Policy Reactions to Recession

Policy Reactions to Recession

Keynes versus Orthodoxy/Classical Economics

Before the Great Depression and the advent of John Maynard Keynes, the classical or orthodox economists propagated the principles such as the invisible hand, free market policy, ability of the markets to correct themselves in the long run and inevitability of business cycles. However, the peak of the Great Depression forced the masses, and the policymakers to question the logic of classical economists since their wisdom had failed in explaining this disaster. Keynes proposed that there were flaws with several assumptions held by the orthodox economists and that the government needed to intervene in order to reduce the cyclical patterns of business cycles because free markets can only correct themselves in the long term and Keynes argued, “In the long term, we are all dead”. Keynes highlighted that, in certain conditions, economic decisions undertaken by individuals at a micro level have the capacity to create macroeconomic crises and thus the governments should prevent such microeconomic decisions through active intervention. Most importantly, Keynes stressed that, during times of recession when the economic output and employment decreases, the government should assume the responsibility of restoring the output and employment through expanding the public sector and making up for the contraction of the private sector (Collins, 2012).

Most Keynesian economists argue that the United States was able to come out the Great Depression because Hoover and Roosevelt followed the policies advocated by Keynes and the Second World War expanded the public sector to the greatest extent, thereby, restoring the economy back on track. Since then, there has been a never ending debate between the orthodox and Keynesian economists regarding the best policy approach for dealing with the recession. The recession of late 2000s reignited the debate where the Keynesian economists are arguing that the government should increase its spending and take an active role to bring the economy out of the recession and classical economists are arguing that the only sustainable solution to this problem is allowing the markets to operate.

Multiplier Effect

The above-mentioned arguments of Keynes became more appealing and fascinating due to the concept of “multiplier effect”. The central idea of the multiplier effect is that even a modest increase in government spending can boost the economy and increase the economic output with a much larger impact. Keynes also highlights two assumptions that are central to this multiplier effect. First, people who receive money through this additional spending would spend most of this money on consumption and save the rest. Second, the business that receive this cash from customers would invest the same to hire more people, thus creating employment and increasing wages, which in turn further stimulates consumer spending and the cycle continues. Important here to note is that tax rates have a negative impact on the multiplier effect since they reduce the amount of consumer spending at every stage.

Problems with Keynesian Stimulus to deal with Recession

Common wisdom suggests that before suggesting a solution, one should explore the dynamics of the problem; more ...