Model Answer
0 min readIntroduction
The Keynesian economic model, developed by John Maynard Keynes in response to the Great Depression, posits that aggregate demand is the primary driver of economic activity and employment. During periods of deep recession or depression, characterized by widespread unemployment and falling prices, the economy can get stuck in a state of insufficient demand. While both monetary and fiscal policies are tools to influence aggregate demand, the complete Keynesian model suggests that during a depression, only fiscal policy remains effective due to the limitations of monetary policy in stimulating investment and consumption.
The Keynesian Framework and Aggregate Demand
The core of the Keynesian model lies in the concept of aggregate demand (AD), which is the total demand for goods and services in an economy at a given price level. AD is composed of Consumption (C), Investment (I), Government Spending (G), and Net Exports (X-M). During a depression, all components of AD tend to fall, leading to a downward spiral of economic activity.
Ineffectiveness of Monetary Policy in a Depression
Monetary policy, typically implemented by central banks, aims to influence AD through changes in interest rates and credit availability. However, in a deep depression, the economy often falls into a liquidity trap. This occurs when interest rates are already very low (near zero lower bound) and further reductions fail to stimulate investment.
- Low Interest Rate Sensitivity: Businesses and consumers are pessimistic about future economic conditions and are unwilling to borrow and invest, even at low interest rates. They prefer to hold onto cash (liquidity).
- Deflationary Expectations: Falling prices (deflation) increase the real burden of debt, discouraging borrowing and investment.
- Bank Reluctance to Lend: Banks, facing potential loan defaults, become risk-averse and reduce lending, even if the central bank increases the money supply.
Therefore, increasing the money supply through monetary policy (e.g., open market operations, reducing reserve requirements) simply leads to individuals and banks hoarding the additional liquidity, rather than spending or investing it. This renders monetary policy impotent.
Efficacy of Fiscal Policy during a Depression
Fiscal policy, involving government spending and taxation, directly impacts aggregate demand. In a depression, the Keynesian model advocates for expansionary fiscal policy to boost AD.
- Government Spending Multiplier: An increase in government spending (G) has a multiplied effect on AD. The multiplier effect arises because the initial government spending creates income for individuals and businesses, who then spend a portion of that income, creating further income for others, and so on. The size of the multiplier depends on the marginal propensity to consume (MPC).
- Tax Cuts: Reducing taxes increases disposable income, leading to increased consumption (C). However, the impact of tax cuts is generally smaller than that of government spending, as some of the tax savings may be saved rather than spent.
- Direct Job Creation: Government spending on infrastructure projects, public works, and social programs directly creates jobs, reducing unemployment and boosting income.
For example, the American Recovery and Reinvestment Act of 2009 (ARRA) in the US, implemented in response to the 2008 financial crisis, involved significant government spending on infrastructure, education, health, and energy, aiming to stimulate AD and create jobs.
Comparing Monetary and Fiscal Policy in a Depression
| Policy | Effectiveness during Depression | Mechanism |
|---|---|---|
| Monetary Policy | Ineffective | Lowering interest rates, increasing money supply – hampered by liquidity trap and deflationary expectations. |
| Fiscal Policy | Effective | Directly increases aggregate demand through government spending and tax cuts; utilizes the multiplier effect. |
Conclusion
In conclusion, the complete Keynesian model demonstrates that during a period of depression, characterized by a liquidity trap and pessimistic expectations, monetary policy loses its effectiveness. Fiscal policy, through deliberate government intervention in the form of increased spending and/or tax cuts, becomes the primary tool for stimulating aggregate demand, boosting economic activity, and mitigating the adverse effects of the downturn. While fiscal policy can lead to increased government debt, the Keynesian perspective argues that this is a necessary trade-off to prevent a prolonged and severe economic contraction.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.