, Research Paper
He hardly seemed cut out to be a workingman s revolutionary, a graduate of England s exclusive Eton prep school, a collector of modern art and a graduate of Cambridge University, nonetheless he transformed the dismal science into a revolutionary engine of social program. Before Keynes economists were gloomy naysayer s. Nothing can be done Don t interfere It will never work , but Keynes was an optimist. Of course we can lick unemployment! The economic problem is not, if we look into the future the permanent problem of the human race he wrote. Keynes took a totally new view to economics, he was one of the first economist s to argue convincingly that governments should take measures to counter a depression. His ideas helped shift emphasis away from laissez-faire. The economic theory that maintains that government should not interfere in economic affairs. Keynes was born in Cambridge and later served in the British treasury from 1915 to 1919. It was from this date that Keynes became internationally prominent. He wrote The Economic Consequences of the Peace . This book attacked the reparation which the Allies demanded from the defeated Central Powers after World War 1 and predicted the breakdown of the Versailles peace settlement. During the 1920 s when England had serious economic difficulties Keynes wrote a series of books and essay s which attack the economic polices of the government and laid the basis for his great book of 1936. The General Theory of Employment Interest and Money . This book marked a completely new departure in economics. He explained how recessions happen, and how government s can act to avoid them. Some of Keynes other work s include A Tract on Monetary Reform (1923), The End of Laissry Faine (1926) and A Treatise on Money (1930). In these works Keynes explained many of his idea s of which many contributed to the development and growth of Europe in the second half of this century. To see how his ideas helped Europe we will first look at each of his main theories and ideas. Then look at some examples of countries in Europe that his theories affected.
Liquidity Preference Theory
Keynes said that people invest not because of the interest rate they receive, but because of the prospective capital gain of the investment, example, people buy shares, not so much for the annual dividend but for the prospective increase in the marked value of the share. He developed a theory known as the liquidity preference theory, this determined interest rates. The Liquidity preference theory can be explained as follows. It concentrates on the demand and supply of money rather than the demand and supply of lonable funds to explain how interest rates are determined. The supply of money was taken as fixed. It was the policy decision of the Central Bank, in accordance with the wishes of the government. It did not depend on the rate of interest. By the demand for money Keynes meant the preference people have for holding their asset or wealth in liquid or monetary form. Keynes wrote that there are three reasons or motives why people demand money.
(1) Transaction s Motive! Day to Day transactions, this motive is not related to the rate of interest. It directly relates to your level of income.
(2) Precaution Motive! This motive depends on your level of income and also the rate of interest. This is when people hold money in case of emergencies, for example illness, breakage of appliance, car repairs etc.
(3) Speculative Motive! The demand to hold money with a view to investing at some future date. This motive depends totally on the rate of interest. If rates are high, people will invest immediately and not hold the money therefore, at high rates of interest the speculative demand for money will be low, and at low rates of interest the speculative demand for money will be high.
Overall, as interest rates fall, the demand for money will increase.
As the rate of interest decreases the demand for money grows.
R1 is the equilibrium rate of interest.
According to Keynes given that the supply of money is fixed by the central bank, the rate of interest is determined by the demand for money i.e., Liquidity preference theory.
This is when the rate of interest is so low that the demand for money now becomes infinite i.e. Perfectly elastic.
The multiplier is when an injection into the economy such as an increase in government expenditure, investments or exports, will increase national income (Y) not by the initial injection but by multiple of that initial injection, this multiple is known as the multiplier. The formulas for the multiplier is as follows:
The Closed economy
1/ 1 MPC
E.g.: MPC= .75 1/( 1- .75) = 1/.25 = 4 1
In this example, the Multiplier is equal to 4.This means that if there was an investment into the economy of 10 million pounds, national income would increase by 40 million pounds. The closed economy does not take into consideration the affect of imports.
The Open Economy:
1/ 1-MPC +MPM
E.g. MPC = .75
MPM= .25 1/ (1 – .75) + .25 = 1/.5 = 2
If 10 million pounds is invested into the economy in this example, national income will increase by 20 million pounds.
In this example the open economy multiplier is half the size of the closed economy multiplier. This is due to imports (MPM) and therefore the effect of an increase in exports, government expenditure or investment on national income is less in an open economy than in a closed economy.
Determination of National Income.
What determines the size of a country s national income?
This is a very important economic question, as the size of GNP determines the rate of economic growth and also effects the level of employment. Keyne s put forward a model of income determination in the 1930 s. It examined the individual components of national income and what determines their size.
In a closed economy, with no exports or imports national income (Y) is made up of consumption expenditure (C ), investment expenditure (I) and government expenditure (G). This can be expressed in the form of a simple equation.
Y = C + I + G.
In an open economy, with exports (X) and imports (M), national income is made up of consumption expenditure, investment expenditure, government expenditure plus exports minus imports. The equation therefore is.
Y = C + I + G + ( X M )
Keyne s then showed what determines each of these five components of national income.
( 1 ) Consumption. (C): This is determined by two factors, Income levels and Margined propensity to consume. Income levels: If a person s income goes up they tend to consume more, if it goes down they consume less. The M.P.C. is the proportion of each extra unit of income (pound) which a person spends, example, if a person s M.P.C. is 80%, they will spend 80% of their income, the other 20% is called the marginal propensity to save. This is the proportion of each extra unit of income that is saved.
(2) Investment. ( I ) : This is determined by two factors, the Rate of Interest and Business people s expectations about the future.
The higher the Rate of Interest, the tendency is that the lower the amount of investment and vice-verse. Business people expectation about the future, if people feel they will make money from investments in the future they will invest, if they fear losses they will not invest.
( 3 ) Government Spending: The government spending is not affected by the usual economic factor such as income levels. The level of government spending is based on a political decision taken usually once a year and outlined in the current and capital budget.
( 4 ) Exports: The level of export sales in an economy is completely independent of the level of national income in the economy. The level of exports depends on the levels of national incomes in external or foreign economies, which purchase the exports.
( 5 ) Imports: The level of imports in an economy is closely related to the level of national income in that economy. As income levels in Ireland rise, so do our imports. As people become better off they tend to spend an increasing proportion of their income on imports.
One single diagram show s to what extent total expenditure is dependent on the level of national income.
Investment is from A to B.
G.C.S is from B to C.
National Income is from O to D.
D is equal to full employment
Let on the difference in 1 and O is 200 million, to increase 1 to 0 and the multiplier is .2, the government must invest 100 million into the economy.
This is the process were by an initial injection of spending power in the economy lends to a serge in economic activities. It is based on the fact that an increase in demand for consumer goods usually leads to a much greater increase in the demand for capital goods.
Example: A company produces as follows:
Year Chairs Machines Dept 10%
1 200 10 1 new machine
2 220 11 1 new + 1 new
You replace the old machine each year due to 10% depreciation, example one new machine each year. When demand rise s by 10% for the chairs the demand for the machine will rise by 100%.
Business Cycles and Unemployment
In his book, The General Theory of Employment, Interest and Money, Keyne s was extremely pessimistic about the ability of the free market economy to lift itself out of economic depression where equilibrium is achieved at the expense of man unemployment. He suggested that an economy could be in equilibrium at less than full employment. According to Keyne s economic depression could be cured by government expenditure and policies being used to manipulate consumption, investment and national income. He advocated government interference in the economy as means of eliminating depression.
The Trade Cycle.
Keynes wrote that when a country is in a boom the government should tax high and save money and when a country is going towards a slump the government should spend the saved money to carry the country out of the slump and into the rising line.
The Manner In Which Keynes Theories Help Europe
The effect of the war was to impoverish all the European participants and to weaken if not destroy the foundations on which the old patterns of trade had been established. Britain s economic development along with that of several other western European Countries, was set back by fire or ten years. Countries such as United States and Japan which had previously imported European goods, and which could not get them during the war had developed new ways of getting the goods, thus European trade suffered.
Before Keyne s had developed his theories most economist felt that nothing could be done about depresssion, that you should not interfere with the economy and that over time it would automatically sort itself out. Then a great Depression swept the world in the early 1930 s; the demand for an activist government arose. Keyne s was ready with a theory, which asserted for the first time that government could indeed manage and control the economy. After Keyne s wrote his books, the whole attitude towards the economy in Europe changed. Economists started to look at his ideas and developed ways to implement them. In the second half of this century this can be seen in most countries in Europe. Here are examples of how Keynes affected some of those:
When a paper on Employment Policy was published and accepted by all three political parties, which recognised the maintenance of high and steady level of employment as a prime objective of government policy, this was a sure sign that Keynes ideas had started to be acknowledged. In 1944 a man know as Beveridge proposed that an unemployment rate of three per cent should represent full employment and act as an attainable goal. To this subsequent government s became normally committed. This was a truly epoch-making development; it was possible because of the work done on the theory of employment by economists in Cambridge, notably Keynes. It can be said that it has formed the foundation of all popular expectation and of all government policy in Britain since the war. The simple fact that the government had recognised that they could help solve unemployment problems and the economy was a massive step forward for the government. From this time on the British government has been involved in guiding its economy, with the help of some of Keynes ideas or tools such as the accelerator or the multiplier.
In France they also felt that in order to ensure economic stability, full employment and efficient production was required. It was also felt that the government must intervene in the economy in order to help it along. In France this can be seen in the Plan s which they implemented between 1945 to 1970. The first plan concentrated on improving the standard of living by developing and modernising the basic sectors such as coal, electricity, iron, steel, cement and transport. The second plan concentrated on scientific and technical development, industrial productivity, specialisation and professional training. These plans were laid down in an effort to guide the economy. In France in 1952 there was a move from 84,000 new homes to 240,000 in 1957, this growth development is mainly due to government intervention which was based on Keynes theories. Like Britain, the French government realised that they could help their economy to develop and grow. They introduced polices where the state ran certain large state owned company s and helped increase the strength of French industry. This first happened in the area of power supplies, there capacity of electricity increased five folds between 1946 and 1970, and they have also supplies of atomic energy. Between 1949 and 1969 automobile production grew tenfold, aluminium sixfold, tractors and cement fourfold and iron and steel was two and a half times greater. Although this was not all due to government involvement in the economy, it did have a large part to play.
Germany is one country where Keynes theories were more evident from the 50,s to today. German economic progress in the two decades after the currency reform was characterised by a tendency for growth rates to decline in cycles, so much so that four complete business cycles can be detected, 1950-1954, 1955-1958, 1959-1963 and 1964-1967. In 1967 a new federal government introduced a pump-priming program which was assisted by their monetary policy and medium term growth planning, through the adoption of new and partly unique economic policy instruments. Their new growth policy instruments were to guarantee the attainment of four economic policy objectives.
Price stability: There objective was to control inflation and have an annual inflation rate of not more than 10%.
Full employment: Their goal was to achieve an unemployment ratio of not more than .8%
External Equilibrium: To have a surplus of the balance of trade of 1% of the GNP
Adequate Growth: They wanted a growth rate of 4% of real GNP annually.
These policies of the German government show how Keynes theories affect their approaches to dealing with their economic problems. The fact that the government were getting so heavily involved with the economy and intervening shows how Keynes influenced the government. At the time the German s also realised how increased export order s stimulated not only the respective branches but also, through the acceleration principal, the producers goods industries to an extreme extent. This increased demand soon affected, through the multiple process, the consumer goods industries. Of course this is nearly thirty years ago, but it set the foundations for Germanys massive economic growth for the future and this basic principle of the government guiding the economy and preventing it slipping into depressions by using Keynes idea of spending in recession and saving in a boom is still there. The fact that Germany accepted Keynes ideas so quickly is one of the reasons why they are one of the strongest industrial and economic powers in the world today.
According to Keynes, the job of the government was to regulate the economy. If no regulation is undertaken booms and recession will occur. If there is a shortage of aggregate demand the government should step in, and increase it s own expenditure, the use of fiscal policy as an instrument of macroeconomics was the greatest legacy of Keynes. Although the implementation of Keynes ideas started to help his contribution to the development and growth in Europe and is mainly seen in around the 50 s and 60 s in Europe when governments rather than ignoring booms and depression, got involved in the economy and followed Keynes idea s. Some countries were laggards in buying into his ideas, but most countries in Europe do follow the policy that the government is involved in the economy. The manner in which Keynes ideas have contributed to the development and growth can be seen by must governments in Europe, by being in some way involved in guiding the economy. Keynes also left us with the international banking institution know as the International Monetary Fund and the World Bank, which was set up as a result of a post World War II conference in the U.S and which was dominated by the presence and works of Keynes.
Keynes theory of income determination, grounded in the concept of the Consumption Function , the liquidity preference theory of interest and the inflexibility of money and wages, have come to be the most influential in our time. The economic ideas of Europe were shaped by the ideas he brought forth in his greatest economic works and theories. The idea of government intervention in order to maintain optimum employment rates has lead to the modern welfare system. The way in which these ideas have helped Europe can be seen today in its continuing economic growth and stability. The General Theory , as it is known also founded modern macroeconomics, and virtually all of the work in that field emerges from Keynes work, if not positively as extensions and adaptation, then negatively as criticism or the extension s of criticism.