The Keynesian Doctrine and Its Impact on Economic Policy

André Gonçalves de Freitas

Hatched by André Gonçalves de Freitas

May 30, 2024

4 min read

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The Keynesian Doctrine and Its Impact on Economic Policy

Introduction:

The Keynesian doctrine, named after renowned British economist John Maynard Keynes, revolutionized the way governments interact with the economy. This doctrine introduced the idea that the public budget could be used as a tool for fiscal policy, a concept that contrasted with prevailing economic theories at the time. Keynes argued that during economic recessions, the government could intervene and stimulate the economy by increasing public spending. On the other hand, during periods of economic expansion, the government could use the public budget to prevent overheating of the economy. These interventions aimed to stabilize the economy and avoid extreme fluctuations in the business cycle.

The Keynesian Model and Aggregate Supply:

According to Keynesian theory, aggregate supply is represented by a horizontal line, with prices and wages being rigid. This means that changes in aggregate demand, influenced by fiscal policy, have a direct impact on output and employment levels. By manipulating government spending, taxes, and investment, policymakers can influence aggregate demand and stimulate economic growth.

The Multiplier Effect:

The multiplier effect plays a crucial role in the Keynesian model. It refers to the idea that an increase in government spending can have a larger impact on the economy than the initial amount spent. This occurs because the additional income generated by government spending leads to higher consumption, which in turn increases demand for goods and services. As a result, businesses expand production and hire more workers, creating a multiplier effect on economic activity.

Equilibrium Income and Taxation in the Keynesian Model:

In a simple Keynesian model with consumption, investment, government, and the external sector, equilibrium income can be calculated using the consumption function. For example, if the marginal propensity to consume is 40% of income, autonomous investment and government spending are both 10 units, the equilibrium income and the tax rate applied to income can be determined.

The Role of Import Propensity in the Keynesian Model:

In the Keynesian model with consumption, investment, government, and the external sector, changes in import propensity and marginal propensity to consume affect the equilibrium income. An increase in the marginal propensity to import reduces the multiplier effect, as more income is spent on imports rather than domestic goods and services. Conversely, a reduction in the marginal propensity to consume increases the multiplier effect, as a larger portion of income is saved and invested domestically.

New Keynesian Theory and Menu Costs:

New Keynesian theory introduces the concept of menu costs as an explanation for price stickiness. Menu costs refer to the expenses incurred by firms when changing prices, such as printing new menus or updating price tags. These costs create an incentive for firms to keep prices stable, even in the face of changes in demand or production costs.

The Adjustment Process in the Keynesian Model:

According to Keynesian logic, if there is excess demand in the goods market, the adjustment occurs through an increase in production and income. This means that when demand exceeds supply, firms respond by producing more to meet the increased demand, leading to higher output and income levels.

Conclusion:

The Keynesian doctrine has had a significant impact on economic policy, introducing the idea of using the public budget as a tool for fiscal policy to stimulate or stabilize the economy. The Keynesian model provides insights into how changes in government spending, taxes, and other factors affect aggregate demand, output, and employment. By understanding these concepts, policymakers can make informed decisions to promote economic growth and stability.

Actionable Advice:

  • 1. Implement countercyclical fiscal policies: During recessions, governments can use expansionary fiscal policies, such as increasing public spending or reducing taxes, to stimulate aggregate demand and boost economic activity. Conversely, during periods of economic expansion, policymakers can use contractionary fiscal policies, such as reducing government spending or increasing taxes, to prevent overheating of the economy.
  • 2. Monitor import propensity: Changes in import propensity can have a significant impact on the multiplier effect and the equilibrium income. Policymakers should closely monitor import trends and consider measures to promote domestic production and reduce reliance on imports.
  • 3. Consider menu costs in price-setting strategies: Firms should take into account the costs associated with changing prices when setting their pricing strategies. By considering menu costs and other factors that influence price stickiness, businesses can make more informed decisions about pricing adjustments.

In conclusion, the Keynesian doctrine revolutionized economic policy by emphasizing the role of fiscal policy in stabilizing and stimulating the economy. By understanding the Keynesian model and its key concepts, policymakers can make informed decisions to promote economic growth and stability. By implementing countercyclical fiscal policies, monitoring import propensity, and considering menu costs in price-setting strategies, governments and businesses can navigate economic fluctuations more effectively.

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