Explain how the aggregate expenditures model emerged as a critique of Classical economics and in response to t

Question

Explain how the aggregate expenditures model emerged as a critique of Classical economics and in response to the Great Depression

Answer 1

In the late 1920s, the world economic system began to break down, after the shaky recovery that followed World War I. With the global drop in production, critics of the gold standard, market self-correction, and production-driven paradigms of economics moved to the fore. Dozens of different schools contended for influence. Further, some pointed to the Soviet Union as a supposedly successful planned economy which had avoided the disasters of the capitalist world and argued for a move toward socialism. Others pointed to the success of fascism in Mussolini's Italy.

Into this tumult stepped Keynes, promising not to institute revolution but to save capitalism. He circulated a simple thesis: there were more factories and transportation networks than could be used at the current ability of individuals to pay, ie that the problem was on the demand side.In the Keynesians theory, aggregate demand determines the level of output and employment in the economy. Keynes is against the saying of “supply creates its own demand” as said by Say’s Law.

Because of what he considered the failure of the “Classical Theory” in the 1930s, Keynes firmly objects its main theory--adjustments in prices would automatically make demand tend to the full employment level.

Neo-classical theory supports that the two main costs that shift demand and supply are labor and money. Through the distribution of the monetary policy, demand and supply can be adjusted. If there were more labor than demand for it, wages would fall until hiring began again. If there was too much saving, and not enough consumption, then interest rates would fall until people either cut their savings rate or started borrowing.

As noted, the classicals wanted to balance the government budget. To Keynes, this would exacerbate the underlying problem: following either policy would raise saving (broadly defined) and thus lower the demand for both products and labor. For example, Keynesians see Herbert Hoover's June 1932 tax increase as making the Depression worse[citation needed].

Keynes's ideas influenced Franklin D. Roosevelt's view that insufficient buying-power caused the Depression. During his presidency, Roosevelt adopted some aspects of Keynesian economics, especially after 1937, when, in the depths of the Depression, the United States suffered from recession yet again following fiscal contraction. Something similar to Keynesian expansionary policies had been applied earlier by both social-democratic Sweden, and n**i Germany[citation needed]. But to many the true success of Keynesian policy can be seen at the onset of World War II, which provided a kick to the world economy, removed uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became almost official in social-democratic Europe after the war and in the U.S. in the 1960s.

Keynes's theory suggested that active government policy could be effective in managing the economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what has been called countercyclical fiscal policies, that is policies which acted against the tide of the business cycle: deficit spending when a nation's economy suffers from recession or when recovery is long-delayed and unemployment is persistently high—and the suppression of inflation in boom times by either increasing taxes or cutting back on government outlays. He argued that governments should solve problems in the short run rather than waiting for market forces to do it in the long run, because "in the long run, we are all dead." [2]

This contrasted with the classical and neoclassical economic analysis of fiscal policy. Fiscal stimulus (deficit spending) could actuate production. But to these schools, there was no reason to believe that this stimulation would outrun the side-effects that "crowd out" private investment: first, it would increase the demand for labor and raise wages, hurting profitability; Second, a government deficit increases the stock of government bonds, reducing their market price and encouraging high interest rates, making it more expensive for business to finance fixed investment. Thus, efforts to stimulate the economy would be self-defeating.

The Keynesian response is that such fiscal policy is only appropriate when unemployment is persistently high, above what is now termed the Non-Accelerating Inflation Rate of Unemployment, or "NAIRU". In that case, crowding out is minimal. Further, private investment can be "crowded in": fiscal stimulus raises the market for business output, raising cash flow and profitability, spurring business optimism. To Keynes, this accelerator effect meant that government and business could be complements rather than substitutes in this situation. Second, as the stimulus occurs, gross domestic product rises, raising the amount of saving, helping to finance the increase in fixed investment. Finally, government outlays need not always be wasteful: government investment in public goods that will not be provided by profit-seekers will encourage the private sector's growth. That is, government spending on such things as basic research, public health, education, and infrastructure could help the long-term growth of potential output.

The revolutionary content of Keynes's economic theory, the bulk of which is contained in A Treatise on Money, the General Theory, and, to a lesser extent, A Tract on Monetary Reform, developed out of his active involvement in England's economic problems during the 1920s and 1930s. During the 1920s, he advocated economic policies, either in an official capacity or as an independent expert, that he arrived at largely by intuition. In The End of Laissez-Faire and Can Lloyd George Do It?, he recommended a government-sponsored program of public works to get the unemployed off welfare, but these works lacked a theoretical foundation, and A Tract on Monetary Reform, which also suggested that government intervention could curb unemployment, was unsuccessful at refuting the classical argument, or so-called "Treasury view," that government spending financed by loans would cause inflation or crowd out private investment. In A Treatise on Money and the General Theory, Keynes sought to establish a firm theoretical basis that would explain the reasoning behind his policy proposals. In A Treatise on Money, he attempted to replace the classical explanation of money and its function in the economy, known as the quantity theory of money, with a more dynamic model that related booms and slumps to oscillations in the credit cycle and that described the causal processes by which the price level is determined. It was not until he began composing the General Theory, however, that Keynes was able to completely break away from the quantity theory of money. When the General Theory was published, it was viewed as a powerful challenge to orthodox economic theory, which held that a decrease in the wage level would stimulate employment because firms would take on more labor at a lower price, and that the interest rate would always adjust in such a manner as to prevent variations in savings and investment from causing any change in spending. Keynes declared this theory nonsense, tracing the origins of unemployment not to excessively high wages but to the total purchasing power in the economy, or aggregate demand. While classical economists focused on the individual firm or household, Keynes looked at output and employment as a whole. He maintained that a decrease in wages would not stimulate employment because it would lower the overall demand for goods and services, thereby causing prices to drop. He also contended that the classical economists erred in thinking that savings would always be equal to investment, arguing that there are times when savers wish to save more than investors are willing to invest, causing part of output to go unsold and leading producers to cut back on employees. Keynes placed great emphasis on the idea that private investment was a function not only of interest rates but also of expectations about costs and demand for products in the future. He was skeptical that monetary policy in the form of lower interest rates would provide a sufficient stimulus to business investment in times of severe economic depression to bring the economy back up to a level of full employment. He therefore proposed that fiscal measures such as public works or subsidies to afflicted groups were the only possible correctives to prolonged unemployment.

On January 1, 1935, during the course of writing the General Theory, Keynes wrote to George Bernard Shaw: "I believe myself to be writing a book on economic theory which will largely revolutionise—not I suppose at once but in the course of the next ten years—the way the world thinks about economic problems." Keynes's prophecy proved accurate. Quickly after the publication of the General Theory, governments everywhere began adopting policies advocated by Keynes or associated with his name, a trend that continued for over thirty years. By the late 1940s, his theories had been incorporated into textbooks in the United States and England, and millions of students were introduced to the idea of national income accounting.