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Wednesday, October 05, 2011

Solow: Keynesian Economics Has Become Dramatically Relevant Again Today

Robert Solow:

... One reason why Keynes’s great book is so difficult to explain is that it is no masterpiece of clarity. ... I want to emphasize two of its themes, because they ... point directly to the reason why Keynesian economics, born in the 1930s, has become dramatically relevant again today. Back then, serious thinking about the general state of the economy was dominated by the notion that prices moved, market by market, to make supply equal to demand. Every act of production, anywhere, generates income and potential demand somewhere, and the price system would sort it all out so that supply and demand for every good would balance. Make no mistake: this is a very deep and valuable idea. ... Much of the time it gives a good account of economic life. But Keynes saw that there would be occasions, in a complicated industrial capitalist economy, when this account of how things work would break down.
The breakdown might come merely because prices in some important markets are too inflexible to do their job adequately; that thought had already occurred to others. It seemed a little implausible that the Great Depression ... should be explicable along those lines. Or the reason might be more fundamental, and apparently less fixable. To take the most important example: we all know that families (and other institutions) set aside part of their incomes as saving. They do not buy any currently produced goods or services with that part. Something, then, has to replace that missing demand. There is ... a natural counterpart: saving today presumably implies some intention to spend in the future, so the “missing” demand should come from real capital investment, the building of new productive capacity to satisfy that future spending. But Keynes pointed out that there is no market or other mechanism to express when that future spending will come or what form it will take. ... The prospect of uncertain demand at some unknown time may not be an adequately powerful incentive for businesses to make risky investments today. ...
So a modern economy can find itself in a situation in which it is held back from full employment ... not by its limited capacity to produce, but by a lack of willing buyers for what it could in fact produce. The result is unemployment and idle factories. ... There are some forces tending to push the economy back to full utilization, but they may sometimes be too weak to do the job in a tolerable interval of time. But if the shortfall of aggregate private demand persists, the government can replace it through direct public spending, or can try to stimulate additional private spending through tax reduction or lower interest rates. ... This was Keynes’s case for conscious corrective fiscal and monetary policy. Its relevance for today should be obvious. ...
A second characteristically Keynesian theme meshes very well with the first. In a complex economy, many business decisions have to be made in a fog of uncertainty. This is especially true of investment decisions... The standard practice is to focus on the uncertainty and think about it in terms of probabilities, which at least allow for an orderly analysis... Keynes preferred to focus on the fog. He thought that some of the important uncertainties were essentially incalculable. They would end up being dealt with in practice by a mixture of apprehensiveness, rules of thumb, herd behavior, and what he called “animal spirits.” The point of this distinction is not merely philosophical: it suggests that long-term investment behavior will sometimes be irregular, unstable, and given to doldrums and stampedes. ...

He also discusses Irving Fisher, Joseph Schumpeter, John Maynard Keynes, Friedrich Hayek, and John Stuart Mill.

    Posted by on Wednesday, October 5, 2011 at 12:42 AM in Economics, Fiscal Policy, Monetary Policy | Permalink  Comments (82)


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