Sunday, November 30, 2008

Nice Primer on Keynesian Economics

If "Keynesian economics" represents for you a vague notion of deficit spending and "monetarism" conjures Milton Friedman's smiling face on the paperback edition of Free To Choose, here's a good recap of some key aspects of each. It comes from Greg Mankiw, a professor of economics at Harvard, and as a former adviser to W, one who presumably has a favorable disposition to free markets.

Professor Mankiw summarizes Keynes on the causes of a recession:

According to Keynes, the root cause of economic downturns is insufficient aggregate demand. When the total demand for goods and services declines, businesses throughout the economy see their sales fall off. Lower sales induce firms to cut back production and to lay off workers. Rising unemployment and declining profits further depress demand, leading to a feedback loop with a very unhappy ending.

Since economists traditionally identify only four sources of demand - consumption, investment, net exports and government purchases - and since economic forces in a recession are working to depress the first three, Keynes famously called for increasing government spending in order to return a sluggish economy to health.

In contrast, Mankiw explains that monetarists react to downturns by lowering interest rates:

In normal times, the Fed can bolster aggregate demand by reducing interest rates. Lower interest rates encourage households and companies to borrow and spend. They also bolster equity values and, by encouraging international capital to look elsewhere, reduce the value of the dollar in foreign-exchange markets. Spending on consumption, investment and net exports all increase.
However, with interest rates already close to zero, the main tool of monetarism is inadequate for stimulating demand in the current crisis and the case for Keynesian stimulation by government spending comes to the fore.

It thus appears that it is not so much Keynesianism vs. monetarism, as it is understanding where the limits of the latter make the former essential.

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