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Keynesian Economics | Here’s How it Works
In the previous post we discovered the Neoclassical School of Economics, and what made it stand out. The idea with the neoclassical school is that markets are self-equilibrating, and they’re able to recover from external shocks themselves.
So why is it that there are such high rates of unemployment at times? The Keynesian School steps in at this point.
The Keynesian School argues that if markets were completely self-correcting, then we would not have long-term unemployment and we wouldn’t have products that cannot be sold (like the solid gold aeroplane in the previous post).
If a good or service is unsold for a prolonged period of time, the Keynesian belief is that the money must be being spent elsewhere in the economy. The money could go into savings, for example; but this has the adverse effect of creating unemployment because this cash is being removed from the economy.
Let’s illustrate this using a thought experiment. Imagine the following scenario:
1. 2 people working at a supermarket
2. 3 customers are currently shopping
3. The customers decide not to spend all of their income – instead they save 1/3 of it
4. This means 3 customers (who save 1/3 of their income) operate the same as 2 customers who save none of their income
Therefore, if the supermarket only requires 1 employee per 2 customers, this would create unemployment within the supermarket.
Keynesian economists therefore believe that the market is capable of creating long-term unemployment, and that the government should intervene via spending to create more available jobs.
You may have been taught that saving is a good thing; however, in the eyes of the economy, it is mostly a bad thing. Saving causes overall spending (also known as aggregate demand) to fall. This then reduces overall income, because consumer spending is basically the same thing as the incomes employees earn.
What should the government do in response according to Keynes’ theory?
The government should invest in the economy. When overall investment is low, confidence is low, available credit is low; the government should intervene and inject money into the economy. This will prevent income shrinkage and give consumers back some confidence.
An example of this is in 2020, when we are experiencing the adverse effects of the coronavirus disease. In times of uncertainty, people stop spending money as they’re fearful that they’ll lose their jobs and incomes. People panic buy necessity goods, and they cut out all luxuries and go into savings mode. To prevent this, the governments of many countries have intervened to guarantee that people will still earn the majority of their monthly wages. They have encouraged banks to offer mortgage holidays so people can keep up with their bills. They have worked with the supermarkets to encourage the creation of more jobs. This has added some confidence in what would have been a bleak time. This intervention may not have eliminated a recession; but it may have diluted it.
When the economy isn’t in a state of shock, the government could do other things. Projects such as increasing or improving existing infrastructure, such as building airports, schools and hospitals could work. These projects require labour and, in return, employees receive wages. This allows more spending on goods and services; this will provide others with jobs. This is the visualisation of the ‘multiplier effect’.
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