Keynesian Principles of Stabilization Policy

Introduction

The great depression of the 1930s resulted in a deep impact on both economic and political outlook. The consequences of this event turned out in the general consent that governments can do their best to prevent such disasters from happening again.

Even beyond this extreme case, there is a general agreement that a stable and predictable economic environment contributes substantially to social and economic welfare. By maintaining a stable macroeconomic environment, economic policy can contribute to economic growth and welfare.

As a result, there emerged a Keynesian school of thought. Keynesian economics is a theory of total spending in the economy known as aggregate demand and its effects on output and inflation.

In the late 1960’s, the Keynesian view became increasingly challenged by Monetarism. The debate between Keynesians and monetarists often focused on the effectiveness of policy instruments, with monetarists arguing for the ineffectiveness of fiscal tools and Keynesians believing in the superiority of fiscal stabilization policy.

Almost all Keynesians and monetarists now think that fiscal and monetary policies equally affect aggregate demand. Monetary policy can yield real effects on output and employment only if some prices are rigid; that is, nominal wages do not adjust instantly. But Keynesians propagate that since prices are rigid, variations in any part of spending, like consumption, investment, or government expenditures, will cause output to waver.

If government spending increases, all other components of spending remain constant, and then output will increase. Keynesians think that prices, particularly wages, respond slowly to changes in supply and demand shortages, resulting in sporadic and surpluses, especially of labour.

Definition of Stabilization

A stabilization policy is a collection or set of actions brought together to stabilize a financial system or an economy. It can refer to policies which are resorted to the situations of business cycle stabilization and crisis stabilization. In these cases, stabilization refers to discretionary policies to control the given situation.

Stabilization can also be denoted as a process for adjusting the usual behaviour of the business cycle. It also refers to correcting inflation or deflation. In this case, the term usually denotes demand management by monetary and fiscal policy to reduce normal fluctuations and output.

The policy alterations in these conditions are typically countercyclical, reimbursing for the projected deviations in employment and output to surge short-run and medium-run welfare.

Keynesian Framework

The great depression of the 1930s led to a deep effect on both economic and political thinking. The consequences of this event evolved a general consensus that governments would do their best to prevent such disasters from happening again. But even beyond this extreme case, there is general agreement that a stable and predictable economic environment provided by the government contributes substantially to social and economic welfare.

In the short run, households favour having economic steadiness with steady employment and unwavering incomes, letting them maintain stable consumption over time. In the long run, unnecessary economic fluctuations can reduce growth, for example, by increasing the riskiness of investments. A highly volatile economic environment might also have a negative impact on the choice of education profiles and career paths.

In short, by maintaining a stable macroeconomic environment, economic policy can thus contribute to economic growth and welfare.

With the evolution of faith in government to provide an appropriate environment for growth and stability, there emerged a Keynesian school of thought. The theory of total spending in the economy (called aggregate demand) and its effects on output and inflation is called Keynesian economics.

However, in the late 1960s, the Keynesian view was majorly challenged by Monetarism. The debate between Keynesians and Monetarists often focused on the effectiveness of policy instruments, with monetarists arguing for the ineffectiveness of fiscal tools and Keynesians believing in the superiority of fiscal stabilization policy.

Concerned about the possibility that monetary policy actions may themselves be a source of economic instability, Friedman argued that macroeconomic stability can be attained best by using an unconditional policy rule “k-percent” money growth rule.

Friedman’s basic underlying idea remains relevant that the economic system is ultimately self-stabilizing, but the available knowledge of the economic system is too limited to comprehend short-run fluctuations.

Robert E. Lucas assured that the welfare gains from the stabilization policy are quite modest. According to the findings, the potential welfare gains from improved stabilization policy going beyond the stability of monetary aggregates and nominal spending are likely to be small.

Some economists like David and Christina Romer suggested that severe recessions have been partly caused by over-ambitious macroeconomic policies.

Keynesian Model: Principles of Stabilization Policy

● 1. Keynesian framework believes that aggregate demand is affected by both public and private, which would include mostly the decisions related to monetary and fiscal policies. Economists quite a few decades ago argued about the relative strength of monetary and fiscal policies, with some Keynesians arguing that monetary policy is ineffective and certain monetarists disagreeing that fiscal policy is ineffective.

Almost all Keynesians and monetarists now think that both fiscal and monetary policies affect aggregate demand. Some economists also believe in debt neutrality, that the swaps of government borrowing for taxes have no effects on total demand.

● 2. According to Keynesian theory, deviations in aggregate demand do not have short-run effects on prices; instead has, they effects on real output and employment. This notion of Keynesian theory is depicted by the concept of Phillips curve. A Phillips curve shows inflation increasing gradually when unemployment falls. Keynesians believe that what is true about the short run cannot always be inferred from what can happen in the long run. Monetary policy can result in real effects on output and employment only when prices are rigid or if nominal wages do not adjust instantly.

So, the Keynesian model generally either assumes rigid prices and wages. However rationalizing rigid prices is difficult as microeconomics postulates real output and demand should not deviate if nominal prices rise and fall proportionately.

But Keynesians argue that because prices are rigid, any change in consumption, investment or government expenditure, that is, a component of spending, would cause output to fluctuate. If government spending increases, keeping other constituents of spending constant, then the output will increase, and it will increase by a manifold of the original change in spending that caused it. For Keynesian economics to work, though, the multiplier must be larger than zero.

● 3. Keynesians believe that prices, especially wages, respond very slowly to changes in supply and demand, resulting in short-term shortages and surpluses of labour. Even Milton Friedman accepted that there is a limited measure of flexibility in prices and wages in the United States.

Difference Between Keynesian Thought and Others- Read in Detail Here

1. Keynesians believe that unemployment is both high on average and too variable.
2. Some Keynesians are more anxious about tackling unemployment than about inflation.
3. New classical think that predicted variations in the money supply do not affect real output.
4. Many Keynesians are sceptical about the idea that people use all available information to form their expectations about economic policy.
5. There exists a “natural rate” of unemployment in the long run.
6. The new classical theory emphasizes the capability of a market economy to heal recessions by lowering in wages and prices.
7. According to new classical theories of the 1970s and 1980s, a decrease in the growth of the money supply, if perceived correctly, should have only small effects on real output.
8. Harvard’s Robert Barro originated the idea of debt neutrality.

Read More in: Theory of Public Finance

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2. Role of Government in Economy
3. Role of Government in Mixed Economy: Public & Private Sector
4. Role of Government under Cooperation and Competition
5. Role of Government in Economic Development and Planning
6. Concept of Public Goods, Private Goods, and Merit Goods
7. Concept of Market Failure and Functions of Government
8. Market Failure and Functions of Government: Decreasing Costs
9. Market Failure and Functions of Government: Externalities
10. Market Failure and Functions of Government: Public Goods
11. Future Market: Meaning, Role & Uncertainty
12. Concept of Information Asymmetry
13. Theory of Second Best: Concept & Explanation
14. Problem of Allocation of Resources: Public & Private Mechanisms
15. Preferences: Meaning, Types & Problems of Preference Revelation
16. Preference Aggregation & Its Mechanism
17. Voting Systems, Direct Democracy, Representative Democracy, Leviathan Hypothesis & Arrow’s Impossibility Theorem
18. Economic Theory of Democracy: Concept & Explanation
19. Politico Eco Bureaucracy: Concept & Explanation
20. Rent-Seeking and Directly Unproductive Profit-Seeking Activities
21. Rationale for Public Goods: Concept & Explanation
22. Benefit Theory or Voluntary Exchange Theory
23. Lindahl Model: Concept, Equilibrium & Limitations
24. Bowen Model: Concept, Advantages & Limitations
25. Samuelson’s Model of Public Expenditure
26. Musgrave’s Model of Public Expenditures
27. Demand Revealing Schemes for Public Goods
28. Vickery-Clarke-Groves Mechanism
29. Groves-Ledyard Mechanism
30. Tiebout Model: Concept, Assumptions Equilibrium & Simple Tiebout Model
31. Theory of Club Goods
32. Keynesian Principles of Stabilization Policy
33. Difference Between Keynesian Economic Thought and Others
34. Role of Expectations and Uncertainty in Formulating Stabilization Policy
35. Intertemporal Markets Efficiency & Failure
36. Liquidity Preference Theory
37. Diamond-Dybvig Banking Model
38. Preference Shocks, Adverse Selection & Central Bank
39. Equilibrium Deposit Contract
40. Social Goods and Its Effect on Stabilization Policy
41. Effect of Infrastructural Facilities on Stabilization Policy
42. Effect of Distributional Inequality on Stabilization Policy
43. Effect of Regional Imbalances on Stabilization Policy
44. Wagner’s Law of Increasing State Activities: Explanation, Graph & Criticism
45. Peacock-Wiseman Hypothesis: Explanation, Graph & Criticism
46. Public Expenditure: Concept, Objectives, & Public vs Private Expenditure
47. Pure Theory of Public Expenditure
48. Structure & Growth of Public Expenditure in India
49. Trends, Lessons & Priorities in Public Expenditure in India
50. Social Cost-Benefit Analysis: Project Evaluation, Estimation of Costs & Discount Rate
51. Performance Based Budgeting and Zero Based Budgeting
52. Theories of Tax Incidence: Concentration Theory, Diffusion Theory & Modern Theory
53. Tax System and Its Principles
54. Equity Principle and Efficiency Principle of Taxation: Meaning, Explanation & Examples
55. Ability to Pay and Benefits Received Principle of Taxation
56. Theory of Optimal Taxation: Excess Burden & Distortions of Taxation
57. Deadweight Loss of Taxation: Causes, Measurement & Example
58. Concept of Equity & Efficiency in Economics
59. Trade-Off Between Equity and Efficiency: Meaning & Example
60. Theory of Measurement of Dead Weight Loss
61. Double Taxation: Meaning, Desirability, Forms & Solution
62. Solution to Problem of Double Taxation: Intra-Country & International
63. Double Taxation Avoidance Agreement (DTAA) and Indian Policy
64. Classical View on Public Debt
65. Compensatory Aspect of Public Debt Policy
66. Public Debt or Borrowings: Concept, Need, Sources & Types
67. Concept of Public Debt or Public Borrowings
68. Need for Public Debt or Public Borrowing
69. Sources of Public Debt
70. Classification of Public Debt
71. Burden of Public Debt: Meaning, Types & Explanation
72. Debt Through Created Money or Deficit Financing
73. Public Debt (Public Borrowings) and Inflation (Price Level)
74. Crowding Out of Private Investment and Activity
75. Principle of Public Debt Management and Debt Repayment