production, but also contribute to inflation. Such situation is sometimes called an “over-heated economy” and most often makes the state implement opposite monetary policies. In order to counterbalance such effect and decrease the speed of the economy growth, central banks may increase their interest rates, so that it would be harder for private households to receive credit for costly purchases and for businesses to borrow money. Such process is known as the “crowding out effect,” when more state spending actually hinders private investment by creating higher interest rates (Pettinger, 2013).

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