A Keynesian Demand Management Example
Keynesian consumption function based assumptions specify that the other components of aggregate demand, i.e. non-consumption components, are autonomous of national income. Those other components are:
- Government spending
- Net Exports (i.e. gross exports minus imports).
Of these components, investment spending in particular is thought to be extremely volatile, and is usually blamed for short-run fluctuations in national income i.e. booms and recessions. To counteract Investment fluctuations, the Keynesians prescribe active manipulation of government spending to even things out and maintain a stable consumption function with a stable national income.
In the diagram, suppose that initially the economy is performing well with an optimal consumption function that achieves a full employment level of national income at Y'.
Now, for some reason, business confidence takes a tumble and investment levels in the economy decline. This will cause a recession and a downward shift of the entire consumption function variables to 'Recession CF' as illustrated in the diagram.
After a delay, called the 'recognition lag', national statistics will start to show that a recession is building up in the economy, and this will prompt the government to put together a stimulus spending package to boost the shrinking national income.
To get back to the full employment income level of Y' (or the 'Natural Rate of Unemployment'), the government increases government spending to fill the gap left by the reduced level of investment spending. After another delay, called the 'policy lag', the stimulus will start to take effect. If the government has correctly predicted the necessary size of the stimulus, it will raise the CF back to its original optimal level and restore full employment in the economy.
You may have noticed that the movement of the consumption function in the diagrams above cause relatively larger impacts on national income. This is due to the effects of the Keynesian multiplier, which I explain in my article:
As a quick heads up, the multiplier is negligible in reality, and with ever increasing levels of debt it may even be less than unity, but check out the link for more details.
Criticisms of Government Induced Income Boosts
Although the model is specifically designed as part of Keynes' general ideas about how boosting aggregate demand can counteract short-run disruptions to the economy (typically caused by declines in business confidence that lead investment levels to fall), it is a fair criticism to note that there is no mention of any implications for the economic growth rate in the long-run when such stimulus policies are followed.
As you will see from my explanation of Endogenous Growth Theory, the key determinant of long-run growth is the rate of saving, because savings fuel private sector investment. This may be a problem if government actions to boost the economy in the short-run come at the expense of permanently lower rates of saving (and a higher consumption rate by extension).
The false counter to this criticism is that saving in the short-run will be reduced if the economy is allowed to decline, as predicted by the Paradox of Thrift, and that once business confidence is restored the stimulus package can be stopped so that saving and investment can return to normal levels.
However, since the 1980s the experiences of most of the developed world have been of persistent budget deficits that have culminated in truly enormous levels of debt, fueled by excessive consumption and all whilst saving rates have been left to dwindle. Monetary policy expansion to prop up yet more borrowing/consumption has brought near zero rates of interest that have discouraged saving, and all at the same time that irresponsible levels of government deficit spending have 'crowded-out' private investment.
Japan is the most obvious example of this sort of economic madness.
Since the mid-1990s successive Japanese governments have borrowed a huge chunk of their country's savings in order to spend on government projects of one sort or another. Savings can only be borrowed once, meaning that as the government increased its debt-fueled spending, the private sector has been denied access to funds that could have been used for investment purposes. The end result of this is that Japan now suffers the highest debt to GDP ratio in the world, and has had zero economic growth since the 1990s.
Another common criticism related to the fact that Keynesian stimulus policy is not always appropriate for every recession. This was demonstrated by the 1970s period of stagflation when a recession was caused via a supply-side contraction in the economy (rather than a demand-side contraction that Keynes' theory was designed to correct).
Boosting aggregate-demand when aggregate-supply is contracting is highly inflationary, and western economies paid a hefty price for following Keynesian policies at that time.
Then there is the fact that the Keynesian consumption function 'fundamental psychological law' (quoted at the top of the page) is actually a ridiculously over-simplified estimation of how consumer spending varies with changes in disposable income. For a more realistic model of consumption expenditures, see:
A final criticism comes from the Austrian school of economics which points out the fact that, when boosting aggregate demand, the stimulus effects are not distributed equally across all sectors of the economy.
Whilst the model assumes that short-run prices are unaffected by stimulus packages (because Keynesian economists assume that the economy is operating on the flat section of the aggregate supply curve), in the long-run prices will rise, and some prices will rise faster than others. This will distort the vitally important functioning of the free-market price-mechanism, which in turn will lead to malinvestment in a sub-optimal mix of industries as businesses chase profits in those industries with artificially high prices.